Europe's puzzling failure to cure its economic ills

Europe suffers from high unemployment, wage stagnation and rising inequality. Of course there are differences among EU countries, but the overall pattern is one of inadequate job creation, more low-paid work, temporary jobs and increased income insecurity. The economic crisis has certainly contributed to these painful problems, but in many cases they were decades in the making.

Has Europe passed its peak? Is it facing a future of lower living standards and diminished opportunities? The answer will depend in large part on the choices made by the European Union’s policymakers and individual governments. History provides lessons of policies that led to recovery – or led to failure – from worse challenges than those currently confronting Europe. If the political will is there, smart policies are available to rescue Europe from its labour market and social malaise. The policy solutions range from the short and medium-term to longer-term measures.

In the short term, the most important cause of slow growth and unemployment in the EU is the shortfall in aggregate demand that’s due to a combination of weak spending by households, investors and governments. Household consumption makes up by far the largest share of GDP and aggregate demand in Europe, and its weakness is the dominant factor depressing growth.

Weak household spending results from unemployment, less secure job prospects and stagnant, or in some EU countries even declining, wages. The result is that investors have been building fewer factories and shops, started fewer new businesses or have not expanded production, so fewer workers have been hired. Both the weak household consumption and weak investment reduce government tax revenues, making it harder to pay off national debts, maintain social benefits and invest in infrastructure. Fiscal consolidation programmes have further reduced government spending.

As for increased exports, which some hoped would make up for the shortfall in domestic demand, the lack of demand pervades the global economy, so that Europe cannot simply export its way out of this downward spiral. In any case, two-thirds of Europe’s trade is within the EU and candidate and partner countries, so weak domestic demand within European countries is also depressing intra-European trade. These weaknesses in all aspects of aggregate demand have become a self-reinforcing negative feedback loop.

How, then, can this negative cycle be broken and then reversed? Fiscal consolidation was supposed to restore confidence and growth, but it has clearly failed to do that. The place to start instead is household consumption, because business will not invest and create jobs unless investors can foresee sustainable increases in demand for their goods and services. And EU governments cannot significantly increase their spending if tax revenues continue to stagnate.

The good news is that governments possess the policy levers for increasing household incomes and thus boosting confidence and consumption. Depending on the particular circumstances of a country, governments can increase incomes by creating or raising minimum wages and by strengthening collective bargaining to encourage employers and workers to translate productivity growth into higher wages. They can also ensure adequate household incomes and security through well-designed social protection systems, so that households will not hold back from spending for fear of their future job prospects.

Why have governments failed to use these levers? Conventional wisdom has it that wages in Europe should not increase because they have outstripped productivity growth. But that is simply not true, either at the European level or in most European countries. The steady growth of wages in line with productivity that was characteristic of the prosperous post-war years has over the last three decades been eroded in most of Europe. It is now time for wages to catch up with productivity.

Another bit of conventional wisdom that is equally unfounded is that Europe must reduce labour costs to compete with low-wage economies elsewhere in the world. Modern Europe cannot compete on the basis of developing countries’ wages, and in fact does not. It competes on technological advantage, innovation and product quality and range. The reality is that wage cuts to lower labour costs in some parts of Europe have further dampened household incomes and reduced aggregate demand. The risks inherent in doing this were demonstrated during the Great Depression of the 1930s, when competitive wage cutting in Europe deepened the overall crisis.

Policymakers must take those pre-World War 2 lessons to heart and raise wages to head off the growing risk of deflation in Europe, particularly in the eurozone. Wage cuts in the southern European countries have been a major deflationary factor there, and that is spilling over into the rest of Europe. Among the lessons that European policymakers should learn is the case of Japan, which has fought deflation for over two decades. The “Abenomics” strategy now being championed by Prime Minister Shinzō Abe has emphasised that earlier efforts to escape through fiscal and monetary stimuli were unsuccessful because household spending did not kick in to amplify and sustain those efforts. That was because of stagnant wages and job fears, and Japanese business leaders and trade unions are now being urged to agree to above-inflation wage increases so as not to repeat that mistake this time. It is a lesson that Europe should learn.

What concrete steps could policymakers take to raise and stabilise Europeans’ incomes? Among the ideas that have been floated is that of a Europe-wide “social minimum wage” that would be set based on indicators regarding poverty and other social factors in each country. Before becoming the European Commission’s President, Jean-Claude Juncker told the European Parliament’s economic and monetary affairs committee back in 2013 that “We need a basis of minimum social rights for workers including, of course, one central thing, a minimum wage, a social, a legally compulsory minimum wage in the eurozone member states; otherwise we are going to lose the support of the working classes”. More recently, the Commission’s Directorate General for Employment argued in 2014 for a basic European unemployment insurance to supplement national schemes as that would stabilise consumption in EU countries hit by future economic crises.

There are also steps that will pay off in the medium term to sustain the boost that European economies can get from increased wages and consumption. One measure would be the acceleration of governments’ investments in infrastructure. With long-term interest rates at historic lows and nearing zero, there couldn’t be a better moment to address Europe’s crumbling road and rail infrastructures and invest more in healthcare along with research and innovation. These longer-term investments should be considered separately from current fiscal balance – the so-called fiscal “golden rule” – and the European Commission should treat national budgets accordingly.

Another vitally important investment drive should be in education, ranging from early childhood and primary education through to apprenticeships, retraining and lifelong learning. Investment in tomorrow’s highly skilled workforce must start today. The EU’s “youth guarantee” is at risk of becoming a cruel misnomer unless significant additional resources are allocated.

Still another area for medium-term innovation is the smarter reform of labour market rules and social protection policies. The conventional wisdom has been that European labour markets should be deregulated and social benefits reduced to produce faster growth. But the evidence shows that deregulation has not raised employment and instead can lead to rising shares of temporary, low-paid and involuntary part-time work and rising household poverty rates. Labour regulation and social policies need periodic updating in line with the evolution of economies, but labour markets will always need sound rules to balance the interests of employers and workers. And adequate social protection is essential to shield households from excessive risk.

While joblessness and underemployment are widespread in Europe today, future labour shortages should also be causing concern. The rapid ageing of most EU countries means that in coming decades the labour supply will shrink. There will be fewer people working to support public spending for the education of the young and the pensions and healthcare of the old. But there are ways to offset this and expand the labour supply by drawing more women into the workforce, by encouraging older workers to remain employed longer and by attracting immigrants. In many countries, doing so will require significant policy reforms. Women will join the labour force if they have affordable child and elder care, if the jobs available to them pay adequately and if tax policy does not discriminate against second earners. Older workers should not face age discrimination, and should not have to choose between pension and work, as happens in many pension systems today. Phased retirement should become a convenient option, with workplace, pension and tax systems aligned to accommodate it. Migration will undoubtedly have to be part of the solution, and creating a sound and welcoming climate is something that will require serious effort in many countries to change public attitudes as well as policies.

Much attention focuses on the need to reform and complete Europe’s banking union and to address tax avoidance and profit shifting. These are indeed needed if Europe is to recover fully from the economic crisis. But strong social and labour policies are equally necessary to tackle Europe’s high levels of unemployment and the inequality and stagnant living standards endured by many.

Many of the policies currently in place have contributed to a negative feedback loop, and it is this that must be broken and turned into a positive and self-reinforcing dynamic. The big question is whether enough political will can be mustered among policymakers and elected politicians to halt the downward spiral and to restore jobs and growth. Unless the erosion of social cohesion within countries and between countries can be arrested, the European dream itself will be at risk.