European Modeling

A much-maligned region is far more heterogeneous than you might think.

Duncan Currie
Friday, November 05, 2010

France has been convulsed by violent demonstrations against modest pension reforms. Britain is imposing a tough fiscal “austerity” regime to plug a cavernous budget gap. Crisis-torn Greece is struggling to avoid a sovereign-debt default. Ireland, Portugal, and Spain are grappling with their own major-league financial woes. Is it fair to say that the much-ballyhooed European model is crumbling?

That depends on which “European model” you’re referring to. Though Western Europe is often lazily portrayed as a monolithic bastion of welfare-state sclerosis, it is in fact robustly heterogeneous. France has a brittle pension system and rigid labor markets, but the Dutch, Swedish, and Swiss pension systems are considered to be among the soundest in the world, and Danish labor flexibility rivals that of the United States. The aggregate tax burden is punishingly heavy in France, Germany, Italy, and the Nordic countries, but it is relatively light in Ireland and Switzerland. As for health care, the government-run systems in Britain and Scandinavia are much different from the consumer-driven Swiss model and the market-friendly Dutch approach, not to mention the French and German schemes.

Doesn’t Western Europe exhibit lackluster innovation prowess? And isn’t the region losing its global competitiveness? Some countries — such as Greece, Italy, Portugal, and Spain — are innovation laggards, but others are innovation leaders. Indeed, a 2009 Economist Intelligence Unit report classified Switzerland, Finland, and Sweden as three of the five most innovative countries on earth, with Germany placing sixth. Meanwhile, the World Economic Forum reckons that Switzerland and Sweden have the planet’s two most competitive economies.

According to the 2010 Index of Economic Freedom (compiled by the Wall Street Journal and the Heritage Foundation), three Western European countries — Ireland, Denmark, and Sweden — offer greater business freedom, trade freedom, monetary freedom, investment freedom, financial freedom, and property-rights protection than does the United States. In terms of overall economic freedom, Denmark (ninth) is virtually tied with America (eighth), which trails Switzerland (sixth) and Ireland (fifth). All of these countries — plus the United Kingdom (eleventh), the Netherlands (15th), Finland (17th), Sweden (21st), and Germany (23rd) — score well ahead of Portugal (62nd), France (64th), Greece (73rd), and Italy (74th).

Just as there is no uniform socioeconomic model in Western Europe, there is no uniform political culture. Transparency International’s 2010 CorruptionPerceptions Index ranks Denmark, Finland, Sweden, the Netherlands, Switzerland, and Norway among the world’s ten least corrupt societies, with the Danes sharing the top spot. By comparison, France (25th) ranks behind Uruguay; Spain (tied for 30th) and Portugal (32nd) rank behind the United Arab Emirates; Italy (67th) ranks behind Rwanda; and Greece (tied for 78th) ranks behind El Salvador.

Not surprisingly, there is tremendous variation in the efficiency of individual Western European governments. Despite the massive size of their bureaucracies and the lavish generosity of their welfare benefits, the Nordic countries stand out for having some of the best-performing institutions.In its 2010 global competitiveness survey, the Swiss business school IMD calculates that the public sector operates more efficiently in Switzerland, Norway, Denmark, Sweden, Finland, the Netherlands, and Ireland than it does in America. But IMD also reckons that the French, Portuguese, Spanish, Italian, and Greek governments function less efficiently than those in Jordan and Russia.

As these findings indicate, there are stark economic and political disparities between Scandinavia and Mediterranean Europe, as there are between Anglophone Europe and Franco-German Europe, which makes it problematic to generalize about the “European model.” A fascinating new McKinsey Global Institute (MGI) study helps crystallize Western Europe’s diversity and illuminate its uneven embrace of structural reform.

MGI divides the original 15 members of the European Union (the “EU-15”) into three separate clusters: Northern Europe (Denmark, Finland, Ireland, Sweden, and the United Kingdom), Continental Europe (Austria, Belgium, France, Germany, Luxembourg, and the Netherlands), and Southern Europe (Greece, Italy, Portugal, and Spain). Northern Europe is characterized by high labor-utilization rates and productivity levels “in line with the EU-15 average,” though Danish productivity has recently declined, and Irish unemployment has skyrocketed since the global financial crisis triggered a calamitous housing bust. Continental Europe (Austria excepted) boasts strong productivity but suffers from low labor utilization, though the Dutch have made extraordinary progress in reducing structural unemployment. Southern Europe is plagued by anemic productivity, and its record on labor utilization is a mixed bag; in Spain, for example, the utilization rate was barreling upward until the Great Recession pushed it back down.

Speaking of Spain, it currently has the highest jobless rate in Western Europe, followed by Ireland. Small wonder: Both countries have been walloped by disastrous property meltdowns and painful deleveraging. According to a San Francisco Fed analysis of real house prices between 1997 and 2008, the pre-crisis bonanza saw prices jump by 172 percent in the Irish Republic and 118 percent in Spain, compared with 89 percent in Denmark, 75 percent in the Netherlands, and about 50 percent in America.

The Danes and Dutch are now enjoying impressively low unemployment, as they were before the recession. In many ways, they have been harvesting the fruits of ambitious, market-oriented labor reforms. Denmark has garnered widespread attention (and bountiful praise) for the “flexicurity” model it implemented during the 1990s, which helped the country slash its adult-unemployment rate from 8.9 percent in 1993 to 2.5 percent in 2008. The Dutch initiatives, while less celebrated than Danish flexicurity, have also proved remarkably successful. Between 2004 and 2008, MGI observes, the Netherlands had both the lowest average adult-unemployment rate (3.3 percent) and the lowest average youth-unemployment rate (6.8 percent) in the EU-15, and its rates were well below those of the United States (4 percent and 11.4 percent, respectively).

No discussion of recent European labor reforms would be complete without citing the neoliberal policy adjustments made by German chancellor Gerhard Schröder, a Social Democrat who held power from 1998 to 2005. Thanks in part to his efforts, which substantially boosted labor flexibility, “the number of unemployed in Germany decreased by one-third” between 2005 and 2008, notes MGI. Prior to the global crisis, Europe’s largest economy did not experience a housing bubble. While Germany fell into a deep cyclical slump when world trade plunged, the strength of its export-led recovery has made it the envy of governments throughout the West. In October, German unemployment hit an 18-year low.

The extent of Western Europe’s reforms over the past two decades — in Germany, the Netherlands, Denmark, and beyond — is not sufficiently appreciated on this side of the Atlantic. Consider the transformation of Sweden, a famously “socialist” country that has undergone dramatic liberalization since the early 1990s, when it was pulverized by a banking crash and a brutal recession. Fiscal retrenchment, deregulation, increased competition, and significant tax cuts have spurred huge productivity gains. Indeed, between 1995 and 2005, Swedish manufacturing became 60 percent more productive, according to MGI. Over that same time span, retail productivity grew at an annual rate of 3.2 percent in the United States and 4.6 percent in Sweden. By 2005, America’s retail sector was 14 percent less productive than its Swedish counterpart.

“Sweden has shown on a national level how to turn a crisis into an opportunity for far-reaching structural reforms as a basis for long-term sustained growth,” says MGI. The Swedish revival, along with muscular economic growth elsewhere in Scandinavia and the British Isles, lifted Western Europe’s per capita–GDP growth between 2000 and 2008. Over that period, such growth was slightly faster in the EU-15 (1.3 percent) than it was in America (1.2 percent). For that matter, from 1995 to 2008, the EU-15 outpaced the United States in total new job creation (23.9 million to 20.5 million), even though its population growth was slower.

On the other hand, per capita GDP is still 24 percent greater in America than it is in the EU-15, and the productivity gap (which favors the United States) has gotten bigger since the mid-1990s (after narrowing from the 1960s onward). Most Western European countries still need to trim marginal tax rates, curtail public spending, and enhance labor flexibility. Moving forward, sluggish population growth — and, in some countries (such as Germany and Italy), population shrinkage — will present a raft of daunting challenges. But certain governments are much better positioned than others to address those challenges. In 2007, for example, the average age of Swedish and Dutch workers exiting the labor force was 63.9, while the corresponding age in France was 59.4.

Here’s how MGI sums up the root causes of the transatlantic per capita–GDP gap: Northern Europe’s problem “is mostly one of productivity; Continental Europe faces a gap in hours per employee; Southern Europe faces simultaneous challenges on productivity, participation, and unemployment.” In other words, the EU-15 economic landscape is kaleidoscopic, just like the policy frameworks of individual member states. Remember that the next time you hear a journalist or politician casually pronounce the death (or laud the virtues) of the “European model.”