Growth and jobs

The clouds clear over Europe

European economies seem to be bouncing back. Unfortunately that will bring little cheer to millions of unemployed people

NOTHING, it seems, could dampen the boisterous mood during the first weekend of Munich’s 1997 Oktoberfest—certainly not the hefty litre glasses of beer being liberally sloshed around by grown men in Lederhosen. A year ago, one would have concluded that the Germans were drowning their economic sorrows. Now, however, they have good reason for cheer. The German economy is bouncing back. Across the rest of continental Europe, too, economies are picking up more strongly than had been expected.

After a period of lacklustre growth, an economic upturn is welcome. The question is whether this is just a standard cyclical recovery, or whether Europe can look forward to something more. In America and in Britain, the mid-1990s have brought a break with the past: their economies have grown briskly without generating inflationary pressures, allowing unemployment rates to fall to the lowest levels for a quarter century. In continental Europe, however, no such promise awaits. The upturn, welcome though it is, will probably do little to put Europe’s 18m unemployed back to work.

Europe’s rebound is based largely on exports. Germany’s exports, for example, were 15% higher in the three months to July than in the same period of 1996. For that, thank the depreciation of European currencies against the dollar. The export boom pushed up GDP in both France and Germany by annual rates of 4% or more in the second quarter. Industrial production is rising at annual rates of 8-10%. In contrast, business investment and consumer spending have remained rather sluggish. But there are now signs that domestic demand is reviving. Surveys of business confidence confirm that firms are feeling cheerier, which should encourage more ambitious investment plans over the coming year.

That good news has set forecasters to revise upwards their growth projections for 1998. Most now expect the European Union (EU) excluding Britain to grow by an average of around 3% next year, up from 21/4% this year. That would be likely to leave continental Europe growing faster than both America and Britain. But it hardly makes up for the ground lost over the past six years (see charts).


Continental Europe’s economic cycle has trailed that of the Anglo-Saxon countries. America came out of recession in 1992. Britain followed in 1993, after its eviction from Europe’s exchange-rate mechanism allowed it to devalue the pound and cut interest rates. Both countries have since enjoyed steady growth. The rest of the EU did not emerge from recession until 1994. What followed was only a short-lived boom: in order to meet the economic conditions for joining Europe’s single currency, which is to begin in 1999, governments raised taxes and cut spending to reduce their budget deficits.

Europe’s latest recovery seems more firmly based. But this does not mean that the continental European economies will follow in America and Britain’s footsteps.

In both America and Britain, unemployment has fallen sharply since the early 1990s: from 8% to 4.9% in the United States and from 10.5% to 5.3% in Britain. In the past, such low levels of unemployment would have reignited inflation. Yet in both countries inflation remains modest. This has provoked talk about a “New Economy” in which the forces of globalisation and new technology supposedly allow faster, inflation-free growth.

In continental Europe, such a happy outcome seems unlikely. Unemployment has been stuck above 11% for the past five years. Although joblessness has fallen in some countries, such as the Netherlands, in others it is still rising. Germany’s unemployment rate reached 11.6% in August, its highest rate since the end of the second world war. It is tempting to hope that stronger growth will halve unemployment on the continent, just as it has done in Britain. This would be optimistic. The reason is that most of Europe’s unemployment is due to its rigid markets for products and labour, not to a lack of demand. It will therefore not disappear automatically as economies expand.

How much will the coming recovery help matters? The IMF estimates that Europe’s unemployment cannot fall much below about 9% before inflation begins to rise. This figure, known as the “structural unemployment rate” or the “natural rate of unemployment”, is far higher on the continent than in Britain or America. Although precise figures are impossible to calculate, the IMF reckons that labour-market reforms, including a weakening of trade-union bargaining power and stricter tests for claiming unemployment benefits, have pushed Britain’s structural unemployment rate down from 81/2% to just 53/4% over the past decade. Economists had long pegged America’s structural unemployment rate at about 6%, but many have lowered their estimates, because unemployment has dipped below 5% this year and inflation is nowhere in sight.

If the IMF’s estimates are right, stronger growth in continental Europe could slice 2-3 percentage points off jobless rates. That would still leave unemployment in many countries at high levels. But while Europe would still have a large pool of spare labour, pushing the economy fast enough to employ it would quickly inflate wages and prices. This view is not the IMF’s alone. Some directors of the Bundesbank, Germany’s central bank, are already fretting that their country’s economic upswing will raise inflation. Many economists expect German interest rates to rise by early next year, although unemployment is still likely to be in the double digits.

Here’s to more jobs
The causes of Europe’s stubbornly high unemployment are now widely accepted. Overly generous unemployment benefits that are paid for long periods discourage workers from seeking jobs. High employment taxes reduce the incentive for firms to hire more people. High minimum wages reduce job opportunities for the low skilled. Strict job-protection laws discourage firms from hiring because it makes firing so costly. All of this has made many European companies look to create jobs abroad rather than at home. German firms, for example, have increased their overseas employment by more than 50% since 1985, while their employment in Germany has barely changed.

Swallow the medicine

The IMF argues that Europe’s structural unemployment rate has ratcheted up over the past two decades as each downturn has left a pool of long-term unemployed workers in its wake. The cure is as obvious as its cause: social-security reform, lower taxes, lower minimum wages, greater wage flexibility and an easing of restrictions on hiring and firing. A few countries, such as the Netherlands and Spain, have taken some of this medicine, but elsewhere the political will is still lacking. Efforts to cut top tax rates have stalled in Germany. The French government is trying to reduce unemployment by trimming the work week and creating public-sector jobs.

In the short term, Europe’s recovery is good news for the future of the single currency, the euro. Stronger growth will boost tax revenues and make it easier for governments to reduce budget deficits to the magic target of 3% of GDP, the main condition for joining. Falling unemployment will also provide a more comfortable economic background for the launch. However, the IMF warned last week that unless European governments reform their labour markets, persistent unemployment could erode support for less government borrowing and tight monetary policies. This would weaken the credibility of the euro even before it is born.

The biggest danger now facing Europe is that an economic bounceback will reduce the pressure for such reforms. There is no reason European unemployment need be so high. But unless Europe’s governments address the rigidities that have kept it so high for so long, the next cyclical downturn may bring even worse.

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