Europe starts to work, but pay claims could yet wreck it

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If there is one enduring stereotype of the European economies, it is that they are burdened by inflexible labour markets. Many people will recite a litany of 35-hour weeks, restrictive labour legislation and mass industrial action.

If there is one enduring stereotype of the European economies, it is that they are burdened by inflexible labour markets. Many people will recite a litany of 35-hour weeks, restrictive labour legislation and mass industrial action.

Like any stereotype, this contains some truth. It helps explain why the euro has such a poor image in London's currency markets. But likewise, all black-and-white generalisations hide huge areas of grey - the truth is somewhere in between.

Unemployment in Europe is at last falling and the numbers in work rising - not as fast as in the UK, but the trend is positive. What is more, the labour market is improving faster than many analysts expected. The latest economic outlook report from the international think-tank, the Organisation for Economic Co-operation and Development, says the EU will enjoy "substantial" job creation that will help to cut the unemployment total by 2 million by 2002.

The unemployment rate was 10 per cent in September, down from 10.7 per cent a year earlier. Employment has grown strongly for the past year as a result of labour market reforms by several countries aimed at making it cheaper to employ people.

Goldman Sachs, the investment bank, says the labour market is one key indicator pointing to economic strengthening.

"Labour market conditions are improving and employment intentions are running at high levels in business surveys," it says in its December analysis of the European economy. "Robust employment growth is likely to nudge consumption growth higher next year."

The bank forecasts that unemployment will continue to fall rapidly, to 9.3 per cent by the end of next year. This will be led by Spain, where the jobless rate is expected to fall from 18 per cent at the end of last year to 14 per cent by December 2000.

Cutting unemployment is laudable, but it is more important to increase employment especially as falling populations in countries such as Germany will, by default, cut the jobless rate. But job creation depends on labour market flexibilities. "Structural rigidities in labour markets will diminish the positive impulse from growth in employment," says Goldman Sachs.

The Confederation of British Industry says it is a serious error to assume that a pan-European approach must be best. "Actions to cut the EU's historically high unemployment must be left to member states, which should tailor policies to suit the unique economic approach," it said in a recent report. "The debate about labour market flexibility has been hampered by stereotypes and generalisations. Many people see the British labour market as flexible and all other European labour markets as inflexible, but the reality is much more complex."

The CBI found that while Germany and France had only moderate geographical, working pattern and wage flexibility, they had high flexibility of skills and job functions. Spain and Italy have low flexibility, but the Netherlands scores well in all categories - better than Britain.

Whether the laggards will want to pursue labour market liberalisation is another matter. At heart this is a political problem, and politicians in Germany must be allowed to question whether they want to go through the agony the UK did in the early 1980s. Certainly, Chancellor Gerhard Schröder appears to have stepped back from the brink; his decision to use £80m of taxpayers' money to save Philip Holzmann, Germany's second-largest construction company, and its 60,000 employees could signal a trend.

However, as Alison Cottrell, chief economist at PaineWebber International, points out, Mr Schröder had little choice given his ratings in the polls. "This is the dying squeal. This is a cultural revolution, and it hurts."

While the improving labour market is good for growth, it is a worry for inflation. The European Central Bank has made it very clear it is keeping an eye on the current wage round.

The smaller Euroland nations, especially Holland, Ireland and Finland, are enjoying strong growth. While pay self-restraint has hitherto been successful, this will come under increasing pressure, especially from sections of the workforce that feel they have been left behind.

But it is the largest country, Germany, that will play a pivotal role, as it represents more than a quarter of the workforce. The most important bargaining round is for engineering. The powerful IG Metall union makes its claim in January and the result will be a benchmark, not only for Germany, but for Europe.

Ms Cottrell said analysts were surprised by a decision by Dutch unions to raise their basic demand from 3 to 4 per cent, plus better conditions worth 0.5 per cent. Although Holland is a small economy, if that trend was followed by the German unions, it could send alarm bells ringing at the ECB.

Win Duisenberg, ECB president, hammered home the message on Thursday following its decision to keep rates on hold. He said the ECB believed inflation would remain below 2 per cent - the ECB's ceiling - next year and in 2001. But he went on: "The actual developments will very much depend on the behaviour of a number of factors, and in particular on wage developments remaining in line with price stability."

In other words, is it justifiable for unions such as the German white-collar DAG to press for wage rises of between 4 and 6 per cent at a time when prices are rising at less than 1 per cent?

However, Ms Cottrell said the worry was not the pressure on inflation but the negative impact inflation-busting pay would have on the business community. "The concern is that we could see companies leaving Euroland and therefore cutting back on employment. If that happens and unemployment goes up, you will have an economic disaster that would jeopardise the viability of economic and monetary union. This is what really concerns Duisenberg."

It is ironic that at the start of a new millennium, the future of the world's new economic superpower can be influenced by one of the largest and most traditional of trade unions.