Don't follow the European model: it's collapsing

The economies of Continental Europe face a serious structural crisis. Unemployment is at historically high levels, and rises almost inexorably. The western German unemployment rate is already above the British rate of about 8 per cent. In France and Italy it is over 12 per cent, in Finland 18 per cent and in Spain 22 per cent. The British government is often accused, with good reason, of massaging the figures, but governments everywhere find the temptation irresistible. In Germany, for example, almost 2 million people are kept off the dole figures by "work" schemes. In France, the nationalised industries such as SNCF and Air France are in effect bankrupt, and employment levels are preserved only by massive subsidies.

Growth rates everywhere in Europe are faltering. Britain's experience since 1979 has hardly been impressive, yet in real terms per capita national income has risen at the same rate as western Germany's, and faster than France's. This represents a dramatic break in the trend that had been in place for over a century. From the 1870s to 1979, the big European economies grew more rapidly than the UK, but since 1979 this has ceased to be the case. Comparisons of growth rates over short periods of time can easily be manipulated by taking economies at different stages of the short-term business cycle, but the 17 years since 1979 span at least two full cycles and so form a reliable basis on which to compare performance.

This is not necessarily to hold up Britain as a model for the rest of the European Union follow. Many problems remain, not least of which is the dramatic widening of inequality that has taken place. But it makes much less sense to argue that Britain should now emulate the European - or "Rhenish" to give it its fashionable intellectual nomenclature - model of capitalism, for it is precisely this latter model whose performance is collapsing. At the heart of the European problem is a crisis in profitability. Compared with a decade ago there has in recent years been some recovery of profitability in Europe, but one which is far from sufficient to underpin a sustainable growth rate of more than 2 per cent a year.

The origins of the crisis go back some 30 years. The late 1960s and early 1970s saw a sharp rise in the share of national income going to the labour force, and a corresponding erosion of profitability. The rise was made up of a combination of rapid increases in real wages in excess of productivity growth, and of rises in the costs of employing labour. Europe's problems were compounded by the global shocks of the mid-1970s, but the fall in profitability, the necessary condition for a deterioration in the sustainable growth rate, was already in place.

Orthodox economic theory insists that this should have carried no consequences for the growth rate. In both its standard neo-classical and notorious "post neo-classical endogenous" variants, conventional theory assumes that savings are translated into investment in an effortless way, regardless of the level of profitability. Quite remarkably, profits are virtually written out of the script. But I prefer Hamlet , with the Prince as part of the cast: profitability has always been the key driving force of capitalism, as the great early economists such as Smith, Ricardo and Marx recognised.

Comparing average growth rates of the past 20 years or so with those of the 1950s and 1960s, some deterioration is entirely to be expected. In the aftermath of the war, the capital stocks of the European economies were ravaged, but the skills of the labour force remained intact. The process of rebuilding the capital stock, taking the opportunity to copy the technology of the world leader, the United States, enabled very rapid growth rates, of 5 per cent a year and more, to be achieved. But this catch-up process was bound to come to an end at some point.

Over and above this entirely natural slowing of the medium-term growth rate has been the impact of the erosion of profitability. The chart plots the changes in the averages of annual GDP growth rates and the share of labour in national income in the largest 18 OECD economies between the 1960-73 period, and the period since 1973. So, for example, the observation for Japan at the bottom right-hand corner shows that comparing the 1974- 95 averages with those of 1960-73, GDP growth in Japan has been over 5 percentage points lower, and the share of labour in national income almost 12 percentage points higher. Each of these periods is sufficiently long to embrace several short-term economic cycles, so the comparisons are not distorted by choice of year.

The striking feature of the chart is the clear negative relationship between these two factors. The larger the increase in labour's share of national income (and, as a corollary, the greater the fall in the share of profits), the more marked has been the fall in the growth rate. It is a straightforward matter to apply sophisticated statistical methods to confirm the validity of this relationship. At the top left-hand corner of the chart are the three economies where the erosion of the profit share has been the least, and where in consequence the fall in the growth rate has been the smallest. The Norwegian experience is obviously due to North Sea oil, which represents a substantial proportion of the overall economy in Norway. In the two Anglo-Saxon economies, the profit share has been protected primarily through policies to promote "flexible" labour markets, which have helped to maintain the growth rate, albeit at the expense of a widening of the distribution of income.

Over the last 20 years annual average growth in the continental EU countries has been 1 percentage point lower than it would otherwise have been because of the lack of profitability.

It is here that the real cost of high payroll taxes is seen. The well- being of all Europeans is worsened by the resulting reduction in the sustainable growth rate. And in many, but not all, countries, lower growth has been the prime reason for the endemic rise in unemployment.

Amazingly, most liberal commentators continue to eulogise the European model and urge its adoption in Britain. But they are living in the past. The crisis in profitability will continue to deliver low growth and high unemployment in the Continental economies.

Paul Ormerod is chairman of Post-Orthodox Economics, an economic consultancy. He was previously a forecaster at the Henley Centre.