Economics: Europe leaving its jobless to languish

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THE CHANCELLOR is right to take his participation in President Clinton's jobs summit so seriously. Even though he comes from Britain's right-wing party while the President comes from America's left-wing one, Kenneth Clarke shares many of the same values and a real desire to see unemployment come down. That is why his paper for the conference, 'Competitiveness and Unemployment: Policies for the industrial countries', is so disappointing.

The problem is not so much with the contents of the paper as with what is left unsaid. The paper is a good summary of many policies that sensible governments in developed countries should pursue. I only wish that we were rather better at implementing what so many people agree are sensible objectives, notably in improving the education and skills of our workforce.

No one should cavil with making the markets for goods and services more responsive to consumers; competition is a jolly good thing. We (almost) all believe in small businesses, entrepreneurship, trade liberalisation, enterprise, profits, motherhood and apple pie. This new consensus is one of the best legacies of the Thatcher period.

But is it realistic implicitly to attribute the long-term rise in unemployment in Europe since the Sixties to structural causes such as high unemployment benefits, trade union power, a mismatch between skills and the available jobs, and so on?

When governments introduced tough monetary and tax policies to control inflation after the first oil crisis in 1973, it became a convenient myth to argue that unemployment was structural rather than amenable to the pull of policy levers such as interest rates. By extension, politicians did not have any influence over the real economy. It was a good alibi to avoid blame from the voters.

The trouble is that it was at best a wilful exaggeration and at worst simply untrue. After all, the rises in unemployment mainly took place in quick bursts, as the first graphs show. This is prima facie evidence that the increases were caused by the sudden downturns in the business cycle triggered by the two oil shocks, rather than by slow-acting causes like rising unemployment benefits.

The real mystery is why European unemployment did not fall back like American unemployment, but instead remained stuck at relatively high levels even during the Eighties recovery. In this case, part of the explanation is surely that Europe's high levels of social protection removed some of the incentive to 'get on your bike'.

As Barry Bosworth points out in a recent paper for International Economic Insights, continued employment in the US has been bought at the expense of falling wages and increased poverty: 'The choice in large measure is between being poor in America or unemployed in Europe.'

But it is also surely no accident that European interest rate and fiscal policies have been more conservative than those pursued in the United States or Japan. For various reasons, European governments have persisted in relatively tight policies even after inflation has come down. In neo-classical theory this should not matter. There should be no medium-run effect on output or unemployment if product and labour markets are working properly. In the long run, the economy will revert to its natural path unaffected by monetary or fiscal policy. This is the implicit assumption in the Chancellor's paper, and it is a view with a long history back to the doctrine of Jean-Baptiste Say, who argued that supply creates its own demand.

But in practice, tough policies may affect the long-run supply capacity of the economy. Indeed, there is an increasing amount of economic theory and evidence to suggest that there is no single, unique equilibrium for any economy. There may well be a variety of different growth rates and unemployment levels at which an economy can happily settle, and it will not move from one to another unless prodded or shocked.

This work may not have penetrated the Treasury, but it is admirably set out in the lucid new edition of Economics, the UK standard textbook for undergraduates (and lawyers newly turned Chancellor) by David Begg, Stanley Fischer and Rudiger Dornbusch. There are, for example, several mechanisms whereby the excessively enthusiastic application of deflationary policies in Europe might reduce the long-run growth rate and raise 'structural' unemployment.

First, there is the question of investment. If businesses' expectations of growth are reduced by a severe and prolonged recession, they will invest less. They may even scrap capacity, selling machine tools overseas.

When the recovery ultimately comes, the economy will hit capacity constraints more rapidly and will be less able to absorb the unemployed. So the long-run unemployment rate consistent with stable inflation will rise.

Second, if people are unemployed for long periods, they become demotivated and less attractive to employers. That in turn may mean that they do not perform their macro-economic function, which is to scare those in work away from demanding more income than the economy is capable of producing.

Only those who are out of work for short periods, and who are still attractive to employers, can properly perform that function. So the growing number of long-term unemployed again means that the overall level of unemployment needed to curb inflation will rise.

A similar explanation stresses that only people already working for firms - insiders - are involved in wage bargaining. They reach a deal with their employer that ensures they can keep their jobs. But a sharp recession means that some of them are sacked. When the recovery comes, those who remain do not set wages at a level that allows the employer to rehire the unemployed. Instead, they seek higher pay for themselves. Unemployment may therefore rise permanently.

There are two policy implications of these analyses. The first is that what goes up cannot as easily go down; active labour market policies and investment-creating policies are likely to be needed to reabsorb large numbers of the unemployed. The obvious model is Sweden, where a big effort to upgrade the skills of the unemployed helped for many years to keep the jobless total at relatively low levels.

The second implication is that policy-makers need to be much less cavalier with interest rates and fiscal policy. In some countries, there may be alternative ways (such as wages policy) to get inflation down. Where deflationary policies are the only realistic instrument available, it is clearly important not to persist with them for too long. The deeper and longer the recession - that period in which growth is less than the long- run trend and unemployment is rising - the worse the ultimate damage.

Yet the European monetary authorities have generally been slow to relax their grip despite the depths of the recession and the freedom to disengage from Bundesbank-set German interest rates that the breakdown of the exchange rate mechanism has given. Like the Chancellor, they stress the importance of competitiveness and supply-side reform. But this cannot be the end of the story. It is not possible for every country to enjoy export-led growth; somebody has to be buying the exports.

This will rightly be one of the themes at Detroit, since it is a central argument of the US administration's paper, largely prepared by the distinguished US economist who is now assistant Treasury Secretary, Larry Summers.

The Clinton paper makes the point that no amount of supply- side policies to reduce unemployment will work if overall demand policies are busy pushing the economy in the other direction: 'Countries that pursue these structural improvements without taking steps to raise aggregate demand will see little or no return for their efforts.'

The attack on unemployment has to be subtle. It must certainly tackle the supply side, and help to cut the long-run level of unemployment consistent with stable inflation. But it must not forget the other blade of the economic scissors. Demand matters too.