The Case for Europe’s Economic Conservatism

The OECD report decrying economic performance in Europe was received with gloating by the bulls of Wall Street and the U.S. commentariat.

Yet, they should not be so quick to gloat: The European economic model is stronger than it appears — and the U.S. model weaker.

The OECD's principal gripes relate to European living standards, which over the past two decades "have fallen further behind the best performers."

True enough, but the past two decades have also seen the liberation of Eastern Europe. That monumental event was bound to be an expensive proposition for Western Europe — particularly Germany — given the appallingly expensive way in which East and West Germany were united.

However, that cost is now paid — and Europe is coming to benefit from a substantial pool of East European labor with high skills and relatively low wage levels.

The OECD noted that European living standards were lower than in the United States, even taking into account the greater European level of leisure time. It also said that anybody with a strong aversion to income inequality would find the gap between the two systems lessened.

The differences between the European and U.S. economic models are well known. The European model involves a higher level of public spending than the U.S. one.

It also requires greater income support at the lower income levels, socialization of the increasingly important healthcare sector, and has a lower remuneration of top management (and somewhat higher taxes on that remuneration), a greater level of unionization as well as a lower level of entrepreneurship (although the small business sectors as a whole are comparable in size.)

Even so, Europe's model does not today involve markedly higher public ownership of the corporate sector than in the United States. Privatization in Europe has greatly reduced public ownership in the power and telecom sectors. In fact, some assets — such as airports — are publicly owned in the United States, but privately owned in some European countries.

It is also true that savings in continental Europe are more directed to bonds than in the United States. As a result, the continent avoided most of the late 1990s' stock market bubble — and the core countries of the EU have avoided a housing bubble.

On the other hand, pension provision is largely through public-sector schemes. That raises the cost of low-skill labor markedly and provides a looming actuarial problem as populations age and move into retirement.

The standard U.S. conservative criticism of the European model notes the high level of unionization, higher social security contributions (for public sector pensions and healthcare), shorter working week, longer vacations and lower entrepreneurship. U.S. conservatives conclude that Europe is hopelessly uncompetitive against the emerging Asian economies — and doomed to become more so as European social security systems slip ever further into deficit.

There's just one problem. It is the United States, not Europe, that persistently runs balance of payments deficits with the rest of the world.

And it is the United States, not Europe, whose public finances appear to be slipping ever further out of control. President George W. Bush's request of February 17, 2006, for an additional $92 billion for the war on terror and Hurricane Katrina recovery — over and above the budget submitted only two weeks before — demonstrates how feeble U.S. controls over spending have become.

Typically, the request was submitted on a Friday before a holiday weekend, to minimize news coverage and market impact.

Looked at in reality, and not in rhetoric, the European economies appear sluggish — but not uncompetitive. Nor is there any real sign that their competitive position is in danger of erosion.

The euro is expected by most commentators to strengthen— not weaken — against the dollar in the near future. The comparison between Europe and the United States tilts even further towards Europe when you take into account that Europe does not use the "hedonic pricing" which has artificially suppressed U.S. inflation.

That practice has boosted reported U.S. growth over the last decade. True European and U.S. economic growth rates, adjusted also to reflect higher U.S. population growth, are much closer than they appear.

This is not to say that Europe's economic future is assured, far from it. The solution to Europe's problems incessantly offered from across the Atlantic, to become more like the United States, is however unlikely to work. American industrial traditions are very different from those in Europe.

To summarize a complex subject, European business successes tend not to be based on supreme manufacturing efficiency, but on quality, branding and features.

In such cases, there is a much greater role than in a more routinized business for highly-experienced workers with a deep knowledge of the company's operations, and for capable middle management with specialist knowledge.

European management and incentive structures reflect this need. Operationally, this is a generalization with many exceptions, but it is a key to European corporate culture and prevents the simple adoption of an American economic model.

Rather than imitating the United States, there are a number of policies which Europe could follow to assure its future.
The continent is somewhat overcrowded, having a high population density and a low level of natural resources per capita.

The current very low European fertility rates will remedy this, but they must be given time to do so. Accordingly, retirements must be delayed, and pensions trimmed, so that the burden of the retiree population does not fall too heavily on the younger generation.

Concurrent with this, immigration to Europe must be tightly restricted, in order for the benefits of declining population to be obtained.

Fantasies that youthful immigrants will pay the pensions of elderly native-born residents must be avoided. In reality, a tide of youthful immigrants will cause the population to continue to increase, while at the same time changing its ethnic and religious mix, thus rendering the old age of the baby boomers both impoverished and troubled.

With the entry into the EU of ten new countries in 2004 — and the potential entry of Romania, Bulgaria and Croatia in 2007-08 — there is an ample supply of low cost labor for the foreseeable future.

This renders the economic arguments for opening the borders further to non-Europeans invalid. Indeed, absorption of nearly 100 million new relatively impoverished citizens will take a long time, probably a generation. After all, East Germany — with a population of only 16 million — is still not fully integrated 16 years after unification.

Thus, further expansion of the EU (other than to the small countries of former Yugoslavia) should be avoided until at least 2030 — or more safely 2050.

Both Ukraine and Turkey have large populations, and Turkey in addition brings cultural and ethnic questions that are difficult to solve. Therefore, the rapid entry of either country into the EU is only too likely to destabilize the economies and politics of existing members.

The Achilles' heel of the European model is its government sector, which tends to grow uncontrollably until economic growth is stalled by its expansion.

Here the Stability and Growth Pact, necessary for the creation of the euro, has been very useful indeed, since it limited the growth of government, unless financed by always unpopular direct tax increases.

Countries such as Italy and Greece, with a tendency to fiscal indiscipline, particularly benefited from its strictures. Germany too, which attempted to solve the problems of East German integration by a tsunami of government spending, has been brought back under control in the last few years and now appears likely to resume growth on a healthy basis.

Fiscal discipline, not just in maintaining balanced budgets, but in forcing the state sector to decline as a percentage of the total except in moments of acute crisis, is an important part of the policy mix.

Finally, one of Europe's principal cost advantages over the emerging markets is its relatively high availability and low cost of capital.

This advantage is minimized in periods of high world liquidity such as the present, when everybody has access to borrowed capital. It is maximized in periods such as the 1950s, when real interest rates are high, money supply is tightly controlled and most investment is financed by well-rewarded domestic savings.

Tight money and restrictive lending practices have an additional advantage in preventing real estate bubbles.

Thus, Germany — with a restrictive housing finance sector and a low level of stock exchange speculation — will benefit enormously in the years to come from having missed out on the world real estate bubble of 2001-05. With population trending downwards, real estate costs can be expected to decline throughout the EU. This will become another significant competitive advantage.

This policy package — of restricted immigration, moderate protectionism, deregulation, opposition to rapid economic restructuring and tight control of state spending and the money supply — is not the one currently pursued by EU policymakers, still less is it that favored by the United States.

It is close to the policy followed by West German Chancellor Konrad Adenauer (1949-63). He was the father of modern Europe and the instigator of the "Wirtschaftswunder", the most impressive period of rapid economic growth any large European economy has ever enjoyed.

Finally, Britain under Tony Blair has enjoyed the best of European and U.S. policies — or has it? With a huge real estate bubble, a heavy trade deficit, resurging inflation and public spending that has shot up to European levels, rising by 5% of GDP in only a few years, Britain has the worst of both worlds.

It is likely to suffer an asset-price-deflation slump similar to that impending in the United States. It will also find its recovery blighted by an overgrown and unresponsive public sector as well as accompanying fiscal strains.

Tony Blair and Gordon Brown may have a very different style to the pipe-smoking populist Harold Wilson (1964-70, 1974-76), but their policies are in the next few years likely to end in the same place — economic collapse.