Economic growth in Europe depends on a recovery in householdconsumption. And that, in turn, requires a rethinking of the balance betweencapital and labor. Over the last 30 years, wage growth has lagged behindproductivity across the industrialized world, leading to a steep fall in wages,salaries and other employee benefits as a proportion of gross domestic product.Simultaneously, there has been a big rise in inequality as the benefits ofeconomic growth have accrued to those at the top of the income scale, as wellas a steady increase in corporate income and profits. These trends have gonehand-in-hand with a steady decline in business investment.
Europe’s strategy for dealing with the eurozone crisis hasexacerbated these trends and is therefore a further obstacle to economic recovery.European countries are relying on two things to boost investment and henceemployment: First, they are trying to lower labor costs, make their businessenvironments more attractive by switching the burden of taxation from thecorporate sector to the consumer, pushing through labor reforms aimed atreducing workers’ bargaining power and curtailing social rights and transfers.Second, they are attempting to boost business confidence by consolidatingpublic finances.
Such a strategy might make sense for individual countries,so long as they can rely on exports, but not for the European economy as awhole. There are a number of things governments can do. But some will requirethem to challenge firmly held assumptions, to work more closely together and todistance themselves from special pleading by business. There is some evidencethat raising skills levels can combat inequality, and governments shouldcertainly redouble their efforts to reduce the number of people who leaveschool early. But even countries that have well-trained work forces haveexperienced sharp falls in labor share and rising inequality. The relationshipbetween risk and reward must be rebuilt by reducing executive remuneration.
Tax systems need to be more redistributive. The better-off needto pay more tax; those on lower incomes need to pay less. In tandem,governments should switch the burden of taxation from consumption to capital byreducing value-added taxes and increasing taxes on capital and wealth. There isno empirical evidence that this would hit investment or work incentives. In aneffort to address beggar-thy-neighbor tax competition, the European Unionshould move to harmonize corporate tax bases and rates. Countries need to endtheir obsession with “competitiveness.” Competitiveness is relative; countriescannot all return to growth by becoming more competitive relative to oneanother. The policies employed to boost competitiveness threaten a furtherdecline in labor share and rising inequality.
Instead of competitiveness, European governments should befocused on boosting domestic demand. This will require expansionarymacroeconomic policies. Monetary policy should be loosened further, and theEuropean Union as a whole needs to put an end to fiscal austerity. Finally,governments should adopt a more skeptical ear when confronted with businesslobbying.
What will happen if governments fail to change track?Economic recovery will prove elusive and public finances will remainchronically weak. This will exacerbate the legitimacy problems of markets,weaken social cohesion and undermine political effectiveness. Voters willassociate structural reforms with declining living standards, increasedinsecurity and inequality. Not only will governments struggle to push throughthe needed reforms, but there will also be a risk of a broader backlash againstthe market economy and the European Union.
Mainstream political parties are likely to lose much oftheir credibility, and euro-skepticism is likely to take hold as more populistpoliticians respond to mounting popular anger by becoming increasingly hostileto the European Union. Support for state control over capital is likely to riseas are demands for greater trade protectionism and tougher curbs onimmigration. These are unlikely to prove transient trends: Events of this kindtend to influence attitudes for decades.
Simon Tilford is chief economist at the Center for EuropeanReform in London
