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Here is the final chapter from David Smith's "Will Europe Work?"

So far I have examined a number of different aspects of European labour markets. In general, despite individual national initiatives aimed at improving the flexibility and adaptability of workers and the unemployed, and the fact that every eu member has signed up to both the oecd Jobs Strategy and the European Commission's version of it, it is fair to conclude that the hard work has yet to be done. In some cases, such as France and the 35-hour week, policy is moving in the wrong direction entirely. In spite of the French government's imaginative attempts to make the 35-hour week work by introducing a range of incentives for employers to have a larger number of employees, each working a smaller average number of hours, it is a policy which goes against the need for greater flexibility. Populist policies in this area are usually the wrong policies. In November 1998 Gerhard Schröder, the new German chancellor, floated the idea of a compulsory retirement age of 60, in order to achieve a more even spread of employment for people below that age. This book has not considered in detail the potential problems and welfare state strains Europe will face in the future from ageing populations. Limiting the age until which people can work at a time when longevity is increasing does not, however, appear to have much to commend it in this or any other context.

If Europe already has inflexible labour markets, low employment-to-population ratios, high unemployment rates and limited geographical mobility of labour both within and among countries, surely this is the choice of those European countries that have chosen this route. In the case, say, of Germany, the Rhineland model has developed in such a way as to provide high-wage, high-skill jobs for considerable numbers of people. The fact that it also throws up a large number of outsiders - the unemployed or never employed, or those on the margins of the workforce - can be seen as a matter of national choice. As long as the employed insiders generate enough wealth to provide sufficient levels of social protection for the outsiders, why should we worry? Why should the fact that Europe is embarking, in this environment, on a bold single-currency experiment be a cause of even greater worry? European governments, as has been shown, are prepared to spend large sums on passive and active labour market measures, and yet taxpayers have not been taking to the streets in protest.

The answer, of course, is that in the context of emu one country's problem becomes the problem of others. Suppose, for the sake of argument, Germany and France became the euro area's problem economies, with unemployment at 20% and rising and social discontent mounting. Even if every other emu member was enjoying a low-unemployment economic renaissance, it is hard to believe such a situation would be politically sustainable. This is perhaps not the most likely emu outcome, although it is possible. It is more likely, as now, that the extreme problems of high unemployment come not at Europe's core but at the periphery, and that they become worse. It would be a difference of degree, and perhaps of visibility, but not of substance. If emu is seen to be the cause of high unemployment, wherever it occurs, national governments and regional authorities will look to Europe to provide a collective solution (of which more below). But are there circumstances in which Europe can develop a flexible and mobile workforce? Could emu, far from being the cause of greater unemployment in Europe, contain the makings of a solution to the continent's labour market problems?

EMU as a catalyst for labour market reform

In Chapter 3 I touched on the optimistic view of emu, its impact on Europe's trend rate of growth and the proposition that, in a period of falling European unemployment, governments could push through the kind of labour market reforms the eu needs for the long term. There is, it should be said, a powerful counter argument to this. Apart from the question of whether there will be a discernible growth bonus, even temporarily, from emu, there is also a huge uncertainty about Europe's response in this situation. Imagine for a moment that the optimistic vision has become a reality. Europe in the early years of emu, partly for cyclical reasons, becomes an area of strong growth in the world. Unemployment falls steadily. The United States, by contrast, having enjoyed a long upswing through most of the 1990s, experiences a cyclical downturn. Unemployment rises, possibly quite sharply. In this environment would European politicians wish to introduce measures which sought to replicate the US labour market model, or any other variant of the Anglo-Saxon approach? I strongly suspect not. Their more likely conclusion would be that the US model had flattered to deceive during the 1990s, and that they were far better-off sticking with what they had.

The European Commission has a robust attitude on this question, arguing that the benefits of emu will be lost if labour market reform is not stepped up:

The foundations of an employment-friendly economic policy are a balanced policy mix, sustained convergence and monetary stability. emu will lay these foundations. But their full impact on employment will not be felt unless they are accompanied by significant progress in the area of structural adjustment. The room for manoeuvre within the budget must be devoted to reducing social security contributions on wages, and especially low wages. If the cost of labour were to be reduced, firms would be encouraged to take on more workers. Job creation would be fostered by more flexible goods, services and labour markets and by a reorganisation of work within industries and firms as part of negotiations between management and unions. Lastly, the near disappearance of inflation means that a closer link can be established between pay levels and worker productivity which will make it easier for management and unions to conduct a responsible wage policy conducive to employment.1 Richard Bronk of Merrill Lynch, in a paper emu and Labour Markets, The Political Economy of Supply-side Reform, sees the momentum for labour market reform in Europe emerging, if it does, in a rather different way. Crisis, he argues, has usually been the handmaiden of controversial and, in the short-term at least, politically unpopular reform. The agreement by the social partners on the need for restructuring the Dutch labour market in the 1980s came after the recognition that there was a crisis of high unemployment which had to be tackled. Similar motivations forced reform on to the agenda in Spain in 1997. Thus it may be only after emu has failed to make a dent on high European unemployment, or exacerbated the problem, that reform measures will be introduced: When next facing a recessionary crisis, countries might finally conclude that, in the brave new world of emu, the absence of adequate fiscal and labour market flexibility is both a serious constraint on their ability to cushion the impact of shocks and a contributory factor to yet more damaging levels of unemployment, and might then be forced to consent to further reform. This may be especially true if persistently high unemployment (and associated expenditure) makes it difficult for the countries concerned to keep within the Stability and Growth Pact budget deficit limits during a recession. Whether serious labour market and fiscal reform has to wait for the next crisis to make the need for it clear to all the social partners is a key question. Reform in such circumstances tends to be more painful than when undertaken in booming conditions, but recent European history suggests that reforms may be more likely to be accepted politically during a crisis.2 This leaves open the question of whether, in such a situation, electorates would be more willing to contemplate far-reaching labour market reforms or, as an alternative, contemplate the break-up of emu. The line between a crisis which forces government to push through necessary reforms and one in which countries decide that life outside emu is more palatable may be a fine one. The emu debate is based on two assumptions. One is that a single currency, once established, is technically irreversible. The other is that governments committed to the success of emu will always be in power in Europe. Both are questionable. In an emu crisis of high unemployment, opportunist politicians who favour withdrawal from emu will come to the fore. They already exist in most countries, although they are generally on the extremes of mainstream politics (Britain's Conservative Party is perhaps an exception, although it has not yet established a position of permanent opposition to emu). This could change. The generation of politicians who saw emu to fruition will pass from power. In Germany this has already occurred, with the defeat of Helmut Kohl's Christian Democrat-led coalition.

Another way emu could act as a catalyst for labour market reform, raised by Bronk and others, is if countries in Europe are prompted to engage in intense job competition. The argument is that in a single-market, single-currency area companies could become much more footloose in terms of their location decisions. Any country that was noticeably out of line in the regulatory demands it placed on employers, in the burden of compulsory social costs faced by firms and in its tax regime could be expected to lose out. To turn this on its head, any country that offered a light regulatory regime, together with low taxes and social costs, could be expected to be a net employment gainer. To take this one stage further, countries could engage in what Bronk describes as `a competitive spiral of bidding down labour market regulations, social welfare support and tax rates'.

Although this offers the potential for driving labour market reform and tax competition, it should be noted that the authorities in Europe have seen it coming and have been anxious to head it off, perhaps calling into question the Commission's true commitment to reform. As employment commissioner Padraig Flynn said in a speech in October 1998:

We do not want just more jobs but more better jobs. Without lowering wage and labour standards, without making the weakest bear the brunt of the adjustment process as we shift further into the new services-based, information-based, economy of the future.3 The Centre for Economic Policy Research (cepr), in a report Social Europe: One For All?,4 points out that social dumping (governments using less regulation and lower social protection to attract investment from elsewhere) is a possibility within the context of emu. It also notes that this could result in lower social protection throughout Europe, although this would not necessarily be a disadvantage to groups which are not well served in the existing framework, such as unskilled workers effectively priced out of jobs by onerous labour market regulations and high social costs. The response, according to the cepr report, will be to beef up Europe-wide social protection by widening the scope of the Social Chapter and making it binding on member countries. Britain, which hitherto had presented the greatest danger of social dumping as seen from Brussels, signed up to the Social Chapter soon after the election of the Blair government in May 1997.

Indeed, the adoption of binding Europe-wide protection could more than offset any labour market benefits the competition to attract capital within the euro area could bring. (There is, as discussed in the context of the geographical mobility of labour, considerable doubt about the extent to which capital will seek out the far corners of Europe, even if there is a cost argument for doing so. If the `hot banana' theory of location applies, and firms take the view that any benefits from easier regulatory regimes or lower social protection are likely to be time-limited, the incentive for governments to engage in social dumping may not exist.) The opposite danger, of countries being forced to adopt inappropriately high standards, is a real one. According to the cepr report, any action by European governments in this area has to recognise the limits of harmonisation. The degree of social protection and labour market regulation that may be appropriate for Germany or France could be wrong for, say, Portugal or Ireland. Drawing a distinction between recognising that national differences should continue to exist, for example, on minimum-wage and benefit levels, and allegations of social dumping will form one of the battlegrounds for eu social and labour market policy in the coming months and years. eu enlargement, and the prospective entry of former centrally planned economies from eastern Europe into both the eu and emu, will add considerable spice to this debate.

emu has been sold to the public, as the comments by Padraig Flynn quoted above imply, as a mechanism not for driving down social standards or wages but for increasing them, or at least ensuring that they converge on the highest. It is a message not lost on European trade unions, which have already declared that they will use the transparency offered by the euro to ensure that workers doing similar jobs (particularly with the same company operating in different parts of Europe) are paid the same wherever they work. Such a process will inevitably take time - the overnight conversion of east German wages into Deutschemarks at a one-for-one exchange rate rendered east German workers instantly uncompetitive and was a key factor in the sharp rise in unemployment following unification. But the fact that such a process is envisaged at all, at least by one set of social partners, should caution against the idea that emu will be a force for either lower wages or reducing social protection.

There are thus three ways in which emu could act as a catalyst for greater labour market flexibility in Europe. The first is if emu proves to be an economic success, with strong growth and falling unemployment providing an environment in which greater flexibility could be introduced while minimising the number of losers. The difficulty is that if Europe is seen to be working under emu, why should there be any political momentum for reform? The second possibility is that labour market reform is forced upon governments by an economic crisis, the first serious emu recession. European unemployment has ratcheted higher with every successive economic cycle. Eventually, a point will come when everybody recognises that enough is enough. As argued above, however, it is not clear that the solution in such circumstances would be sought in far-reaching labour market reform. The third possibility could be the existence of the single-market, single-currency area itself. If the prizes, in terms of jobs, are seen to be going to the least regulated, most flexible, economies, governments in other countries will be under pressure to follow suit. It could happen, but for the reasons outlined above it is hard to see this as the most likely outcome. This leaves an alternative set of possibilities. What happens if Europe does not reform its labour markets?

EMU and labour market failure

Even if emu is not the catalyst for labour market reform in Europe, can it possibly make anything worse? After all, although it would cause problems for regions and in some cases entire countries if the distribution of employment within Europe changed radically as a result of the single currency, could it be, for Europe as a whole, a price worth paying? This, indeed, as I shall discuss later, will be the main momentum for large-scale fiscal transfers from advantaged to disadvantaged parts of the euro area. There are also reasons to believe, however, that over the medium to long term emu, far from putting Europe on to a path of stronger economic growth, could condemn it to even higher unemployment.

Walter Eltis, in a Centre for Policy Studies paper Further Considerations on emu, argues that Europe's job-creation problem has, if anything intensified in the 1990s. According to the European Commission, the eu should be creating jobs whenever economic growth exceeds 2% a year, but recent experience suggests that even stronger growth is required before there is any impact:

Europe's private sectors have created no jobs (in the aggregate) since 1970; such job creation as has occurred has been by government. In each economic cycle, no European jobs are created in the expansion phase, and this is followed by job destruction in the subsequent recession. From 1990 to 1993 when recession predominated, 4.4 million eu jobs were lost. From 1993 to 1997 when European economies expanded at a rate of 2.4% per annum, average unemployment remained stuck at 11%. With this trend, unemployment will rise to more than 13% in the next recession ... French and Italian unemployment is 1.5% above the European average, so if it rises from 11% to 13% in the next recession unemployment in France and Italy will approach 15%.5 But how could emu aggravate this problem? It could do so in two main ways. The first arises from the expectation that the combination of a single currency and the single market will spark off a wave of corporate restructuring, rationalisation, relocation and merger activity. One certainty about such activity is that it is usually associated with net job losses for the industry or companies concerned. In fact, one of the chief motivations for rationalisations and mergers is that there will be job savings, if only by cutting out duplication. We have already seen that the response of German firms to the competitive pressures they have encountered in the 1990s has been to abandon some aspects of the normal consensus approach and instead cut employment to secure productivity gains. When this happens on a European scale, the shake-out in jobs could be considerable.

This would not matter too much if there were new employment opportunities for the displaced workers to take up. After all, corporate downsizing in the United States in the 1990s has not resulted in a high unemployment problem - it has led to the opposite. Unfortunately, in this respect Europe is not the United States. As has already been noted, the engine of job creation in the United States has been the services sector, and many of the jobs created have been for low-skilled workers at low wages. In Europe this engine either does not exist to the same extent, because of the high cost of employment, or has failed to get out of first gear. The other source of new jobs, as Eltis points out, is the small business sector, sometimes in the services sector:

The creation of new businesses is central to the achievement of growth in private-sector employment, and this is especially inhibited by taxation and the labour market rigidities which proliferate in continental Europe. Jobs are crowded out by uneconomic minimum wages, especially for the young. In addition, as a result of making workers redundant, employers are reluctant to offer new jobs. France is replete with firms which limit their employment to 9 or 49 in order to escape the additional regulations which apply to firms with more than 10 and more than 50 employees. Small service sector firms are beginning to register in the UK to reduce their tax liabilities.6 The second risk goes to the heart of the dangers posed by an inappropriate monetary union. What are the consequences of Europe not being an optimal currency area? A single monetary policy, sometimes called a one-size-fits-all policy, and what will be for emu participants permanently fixed exchange rates against one another represent a huge leap in the dark. There have been fixed currency arrangements before. In the Latin monetary union from 1865 to the mid-1890s France, Belgium, Italy and Switzerland, and for a time the Papal states and Greece, used the French franc as a common currency. The gold standard and the post-war Bretton Woods system are more familiar examples. None stood the test of time. The history of European currencies in the post-Bretton Woods period does not offer much encouragement. In the floating rate era, up to the adoption of the franc fort policy, the French franc lost about two-thirds of its value against the Deutschemark and others lost even more. Sterling, for example, lost 75% of its value against the German currency. The optimistic view is to say `that was then but this is now'. European countries, in other words, may have needed a regular fix of devaluation or depreciation in the past but not any longer. It is more likely, however, that part, probably a substantial part, of the adjustment will shift from the exchange rate to the real economy. In other words, without the opportunity for changing the external value of their currency, several emu members could suffer significantly slower growth over the medium and long term, thus dragging down the eu's overall growth rate. According to Richard Jackman and Savvas Sarouri, in a paper `eu Labour Markets and Monetary Union': There are two mechanisms of labour market adjustment to shocks. The first is changes in relative wages, working through the exchange rate or sometimes through nominal wage flexibility, and this mechanism operates where markets are separated from one another. The second is labour migration, and this mechanism operates where the markets, despite being geographically apart, constitute for economic purposes a single market. The single currency appears to be closing down the first mechanism of adjustment among its member states before there is sufficient real convergence of their economies to make the second a realistic prospect. A single European language and harmonisation of laws and institutional practices seem prerequisite for a substantial increase in labour mobility. Only then can Europe hope to match the great single market of the US. Without it, the single currency may commit great regions of Europe to prolonged recession and persistent unemployment.7 A similar mechanism is likely to work for monetary policy. In the run-up to 1 January 1999 much attention was focused on the fact that strongly growing peripheral economies such as Ireland, Portugal and Spain were required to cut interest rates significantly to achieve convergence with the emu starting rate of short-term interest, set by the ecb in December 1998, of 3%. Just as eu membership had been a bonanza for these economies, as prime recipients of both Common Agricultural Policy (cap) payments and regional aid, so it appeared that emu would have similar consequences. It was plain, however, that any such effects could operate only in the short term. Any emu boom would not only be a one-off event, but it would also be followed by a bust in which interest rates are likely to be set at a level that would suit the needs of the core economies but would be too high for the rest. Perhaps the most common fear about emu, even in countries which are enthusiastic about it, is that an autonomous central bank will set monetary policy in such a way that guarantees ultra-low inflation, even stable prices, but at the expense of growth. Moreover, removing the ability of national central banks to set interest rates and national governments to vary exchange rates could accentuate boom-bust cycles within Europe, again with adverse growth and employment effects. It has yet to be proved that the one-size-fits-all monetary policy which will operate under emu will confer any growth advantages. It is more likely that European growth will remain low overall, weighed down by poor performance in uncompetitive regions.

The consequences of a high-unemployment EMU

What if, as Walter Eltis suggests, Europe, particularly those parts of it participating in the single currency, are condemned to a future in which cyclical upturns have little effect on high unemployment levels but each downturn produces a further rise in the jobless total? In my book Eurofutures8 I sketched out a scenario, `the dark ages', in which this would happen, with an initial rise in emu unemployment to an average of 15% disguising rates in the most depressed regions of 30-40%. Looking further ahead, it was possible to see the average unemployment rate climbing to 20-30%, with rates in the worst-hit regions reaching 50-60%. Inevitably, if such a scenario came about there would be a dangerous rise in social tensions. But there would also be other responses. Peter Jay, in his Darlington economics lecture, envisaged a situation in which, in such circumstances, there would be a forced increase in geographical mobility, not of the kind where workers would seek opportunities elsewhere to better their living standards, but, instead, something like a mass migration of economic refugees: However much money and power the Commission will have, it is improbable that they will be able to have any significant impact on the competitiveness imbalance problem which a single currency will pose. This will leave the problem to nature's remedy - the migration of population. It seems hard to believe that the political, economic and social success of Europe, whether one approves or disapproves of the objective, will be promoted by establishing at the heart of its economic functioning a mechanism which depends for equilibrium on the enforced migration, on pain of destitution, of its population in the tens of millions ... If this is the character of monetary union, conceived by politicians who saw it as little more than a trite gesture of nationhood, to go with a blue flag and a jolly anthem, then we can say that it is not in the long-term interests of Europe and very far from being a sensible economic sacrifice even for the sake of a large political goal. Indeed, one may wonder that anyone who professes to hope for the success of political union in Europe could wish to implant in its foundations such an engine of mass destruction.9 Long before this point was reached, I would suggest, the politics of self-preservation would come into play. It would operate in several ways. The first route would be an attempt by politicians to influence the monetary stance of the European Central Bank (ecb), and to make it more growth-friendly in its decisions. Related to this would be the degree to which the external value of the euro would be allowed to strengthen, the risk being that an over-strong single currency would pose significant problems, not just for the peripheral economies of Europe but also for the core. Both of these sources of pressure on the ecb might have been expected to emerge some way down the road. In fact they surfaced in the autumn of 1998, before the start of stage three of emu, following the German federal election. Oskar Lafontaine, the newly appointed finance minister, made it clear not only that he had little time for the monetary conservatism of the Bundesbank, and by extension the ecb, but also that he favoured a system of global managed exchange rates, in which the euro's relationship with the dollar and the yen would be subject to targets, with policy decisions reflecting these targets.

The issue of the euro's external value is an interesting one. Although responsibility for the euro exchange rate remains with elected finance ministers rather than the ecb, as was the case for sterling following Bank of England independence, and is the case for the dollar, whose value is the responsibility of the US Treasury and not the Federal Reserve Board, this influence can be exerted only through currency intervention, very much a second-best means of acting upon exchange rates, rather than through the level of interest rates. The position is not clear-cut. In the UK tradition, but rather less so in the United States or Germany, the currency's strength or weakness has an influence on monetary policy decisions. One potential headache for the emu countries could be that the euro's novelty, and its appearance on the scene as a ready-made reserve currency which could, according to some analysts, come to rival the dollar, will guarantee that portfolio demand for it is strong in the early years, pushing it to uncompetitive levels.

The second response from politicians, to reactivate more expansionary national fiscal policies, if necessary by relaxing the terms of the Stability and Growth Pact, has already been discussed. In November 1998 Carlo Ciampi, the Italian finance minister, weighed in behind Lafontaine in support of such a strategy.

Ultimately, political self-defence mechanisms, in the context of a rise in European unemployment to socially dangerous levels, could react by abandoning emu itself. As has been noted, the politicians who were the modern founding fathers of the single currency are, in many cases, no longer in power, although those in office at the time of writing still support the euro project and would merely wish to refine or redesign it. Even this may not last. Governments openly hostile to emu could be elected on a wave of popular discontent sparked by high unemployment, at a time when the euro and the ecb are the obvious targets for such discontent. There have been, as noted above, apparently permanent monetary arrangements before. From a British perspective this has more resonance perhaps than elsewhere in Europe. Britain's experience of going back on to and then coming off the gold standard in the mid-1920s and early 1930s was a bitter one. In 1972, after the collapse of the Bretton Woods system, the Conservative government of Edward Heath took sterling into the European currency snake, but the experience lasted only six weeks. In October 1990, in a coup de grâce, the Thatcher government, with John Major as chancellor, took sterling into the exchange rate mechanism of the European Monetary System, an event that was supposed to represent a permanent closing-off of the devaluation/depreciation option. Less than two years later, on Black Wednesday (16 September 1992), this arrangement too came to an end.

emu is, of course, supposed to be different. It is supposed to be irreversible and irrevocable, and perhaps it will be. Just because one set of governments has negotiated apparently binding international arrangements, the ending of which would admittedly be messy and complicated, does not mean a future set, or one or more individual governments, cannot seek to reverse such arrangements. If emu turned out to be a European employment disaster, with no relief in sight, it would not last. Long before that point was reached, however, European governments would seek to make it work. In the case of chronically high unemployment, with particularly high levels in the most depressed regions, the main mechanism for trying to make it work, in addition to those set out above, would be large-scale fiscal transfers.

Fiscal union

Critics of the arrangements for emu, who nevertheless support the single-currency project, argue that its weakest element is that there is little provision for fiscal transfers among countries to provide either temporary or long-term support in response, for example, to an asymmetric shock (an event that has more impact on unemployment and incomes in some countries than in others). Even the United States, with its labour market flexibility and its much higher geographical mobility of labour, it is argued, has such transfers, and they are important in minimising the social costs of such shocks. There is an intense debate among economists concerning the size of fiscal transfers in the United States. Xavier Sala-i-Martin and Jeffrey Sachs, in a 1992 paper `Fiscal federalism and optimum currency areas: evidence for European from the United States', suggested that in the period 1970-88 federal transfers (including benefits) and taxes offset 40% of the loss of personal income resulting from regional economic shocks.10 This view was challenged by Jürgen von Hagen, also in a 1992 paper, `Fiscal arrangements in a monetary union: evidence from the US', who suggested that the effect on the gdp of US states was nearer to 10%, although he also came up with a larger figure, of more than 40%, for long-run redistribution effects.11 The consensus view among economists, according to a review of the literature by Maurice Obstfeld and Giovanni Peri in emu: Prospects and Challenges for the Euro, is that through government expenditure and because states hit by economic shocks make smaller tax payments to the federal government the US system provides for around a 20% offset.12

These results are interesting, not least because they are somewhat counter-intuitive. We would expect the effect of net transfers to be much smaller in the US economy because other forms of adjustment, through labour market flexibility and geographical mobility, are high. We would also expect such effects to tail off fairly rapidly, because in the case of unemployment benefit payments under federal schemes are highest in the first six to nine months. But the fact that such transfers exist, and have been even greater in other countries with federal systems, notably Canada and Germany since unification, is grist to the mill of those who argue strongly for such a policy in Europe. At present, the scope for offsetting fiscal transfers from the centre in Europe (from Brussels) is limited to just over 1% of the gdp of member states, although as noted above the benefits to some member states have been disproportionately large.

Jacques Attali, former adviser to President Mitterrand and former head of the European Bank for Reconstruction and Development, set out in Time's Golden Anniversary Issue on Europe in 1996 what he described as a worst-case scenario for Europe, in which:

Twenty odd European countries will be assembled into a single European Union, a unified economic space in which a dozen or so of these states will share a common currency, the euro. This large market, entirely open to outside investment, will have no common budgetary, fiscal or social policy. It will be under the domination of the Continent's premier industrial power, Germany, which will turn the euro into a kind of supermark. Lacking financial resources of its own, this monetary union will probably not create social mechanisms capable of compensating for the devastating effects on employment caused by productivity differences between regions.13 Part of the solution, according to Attali, would be the creation of a powerful European treasury ministry, to manage the European economy and to co-ordinate fiscal transfers in a way that would prevent his worst case from becoming a reality. But has this option already been closed? Aware that monetary union would be seen as a stepping stone towards a federal Europe, which at that time was unacceptable to the signatories, the drafters of the Maastricht treaty were careful to put in plenty of safeguards against the future creation of a European treasury. As Bernard Moss and Jonathan Michie put it: With the single currency, the eu encroached upon national fiscal and budgetary policies without taking up responsibility for them. Under an `asymmetrical' emu governments would be spread-eagled between monetary policy set by Frankfurt and social and economic policy decided within deficit limits at home. The treaty provides in article 103 for council to formulate broad guidelines for national economic policy but without an enforcement mechanism and without the co-ordination with the ecb that the Delors Report recommended. Under article 104c and the Stability Pact approved at Amsterdam, national economic policy is circumscribed by the convergence criteria. It must be subordinated to the ecb's pursuit of price stability. At the core of emu is the absence of European government.14 This is at the heart of the present political debate, which will intensify over the next few years. To what extent is emu a stand-alone venture, a monetary arrangement entered into by governments which will retain control over fiscal policy? Or to what extent will this be seen to be increasingly untenable, as the Euro-11 committee of emu finance ministers, set up to co-ordinate economic policy among the euro area countries, gradually takes on a European treasury role?

Fiscal conservatism

The main argument against the idea that Europe will gradually develop a central treasury function, and that large-scale fiscal transfers between better-off and worse-off regions will become the norm, is that the voters will not wear it. There is something about contributions to the eu budget which reinforces the nationalistic instincts even of committed Europeans. Thus Britain under Margaret Thatcher, and more recently Germany and the Netherlands, the three largest per head net contributors, have sought to reduce their net contributions to the eu budget, arguing that the existing framework is unfair. Thatcher secured a significant UK rebate at Fontainebleau in 1984. Germany and the Netherlands made clear during 1998 that in the new budget settlement for the early years of the 21st century both the UK rebate and other countries' net contributions would be up for renegotiation. This is not an environment in which governments could easily persuade their electorates of the case for paying a European tax or for increasing the size of the eu budget to create a fiscal counterweight to the powerful single monetary authority, the ecb. Just as Europeans are rather good at guarding their labour markets against outside incursion, so they would be good at ensuring their politicians did not commit them to paying extra taxes to meet the cost of labour market failure in other countries. The size of the eu budget, a mere 1.27% of eu gdp including the expensive cap, although admittedly higher than just 0.03% of gdp in 1960, speaks volumes. This is one area of public expenditure which otherwise profligate politicians have been reasonably effective in restricting.

Does this mean that the idea of a European treasury, of those large-scale fiscal transfers to the regions emu would leave permanently depressed, is a non-starter? This may indeed be so, in which case the outlook for such regions and for the survival of emu would be even bleaker than it is. There are four reasons to suppose, however, that things could change. The first is that attitudes do shift. Conventional wisdom, even quite recently, was that the German people would never countenance surrendering their trusted Deutschemark for the euro, let alone a euro which included Italy among its participants. If voters can be softened up to accept monetary union, however grudgingly, it would not be stretching things too far to argue that they could also be persuaded into grudging acceptance of its tax consequences.

The second reason for believing that fiscal transfers will gain acceptance is that they could be preferable to the alternative. West Germans were not, in the main, persuaded of the need to rush to unification with the east following the destruction of the Berlin wall in 1989. Neither was the then Bonn government. The problem was that east Germans, together with ethnic Germans from elsewhere in eastern Europe, were voting with their feet. The only way to keep east Germans where they were, and to prevent west Germany being swamped by wave upon wave of economic migrants, was rapid unification, immediately followed by large-scale transfers of tax-funded resources. West Germans did not relish paying unification taxes, even to support their cousins in the eastern Länder. But the alternative was much less attractive. The same is likely to be true, but on a much larger scale, for Europe under emu.

Third, fiscal transfers would occur, certainly in the early stages of emu, not through the payment of ever-larger contributions to a central budget administered by faceless bureaucrats in Brussels, but (more likely) through a beefed-up committee of national finance ministers of emu countries, based on the existing Euro-11 committee. Such a group's decisions would be presented as co-ordinated fiscal policy and would focus on mutually beneficial expenditure, such as infrastructure projects, as the Commission has already sought to do through Trans-European Networks. European voters would, in other words, be party to the gradual Europeanisation of fiscal policy without being fully aware of it.

Fourth, perhaps most tellingly, monetary union itself could build popular support for greater centralisation of budgetary policy. If the perception grows of an all-powerful ecb, much more powerful than any national politicians, then the argument in favour of a political (budgetary) counterweight to the ecb could easily grow. This would be the case particularly if, as its supporters argue, emu means that people and businesses will increasingly think not in national terms, but on a European scale. It is easy to think of the euro area as being preserved in aspic, with 11 (initially) separate but integrated economies continuing to operate as they do now. Increasingly, however, the single market and a single currency will mean a unified economy. Taking this to its logical conclusion, the resistance of richer European regions to paying taxes to help out the poorer parts could be no greater than is presently the case, for example, for northern Italians reluctantly being prepared to transfer resources to the south, or, as already noted, Germans from west to east.

It may be, of course, that none of the above will come about, and that European electorates will adopt a stance of `thus far and no further' following emu, particularly when it comes to fiscal integration. The beginnings of a new approach can, however, already be detected. A single-market, single-currency economy will lead to inexorable pressure for tax harmonisation - in a transparent world of prices set in euros, member countries will be strongly discouraged from attracting businesses or consumers through lower taxes. It will also lead to similar pressure, as already discussed, for the harmonisation of welfare benefits and labour market standards, to prevent social dumping. Ultimately, it will lead to a drive towards greater centralisation of all fiscal policy decisions, although how rapidly this occurs remains to be seen.

In November 1998, at a meeting in Brussels, finance ministers from the 11 socialist countries in the eu, including Britain, Germany and France (thus Gordon Brown, Oskar Lafontaine and Dominique Strauss-Kahn), signed a joint document, `The New European Way - Economic Reform in the Framework of emu', drawn up by the EcoFin Group of the Party of European Socialists.15 It committed them to `macroeconomic policies that create stability and are conducive to sustainable expansion', `co-ordination of budgetary policies and economic policies in order to achieve strong and sustainable economic growth and full employment in accordance with the single monetary policy', and said that `further efforts have to be undertaken to avoid harmful tax competition among the member states'. All this, it should be noted, was couched in terms of adherence to the Stability and Growth Pact and `the importance of budgetary discipline'. The broad message, indeed, like that of Britain's Labour Party before the May 1997 election, was that by cutting welfare payments (`the bills for economic failure') resources would be freed for more productive, and employment-friendly, use of public expenditure. The omens, however, were not good. The Labour government, in summer 1998, announced substantial increases in public spending, notably health and education, alongside a significant rise in welfare (social security) spending.

An interesting question, with governments in power in most European countries that do not see reducing the share of public expenditure in gdp as a desirable policy aim, is how much upward creep there will be in that share, under the guise of co-ordinated fiscal policy. The consequence of this, coupled with greater moves towards tax harmonisation, will be a parallel increase in overall tax levels in Europe, at a time when the impact of high taxation on inward investment, enterprise and employment is already a significant competitive problem for eu countries. If government spending and taxation rise together there need be no threat to the Stability and Growth Pact, which requires, in normal circumstances, that emu countries restrict their budget deficits to 3% of gdp or less.

The pact itself, however, is not as tough or as binding as it is sometimes portrayed. Although there is provision for potentially onerous fines on countries exceeding the deficit limit, it was designed to tackle the problem of free-rider economies, which, it was feared, would jeopardise emu by persistently breaking the rules. It is hard to see how fines, which have to be decided upon by qualified majority voting among the member states themselves, could come into play if all countries decided on the need for a more flexible interpretation of the rules, that is higher budget deficits, at the same time. Countries do not typically impose fines on themselves. Similarly, there is provision for the rules to be waived if budget deficits increase as a result of events outside a country's immediate control. It would not be hard to construct a set of circumstances in which European economic problems, and continued high unemployment, were deemed to be the consequence of global economic events, or even events in another eu economy. Suppose, for example, that the German economy went into serious recession and thus gained automatic exemption from penalties under the pact. Others could argue that Germany's impact on them made the case for similar exemption, and so the process would go on.

How big an EU budget under EMU?

An interesting aspect of the debate on fiscal policy in Europe, as noted above, is that the move towards greater co-ordination of budgetary policy, and a more activist role for government spending, has coincided with a strong political desire to control the size of the eu budget itself, currently only 1.27% of eu gdp, effectively freezing it for the 2000-6 period. This is a result of two things. First, the desire of large contributor countries, notably Germany and the Netherlands, to see their net contributions to the budget reduced, and of Britain not to see its rebate threatened. Second, a perception that any increase in the budget would not only reduce the momentum for reform of the cap, but also inevitably see a greater proportion of cap spending being directed to the new entrants from eastern Europe, particularly countries such as Poland.

However, there is more than one way of skinning a cat. In its overall economic effects, greater fiscal activism in which individual member countries retain ownership of additional government spending, rather than leaving it to the discretion of the Commission, does not differ greatly from an increase in the eu budget. But what kind of increase in spending are we talking about? As we have seen, some eu members already spend more than 5% of gdp on labour market measures, both passive and active. How large might be co-ordinated spending to overcome labour market failures within emu?

The starting-point for answering such a question is usually the MacDougall report.16 In 1974 the Commission asked a committee of experts, chaired by Sir Donald MacDougall, then the chief economic adviser to the Confederation of British Industry, to examine the likely size and scope of the eu budget under various phases of European integration. The committee's report, published in 1977, envisaged the retention by national governments of responsibility for some aspects of public spending. But the experts were also struck by the extent of federal spending in the United States, and its role in transferring resources between rich and poor regions. The greater the degree of European integration, they argued, the greater was the need for similar mechanisms in the eu. The committee envisaged three phases of integration, with the European budget larger in each stage. It concluded that with Europe in a pre-federal stage of integration the central budget would need to be between 2% and 2.5% of eu gdp, rising to between 5% and 7% of gdp (or 7.5% and 10% if defence was included) at a more advanced stage of integration, and 20% to 25% of gdp for a full federation.

These figures, it should be noted, were envisaged as being not in addition to national public spending, then averaging 45% of gdp, but a replacement for it. Indeed, it was argued that it should be possible to generate economies of scale from the shift of spending from the national to the Community level, by reducing duplication. The context in which the MacDougall report was written, however, was one of significantly lower unemployment, and somewhat lower government spending as a share of gdp. Although Europe's unemployment rate had begun to rise following the first opec (Organisation of Petroleum Exporting Countries) price shock of 1973-74, the Community average was below 5%, and there were reasons to believe that this was a temporary phenomenon. Not until the beginning of the 1980s did European unemployment, in common with most other industrial countries, including at that time the United States, begin to rise to chronically high levels.

How much would government spending have to increase, on a co-ordinated basis, to alleviate the impact of emu on regional unemployment within the eu, and to provide the kind of resource transfers needed to compensate for the effects of labour market inflexibility and geographical immobility? The answer, of course, is that it depends on the degree of the unemployment problem, and the extent to which governments (and taxpayers) would accept the burden of compensating for wide unemployment differentials within the euro area. It is quite likely, for example, that governments within the more successful core (the hot banana) would resist such transfers, although even they would be forced to widen the scope of resource transfers, through benefits and much more active regional policies, within their own countries. It is hard to see how they could ignore the plight of peripheral countries for too long, however, for the reasons outlined above. Either emu itself would not survive in such circumstances, or it would do so only at a huge price, that of significant social unrest on the edge of the prosperous core.

An increase in the centralisation of spending decisions and in the scale of resource transfers to poorer areas thus appears inevitable; and over time this could become extremely significant. Where I would take issue with the MacDougall conclusions is in the idea that such action would merely represent a shift from national to eu-wide spending. If the broad conclusions of this book are right, and emu represents a significant addition certainly to regional unemployment differentials within Europe and to the overall unemployment problem, then such spending would be on top of existing national outlays. This is at a time, incidentally, when, to add to the list of concerns, there will be pressure anyway for rising government spending. For the 11 first-wave emu countries, ageing populations will mean that over the next 30 years, in the absence of compensating savings, there will be an increase in the public expenditure share of gdp of seven percentage points, according to the imf, to meet pension entitlements and healthcare requirements.

EMU: tax and die?

The new left-of-centre governments in Europe do not, in the main, accept that labour market inflexibilities have much to do with Europe's unemployment problem. Oskar Lafontaine, finance minister in Gerhard Schröder's Social Democrat-led coalition elected in September 1998, in his book Don't Be Afraid Of Globalisation,17 co-written with his wife Christa Müller, explained the better employment and unemployment performance of the United States in the 1980s and 1990s not in terms of deregulation and labour market flexibility, but as a result of policymakers in the United States engaging in more expansionary fiscal and monetary policies. Thus under Ronald Reagan in the 1980s, when the US budget deficit emerged, fiscal policy was heavily expansionary, and the Federal Reserve supported growth with a more accommodating approach to monetary policy than the Bundesbank and its counterparts elsewhere in Europe. The European economy has thus been condemned, through over-restrictive macroeconomic policies, to running significantly below capacity, which has resulted in high unemployment. Microeconomic differences between Europe and the United States, on this view, represent a far less potent explanation.

A fascinating European experiment is thus in prospect, but not one that offers much hope of success. According to the imf in its September 1998 World Economic Outlook:

It is in the area of labour markets that the euro area faces its greatest policy challenge. High labour costs and entitlement systems that hamper incentives for job search have depressed employment creation. The flexibility of European labour markets needs to be addressed through structural reform measures across a wide front to safeguard the key principles and objectives of European welfare systems and at the same time lessen distortions and strengthen incentives to work and create jobs. This would facilitate adjustment to adverse economic disturbances and lessen the magnitude and duration of divergent economic trends across the area. And even in the absence of disturbances, greater labour market flexibility is needed to promote job creation, reduce structural unemployment, enhance budgetary performance, and strengthen the area's resilience to inflationary pressures. Unfortunately, despite progress in some areas, labour market reform efforts have remained inadequate in most of Europe. In the absence of deeper and more comprehensive reforms, emerging wage pressures could choke off the recovery prematurely by leading to a need to tighten monetary policy more quickly than would be the case if labour markets were more flexible. Moreover, without reforms, there is a serious risk that structural unemployment will continue to rise in some countries and regions, even as cyclical unemployment may be falling, thus compromising efforts to contain longer-term fiscal imbalances. A tendency for unemployment to continue to rise secularly along the trend of the past two or three decades would risk eventually increasing pressures for an undue relaxation of monetary policy. And down the road it could ultimately erode public support for monetary union, which might unjustly be regarded as the cause of rising unemployment. With activity strengthening across Europe, the time is more than ripe for bold reforms to address the Achilles heel of the Economic and Monetary Union (emu) project.18 This is an orthodox view, as would be expected from the imf, but it is also the right one. In the past Europe may have had a problem of weak demand and over-restrictive policy, both monetary and to a lesser extent fiscal. But during the 1980s and 1990s inflexible labour markets increasingly acted as a drag on activity and competitiveness and structural unemployment rates rose, to close to 10% in some cases. It is fanciful to imagine that by simply switching on demand through expansionary policies Europe could enjoy a painless transition to the full employment goal adopted by socialist finance ministers in November 1998. It would be rather like asking an athlete, by now paunchy and out of training, to do a four-minute mile. It cannot be done.

If there is one thing we have learned about the European economy in recent years it is that growth always disappoints. The single market, despite the optimistic assessments by Padio-Schioppa and others, may be a desirable end in itself, but it is hard to discern that it has had any impact on the underlying growth rate of the eu economy, still less a rise in trend growth, if only temporarily, from 2.5% to 3.5% a year. Nor is emu likely to fare better, as the debate about trying artificially to inject growth into the European economy by fiscal means implicitly recognises.

The most worrying thing, after a long period in which European politicians at least paid lip-service to the need for labour market reform, is that there are governments in power in Europe now which have never really bought the story about the need for greater labour market flexibility, let alone increased mobility. Their belief, more or less, is that Europe's unemployment problem is a result of lack of demand, and that governments can make up for that lack of demand. Europe, in other words, has too little public spending, not too much. The difference now is that the irresistible force of governments wanting to indulge in expansionary fiscal policies will meet the immovable object of an ecb determined to bear down on inflation, and prepared to put up interest rates if it believes governments are behaving irresponsibly and threatening the terms of the Stability and Growth Pact.

In conclusion, for all the reasons outlined in this book, it seems highly unlikely that we will see significantly greater geographical mobility of labour in Europe, or indeed that such mobility will be sought as a goal of policy. There are serious doubts that the hot banana at the core of Europe will in fact be that hot, or that it will expand beyond the core to become, perhaps, a hot marrow. The new economic geography, which suggests that such an outward spread of activity will take place, says nothing that the old economic geography did not. Without wage flexibility capital will not be geographically mobile enough to compensate for an absence of geographical labour mobility. It is hard, particularly now, to be optimistic about either wage flexibility or more general labour market flexibility in Europe, or to believe that, beyond a possible short-term growth boost (relative to what would otherwise have been the case), Europe is about to embark on a new, high-growth era. Even if this were the case there would be no guarantee that such growth would be accompanied by lower unemployment. Europe could have high growth owing to large productivity gains but without any reduction in unemployment, that is, a prolonged period of `jobless' growth.

The result is that the pressure will build inexorably for large-scale fiscal transfers from the centre, for a beefed-up European budget, albeit one, initially at least, that operates on a co-ordinated basis, rather than as a centralised, Brussels-run eu finance ministry. Resource transfers will occur, but they will not solve the underlying problem, namely that European labour markets do not have the characteristics necessary for the achievement of a successful monetary union. Resource transfers and higher public expenditure generally will mean, as sure as night follows day, higher taxes, which Europe needs like a hole in the head. Benjamin Franklin said that nothing is certain in life except death and taxes. Nothing is more certain than that a highly taxed, inflexible Europe under monetary union is doomed to eventual failure.
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