Charlemagne. Stability v flexibility

Another sorry chapter in Europe's chronicle of unintended consequences

IN THEIR effort to run caring, efficient societies, European countries combine extensive state intervention in labour and other markets with a strict self-denying ordinance in fiscal and monetary affairs. This combination sounds reasonable. The first sorts of measures embody the kinder, gentler qualities of Europe's "social model"; the second limits financial irresponsibility and should thus safeguard the model's long-term viability.

If only. The reality, as evidence from France and Germany is showing, is that European governments seem to have to choose between fiscal and monetary stability on one side, and reforms to make their economies more flexible on the other. And they often choose to deal with the public finances first. As a result, their overall reform effort is weaker than it should be.

It might seem odd that one kind of reform should be easier to carry out than the other. After all, they should be mutually reinforcing. All reform creates winners and losers. By muting its distributional impact, fiscal policy can make the medicine more palatable. Once reform has begun to work, it should increase potential growth, stabilising the public finances again.

This is roughly what has happened in countries that have faced a crisis in which everything went wrong at once--such as Sweden in the early 1990s. But in other cases, fiscal measures and broader reforms have not gone hand in hand: indeed, they have often been inversely related. You can have the first without the second, as in eastern European countries after the fall of communism. In western Europe it is more common to have fiscal (and monetary) stabilisation without reforms to improve flexibility, as in Germany and, fitfully, Italy. What you cannot have, it seems, is both.

Each spring, the Centre for European Reform in London publishes a "scorecard" assessing what EU countries have done to implement the Lisbon agenda of reforms--everything from innovation to liberalising services to labour-market flexibility. Year after year, countries that have done the most to stabilise their public finances do worst on the reform scorecard (this year, they include Poland, Italy and Portugal); whereas countries that do best on the scorecard have done little on the macroeconomic front (admittedly, this may be because their fiscal deficits are under control to begin with).

It is rather as if in Europe there is only a fixed lump of reform to go round. If governments invest time and trouble on improving the public finances, they give up on other reforms. This is damaging. Since countries in the euro can no longer deploy macroeconomic policy to offset the pain of other measures, it drives up the overall cost of reform. As a result, there are fewer reforms than there might be, economies work less efficiently--and it is harder to keep the public finances in order.

But there is more to it even than this. European governments do not just face a difficult choice: they are actively pushed towards favouring macroeconomic stabilisation against structural change to increase flexibility.

Consider the cases of France and Germany. The French prime minister has tried to push through a relatively minor labour-market reform--and his entire position is under threat. Germany's grand coalition, by contrast, is planning what may be the biggest fiscal belt-tightening in decades--and it has just won a round of state elections. Europeans' response to reform seem to be the mirror image of Americans'. In the United States, there is no big opposition to labour-market change, but politicians who propose to raise taxes have a death wish. In Europe, labour reform appears all but impossible, but there is barely a peep of protest against even quite big tax rises.

Why should one sort of reform be politically harder than the other? Partly, because structural, supply-side reforms affect fundamental conditions of life, such as job contracts or pensions, so any planned change is likely to be resisted. Moreover, piecemeal reform that puts the burden of adjustment on particular groups can seem especially unfair. Last year the French government introduced a new labour contract similar to the one that has caused all the protests, for companies with fewer than 20 employees. Employees of small firms were not seen as a group (nor are they organised or powerful), so the change did not run into much opposition (though it is now). But young people are a group that could claim to be singled out by the new contract for those under 26.

Instability and lack of reform pact

The rules of the game make it especially hard for euro members to use macroeconomic policy to support other reforms. Fiscal policy is supposedly constrained by the stability pact, which sets a ceiling on budget deficits of 3% of GDP. Members of the euro have no independent monetary policy: interest rates are set by the European Central Bank. Even if there were a case for easing rates to facilitate reform in one country (say, France), that would be outweighed by the needs of others in the block. Economists also know that the key determinant of success in a single-currency area is economic flexibility. But countries that want to join the euro have to meet targets for macroeconomic stability, not improve their flexibility.

Such problems, argues Jean Pisani-Ferry of Bruegel, a think-tank in Brussels, are rooted in the design of policymaking in Europe. Each policy instrument has been assigned a specific responsibility. Price stability is the preserve of monetary policy; orderly public finances are for budget policy; structural reforms are desirable to boost growth. It is all neat and tidy. It also makes clear who is responsible for what--vital in a Europe where national governments, the European Central Bank and the European Commission could easily collide. But it can also sever the links between policy areas, and make it harder for countries to pursue all necessary reforms at once.

Commentary feature says that European countries seem incapable of carrying out all the types of economic reforms needed.

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