A quarterly magazine of the IMF

September 2006, Volume 43, Number 3

Reform in Europe: What Went Right?
Anthony Annett

Successful reformers can offer valuable lessons for the rest of the EU

Acloud hangs over continental Europe's future. Its economic and social models, reflecting a penchant for egalitarianism and social solidarity, are increasingly under pressure. Notwithstanding progress on reform, unemployment remains persistently high, and per capita income has been stuck at about three-fourths of the U.S. level since the mid-1970s. More recently, productivity also suffered a protracted slowdown, as countries found it difficult to adapt to ongoing technological change and globalization. The upshot is sluggish growth, with limited prospects for improvement in light of the impending onset of population aging. In the unfolding debate, many point the finger at Europe's welfare states, arguing that high levels of taxes and transfers hurt employment, while underlying rigidities hinder an effective reallocation of resources. Nobody denies that some kind of reform is necessary, but there is no consensus on what to do.

So how should these countries approach reform? And to become more efficient and prosperous, will they need to abandon their comfortable social models? In an effort to answer these questions, the IMF analyzed the reform strategies pursued by four countries—Denmark, Ireland, the Netherlands, and the United Kingdom (U.K.)—that have succeeded in reducing unemployment and stimulating output growth over the past two decades despite their widely differing economic conditions. Although they had diverse starting points and in many regards followed different paths, what binds these countries together is that they all adopted winning combinations of fiscal adjustment and labor and product market reform.

Crisis and reform

By the start of the 1980s, these countries faced severe macroeconomic crises in the face of persistent policy errors and a global downturn. Symptoms included declines in real GDP, rapid inflation, rising unemployment (reaching more than 16 percent in Ireland), dwindling international competitiveness, and mushrooming social expenditures. Wages spiraled out of control in some countries, with the wage share of GDP in the Netherlands hitting 95 percent, and belligerent unions in the U.K. winning large wage increases despite slow growth in labor productivity. Not surprisingly, public finances also deteriorated, with large fiscal deficits emerging in Denmark (8!/2 percent of GDP), Ireland (13 percent), and the Netherlands (6 percent).

Policymakers responded by using combinations of labor market, product market, and fiscal reforms that complemented and reinforced each other, and all but Denmark set the stage for long-term cutbacks in the government's economic role (see table).

Labor market reform. The cornerstone of the reforms was a desire to moderate wage rates and expand employment. Based on a model in which unions and employers bargain over wages, wage moderation can be interpreted as a structural change in unions' approach to wage bargaining. Several factors can cause such a change: shifts in the attitudes of unions and workers, with a greater emphasis on the numbers of jobs than on the size of pay packets; lower labor taxation, allowing workers to accept lower gross wages for the same net wage; a reform of unemployment benefits; or a reduction in government employment or government wages, given that government employment is an alternative to private sector employment.

In the Netherlands and Ireland, wage moderation was abetted by coordinated agreements between governments, employers, and labor unions. The U.K. program focused on progressively reducing the power of the unions throughout the 1980s, and Denmark also adopted a confrontational approach to unions. Some have argued that a cooperative approach would not have succeeded in the U.K. because its union structure was too decentralized. But the same could have been said about Ireland. Perhaps the large size of the U.K., including a high degree of ideological polarization, played a greater role in hindering the emergence of a consensus-based approach.

To boost labor supply, the case study countries also undertook a variety of institutional reforms. Despite vastly different starting points and preferences, they reduced taxes on labor to some extent, bucking the trend in Europe at the time. In Ireland and the Netherlands, this step was a core component of the coordinated agreements and was intended to compensate for wage moderation. To varying degrees, these countries also engaged in welfare reform, cutting the level or duration of benefits and imposing stronger eligibility requirements (especially Denmark, the Netherlands, and the United Kingdom). Some expanded the use of active labor market policies—such as employment subsidies, labor market training, and measures to promote jobs for disabled workers and youth—and some reduced employment protection. But especially by European standards, these countries (particularly Ireland and the United Kingdom) tended to have relatively unrestricted labor markets with little recourse to employment protection legislation.

Product market reform. Another key area of reform, favored by all four countries, was enacting less stringent product market regulation than the average among European Union (EU) countries—a step that has been shown to spur liberalization in the labor market by freeing up competition and easing the entry of new firms into the market. According to OECD indices, these countries are all among the most deregulated in Europe despite diverging preferences pertaining to the role of government in other areas.

Fiscal policy reform. In tandem with the shifts in labor supply, the four countries undertook extensive fiscal adjustments. The fiscal turnaround in Denmark, Ireland, and the Netherlands, in particular, is impressive (see Chart 1). The most successful episodes of fiscal adjustment tended to be expenditure-based. In Ireland, whose stabilization program included a freeze on the public sector wage bill, public employment fell by more than 10 percent in two years. The Netherlands held down the government wage bill by containing both salaries and employment, cutting social benefits, and freezing the nominal minimum wage. The mid-1990s adjustments in Denmark and the U.K. were also expenditure-based, with government transfers dwindling in both countries and government wages declining in the latter. Taking a longer-term perspective, three of the countries (Ireland, the Netherlands, and the U.K.) reduced their expenditure and revenue ratios substantially over two decades—this went against the grain in the EU at this time. Denmark's initial expenditure consolidation was reversed until a second adjustment phase took off in the mid-1990s.

Another lesson is the difficulty of basing fiscal consolidation on labor tax increases. Although Denmark cut spending substantially during its first adjustment episode in the early 1980s, its equal reliance on labor tax increases eventually led to wage pressures in 1987 and an end to the accompanying growth boom. Similarly, in Ireland, an early 1980s consolidation episode based prominently on labor taxes was not successful. But reducing expenditures (especially transfers and government wages) and labor taxes simultaneously actually reinforced the wage moderation strategy that underpinned the outward shift in labor supply.

In all cases, growth accelerated in the wake of the reforms. The countries also enjoyed employment booms, especially Ireland and the Netherlands, which benefited from catch-up in participation rates (see Chart 2). Because they began with higher participation rates, employment growth in Denmark and the U.K. was less sharp. But all four countries scored solid successes in increasing their employment–labor force ratios over a two-decade horizon and, as a result, now have four of the five lowest unemployment rates in the EU15.

Political economy of reform

Why did reform occur in some countries and not others? And why did they continue reforming over long periods of time? Certainly, these countries had their backs to the wall, as real GDP contracted for two consecutive years in Denmark, the Netherlands, and the U.K., and debt dynamics were clearly out of control in Ireland. But, although the reforms were initially in response to crises, their continuation depended on favorable macroeconomic circumstances and the muting of potential opposition. The initial successes heralded strong growth and provided the political space for the reforms to continue. Policymakers overcame the well-known obstacles to reform by staying committed to a consistent and mutually reinforcing set of policies on both labor supply and fiscal management. Success also depended on allowing different groups to buy into the reform process, as evidenced by the trade-off between slow wage growth and tax cuts in Ireland and the Netherlands, and the Danish policy of guaranteeing high unemployment benefits in the face of tougher requirements and a flexible labor market. As a result, all types of government—single-party, coalition, majority, and minority—were able to start and sustain the reform engine.

In all cases, the reforms were launched by a new government in a decisive break with the past. But the governments tended to win reelection following the reforms. In Denmark, the government was forced to call elections following a budgetary defeat in 1984, when the opposition parties refused to back cuts in benefits. But after an election victory, it continued the adjustment program. The Irish, Dutch, and U.K. governments also secured reelection. Interestingly, once a reform program succeeded, it tended to be emulated by future governments, even those of a different ideological hue.

The social fallout

What happened on the social front as a result of the reforms? Countries like Denmark and the Netherlands have consistently outperformed when it comes to indicators like inequality and poverty (see Chart 3). Gini coefficients, which measure the degree of inequality in terms of household disposable income, show Denmark as the most equal country in Europe, with the Netherlands not far behind. Although the U.K. and Ireland are located at the other end of the scale, they still score better than Southern EU countries. Poverty rates display a broadly similar pattern.

While the outcome is mixed, the reform experience shows that social cohesion need not necessarily be sacrificed. Denmark and the Netherlands remained in favorable positions after their reforms. While inequality nudged up in the U.K. over the period in question, it declined a little in Ireland. And although poverty rates increased in three of the four countries (except Denmark), the relative positions were again broadly unchanged.

But social problems persist in all of these countries, even the most equitable ones. Poverty rates remain elevated in Ireland and the U.K. And, despite the success of reforms, labor inactivity is still pervasive in some countries—the cost of disability leave is about 4 percent of GDP in both the Netherlands and Denmark. Denmark has also had a hard time integrating immigrants, whose jobless rates are much higher than those of native-born Danes. The U.K. has particular problems with the coexistence of unemployment and poverty among jobless households: 17 percent of households had no adult working by the late 1990s.

Thoughts for policymakers

There is no single recipe for success. Responding to different circumstances and challenges, countries adopted different reform programs. Nonetheless, a number of common threads weave through the experiences of the successful reformers: they undertook both expenditure-based fiscal adjustment alongside policies to boost labor supply, and they favored relatively deregulated product and labor markets. Looking at a broader sample of reformers, using event studies and econometric analysis, points in the same direction—wage moderation is associated with reductions in expenditure (especially transfers and government wages) and lower labor taxation, and is more successful at creating jobs when product and labor markets are flexible.

How can present-day policymakers emulate the success of these early reformers? A starting point would be to follow a set of basic guidelines:

Make policies internally consistent. The countries that did best adopted a mix of labor market, fiscal, and product market reforms that complemented and reinforced each other. Cutting government spending and reducing labor taxes increased the labor supply and supported prudent wage setting. Relatively free product and labor markets allowed labor supply reforms to translate into more jobs rather than higher rents. In turn, job growth generated further revenue, which paved the way for further tax cuts and continued wage moderation—a virtuous cycle.

Pursue consistent policies. Once reforms are started, keep backtracking to a minimum. In the most successful cases, the same mix of fiscal and labor market policies continued unabated over two decades, and the principle of boosting labor supply through moderating wage demands became entrenched.

Up-front fiscal adjustment adds credibility. Aside from providing macroeconomic stability, fiscal adjustment can create space for labor market reforms by laying the groundwork for labor supply increases and making the adoption of complementary tax cuts credible.

Coordination and competition can both succeed. The experiences of Ireland and the Netherlands show that a consensus-based approach, trading outright wage moderation for fiscal probity and tax cuts, can be highly successful both politically and economically. But this approach may work best only in smaller countries. The U.K. successfully used an approach based on competition, curbing the power of unions and rewarding workers with tax cuts. But, as noted, inequality rose in the U.K. but not in those countries that relied on coordination and social partnership.

Neutralize the opposition. The different parties and vested interests must be given a stake in the process by using, for example, labor tax cuts to reward responsible wage-setting behavior by unions.

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One final word: it took dire economic circumstances to launch the reform programs in the most successful countries. Although these conditions—typically two consecutive years of falling output—do not exist in Europe today, the level of unemployment in those countries that have not engaged in sustained reforms does not differ much from that seen in the crisis countries at that time. This, plus the imminent onset of population aging—with its adverse implications for labor utilization, potential growth, and fiscal policy—ought to provide the needed urgency for new reform efforts.