Reform in Europe: What Went Right?

• Author: Anthony Annett
• Position: Senior Economist in the IMF's European Department

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).

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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...