Commission of the European Communities

1997 Annual Economic Report

Brussels, 12.02.1997

COM(97) 27 final

Chapter 2: Key structural challenges facing the Community

2.1. Technological progress

2.2. Globalisation

2.2.1. Trade

2.2.2. Foreign direct investment

2.2.3 Financial capital movements

2.2.4. Economic implications

2.3. Competitiveness

2.4. Capital-labour substitution and employment growth

2.4.1. Substitution of labour by capital

2.4.2. Substitution and wage developments

2.5. Policy implications

Chapter 2: Key structural challenges facing the Community

The unsatisfactory performance of the Community economy during the first half of the 1990s has sparked new concerns about the effects of certain long-term structural trends affecting the Community. One is the emergence of new technological advances which, it is often felt, not only tend to be skill-biased but also labour-saving, reducing the demand even for skilled workers. Another trend is the increased globalisation of the world economy which has given rise to fears that jobs are being siphoned out of the Community by the newly industrialised countries, especially in Southeast Asia, and that under these market forces, low-skilled workers in the Community face either downward pressure on wages or high unemployment. These apprehensions have been exacerbated by the relocation activities of Community-based firms towards emerging newly-industrialised countries.

While these concerns and fears are understandable, they tend to be built upon an erroneous analysis of the economic impact of technological progress and globalisation. These factors have been and will continue to be the key driving forces behind long-term improvements in productivity, growth, employment and living standards in the Community. But in the short run they require sometimes painful adjustments in some sectors of the economy. The achievement of the potentially significant long-term gains of enhanced technological progress, greater globalisation and intensified efforts to improve competitiveness crucially hinges upon the fulfilment of two essential conditions: the inevitable adjustments must occur in a smooth and socially-acceptable manner and economic growth must be sufficiently strong to absorb the resources freed by technological progress and globalisation.

Technological progress

The last three decades have seen the emergence of a new wave of technological advances in important areas such as electronics, computers, telecommunications and bio- and ecotechnologies. Most of these new technologies have ramifications for all sectors of the economy. In particular, information and communication technologies (ICT) are driving the ongoing process of structural change. Their impact on the economy is pervasive. They not only entail rapidly falling costs but they also bring about fundamental modifications in working methods and relations, the organisation of companies and the way in which knowledge is produced and distributed.

In macroeconomic terms, the role of technology in the economy can be assessed by the trend in total factor productivity (TFP) growth. The latter is defined as the proportion of output growth which is not accounted for by increases in inputs of labour and capital, the two most fundamental factors of production. In this sense, improvements in TFP reflect the impact of technological progress, human capital endowments and organisational efficiency incorporated in the economic process. TFP can therefore be interpreted as an indicator of the strength of the endogenous growth forces in the economy.

As shown in Table 11, TFP growth in the Community, as well as among the Community’s main partners, slowed down significantly between 1960-73 and 1974-85. For the Community, this slowdown can to a large extent be explained by three factors: the substantial narrowing of the room to catch-up with the technological leader, the United States; the adverse impact of macroeconomic shocks resulting from large and abrupt changes in relative prices with slow adjustment to the new conditions in the post-1973 era; and the trend decline in the share of investment in GDP in the Community.

During the last decade, despite significant changes in technology, especially in the field of information and communication, there has not been a pronounced rebound in TFP growth from the low rate experienced during the second half of the 1970s and the early 1980s. Nevertheless, since the launching and implementation of the Single Market Programme, the slowdown has been arrested and a slight recovery is even noticeable. The latter essentially reflects a partly cyclical pick-up in TFP growth in the second half of the eighties when buoyant investment characterised the Community economy. Over the last two decades, TFP in the Community grew at a broadly similar pace as in Japan and about twice as fast as in the United States.

The failure of the rapid technological advance to show up in economy-wide TFP growth in the 1980s and 1990s (the so-called "productivity or Solow paradox") may be related largely to insufficient economic growth and, particularly, low investment. Otherexplanations have also been offered, including problems in measuring technological change and productivity, especially in services; the need for complementary organisational investment and institutional changes; shifts in the nature of innovation, with more effort devoted to product differentiation rather than to productivity enhancement or radically new products; and lags for new technologies to ripple through the economy.

None of these explanations puts into doubt, however, that technological progress and the move to a knowledged-based economy are the driving forces behind medium and long run growth of economic activity, productivity and living standards in the Community. Technological progress implies a continued shift in the structure of output and employment, out of agriculture and manufacturing and into services and the new growth areas of communication, bio- and ecotechnologies, health care, leisure, and the environment. In particular, the use of new technologies eliminates certain low-wage, low-productivity jobs of the unskilled and creates jobs that are more productive, high-skill and better paid. Such a transformation process has continuously taken place in the Community since its inception.

As shown in Graph 12, over the last 25 years, employment in agriculture and industry has been on a downward trend. But in contrast with the steady fall in the number of persons employed in agriculture, employment in industry stabilised or even increased at times when macroeconomic growth was relatively strong. The job losses in agriculture and industry have been compensated for by increased employment in the services sector. The latter upward trend was only temporarily interrupted during the 1992/93 recession, partly under the impact of a more competitive environment, for instance in financial services, and due to the cyclical vulnerability of many small and medium-sized enterprises.

Within the manufacturing sector, Graph 13 indicates that employment in the high-technology manufacturing industries in the Community has expanded markedly during the 1980s although these employment gains have been lost during the slow-growth period of the first half of the 1990s. By contrast, low-technology manufacturing industries have seen pronounced and steady job losses since the early 1970s.To reap the full benefits of the new wave of technological progress, it is necessary that four requirements are met.

Firstly, efficient goods and services markets must allow for swift changes in relative prices. In sectors where productivity rises relatively fast under the influence of technological innovation, the opening-up of markets or deregulation, relative prices must fall in order to pass on the productivity gains to the rest of the economy. In this way, relative prices could increase in sectors with below-average productivity growth. Only under this condition will the more labour-intensive sectors be capable of creating profitable jobs. There is evidence that this requirement is relatively well respected in the

Community. Competitive pressures and effective competition policies should ensure that this condition is even better fulfilled in future.

Secondly, the unavoidable sectoral changes must occur smoothly and be socially acceptable. In the Community economy it appears that this condition is fulfilled albeit with some difficulties. Increased professional and geographical mobility as well as a lowering of non-wage labour costs and temporary entry wages targeted at low-skilled workers could help cushion the adjustments resulting from technological progress, globalisation and falling subsidies for ailing sectors and industries.

Thirdly, the move towards a knowledged-based pattern of production of goods and services must be assisted by policies to improve human capital formation in the Community in general and by measures to enhance the employability of the low-skilled in particular (for instance through lower non-wage costs, lower taxes, temporary entry wages, better education and training, etc.)

Fourthly, the production potential created by technological progress and enhanced competition must actually be absorbed by higher economic growth, exceeding the productivity trend. If the resources freed are not put to use, the overall balance between job creation and job destruction will not be sufficiently positive to employ the growing labour force and to reduce unemployment. Deficient economic growth has been the Community’s major problem, underscoring the need to resolutely eliminate the obstacles to macroeconomic growth highlighted in Chapter 1.

Globalisation

Technological progress, competition and globalisation are mutually reinforcing. Globalisation can be defined as the process by which markets and production in different countries are becoming increasingly interdependent due to the dynamics of trade in goods and services and flows of capital and technology. It is not a new phenomenon but the continuation of developments that have been in train for some considerable time. Indeed, a greater integration of the world economy has been actively pursued since the end of the second world war. The well-recognised case for globalisation is that it has played, and will continue to play, a major role in the rise in living standards by improving the allocation of resources and by exerting discipline on economic policies. Since its

inception, the Community has had an important effect on this process. European integration may not only be considered as an integral part of this process, it also adds another dimension. The quest for further integration through inter alia the creation of a customs union, the completion of a single market and the forthcoming economic and monetary union has been accompanied by important institutional developments and a sharing of sovereignty in certain policy areas.

Over the last two decades, globalisation has gained additional momentum. Driven by various powerful forces, the economic links between the industrialised countries have intensified significantly since the mid-1970s. Chief amongst these forces are the impressive reductions in communication and transport costs, the progressive world-wide reduction of barriers to trade (including since the Uruguay Round agricultural products and with the GATS agreement a first liberalisation of services), the continued liberalisation of capital movements and, finally, changes in enterprise organisation and strategy. In addition, hitherto inward-looking developing countries have gradually opened up their markets and have increasingly become integrated in the world economy. The most recent development in this context is the opening of the former state-controlled countries of central and eastern Europe (CCEEs) and the Former Soviet Union (FSU). In the medium to longer run, this trend is bound to accelerate and to encompass a larger, more populated group of countries.

The scale of globalisation can be assessed on the basis of trends in international trade and capital flows.

Trade

During 1950-73, the volume of world trade (in goods and services) increased at an annual rate of nearly 8 per cent, while world GDP rose annually by 5 per cent in volume. In the decade following the abandoning of the fixed exchange rate regime under Bretton Woods and the first oil price shock, the rate of expansion of both world trade and world GDP slowed down substantially.

However, since 1983, the pace of world trade has accelerated again (average annual rate of 5.7 per cent) thereby well outpacing the expansion of world GDP (which rose at only 3.4 per cent per year). Since the beginning of the 1990s, the elasticity of world trade to world GDP has even jumped to above 2 (see Graph 14). As a corollary, the ratio of exports (goods and services) to GDP for the world as a whole has risen considerably. Having doubled between 1950 and 1973 to 16 per cent, it reached almost 25 per cent in 1995.The Community has participated actively and positively in this globalisation process. It has also withstood the increased competitive pressures relatively well. Since the early 1970s, the Community's share in world merchandise exports has shrunk but it remains high at about 24 per cent (excluding intra-EC trade).

To the extent that the drop in its world market share reflects the emergence of new trading partners on the world scene and increased trade integration amongst member countries, this is not a worrying phenomenon. In this respect, it is noteworthy that the bulk of the rise of the share in world trade of the Asian countries came primarily at the expense of the other developing countries.

The Community has a comparatively low share of extra-EC exports directed towards the Asian markets which have been growing quickly and are likely to continue to do so in the foreseeable future. In 1995, Community exports to Asia (including China) represented only 17 per cent of total extra-EC exports against 20 per cent and 44 per cent for the United States and Japan respectively. It should be noted, however, that Community exports to these countries have risen strongly since the late 1980s (see Table 12). Furthermore, the share of Community exports directed towards the CCEEs, which also constitute high-growth markets, is significantly higher than that of the United States and Japan.

However, there is some cause for concern. The Community exhibits a comparatively low degree of specialisation in the strong-demand, high-tech sectors. The share of the high-demand sectors in total extra-EC exports amounted to 30 per cent in 1994 which compares with 39 per cent in the United States and 34 per cent in Japan; the share of the high-tech sectors in total extra-EC exports (in 1993) amounted to 23 per cent against about 37 per cent in the United States and Japan.

One of the most prominent features of the recent globalisation process is the emergence of newly industrialised countries as major suppliers and exporters of internationally traded goods (especially manufactures). Imports from Asian countries to the EC rose dramatically during the last decade, resulting in a sharp increase in their share in extra-EC imports. While imports from Asian countries only accounted for 1.3 per cent of Community GDP in 1995, these countries are increasingly establishing themselves as serious competitors in EC markets. In 1995, they accounted for around 18 per cent of total EC imports from the rest of the world (Table 12).

Table 13 shows that the growth of Asian exports to the Community is not restricted to traditional, low-skilled sectors such as clothing and textiles. High-skilled, capital-intensive sectors such as machinery and transport equipment and high-tech products represent a rising share of Asian exports to the Community. Greater global mobility of financial capital and easier access to technology since the early 1980s have contributed importantly to this trend. Moreover, restricted market access for "sensitive" products (e.g. textiles and clothing, steel and iron) may have encouraged the shift in Asian countries towards a greater specialisation in more sophisticated market segments. As a result, part of the adjustment burden in the EC has been shifted towards sectors in which EC countries have not until very recently faced direct competition from Asian exports.

Growth in Community exports to and imports from other regions in the world have remained roughly in balance. At the same time, the Community’s trade balance against the developing countries has shifted from a deficit of the order of 1 per cent of GDP just after the first oil price shock to a modest surplus at present. On the other hand, trade with the new "emerging" economies of Asia and the CCEEs has been broadly in balance during the last two decades.

Foreign direct investment (FDI)

Direct investment abroad is a normal element in corporate growth strategies that enables a company to exploit its particular strength on a broader scale. From this perspective, FDI outflows to dynamic, fast-growing economies might be an indicator of a competitive edge. It is only when this relocation is not matched with broadly equivalent FDI inflows or when it is accompanied with weak domestic investment that the attractiveness of a country as a production site may be in question. So far, the Community has done fairly well in international competition for direct investment as witnessed by both the strong growth in inflows and its moderate surplus in net FDI flows. It seems that Community location and foreign production are complementary given the strong, albeit declining, correlation between the direction of exports and FDI outflows. Furthermore, there are no signs that the foreign transfer of production is predominantly determined on wage-cost grounds, even if this might be the case for some labour-intensive sectors such as clothing, footwear or toys.

Financial capital movements

Not only have FDI flows risen significantly over the last 20 years, but also international financial capital movements have expanded enormously under the combined impact of financial deregulation and innovation. For instance, cross-border transactions in bonds and equities soared in major industrial countries from less than 10 per cent of GDP in 1980 to between 150 and 250 per cent in 1995. The world-wide volume of foreign exchange trading has also risen very fast, with the daily turnover now amounting to $1500 bn. It should be noted that these transactions primarily concern movements in stocks of financial assests (including government bonds) which have been built up over time and which react instantaneously to even marginal differences in yields.

The liberalisation of financial markets also contributes to a better allocation of resources. Since holdings of financial assets are very sensitive to shifts in sentiment in international financial markets, they exert a strong discipline on exchange rates and economic policy. Ignoring market signals inevitably leads to turbulence on currency and bond markets which in turn -- as shown in Chapter 1 -- constitutes an important obstacle to macroeconomic growth.

Economic implications

There is little evidence that globalisation in itself, and especially increased trade and investment with developing countries, is a major cause of unemployment in the Community. On the contrary, increased trade is a major source of economic growth and rising living standards due to improved allocation of resources.

First of all, it should be borne in mind that the degree of openness of the Community to the world economy is relatively small and broadly similar to that of the United States and Japan. In 1995, the degree of openness in the Community was about 10 per cent, compared with 12 per cent in the United States and 9 per cent in Japan. This implies that the globalisation of trade direcly affects only a limited part of the Community economy.

Secondly, it should be noted that the majority of the EC’s economic links are within the Community and with its major industrial partners. This means that globalisation is primarily taking place between countries with broadly similar economic structures, factor endowments and wage and productivity levels. Hence, the primary impact of international trade and FDI flows on employment creation is within the Triad (i.e. between the Community, the United States and Japan). The intensification of economic links between industrial countries should not be perceived as a disadvantage but rather as a boon for the Community’s prosperity. This has been the motivation for a variety of EC policies, notably the new Market Access Initiative, which seek to maximise the benefits accruing to the Community from globalisation.

Thirdly, the size of the Community’s trade with low-wage economies is still small: extra-EC imports from low-wage countries amount to less than 3 per cent of Community GDP at present and the Community’s trade with these economies is broadly in balance. It is sometimes argued that even a balanced trade account with these countries could involve overall job losses for the Community because imports from low-wage economies tend to have a higher (low-skill) labour-intensity than the Community exports to these countries. However, this argument does not take account of the dynamic effects resulting from a better resource allocation nor of the fact that cheap imports mean an increase in Community real incomes and internal demand. Overall, this trade embodies the exchange of low-skilled work against high-skilled and better paid work.

Fourthly, the extent of outward relocation of certain types of economic activity should not be exaggerated nor is it necessarily undesirable. A job created in the low-wage countries cannot be equated with a job lost in the Community and it cannot be assumed that this foreign production and employment could be relocated to the Community. Rather than displacing Community exports, sales-oriented investment abroad can open up markets and lead to additional exports by competitive Community industries. Community businesses are exploiting these opportunities as can be seen from the Community's continued trade surplus with the CCEEs and the newly industrialised countries of Asia.

Nevertheless, the globalisation of product and financial markets accelerates sectoral change and exerts downward pressures on the wages of low-skilled labour. It also exercises powerful pressures on the Community economy to apply new technologies, to maintain and improve competitiveness, to optimise the allocation of resources and to conduct sound economic policies.

Competitiveness

Technological progress and globalisation puts constant pressure on Member States to maintain and improve their competitive position. Competitiveness is a complex and ambiguous concept that is often confused with other notions, for instance profitability.

At the firm level, the meaning of competitiveness is clear-cut: an enterprise is competitive if it can sell its products at the market price and be profitable in the medium and long term.

At the country level, the notion of competitiveness is less straightforward. For a country, the ultimate policy objective is to improve its citizens’ living standards and well-being. In this context, the external performance of a country is generally considered important because it is a useful indicator of the long-term ability to raise productivity and to turn international economic growth into domestic jobs. In this respect, a country’s competitiveness is often assessed on the basis of trends in its export performance. As shown in Table 16, the Community has experienced a steady, moderate decline in export markets shares since the mid-1980s. As regards the other regions listed in the table, it is noteworthy that Japan also has suffered from continued, marked losses in export market shares whereas the United States (in the second half of the 1980s ) and the Asian economies (since the early 1980s) have enjoyed considerable gains.

The evolution in export market shares can in part be explained by movements in international cost competitiveness (as measured by real effective exchange rates). In this context, Graph 17 reveals that the deterioration in export performance over the last decade in the Community has partly been a consequence of the substantial appreciation of its real effective exchange rate. A negative correlation between the two variables is apparent at the time of the hike in the value of the Community currencies in the mid-1980s and the early 1990s.

Though trends in export performance and cost competitiveness may contain interesting insights, they only shed a partial light on the competitiveness of a country. In macroeconomic terms, and viewed in a medium to long-term perspective, a convenient, comprehensive definition of the notion of competitiveness is as follows: A country is internationally competitive if concurrently:

- its productivity increases at a rate which is similar to or higher than that of its major trading partners with a comparable level of development;

- it maintains external equilibrium in the context of an open free-market economy; and

- it realises a high level of employment.

Table 17 shows that according to this definition the Community’s record is mixed. The Community has had higher labour productivity growth than the United States and, in recent years, Japan while maintaining external equilibrium, but its employment performance is significantly worse than in its two main trading partners.

All industrial countries have been affected by a structural break in apparent labour productivity growth in the wake of the first oil price shock. In the Community, labour productivity has risen at a stable rate of 2 per cent per year on average over the last twenty years, thereby increasing about three times as fast as in the United States. In Japan, which showed the strongest performance over the period 1960-90, labour productivity growth fell dramatically in the first half of the 1990s, to rates well below those experienced in the Community and even the United States. Japan’s recent record reflects labour hoarding during the strong and protracted economic downturn in the early 1990s.

The better labour productivity growth performance of the Community has resulted in a steady catching-up with the productivity level of the United States (see Graph 18). The economy-wide Community productivity level (on a purchasing-power-standard basis) relative to the United States increased from 45 per cent in 1960 to 82 per cent in 1995, still well above the Japanese level despite the latter's leadership in some manufacturing industries. However, over this period, the Community did not succeed in narrowing the gap in living standards with the United States to a similar degree. GDP per head of population relative to the United States increased from 55 per cent in 1960 to only 71 per cent in 1995. This essentially reflects divergent trends in employment rates in both economies (see below). Community output per person employed measured in current prices and exchange rates is now similar to that in the United States but well below the Japanese level. This means that, at prevailing exchange rates, a worker in the Community on average creates a similar amount of economic wealth as a worker in the United States.

Historically, the Community has never experienced real problems concerning the external equilibrium. From 1960 until the late 1980s, the Community's current account was generally broadly balanced or in slight surplus. This good performance is somewhat concealed in Table 17 (which presents period averages) by the short-lived but non-negligible deficits on the Community’s current transactions with the rest of the world at the time of the two oil price shocks. In the wake of the overheating of 1989-90 and German unification, the current account turned temporarily negative but since 1995 the Community has again shown a surplus of the order of ¾ per cent of GDP. Conversely, the United States has run significant current account deficits since the early 1980s whereas Japan has experienced a strong external surplus, reflecting a significant structural excess of national saving over domestic investment.

Compared with its two major trading partners, the Community economy displays dismal employment performance. In the Community, employment was not a major worry until the early 1970s. But since then, apart from the growth period of the second half of the eighties, the rate of job creation has been too slow and below the comparatively modest rise in the labour force. The United States, by contrast, has enjoyed rapid employment growth since the early 1960s, broadly in tandem with a strong increase in the labour force. As a result, the two regions experienced opposite trends in the employment ratio (i.e. employment relative to the working age population). Starting from a level somewhat below that in the Community, the employment rate in the United States rose to around 73 per cent at present whereas it declined to below 60 per cent in the Community.

Capital-labour substitution and employment growth

Substitution of labour by capital

Against the backdrop of rapid technological progress and increased globalisation, constant efforts to maintain and reinforce competitiveness are required. The Community and its two main trading partners have been confronted with similar adjustment problems but the results for the labour market have been strikingly different. A major explanation for the divergent employment trends on both sides of the Atlantic seems to reside in the interplay of labour productivity, capital-labour substitution and growth.

As discussed in the previous section, over the last 35 years the Community has continuously experienced stronger labour productivity growth than its principal trading partner, the United States, and recently even outperformed Japan. However, it appears that almost half of the increase in labour productivity has resulted from substitution of labour by capital.

Labour productivity growth can be decomposed into growth of embodied technological progress (total factor productivity) and capital-labour substitution. Table 18 indicates that in the Community about 3 points of the annual increase in labour productivity of 4½ per cent in the period 1961-73 can be attributed to an increase in total factor productivity and the remainder or 1½ points to the substitution of labour by capital. During the two decades following the first oil price shock, labour productivity rose at a stable annual rateof 2 per cent. Only a little over half of this can be explained by technologicalprogress. Nearly half of labour productivity growth is caused by substitution of labour by capital.

A strikingly different picture is noticeable in the United States. During 1961-73 and 1974-95, the growth in labour productivity was about one third of that in the Community, and capital-labour substitution contributed only a marginal fraction. The US economy has thus been expanding its input of capital and labour broadly in parallel. It is noteworthy that since the mid-1980s the rate of TFP growth in the United States seems to have risen from the very low rate experienced in the previous decade, in part reflecting a strong expansion of investment.

In itself, capital-labour substitution is not a distressing phenomenon. A high degree of capital-labour substitution allows continued high growth in economic activity and living standards. But with a large part of the available labour reserve unemployed, as has been increasingly the case in the Community since the first oil price shock (see Table 18), a twofold problem emerged:

- a lack of adjustment in the labour market compelled enterprises to keep up a strong substitution of labour by capital in order to safeguard their competitiveness through productivity increases;

- macroeconomic growth was insufficiently strong relative to the given and stable labour productivity growth to create an adequate number of jobs.

The potential labour reserve, amounting to about 17 million persons if the average employment rate of the period 1961-73 is taken as a yardstick or to some 26 million if the benchmark is the employment rate in the Scandinanvian countries, the USA and Japan, constitutes an important growth potential. But this implies that adequate policies should be implemented to take advantage of this labour reserve.

Substitution and wage developments

As highlighted above, in the Community substitution of labour by capital explains about half the growth in labour productivity. In the United States, which has had an only slightly weaker pace of technological progress, nearly no macroeconomic substitution has taken place. The question therefore arises of whether it is possible to slow down this substitution process without impairing competitiveness.

A first answer to this question is provided by developments in relative factor prices at the macroeconomic level. Following excessive wage increases in the wake of the two oil price shocks, which laid the ground for the upsurge in unemployment, macroeconomic wage behaviour in the Community has become increasingly appropriate. Since 1982, with the exception of 1990-92, the trend in total wage costs (including social security contributions) per head has kept in line with the fall in inflation. The growth of unit labour costs has remained below increases in the GDP price deflator and the rise in real

wages has stayed about 1 percentage point behind overall labour productivity growth (Graph 20). This evolution has led to a remarkable improvement in the profitability of capital (see Graph 9 in Chapter 1) and constitutes a solid foundation for higher, investment-driven economic growth as demand prospects brighten. As a consequence, appropriate macroeconomic wage developments are important to reduce unemployment through investment-supported growth (in line with the macroeconomic part of the Broad Economic Policy Guidelines). However, econometric analyses suggest that favourable aggregate wage trends slow down the macroeconomic substitution of labour by capital only very gradually.

A faster way to weaken the substitution process is a downward widening of the wage (cost) scale. The market forces acting in this direction are strong and will probably strengthen as a result of globalisation, especially with the opening up of the CCEEs and the Former Soviet Union. In the case of a very dispersed wage structure, economic growth becomes more employment-creating because the wide wage spread enables activities with low productivity to remain and/or to become viable.

During the 1970s and 1980s, in the United States the wage scale for male workers underwent a downward widening of more than 30 per cent. This means that the relatively small increase in average real wages observed in the United States (annual average rate of growth of around ½ per cent during the period 1974-90) was accompanied by a dramatic fall in real wages at the lower end of the earnings distribution. It can be argued that the large degree of wage dispersion in the United States has been the price to pay for high employment. The downward wage flexibility has ensured a closer match between relative wages and the widening of labour productivity differentials (resulting from technological progress and globalisation).

Although this tendency may have tended to weaken somewhat in the United States in recent years, the wage distribution remains very wide and continues to influence the employment-intensity of output growth positively. Furthermore, the United States is implementing policies aimed at more investment, higher productivity growth and higher wages for the unskilled. In this context, evidence suggests that the bulk of the jobs which have been created in recent years in the United States are not low-paid, low-quality jobs but rather they have been concentrated in highly skilled activities. Indeed, 68 per cent of the net growth in full-time employment between 1994-96 was found in job categories paying above-median wages.

Conversely, in the Community, the earnings distribution either remained broadly unchanged or widened only slightly despite the changes in the pattern of labour demand. The exceptions to this general situation have been the United Kingdom and, to a lesser extent, Italy since 1991 (see also Box 3). A major explanation for the discrepancy in the degree of earnings inequality between the United States and the Community are differences in labour market institutions. These differences reside essentially in a much greater reliance on market forces in the United States than in the Community. For example, compared with the Community, minimum wages are low and unemployment benefits and other social transfers are markedly less generous in the United States. Other differences are less widespread collective wage bargaining, a smaller proportion of government employment and less support for education and job training in the United States than in the Community.

For social and political reasons, an emulation of the US-approach is neither feasible nor desirable in the Community as it would mean a dramatic change in the European social model. For instance, the application of the US model to the Community would require a substantial lowering of unemployment compensation and social benefits. This would ceteris paribus imply a widening of the wage structure and generate greater income inequality. It would introduce in the Community the working poor syndrome -- a form of exclusion just as harmful for the social fabric as unemployment.

The above considerations do not mean, however, that some relief should not be sought through pragmatic solutions, in line with the strategy adopted by the Essen European Council aiming at a higher employment-intensity of growth. In particular, the following principles are worth pursuing in this context. The wage agreements of the social partners should provide for more differentiation according to qualifications, between regions and, to some extent, sectors. Non-wage labour costs (or income taxes) at the lower end of the wage scale should be lowered with the government revenue losses being compensated for by a stricter control of increases in overall government spending and/or increases in other taxes (e.g. environmental levies). In a similar vein, temporary entry-wages for the low-skilled, youth or long-term unemployed could usefully be introduced. Such measures should be carefully targeted and gradually phased out. Furthermore, a higher flexibility of working time arrangements, tailored to the specific needs of firms and workers, greater use of voluntary part-time work and the promotion of local employment initiatives are likely to foster both new jobs and higher participation in the labour market.

Hence, the solution to the Community’s unemployment problem must primarily be found through high economic growth, structural reforms and microeconomic flexibility.

Policy implications

Since the early 1960s, unemployment in the Community has risen from around 2¼ per cent of the civilian labour force to about 11 per cent at present. During this period, employment has grown at an average annual rate of barely 0.3 per cent whereas both the activity rate and the employment ratio have been on a downward trend. The result has been that the Community presently displays a large reserve of unused labour. As discussed above, there is little evidence to suggest that the Community’s dismal labour market performance is closely related to technological progress, globalisation and competitiveness.

Nevertheless, the inherent consequences of technological advances and globalisation, viz fierce world-wide competition and far-reaching sectoral change, underscore the urgent need to implement measures to enhance competitiveness on the one hand and to modernise product and labour markets on the other. The policy requirements are those already presented in the White Paper on "Growth, competitiveness and employment" and in successive Broad Economic Policy Guidelines adopted since 1993. Recognizing this urgency, Member States have introduced, sometimes bold, reform programmes aimed at responding positively to the key structural challenges confronting their economies. Efforts should continue and be stepped up, especially in those areas where progress has been less visible or lacking.

In order to safeguard and promote the EC's competitiveness and employment in a world of free trade and evolving technological change it is essential that Member States and the Community, in line with the Broad Guidelines for Economic Policies, intensify their efforts to modernise their markets for goods and services. This involves in the first place the full completion of the European Single Market, the importance of which has clearly been highlighted in the Commission's recent evaluation. According to this study, the Single Market Programme has so far contributed to a rise in the level of GDP of up to 1.5 per cent and created up to 900 000 jobs due to increased trade and competition. Further action is needed to complete the legal framework in areas such as taxation and company law and the liberalisation of the telecom and energy markets. Even more importantly, it is necessary to ensure the effective application and enforcement of existing Community law and reduce the burden of over-regulation, particularly but not exclusively at the national level, which still impedes the operation of the single market. The creation of a flexible

economy also needs enhanced structural reforms in other important areas, including the realisation of the transeuropean transport and communication networks, the promotion of research and development, the promotion of the information society and the removal of barriers to entry and excessive regulation facing SME's. These policies will all strengthen endogenous growth and lead to strong improvements in the overall productivity of the Community economy. Provided the appropriate policy framework is put in place, there need not be any contradiction between sustained, investment-supported growth and the preservation of a healthy environment (see Box 4).

As emphasised in the 1996 Joint Employment Report from the Council and the Commission "Employment and growth in the Community - The way forward" approved by the Dublin European Council, there is a continued need to further improve the responsiveness of Member States' labour markets to changes in the economy through a modernisation of the organisation of work, increased geographical and professional mobility and productivity-related labour cost differentiation. In particular, it is essential to reinforce education and training so that the skills of the workforce are able to adapt to evolving technological and other changes. These efforts are also necessary in order to avoid labour market bottlenecks and a resumption of wage inflation as unemployment comes down. Furthermore, pragmatic solutions to increase the labour-content of growth (see sub-section 2.4.2) should be pursued actively. They not only contribute to increased employment but they also help to cushion the painful adjustment efforts.

Full text of this report is available online: http://www.europa.eu.int/comm/off/rep/index.htm