At the beginning of the 1990s, Western Europe is clearly facing more acute economic problems than are the other major countries of the OECD area. Both the United States and Japan seem to be hesitantly recovering in 1993from their earlier, and relatively modest, slowdowns. Europe, on the other hand, after very slow growth in 199192, is heading into a slump that could well be deeper and more prolonged than the oil-induced recessions of 1975and 198182 (Table 1). Gone is the euphoria that embraced the area in the late 1980s, when the rate of growth of output had (temporarily) surged. Its place has been taken instead by Eurosclerosis, a thesis already fashionable in the early 1980s, according to which the European economy is hopelessly ossified by (inter alia) overblown welfare states and powerful trade unions.

Pervasive Eurogloom should perhaps be qualified. Even if trends over the 1980s and prospects for the 1990s look disappointing in comparative per-spective, they remain very respectable in an absolute sense. Given a growth

Andrea Boltho

Western Europes Economic Stagnation

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in population of less than per cent per annum, average living stan-dards rose by some 20 per cent over the last decade and could rise by a further 10 to 15 per cent in the 1990s. For an area that is already rela-tively rich, that is increasingly sensitive to environmental issues and that exhibits a strong preference for leisure, as shown by the compar-ative shortness of the working year, such increases in per capita incomes would be considered by many as being perfectly sufficient.

There are, however, two problems with this relatively Panglossian view of recent trends. First, slow European growth implies an increase in income inequalities within the OECD area. Figure a presents esti-mates of living standards (measured at purchasing power parity) for Western Europe, the United States and Japan. It will be seen that Europes catch-up on America, rapid in the 1950s and 1960s, stalled in the 1970s and came to a virtual halt more recently. Indeed, during the1980s, Europe was also overtaken by Japan. While relative impover-ishment at the international level must matter much less for welfare than does relative impoverishment within a country, the efforts Brit-ain made in the 1960s to step up its economic performance, as it became aware that living standards had slipped behind those of France or Germany, suggest that policy-makers and public opinion may well display some sensitivity to cross-country income differentials.1

Table I

GDP Growth in the OECD Area(average annual percentage changes)

192938 195373 197379 197989 198995

Western Europea 1.5 4.8 2.4 2.2 1.2United States 0.7 3.3 2.4 2.8 1.9Japan 3.6 9.1 3.6 4.1 3.0

a Excluding Turkey

Sources: A. Maddison, Dynamic Forces in Capitalist Development, Oxford 1991; oecd,Historical Statistics and National Accounts; Oxford Economic Forecasting, World Economic Prospects, spring 1993.

Second, and much more important, slow growth in Europe has led to a massive increase in unemployment which must be contributing to the rise in income inequalities within most countries. Table II illus-trates the magnitude of the problem. From virtual full employment in the 1960s (a state probably never before witnessed in recorded human history), Europe had, by the early 1990s, gone back to rates of unem-ployment reminiscent of, and indeed often above, those of the 1930s. And while European unemployment before the War had peaked by 1933 and declined thereafter, there are no such declines in sight in the first half of the 1990s.

1 The Japanese public was clearly delighted in the 1960s by the countrys regular over-taking of one economy after the other, and a similar spell of well-being seemed to sweep over Italy when, in 1986, living standards surpassed those of Britain, thanks to the inclusion in the national accounts of a hefty proportion of the underground eco-nomy (equivalent to nearly 20 per cent of GDP).

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Interestingly, however, Table II also shows that the areas unemploy-ment experience is not uniform. While virtually all the eec member countries are at present recording double-digit rates of unemployment, the five small non-ec members (Austria, Finland, Norway, Sweden and Switzerland) have, on average, had a much more favourable per-formance, even though their output growth rates have been only very marginally above those of the ec countries.

Table II

Unemployment in the OECD Area(in per cent of the labour force)

193038 195473 197479 198089 199095

Western Europea 7.2 2.7 4.5 8.9 10.2EC 7.2 2.8 4.8 9.6 10.7non-ECb 7.4 1.6 1.8 2.7 5.8

United States 18.2 4.9 6.7 7.2 6.5Japan l. lc 1.3 1.9 2.5 2.2

Note: Data are not strictly comparable across countries and between the pre- and post-war periods.

a Excluding Turkey.b Austria, Finland, Norway, Sweden and Switzerland.c 1930 only.

Sources: A. Maddison, Dynamic Forces in Capitalist Development, Oxford 1991; R. Minami, The Economic Development of Japan, London 1986; OECD, Historical Statistics and Labour Force Statistics; Oxford Economic Forecasting, World Economic Prospects, spring 1993; C. Sorrentino,Methodological and Conceptual Problems in Measuring Unemployment in OECDCountries, mimeo, OECD, Paris, 1976.

The rest of the article examines these two issues more closely. It first surveys the various explanations that have been given for the growth slowdown of the last two decades. It then looks at the rise in unem-ployment and at the reasons for the very different performance withinEurope shown in Table II. The conclusion summarizes the main argu-ments and presents some speculative comments on possible future trends.

The Growth Slowdown

Though the forecasting consensus in the early 1970s was happily pro-jecting growth rates for Western Europe similar to those experienced in the previous two decades,2 with the benefit of hindsight it is apparent that some deceleration was inevitable. A major reason is to be found in the gradual weakening of three factors which had strongly contributed to expansion from the 1950s onwards. First, trade liberalization which had stimulated investment in the manufacturing sector, was bound to slow down after the Common Markets completion in 1968.3 Second,

2 See for example OECD, The Growth of Output 19601980, Paris 1970.3 The demise of the Bretton Woods system may have also contributed. The switch tofloating, by raising exchange-rate uncertainty, is likely to have further reduced invest-ment in the tradeable sector.

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Europes technological gap vis--vis the United States, which had allowed rapid productivity growth at relatively low costs,4 was being gradually closed. Third, Europes abundant supplies of cheap agricul-tural and/or immigrant labour, which had boosted high profits for a number of years,5 were being progressively exhausted or (in the case of immigrants) prevented from entering.

4 A. Maddison, Economic Growth in the West, London 1964.5 C.P. Kindleberger, Europes Postwar Growth, Cambridge, Mass. 1967.

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Figure A

Per Capita GDPs at Purchasing Power Parity(United States = 100)

Sources: OECD, National Accounts; R. Summers and A. Heston, Improved InternationalComparisons of Real Product and its Composition, Review of Income and Wealth, vol. 30,no. 2 (1984).

Figure B

Trade Balances in High-Tech Manufactures (in per cent of GDP; three-year moving averages)

Source: OECD Data Bank.

The disappearance of an elastic labour supply was particularly impor-tant since, by leading to a state of virtual full employment in most countries of north-western Europe, it greatly strengthened the power of labour and of trade unions. Wages began to rise more rapidly than productivity already in the second half of the 1960s and this led, in turn, to a combination of higher inflation and reduced profits in the early 1970s, both messengers of lower growth to come.6

Seen in this light, the oil price explosions of 1974 and 197879 were no more than detonators for something that would have happened anyway. This being said, both their size and their naturea combina-tion of negative demand and supply shocks7significantly amplified what would otherwise have been a gradual trend deceleration. Faced with a concomitant sharp worsening in the terms of trade and a pro-nounced productivity slowdown, wage aspirations did not decline sufficiently in the later 1970s. In a neo-classical view this brought real wages way above market-clearing levels;8 in a more Marxist-oriented view it squeezed profits;9 in both approaches it sharply lowered invest-ment and this effect on demand was compounded by the drop in world trade consequent upon the shift of income from the (relatively) high-consuming oil importers to the low-absorbing OPEC countries.

This familiar story has much to commend itself. Its major difficulty is that it is unable to explain why, nearly twenty years after the first oil shock, Western Europe should still be stagnating. While the growth tempo of the 1960s may be unattainable, little would seem to justify expansion at rates of 2 per cent per annum or less and mounting unemployment. After all, real oil prices, thanks to the 1986 counter-shock, have returned to levels not much above those of 1973, inflation is down to rates not recorded since the early 1960s and profits (at the heart of many of the explanations for slowdown) are now back, in most European countries, at, or even above, their levels of the early 1970s (Table III).

Indeed, the conditions for an endogenous upswing in the early 1990s could seldom have been better. An eclectic view of what makes such spontaneous recoveries possible would probably stress a number of conditions, all of which appear to be more or less present in todays Europe.10 One is the reappearance of a reserve army of unemployed this has been obviously achieved following a decade of rising job-lessness. Indeed, mass unemployment seems also to have shattered earlier wage aspirations and, together with the conservative revolu-tion in politics, to have greatly weakened the power of trade unions.

6 P. Armstrong, A. Glyn and J. Harrison, Capitalism Since 1945, Oxford 1991. C.L.Schultze, Real Wates, Real Wage Aspirations, and Unemployment in Europe, in R.Z. Lawrence and C.L. Schultze, eds, Barriers to European Growth, Brookings Institu-tion, Washington, dc 1987.7 M. Bruno, Stagflation in the ec Countries 197381: A Cross-Sectional View, in M. Emerson, ed., Europes Stagflation, Oxford 1984.8 M. Bruno and J. Sachs, Economics of Worldwide Stagflation, Cambridge, Mass. 1985.9 A. Glyn, A. Hughes, A. Lipietz and A. Singh, The Rise and Fall of the Golden Age,in S. Marglin and J. Schor, eds, The Golden Age of Capitalism, Oxford 1990. 10 A. Boltho, Is Western Europe Caught in an Expectations Trap?, Lloyds Bank Review 148, April 1983.

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Table III

Selected Indicators of European Profitability (percentages)

Whole Economy Business Sector Industry, Transport andCommunications

Capital sharea Profit shareb Gross operating surplusc, d

196061 26.0 28.4 (40.0)e

196869 27.0 27.4 36.4

197273 26.2 25.0 34.1

197879 25.4 22.6 33.9

198889 28.2 27.3f 39.0

a Total ec; adjusted for the share of self-employment in the labour force.b France, Germany, Italy and United Kingdom.c Germany, Italy and United Kingdom.d In per cent of value added.e 1960.f 1987.

Sources: P. Armstrong, A. Glyn and J. Harrison, Capitalism Since 1945, Oxford 1991; EEC, European Economy, May 1992; OECD, Historical Statistics.

Second is the accumulation of a backlog of unexploited innovationsby all accounts, technological progress appears to have been rapid in the past decade or so. Third would come the retirement of significant segments of the capital stock, so as to generate potential demand for new investmenthere again a long period of sluggish growth has clearly lowered capital accumulation, while significant relative price shifts must have further hastened the scrapping of equipment.

Finally, one may also need the emergence of Schumpeterian entrepre-neurs, ready to venture into risky projects by seizing the opportunities provided by ongoing technical progress, scarce capital and abundant labour. Such a condition is clearly more elusive and the presence (or absence) of such a breed of businessmen can hardly be ascertained. All that can be said, however, is that the deregulation of many important sectors (witness, in particular, the 1992 Single European Market programme), combined with the technologically led move-ment towards smaller-scale firms must, at the very least, have encour-aged entrepreneurship.

It could be argued, of course, that precisely such an autonomous recovery did take place in Western Europe in the later 1980s. After all, output growth between 1985 and 1990 was above 3 per cent per annum and unemployment in the area as a whole declined by 2 per-centage points. Unfortunately, however, closer examination suggests that there was little that was spontaneous, or endogenous, about that episode. The initial trigger for faster growth in Europe (and elsewhere) came from the counter-oil shock of 1986 which, in symmetric fashion to the earlier shocks, boosted output and lowered inflation. Its effects were then compounded in the EC by the anticipated impact of the 1992 project which led to an investment upswing by companies eager to position themselves in the new and much more open common

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market.11 Thirdly, the collapse of communism may also have gener-ated greater business optimism.

In addition, booms in two countries strongly contributed to Europes short-lived prosperity of the time. Between 1985 and 1988 Britain grew by over 4 per cent per annum, largely in the wake of expansion-ary policies and the intoxicating effects of financial deregulation. And between 1988 and 1990, it was West Germanys turn to expand at an annual rate of some 4 per cent, under the influence of a massive fiscal boost following union with the East. Elsewhere (with the exception of Spain which benefited from having joined the EC), growth remained more subdued and was, in any case, strongly helped by the surges in British and German import demand.12

Exogenous shocks and once-and-for-all policy changes seem thus to have been largely responsible for this brief interlude. In their absence, growth might have decelerated further from the modest tempos of the early 1980s, the more so as the United States economy was slowingdown and the dollar was falling rapidly. Hence some explanation for the persistent weakness of the European economy still seems necessary.

One possible reason could be found in Europes lack of international competitiveness, often bemoaned by many observers. Evidence onthis is mixed. Europes real exchange rate appreciated only very slightly vis--vis the dollar and the yen between 1973 and 1979, and remained virtually stable in the decade to 1989 (having, of course, fallen sharply in the first half of the 1980s and risen thereafter, in response to the gyrations of the dollar). Prima facie, such trends do not seem alarming, nor do those of the current account which remained in broad balance throughout the 1980s.

Two reasons, however, suggest some caution. First, the real exchange-rate data do not cover relations with the East Asian NICs, whose currencies probably depreciated vis--vis those of Europe in the 1980s. Second, an examination of the four major countries import and export income elasticities suggests that the former are, on average, somewhat larger than the latter (indeed, in the more recent estimates, this gap has grown significantly).13 This in turn would mean that, to secure rough trade equilibrium in the absence of further slowdowns in growth, Europe may need regular depreciations. Some lack of com-petitiveness is also suggested by absolute figures of hourly labour costs

11 EC, European Economy 38, November 1988.12 The volume of British imports rose by 30 per cent between 1985 and 1988, and thatof German imports by 20 per cent between 1988 and 1990.13 For the four countries the mean values of comparable estimatesas given by Gold-stein and Kahn, Income and Price Effects in Foreign Trade, in R.W. Jones and P.B.Kenen, eds, Handbook of International Economics, vol. ii, Amsterdam 1985; P. Krugman,Differences in Income Elasticities and Trends in Real Exchange Rates, European Eco-nomic Review, vol. 33, no. 5 (1989); and W.R. Cline, American Trade Adjustment: TheGlobal Impact, Institute for International Economics, Washington, DC 1989are of 1.7and 1.9 for the export and import income elasticities respectively. Goldstein and Kahn,however, provide a number of rather old estimates based on data for the 1950s and 1960s. Averaging only the values given in the two more recent sources results in anincome elasticity of 2.0 for exports and 2.7 for imports.

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in manufacturing (which show Europe as much more expensive than North America or Japan, let alone the NICs),14 or by trends in the trade balance for high-tech products (Figure B) in which Europe has moved from earlier surpluses to present deficits.

More important, however, in explaining Europes growth problems has almost certainly been the stance of economic policy. While between the first and the second oil shocks, fiscal policy was used in a deliberate counter-cyclical way, the opposite was the case after 1979(Table IV). And not only were structural budget deficits reduced, but monetary policy also moved into a sharply restrictive direction as real interest rates rose to unprecedentedly high levels in the wake of developments in the United States.15 This prolonged combination of tight money and tight budgets, by depressing demand, interacted withbusiness expectations, thus reinforcing the tendency to stagnation.

Table IV

Indicators of Policy Stance in the OECD Area

Fiscal Policy Monetary Policy Structural budget Real long-term interest

deficitsa ratesb

1972 1978 1988 1972 1978 198873 79 89 73 79 89

Western Europec 1.2 5.0 2.7 0.6 1.0 4.3United States 0.3 0.9 2.9 0.8 0.6 4.3Japan 0.8 5.5 1.8 2.2 2.9 3.5

a In per cent of GDP at current prices.b Government bond yields deflated by GDP deflator.c Excluding Turkey.

Sources: IMF, International Financial Statistics Yearbook; R.W.R. Price and P. Muller,Structural Budget Indicators and the Interpretation of Fiscal Policy Stance for OECDEconomies, OECD Economic Studies 3, autumn 1984; OECD, Data Bank.

The reasons for restrictive policies through most of the 1980s are to be mainly found in either continuing high inflation, particularly in some of the countries linked together by the European Monetary System, or in fears that inflation might reaccelerate, despite high unemployment, should policies be relaxed. The desire to reduce public indebtedness, but also to curb what were seen as the excesses of the welfare state, played a role as well. An additional restrictive influence emerged at the beginning of the 1990s. The acceleration in German inflation, con-sequent upon the late 1980s mini-boom, further raised German, and therefore pan-European interest rates.

14 United States Department of Labor estimates of the 1992 hourly labour cost in manufacturing show figures of $20.4 for Europe, $16.2 for both the United States and Japan and $4.80 for the four Asian NICs.15 The reasons for the high real long-term interest rates that have prevailed since the early 1980s go beyond tight monetary policies and encompass institutional as well as demographic changes.

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While this factor may be expected to wane as German inflation declines again, fiscal policies are if anything likely to get tighter vir-tually everywhere in Europe despite the present slowdown. The Maas-tricht Treaty, which paves the way to an eventual monetary union, requires a certain number of conditions to be fulfilled for accession and, in particular, that the ratios of countries budget deficits and gross public debts to GDP be reduced to 3 and 60 per cent respectively by the end of the decade. In 1992 only France (and Luxembourg) were able to meet this requirement. In 1993, not even France will be able tokeep its budget deficit below 3 per cent of gdp.

While the virtual breakdown of the European Monetary System sug-gests that monetary union by 1999 is no longer on the cards, virtually all the ec member countries (and also the new efta applicants) still seem committed to fulfilling the Treatys obligationsa commitment that is thus bound to entail continuing fiscal restraint. For some countries (in particular Italy, Belgium and Ireland, but possibly alsoGermany in view of the costs of unification) this restraint may well have to stretch until the end of the century or even beyond, implying that, on present policies, the unemployment outlook can only worsen.

The Unemployment Experience

A much diminished growth in output, combined with a continuing expansion of the labour force and positive productivity growth, ledWestern Europe, and especially the ec countries, into massively higherunemployment. As already mentioned, there are two important fea-tures to this unemployment experience. The first is its persistence across so many countries, a persistence reminiscent, if in an aggra-vated form, of the experience of the Great Depression. The second is the very marked difference in performance within Europe between the ec and the non-ec countries.

Persistence, in the ec, is unlikely to have been caused by continuing negative shocks to output growth or by changes in preferences towardsleisure. A much more plausible explanation focuses on a failure of thelabour market to work properly so that a return to market clearing equilibrium is prevented or significantly retarded.16 That such struc-tural changes in how the labour market operates are likely to have occurred is vividly illlustrated in Figures c and d by the pronounced outward shifts in the ecs Phillips and Beveridge curves between the 1960s and the 1980s (and the near absence of such movements in the non-ec countries).17 The shift in the Phillips curve suggests that the costs of disinflation have increased sharply in the ec; the shift in the unemploymentvacancies relationship that the ecs labour market now works much less efficiently.

The traditional, Eurosclerosis, explanation for such changes involves variables such as greater trade-union strength and/or more generous

16 G. Alogoskoufis and A. Manning, On the Persistence of Unemployment, EconomicPolicy 6, October 1988.17 C.R. Bean, European Unemployment: A Survey, LSE Centre for Economic Perform-ance Discussion Paper 71, 1992.

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unemployment benefits, both of which would raise wages above equi-librium levels. The problem with such explanations is that they are hardly consistent with the facts of the 1980s. Trade-union push, be it measured by the share of employees affiliated to unions or by the inci-dence of strikes, has declined markedly in most EC economies during the decade. Similarly, while the generosity of unemployment benefit systems did increase in a number of countries in the 1970s, the 1980s saw either retrenchment or no change, suggesting that the contribution of such schemes to persistence can only have been very small at best.

Figure C

West European Phillips Curves: 196069 and 198089

EC CountriesInflation (per cent)

Unemployment (per cent)Non-EC CountriesInflation (per cent)

Unemployment (per cent)

Sources: EC, European Economy; OECD, Economic Outlook, Labour Force Statistics and Main Economic Indicators.

Equally inconclusive are approaches that stress increasing rigidities (e.g. greater worker immobility, more constraining legislation on firms freedom to manage the work force), or increasing mismatchesbetween the supply of, and the demand for, labour (due, for instance, to more rapid technological progress and structural changes). Here too, the available research suggests that these factors are hardly important. Rigidities are more usually a function of rising unemploy-ment rather than the opposite,18 while mismatch, on the limited evi-dence available, does not seem to have increased markedly in the late 1970s or early 1980s.19

In any case, none of these hypotheses is able to discriminate between the EC and the non-EC countries, given that the latter, with the excep-tion of Switzerland, have traditionally had strong trade unions, have relatively generous unemployment benefits (though it is true that the duration of such benefits is usually shorter),20 suffer from similar institutional rigidities in the labour market and are, presumably, sub-ject to similar technological and structural changes.

Explanations have thus increasingly concentrated on the idea that market clearing may not occur, or may occur only extremely slowly, asunemployment feeds on itself rather than laying the foundations for its own absorption via a lowering of wage claims. The hysteresis con-cept advanced in this context takes several variants which stress both the labour market and capital formation. For the latter, the idea is that the sharp fall in investment which has occurred in the 1980s (Figure E) has reduced the capital stock to a level which is now insuf-ficient to employ all the labour force. This is indirectly suggested by the relationship between capacity utilization and unemploymentwhile the latter has increased massively, the former has remained vir-tually unchanged between the peak of the early 1970s and that of the late 1980s.21

To be valid, such an argument has to rely either on an extremely low substitutability between capital and labour or on a lack of real-wageresponses to mounting unemployment. The former hypothesis may be true for some areas of manufacturing, but is unlikely to hold in most services. The latter receives greater confirmation by estimates of real-wage rigidity. In a survey of the fairly abundant evidence on this issue, the conclusion is reached that: The responsiveness of wages to unemployment is markedly lower in . . . the European Community than in . . . Austria, Switzerland and the Nordic countries.22

The reasons for such low wage responsiveness could be provided by

18 R.J. Flanagan, Labor Market Behavior and European Economic Growth, in R.Z.Lawrence and C.L. Schultze, eds, Barriers to European Growth.19 R. Jackman and S. Roper, Structural Unemployment, Oxford Bulletin of Economics and Statistics, vol. 49, no. 1, February 1987.20 M. Burda, Wait Unemployment in Europe, Economic Policy 7, October 1988.21 C.R. Bean, European Unemployment: A Survey. Capacity utilization in manufac-turing in the ec was at virtually identical levels in 197273 and 198889 (84.4 and 84.8 per cent respectively), yet unemployment between these two dates had gone from3.1 per cent of the labour force to 9.5 per cent.22 Ibid., p. 54.

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two further interpretations of hysteresis that focus on the labour market. In one strand of the literature, the stress is on the power of insiders, or fully employed workers, who ignore the problems of outsiders (the unemployed) when conducting wage negotiations. Hence unemployment bears no influence on inflation. Any negative

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Figure D

West European Beveridge Curves: 196069 and 1980-89

EC Countries

Vacancies (per cent)Unemployment (per cent)

Non-EC Countries

Vacancies (per cent)

Unemployment (per cent)

Sources: EC, European Economy; OECD, Economic Outlook, Labour Force Statistics and MainEconomic Indicators.

shock merely increases the pool of the unemployed without affecting the power of the insiders, while any positive shock is preempted by their wage increases. In this extreme form, the thesis is clearly unwar-ranted since employers are bound to take into account the presence ofcheaper outside labour. In a milder form, however, there may well be some (increasing) truth to itas production becomes gradually more complex, the value of on-the-job-training must also rise, thus confer-ring increased power to the permanent work force at the expense of outsiders whose skills and efficiency are unknown to employers.

The other strand puts the emphasis on the weakness of outsiders. On the one hand, prolonged unemployment discourages efforts to search for work and leads to skill erosion. On the other hand, and more importantly, employers discriminate against workers who they see as having been unemployed for a prolonged period of time. The macro-economic outcome is the same. Large segments of the unemployed labour force are disenfranchised, i.e. have little or no impact on wage negotiations. Increases in demand thus quickly lead to rising inflation, once the small margin of Keynesian unemployment is absorbed, thus justifying the restrictive macroeconomic stances of governments.

These various strands combine in creating an almost insoluble conun-drum: Hysteresis imposes an especially nasty choice on policy-makers. They can reduce inflation but only at the cost of permanentlyhigher unemployment, or vice versa.23 The British and German mini-booms of the late 1980s provide some evidence for thisin the United Kingdom, consumer price inflation rose from 3 to 8 per cent between 1986 and 1989 as unemployment declined by 4 percent-age points, while German inflation went from 2.8 to nearly 4 per cent between 1989 and early 1992, in the wake of only a modest (1percentage points) fall in the rate of joblessness.24

While all this may throw light on the experience of the ec member countries, it does little to explain why no similar developments occurred in the smaller non-EC economies. The most plausible set of factors that the literature provides in this area is linked to differing labour-market institutions. In particular, it has been argued that highly centralized systems of wage negotiations, as those to be found in the Nordic countries and Austria, as well as highly decentralized systems, as those of Switzerland (and Japan), are much more con-ducive to real wage moderation than are the intermediate systems common in most of the EC countries.25

In fact, the contention that the Swiss labour market comes close to the ideal of a highly decentralized and atomistic market has been dis-puted. It has been plausibly argued that behind a facade of apparent

23 P.R. Krugman, Slow Growth in Europea; Conceptual Issues, in R.Z. Lawrence and C.L. Schultze, eds, Barriers to European Growth, pp. 745.24 In Germany, wage inflation was even more virulent, moving from 3 to more than 6per cent between the two dates. In Britain, however, wages responded only moder-ately, rising from 7 to 9 per cent.25 L. Calmfors and J. Driffill, Bargaining Structure, Corporatism and MacroeconomicPerformance, Economic Policy 6, April 1988.

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high decentralization lurk very strong tendencies of economy-wide consultation and cooperation thanks to powerfully coordinated employer organizations and networks.26 These, de facto, turn Swit-zerland, as also Japan, into a relatively corporatist economy.27

Extensive centralization of wage negotiations, which can internalize the costs of more decentralized wage claims, is highly likely to lead to a much greater responsiveness of real wages to unfavourable shocks, and is equally likely to prevent extreme forms of monopolistic action on the part of insiders. In addition, the widespread retraining poli-cies followed in at least some of the Nordic countries28 will minimize the danger that those who are, after all, made unemployed will pro-gressively lose skills and motivation thus making them unfit for recruitment in the eyes of employers.

For the EC countries, therefore, the explanation stresses the impact of initial negative terms-of-trade shocks, low growth and subsequent policy restraint. In the labour market these various forces led to a pro-gressive deviation away from equilibrium, as demand and supply forces turned out to be unable to fulfil their textbook role. For the non-EC countries, the initial shocks were similar and so, on the whole, were the policy responses, but their destructive effect on unemploy-ment was greatly mitigated by economy-wide institutions that pro-vided an effective and relatively rapid way to accommodate the shocks.

26 D. Soskice, Wage Determination: The Changing Role of Institutions in AdvancedIndustrialized Countries, Oxford Review of Economic Policy, vol. 6, no. 4, (1990), p. 41.27 J. Cornwall, The Theory of Economic Breakdown, Oxford 1990.28 R. Jackman, C. Pissarides and S. Savouri, Labour Market Policies and Unemploy-ment in the OECD, Economic Policy ii, October 1990.

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Figure EWestern Europe: Investment Shortfall on 196073 Trend(investment in per cent of constant price GDP)

Sources: OECD, National Accounts.

A Difficult Resolution

The foregoing has argued that two major problems have beset the West-ern European economy in the 1980sa relatively slow growth rate and, more importantly, massive and rising unemployment in most countries of the area. Unfavourable exogenous shocks (superimposed on a gently decelerating potential output trend), overly restrictive policies, a possible gradual loss of international competitiveness, andlabour-market institutions that (at least in the EC) are not conducive to reducing the employment costs of such forces, have combined in generating an increasingly intractable rise in unemployment. Indeed, the problem could well worsen in the 1990s as most European econo-mies strive to meet the virtually unattainable fiscal policy targets enshrined in the Maastricht Treaty for monetary union.

The next few paragraphs will try to see what alternative solutions there could be for Europes economic difficulties, other than acts of faith, such as expectations of an upward phase of the Kondratieff cycle, or reliance on outright liberalization along Olsonian lines to destroy the institutional sclerosis that prosperity may have created.Kondratieff cycles are highly unlikely to exist in practice,29 while relatively slow growth may actually strengthen the tendencies for distributional coalitions to vie for rents, thus slowing growth down further.30

An alternative, and easy, solution could of course be provided by some favourable external shock. The problem with this is dual. For one thing, it is difficult to envisage such a shock (oil prices are unlikely to collapse a second time round; Eastern Europes plight willhardly provide Western Europe with a buoyant market for years to come; if anything, Chinas surge could well threaten Europes compet-itiveness in a number of labour-intensive areas). Second, even if a favourable shock were to come (and after all, by their nature such shocks are unpredictable), it is unlikely that, unless it is massive, it will suffice to lift growth and employment. After all, 198689 saw a succession of large and positive shocks, yet their impact turned out to have been merely temporary.

Policies, in other words, must also change. At the demand-managementlevel, one option would be a significant devaluation vis--vis both the dollar and the East Asian currencies. Yet this is unlikely because of resistances both from the rest of the world and from the Bundesbank, fearful of the inflationary consequences of such a move. The alterna-tive is that of embarking on coordinated reflation at home combined with an abandonment of the Maastricht Treatys fiscal goals. The opposition to such moves comes from pervasive (if unsubstantiated) scepticism as to the value of international economic cooperation and from the continuing commitment to European economic and

29 M. Abramovitz and P.A. David, Reinterpreting Economic Growth: Parables andRealities, American Economic Review, vol. 73, no. 2 (1973).30 J.-C. Asselain and C. Morrison, Economic Growth and Interest Groups: The French Experience, in D.C. Mueller, ed., The Political Economy of Growth, New Haven, CT 1983.

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monetary union which would clearly be jeopardized if the MaastrichtTreaty had to be renegotiated, let alone abandoned. In any case, if the fears of labour-market hysteresis voiced above are correct, reflation could well lead to rapidly accelerating inflation.

In the absence of moves on the macroeconomic front, solutions to Europes unemployment problem could come from institutional changes. Work sharing is one of them, yet one that gets little support, be it from economists, politicians or trade unionists. More construct-ive would be an attempt at changing labour-market institutions in a more corporatist direction. Yet here too there are difficulties. For one thing, institutions can be formally copied, but there is no insur-ance that the informal ways in which such institutions work, and which have been moulded by history, can be easily transplanted. Foranother, present trends point firmly in the opposite directionfar from the EC countries trying to imitate the Nordic ones, Sweden has virtually abandoned its centralized wage formation mechanisms in favour of more decentralized and market-oriented processes.

This belief that markets know best still permeates European policy attitudes, despite the accumulating evidence of the last decade that, in the labour market at least, equilibrium has not been restored. It is of course true that eventually markets do clear. Eventually, however, can be a long time ahead and the clearance may occur at levels that have been depressed by the intervening path. It took rearmament andWorld War II to eliminate hysteresis from the European labour mar-ket of the 1930s. It is difficult to see what can achieve a similar feat in the Europe of the 1990s.

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