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Europe’s stony ground for the seeds of growth:
Continental nations must cast off corporatism if they are to emulate thriving economies
Edmund Phelps, Financial Times, 09-Aug-2000

No one doubts that the thriving US economy has deep significance for economic policy. Yet a misperception of the mechanism driving the growth prevents many from looking in the right place for the lessons to be drawn.

In Europe, most commentators view the accelerated growth through the lens of Keynesian economics. They attribute the rise in employment to an increase in output stemming from higher effective demand - more money chasing goods. They put the rise in effective demand down to consumption and investment spending induced by the rise in share prices.

But this monetary interpretation is implausible. Past studies have not found effective demand to be very sensitive to share prices: witness the toothless stock market crash of 1987. Besides, if effective demand were the main agent of the increased employment, inflation would be rising steeply by now.

Europeans reply that the US escapes rising inflation through its limitless ability to import and borrow abroad. But that overlooks a similar non-inflationary employment expansion in Australia, Britain, Canada, Holland, Sweden and also tiny Denmark, Finland, and Iceland. In these economies, effective demand rose only as an effect of what was really a structural expansion - a drop in the natural unemployment rate, temporary or permanent.

What forces brought about this structural expansion? And why first in those nations, not others? A clue is that the forces became powerful suddenly, even if the gestation took years. The strong growth hit the US in 1996, when unemployment rates in every education group started a steep four-year descent. It struck the others with equal suddenness. So the expansion is not due to slow-moving demographic changes in the labour force.

The critical clue is the broad surge of business investment in the thriving economies. Expenditure on new plant and equipment has climbed steeply and there has been heavy investment in new customers and new employees. Non-monetary models of unemployment show most of this investment to have a structural impact that raises both employment and compensation per employee. A shift of output towards construction creates more jobs than it destroys and raises wages, since construction is so labour-intensive. A shift of emphasis from current profits to accumulating new customers leads to lower mark-ups, which increases labour demand. A shift from producing now to recruiting and breaking-in new employees creates jobs and prompts pay increases aimed at retaining staff.

Hence a rise in compensation is a sign of a broad investment surge. So is a rise in real exchange rates.

The impetus for all this investment is a rise in productivity and hence the profits expected from business assets. Faster growth of productivity since the mid-1990s in some thriving economies has surely raised expectations of the trend growth rate. In my analysis, however, both investment and share prices in the thriving economies exceed what can be rationalised by past experience. Much investment is intended to prepare for a future leap in productivity and the profit bonanza not ruined by the preparatory investment. These hopes are conveyed to analysts and on to their clients.

No doubt these expectations are mostly inspired by visions of a ”new economy” built on information. Yet the strong expansion’s typical industrial composition does not explain why it came to some industrialised economies and hardly at all to western Europe.

A commonplace answer blames the welfare state. This saddles European economies with fiscal burdens and handouts, which blunt employee incentives and raise production costs. This helps to explain why western Europe has chronically high unemployment in times of normal productivity growth.

But it does not explain why, from 1995, the unemployment rate in Germany and Italy actually rose and the rate in France fell only modestly in contrast to the big strides in the high-expansion economies.

Nor does it explain why productivity and investment have failed to surge in most of Europe in contrast to the high-growth economies. After all, some thriving economies also have high taxes and welfare benefits. And Europe’s productivity and investment easily kept up with the US in the 1980s.

The reason why Europe has missed out is that when this expansion was gathering force, the core of the typical European economy was still organised on the corporatist model - a tripartite system of established companies, large trade unions and an interventionist government all bent on preserving their interests. In this model, business investment is controlled through bureaucracy and a closed system of big banks taking guidance from the state and loathe to finance start-ups without state guarantees.

In the US and the other high-expansion economies, by contrast, entrepreneurs could launch ”new economy” ventures because they had the right institutions: capital and product markets open to start-ups and capable of supplying risk capital. Notably, these economies also had more developed stock markets. That was crucial to venture capitalists who could later sell shares in start-ups they financed. Also, a liquid market for shares was crucial to the rise of stock options to focus managers on earnings growth.

Data on the size of national stock markets 12 years ago are uncanny predictors of the winners and losers in the 1990s. In the US, Australia, Sweden and Canada, 1988 stock market capitalisation stood around 50 as a percentage of gross domestic product; in Britain about 80; Holland, 40.

In Germany and Italy it was only 20; in France and Spain, about 25. Higher education was also a good predictor, but it, too, is an effect of the entrepreneurial economy.

The Continental nations have a choice. They can preserve their corporatism, holding down new entry and catching up slowly by copying proven innovations in the high-expansion economies but without having a boom. Or they can join the expansion by casting off corporatism for a vital capitalism.

The writer is McVickar Professor of Political Economy at Columbia University.

Om Phelps hos IntCom

US expansion may be more fragile than supposed
Financial Times, 11-Aug-2000
By Prof Wynne Godley.

Sir, Prof Edmund Phelps ("Europe's stony ground for the seeds of growth", August 9) denies that the US expansion has been generated by rising effective demand on the grounds that the wealth effect on consumption is small; also because, had demand been the driving force, there would have been more inflation. His conclusion is that the US expansion is "structural".

But while there has indeed been an improvement in the growth of the US's productive potential, the expansion could not have taken place without an extra-large rise in private expenditure, as fiscal policy has been so restrictive while net export demand has fallen. During the last eight years consumption, for whatever reason, has risen about 1 per cent a year more, on average, than disposable income, and personal saving has fallen to an unprecedented extent, from about 9 per cent of disposable income to about zero.

Net lending to the private sector has been unusually high, so that debt to income ratios are now at record levels. As these are processes that cannot continue indefinitely, the US expansion may well be more fragile than Prof Phelps supposes.

As to the failure of inflation to re-ignite, this is something for proponents of the non-accelerating inflation rate of unemployment to explain away; many of those who look at the world through "a Keynesian lens" never believed in the Nairu in the the first place.

Wynne Godley
The Jerome Levy Institute

Danger in viewing Europe from perspective of weak euro
Financial Times, 11-Aug-2000 By Mr Avinash Persaud.

Sir, Prof Edmund Phelps' analysis of why continental European economies are floundering takes many liberties with the data to draw an outdated view of Europe.

For a start, he defines corporatism and capitalism too conveniently to equal economic failure and success respectively. For instance, he characterises high growing Sweden and the Netherlands as "capitalist" when many view them as the icons of "corporatism".

Second, he fails to point out that, over the period he chooses to analyse, 1996-1999, all of the continental economies he chides for low growth were held back by restrictive fiscal and monetary policies as they tried to meet the Maastricht convergence criteria for European monetary union. In Italy, despite a recession, the structural budget deficit was reduced by 7 per cent of GDP over this period, or twice the pace of the decline in the US structural deficit during the recent economic boom.

There is little doubt that the current dynamism of the US economy relates to the ease with which private capital chases private innovation. This has much to do with two related factors: the private provision of pensions and the depth of financial markets. These factors are neglected by Prof Phelps but are being partially addressed by the recent passage of pension reform in Germany and the arrival of a single currency.

The current tendency to view Europe only through the perspective of the weak euro has led many to find signs of structural weakness and to be blind to important changes underfoot.

Avinash Persaud

Managing Director, Global Markets Analysis and Research,
State Street Bank
The Royal Exchange
London EC3V 3RT, UK

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