The Netherlands is generally viewed as a bright spot in a continent plagued by low productivity and high unemployment. Thanks to a decade of effective social and economic policies, the Dutch economy has indeed recovered from the job losses it suffered in the 1970s and early 1980s. But domestic rates of growth shed little light on how the country is performing in comparison to others today.

To see just where the Netherlands stands in the global economy, we conducted a study comparing Dutch output, employment, and productivity to world benchmarks and investigating the underlying reasons for differences in performance.¹ We then tried to determine what the Dutch government, unions, and individual companies could do to close the gaps. As in earlier McKinsey Global Institute studies, we looked at the performance of both the national economy and key industries: in this case, food processing, housing construction, personal financial services, public transportation, retail, and computer software.

Our principal findings are:

• Contrary to popular belief, the Netherlands' performance still trails that of other major economies by a wide margin. In terms of gross domestic product per capita, the Dutch economy ranks eighth out of 16 Western European countries. Dutch GDP matches that of France, but lags that of Germany by 15 percent and that of the United States by 37 percent. The gaps are largest in the market sector, where the Netherlands trails Germany by 25 percent and the United States by 57 percent, primarily because of lower employment (Exhibit 1).
  
• The official Dutch unemployment rate of 7.4 percent in 1996 understates real unemployment. If Dutch statistics took into account everyone who is seeking work and everyone who is able to work but instead is supported by welfare benefits, real unemployment would stand at more than 20 percent, or over 1.3 million people (Exhibit 2). The employment gap is most striking in rapidly growing sectors: for example, US employment per capita in packaged software is four times that of the Netherlands.
  
• In housing construction, food processing, and certain personal financial services, Dutch companies lead the world in productivity, which suggests there is considerable scope for globalization. Dutch home builders are as productive as those in the United States, for example, and 40 percent more productive than those in Germany. However, this high productivity has been attained at the price of excluding low-skilled, less productive individuals from the working population.
• At least six artificial barriers are stifling output and employment growth in the Netherlands. Two of them—lack of incentives to create and seek jobs and restrictive land designation procedures—directly reduce output. Four others—lack of competition, inflexible work and compensation rules, obstacles to new business development, and weak corporate governance—hinder innovation and thus indirectly reduce output (Exhibit 3). Innovation is key to economic success because it can lead to simultaneous gains in productivity and employment.
• Over the next decade, the Dutch economy could raise its output by 15 percent and create 1 million jobs by lowering these barriers. These gains are over and above the growth that would be realized in any case. The result would be total economic growth of 3.3 percent per year and the creation of 1.5 million new full-time jobs, while productivity growth would be sustained at an annual rate of 1 percent, despite the lift in employment. Real unemployment could drop from over 20 percent to as low as 5 percent. Such figures would place the Netherlands among the three best-performing economies in Western Europe ten years from now.

Since 1970, the Dutch economy has gone through two distinct phases (Exhibit 4). Between 1970 and 1985, it was in decline. Employment in terms of hours worked per capita fell by one-third as the manufacturing sector restructured. By 1985, employment levels in the Dutch market sector were roughly two-thirds those of Germany and the United States.

After 1985, the trend was reversed. The Netherlands started creating jobs at about the same rate as the United States, and recovered roughly a third of its earlier job losses. France and Germany, meanwhile, experienced further declines in employment. By 1995, Dutch market sector employment had caught up with that of France, but still lagged Germany's by more than 10 percent and the United States' by 50 percent.

Unlike Germany and France, the Netherlands looks set to continue on its upward trajectory. It began restructuring its manufacturing sector in the 1970s and suffered huge job losses as a result, but over the past decade it has created many jobs in the service sector. By contrast, Germany has maintained its large manufacturing base and is now being forced to shed jobs at a rapid rate to match the productivity of its global competitors. Germany, like France, also has far greater difficulty creating jobs in the service sector, the primary source of jobs in modern economies (Exhibit 5).

If it is to raise output and reduce real unemployment, the Netherlands will need to tackle the six barriers we have identified:

Lack of competition

Analysis of the retail and personal financial services industries suggests that lack of competition hampers economic growth and job creation. In retail, the lack of competition among retailers, suppliers, and importers keeps prices high: consumer products such as bicycles, sporting goods, and clothing cost some 20 percent more in real terms in the Netherlands, the United Kingdom, and Germany than they do in the United States. These high prices stifle demand, curbing growth and job creation in the retail sector.

To cut prices and boost growth, the Netherlands will need to enforce antitrust laws rigorously and work with European partners to lift the current ban on parallel imports. In New Zealand, similar initiatives, combined with longer shopping hours and flexible wage agreements, have increased retail employment by 11 percent over the past five years.

Similarly, Dutch banks, although efficient, are far less innovative in savings and investment products than US financial institutions, which offer twice as many mutual funds per capita and have created over 60 percent more jobs in savings and investment services. Again, the main reason for the gap is the lack of competitive pressure to introduce new products. Almost half of all Dutch personal savings are in collective pension funds, which reduces the competitive arena for savings and investment products. In addition, the Dutch banking industry is highly consolidated, and since savings products are an attractive source of profits, banks have little incentive to market mutual funds more actively.

To transfer a share of Dutch pension reserves from the collective "defined benefit" system to an individual "defined contribution" system would stimulate competition and help trigger latent demand for investment products. A rough estimate suggests that over the next decade, the resulting growth in demand could raise overall output in personal financial services by 10 percent and employment by 5 percent.

Inflexible work rules

While Dutch labor market regulations offer solid protection for individual workers, they dampen economic growth. The poor productivity of the public transportation sector can be largely attributed to the lower utilization of drivers, maintenance workers, and overhead that results from inflexible work rules.

In Amsterdam, for instance, bus drivers spend only 35 percent of their working hours actually driving vehicles with passengers in them, compared to 60 percent in Stockholm. The experience of other countries suggests that exposure to market competition and subsequent changes to work rules improve labor utilization by 30 to 70 percent over time. They also lead to increased job satisfaction, better service, and greater demand for public transport.

The Dutch might also consider introducing simpler and more flexible collective labor agreements (CLAs). In retail, for instance, the current plethora of CLAs limits players' ability to broaden their services, extend their opening hours, and create innovative new formats. It also restricts the hours worked and range of jobs performed by employees. If CLAs were reduced in number and made more flexible, and retail space in shopping malls was expanded, retail service output could rise by 5 percent.

Dutch procedures for laying off workers are among the strictest in Europe, though steps have recently been taken to make the labor market more flexible. Temporary contracts can now be extended for up to three years instead of one, and temporary workers can stay on for a year and a half instead of just six weeks. The procedure for laying off employees has also been shortened by three weeks.

However, there is still scope to adjust work rules to stimulate economic growth. The Netherlands is unusual, for instance, in allowing employees who have been fired to lodge an appeal with two separate institutions. For start-up companies in fast-growing sectors that typically need to replace staff quickly as their business focus changes, such a situation cramps development and diminishes their chance of success.

Obstacles to new business development

Despite the Netherlands' strong record of business startups, numerous obstacles inhibit the growth of high-tech businesses. The packaged software sector offers considerable potential for high-wage employment, for instance, but has yet to take off. If the obstacles to new business creation were removed, this sector could at least triple its output and double employment by 2004.

The main reason for packaged software's slow start is the absence of a virtuous cycle of new ideas and entrepreneurial initiative. Unlike leading US universities, most Dutch universities do not provide fertile ground for new business ideas. In order to do so, they would need to build hands-on business courses into the science and engineering curricula, get involved in technology licensing, and encourage faculty to support startups. In addition, expertise and financial backing would be needed from Dutch venture capitalists, who have had dismal returns on their investments in startups in the past; during 1986-95, their average return was minus 4 percent. As a result, only 30 percent of Dutch venture capital (representing 0.3 percent of GDP) is invested in the high-tech sector, compared with 80 percent in the United States.

Investment returns and sector output could perhaps be improved through the creation of "silicon polders"—bundles of small software companies grouped around such areas as enterprise resource planning, Internet-based software applications, and European software distribution. Leading-edge customers are another critical element in the success of software startups. Dutch companies could stimulate demand for packaged software, while the government could act as a catalyst. To encourage growth, it might experiment with enterprise zones featuring more relaxed labor regulations and assume the role of lead customer for new Internet applications.

Weak corporate governance

Publicly traded companies in the Netherlands failed to earn their cost of capital between 1970 and 1990

Corporate governance and economic performance are closely linked. Recent research shows that companies with weak corporate governance not only destroy shareholder value, but also generate less employment.² The research also reveals that publicly traded companies in the Netherlands failed to earn their cost of capital between 1970 and 1990, and therefore destroyed shareholder value.

This picture is confirmed by our industry case studies. Witness Dutch banks' slowness in introducing retail investment products compared with their UK and US counterparts; the limited efforts by established custom software providers to develop packaged software; the sluggish development of innovative retail formats; and the lack of product differentiation in the dairy industry.

A notable case of poor corporate governance can be found in the Dutch food processing industry, whose cooperative structure discourages long-term investment in R&D and brand building. Dutch dairy cooperatives dedicate less than 3 percent of their sales to these areas—a third of the sum spent by private food processors. As a result, the coops have tended to focus on bulk products such as plain cheese, rather than on high value-added products such as prepared meals. Though this approach has fostered world-class productivity, it has inhibited output growth. Worse, it poses a risk with the imminent arrival in the European Union of low-cost producers from Eastern Europe.

The Netherlands could take four steps to strengthen corporate governance. First, companies could boost the effectiveness of external corporate boards. Second, stricter accounting principles could be adopted to reduce any tendency to smooth out profits and underestimate equity reserves. Third, regulators could consider limiting the number of legal anti-takeover defences, of which 121 out of 135 publicly traded Dutch companies currently avail themselves. Fourth, companies could evaluate and reward more of their managers on the basis of the shareholder value they create.

Lack of incentives to create or seek jobs

The Dutch labor market provides few jobs for less skilled workers. Official unemployment in this group is 60 percent higher than in the labor force as a whole; actual unemployment is higher still. While creating highly skilled, well-paid jobs might be preferable, increasing the number of less skilled jobs at minimum wage levels would still boost total output and employment, and thus improve overall economic performance.

The Netherlands' system of social security taxes and benefits stifles the creation of low-skilled jobs in two ways. First, since Dutch unemployment benefits average 78 percent of the minimum wage compared with a European average of 64 percent, the unemployed have little financial incentive to find work. Only Denmark has higher unemployment benefits. Second, since Dutch social security taxes are among Europe's highest, representing 32 percent of the cost of hiring a minimum-wage employee, employers have little incentive to create low-skilled jobs. Only Belgium, Italy, and Greece have higher social security taxes.

In addition to those who are officially unemployed, about 600,000 people, equivalent to 9 percent of the workforce, are on early retirement, disability, or other social benefit schemes, even though they would be considered able to work in other European countries. In the Netherlands, they have no obligation to seek work and fall outside unemployment statistics.

To stimulate growth in low-skilled employment, the system of minimum wages, welfare benefits, and social security taxes must be reformed

To stimulate growth in low-skilled employment, the system of minimum wages, welfare benefits, and social security taxes must be reformed. While preserving a safety net, it should ensure that all those who can work either have a job or are in a work training program. This would entail setting the total cost of employing low-skilled workers at a level close to or even below their net wage—for example, through the use of an earned income tax credit. Such a subsidy could be funded via a tax, for example on consumption.

Reforms of this kind could make a tremendous impact. In the retail sector alone, changes in the social security system, together with other measures to stimulate growth, could help create 150,000 new jobs and raise output by more than 10 percent.

Restrictive land designation procedures

The final barrier to economic growth is a land designation process that delays housing construction and produces an artificial scarcity in housing and retail space. The Dutch have designated almost 70 percent of their available land for agriculture, leaving 13 percent for nature, 9 percent for infrastructure and commerce, and less than 8 percent for housing. As a result, the cost of land for housing has doubled in the past six years, limiting the size of houses and housing lots available to Dutch families.

Policy makers could seek to establish a more flexible, dynamic planning system. The process of land designation and zoning approval could be shortened from 11 to six years, and the government could designate more land for housing while simultaneously setting aside extra land for nature and landscape preservation. These reforms would speed up housing construction and cut the cost of new houses by at least 10 percent.

Our research shows that the Dutch economy enjoys tremendous opportunities to boost output and employment. By lowering the barriers that impede economic growth, the Netherlands could cut real unemployment, join the European top three in economic performance within a decade, and attain world-class performance in the longer term.

To achieve their full potential, the Dutch need to take steps to lower all six barriers simultaneously, because each step will reinforce the others. In retail, for example, boosting competition and building shopping malls should stimulate demand for low-skilled labor. However, labor market measures must also be taken to give unemployed people sufficient incentive to seek work and to cut the cost of hiring low-skilled workers if jobs are to be created on a large scale.

Economic growth would enable the Netherlands to achieve a number of important social and economic objectives: to employ the long-term jobless; to raise incomes across the board; to care for an aging population; to invest in health, education, and environmental protection; and to secure the competitiveness of its international sectors. In the past, the Dutch economy has spawned some of the world's truly global companies: Shell, Unilever, Philips. If it succeeds in lowering the barriers to growth, it will be well placed to produce a fresh crop of global leaders.

The real challenge is to strike the right balance between capturing growth opportunities and safeguarding the core values of Dutch society, such as providing a safety net for those without an income and preserving the unique landscape. In striking this balance, it is important to distinguish between arguments that genuinely seek to preserve these values and arguments that merely serve to protect established interests.