Europe’s socio-economic systems are heading for their severest test ever. The unique philosophy of social support and inclusiveness on which they rest now threatens to become a fatal handicap. The danger is real: a number of powerful forces are working to destabilize systems that already impose heavy costs on corporations via high labor charges and limited operational flexibility. In addition, the growing burden of an aging population will, if nothing is done, consume an unsustainably large share of GDP. But no corrective action can prove effective unless it allows, enables, and encourages private firms to create the wealth on which all social systems are based. In practice, this means that the perpetual battle to improve productivity will, more than ever, become the major determinant of Europe’s future welfare, social as well as economic.

Western Europe’s uniquely supportive social systems have long been seen as models for other countries to emulate. The paradigm they offer for the relationship between governments and their citizens (and companies and their employees as well) stresses inclusiveness and social justice—a "third way" between the extremes of socialism, which most recognize to have failed, and capitalism, which has often been criticized for its indifference to human suffering. Evidence now emerging, however, suggests that the European approach offers not so much a model as a cautionary tale. Whatever its benefits, it has created—and continues to create—an intolerable burden of high costs, low productivity, and global uncompetitiveness.

Until recently, this burden has largely remained hidden. But the depth of the current recession, the economic hardships born of German reunification, the acrimony surrounding the Maastricht Treaty, and the continued globalization of the world’s markets have at last conspired to make it painfully visible. Europe’s social costs are already straining national resources to the limit and making its corporations global laggards in industries as diverse and crucial as autos, airlines, and telecom.

A horizon of challenges

Today’s systems will need major adjustment if Europe is to remain economically and socially viable in the next century

The worst is still to come. During the coming decades, Europe’s present weaknesses will be aggravated by, among much else, an aging population, high unemployment, rising health costs, and the challenge of potentially unprecedented levels of immigration. Today’s systems will need major adjustment if Europe is to remain economically and socially viable in the next century. The challenges are daunting:

Obstacles to competitiveness. The European economies in general lag behind those of the United States and Japan in both service sector and manufacturing productivity (see Exhibit 1). There are many reasons for this, but the European social system takes a good share of the blame. Paradoxically, policies designed to create social harmony and stability are threatening to bring about the exact opposite. Absenteeism in Europe is far higher than elsewhere in the Triad, as are pay for time not worked and the social charges borne by employers.

If this productivity gap is not closed, European companies will inevitably lose out in the competitive battle. As a result, the region’s share of the global economy will further diminish, GDP growth will be put in danger, Europe’s standard of living will be jeopardized, and its ability to support an already demographically lopsided population will be impaired.

Demographic mismatch. Pension and healthcare costs for a rapidly growing elderly population are set to explode. At the same time, Europe’s working population is shrinking and will be less and less able to support the burden. In Germany, Benelux and the Scandinavian countries, for instance, social costs now stand at nearly 40 percent of GDP, compared to 32 percent in the United States.

The typical pay-as-you-go pension systems of Europe, in which today’s workers directly fund the benefits of today’s retirees, are now faced with a grotesque demographic mismatch that will grow worse with every year that passes. If the present trend persists, German public pensions payments alone could account for over 14 percent of the country’s GDP by the end of this century, swelling to nearly one-quarter of total economic output by 2030.

Wrong remedies. In the medium to long term, the main challenge for Europe, therefore, is to expand the workforce and increase its productivity to provide for the imminent wave of retirees. Yet faced with the immediate problems of recession and unemployment, policymakers across the continent have still resorted to traditional remedies such as lowering the age of mandatory retirement, shortening the working week, and limiting immigration. Such policies will shrink the supply of labor and thus heighten the demographic mismatch, increasing rather than reducing the stress on European societies. Though politically unpopular, a more forward-looking solution would be to make a modest increase in working hours or the retirement age and maintain open borders for trade, investment, and immigration.

Comparing the systems

All European countries have a more extensive safety net and social system than does the United States

Although practices and policies vary widely across Europe, all European countries have a more extensive safety net and social system, as well as greater regulation of working practices, than does the United States. The state is heavily involved in the funding and provision of education and health services, and transfer payments under social security and welfare programs are generous. In most of these countries, over 80 percent of social expenditures are made by the state, compared with only 55 percent in the US. The total effort society makes to finance social spending is also greater—and this in spite of America’s far higher and wildly ballooning health costs, which eat up 14 percent of the nation’s wealth.

Europe’s costly systems have been built up gradually during more than a century to address social problems very different from those that it faces today. They are founded on a broad consensus concerning the desirability of measures to redistribute income. Opinion surveys show that only 28 percent of Americans consider it the government’s responsibility to reduce income differences; by contrast, fully 81 percent of Italians and 63 percent of Britons hold this belief. An "entitlement" culture has developed in many countries, with individuals treating social services and benefits as if they really were "free."

It is far from clear, however, that these levels of support have resulted in performance superior to that of other rich countries, in terms of either material wealth or social well-being. The social benefits of different systems are, of course, hard to compare and heavily dependent on each society’s specific priorities. As Exhibit 2 illustrates, a quick comparison of different social indicators around the world shows just how perplexing the choices made by modern societies can be. Japan has the fewest murders per capita, but the most suicides. The United States has the highest GDP per capita, but the greatest poverty.

Inappropriate comparisons

In relative terms, Europe has been successful in achieving income redistribution and combating poverty—its implicit objectives. A Luxemburg institute’s study of household income, adjusted for government transfers, taxes, and social security contributions, found that the middle class, defined in economic terms, was far larger in European countries than in the United States.

In Sweden, for example, only 5 percent of households would be classified as poor; in the US, 16 percent. Conversely, the study found that only 10 percent of Swedes were "well to do," compared with 22 percent of Americans. A report by Towers Perrin on executive compensation confirms these differences from a different angle: a CEO in the US earns 25 times as much as an average employee in manufacturing; in Europe, the gap is only half as wide.

Nevertheless, although income may be distributed more evenly in Europe, the average level of material wealth is still significantly higher in the United States. When assessed using purchasing power parity, which compares incomes across different countries by measuring them against the same basket of goods and services, Americans are one-third better off than Europeans. This gap has narrowed only slightly during the past two decades, while Japan has overtaken all but the very richest European countries. Furthermore, in addition to lower standards of living than in the US, Europe has paid with consistently higher unemployment. Unemployment represents a collective as well as an individual social problem; it is a waste of economic resources for society as a whole.

Rigidities and distortions

Part of the explanation for Europe’s relative lack of competitiveness and unsatisfactory economic performance within the Triad can be found in the rigidities introduced by well-meaning but misguided social policies, particularly in the labor market. Examples of outright abuse of an over-generous system are all too common and represent a waste of resources that could be targeted to those in real need. In Sweden, for instance, the government has been forced to reconsider the allowances it pays to convicted prisoners: Russians had been traveling to Sweden and committing crimes in order to go to jail, where they could earn up to eight times more per day than at home. Less dramatically, almost 15 percent of the workforce in the Netherlands claims permanent disability benefits. In both cases, the system motivates individuals to make decisions that are rational from their personal perspectives, but that have adverse consequences for society as a whole.

By giving the wrong incentives concerning participation in the labor market, social systems may cause perverse effects such as prolonged unemployment

More harmful than these striking, but nonetheless limited, cases of abuse is the systematic distortion of attitudes and behavior caused by too-high levels of unemployment benefits and other transfer payments when they are not accompanied by adequate controls and complementary measures such as retraining. By giving the wrong incentives concerning participation in the labor market, social systems may cause perverse effects such as prolonged unemployment.

To illustrate the problem, take the case of a typical married man with two children who was employed at an average wage before losing his job. In France or Germany, he is eligible for benefits equal to more than 75 percent of his previous net income, including family allowances, for a period that is in practice unlimited. This compares to a ratio of benefits to previous income in a typical state in the US of 55 percent, which falls after just three months to 28 percent. Clearly, the American has a much greater incentive to accept a new job when it is offered, even if it is at a lower wage than his previous employment.

Such differences—along with comparatively high minimum wage levels that tend to price the young and unqualified out of jobs—help to explain why unemployment accounts for a far higher proportion of the labor force in Europe than in the US, despite lower rates of participation, and why the long-term unemployed make up over 50 percent of the European total, compared with less than 6 percent in the US (see Exhibit 3). In effect, labor in Europe remains "parked" on the sidelines for long periods (or goes underground) rather than being quickly re-routed into another productive activity.

Resistance to change

From the point of view of the employer, inflexible work rules and high firing costs are among the chief obstacles to increased productivity and employment

Many other factors linked to the social system have contributed to Europe’s economic woes. Again, if we look at the labor supply, even Germany’s celebrated apprenticeship system is now being criticized for the rigidities it instills in a workforce raised with the expectation of lifetime employment that has difficulty adapting to new challenges such as lifetime learning in an era of rapid change. From the point of view of the employer and the demand for labor, inflexible work rules and high firing costs are among the chief obstacles to increased productivity and employment. Moreover, in such EC countries as Spain, Portugal, Greece, Italy, France, the Netherlands, and Germany, the government—or employees themselves—can prevent management from restructuring a company.

Preserving existing jobs has been the top priority of European economies. As a result, they have largely failed to change with the times. By contrast, the strength of the American economy during the past two decades has been its ability to create new jobs in the service sector to replace those lost in manufacturing and to absorb the growing labor force.

Between 1970 and 1990, the United States created 38.2 million net new jobs and employed more than 93 percent of those who decided to join the workforce in this period. Nearly half the jobs were in high-skill industries like financial services, healthcare, education, and business services. During the same period, the twelve members of the European Community, with a larger combined labor force than the United States, managed to create less than one-third as many jobs. The inevitable result: unemployment.

Obstacles to competitiveness

Faced with adverse economic circumstances, individual members of society may be forced to lower their expectations and accept a reduced standard of living. For firms competing in the international marketplace, similar pressures may mean that they simply cannot survive—especially if their costs continue to rise.

Both companies and their employees may become trapped in a "vicious circle" of decline that works like this: As joblessness ratchets upward in recession, unemployment benefits and the other costs imposed by the social system must be borne by a smaller working population. Tax rates and social security contributions are pushed higher, increasing the cost of labor per unit of output. This has two effects: abroad, it causes the competitiveness of that output on world markets to decline; at home, it encourages employers to substitute capital—often in the form of increasing automation—for labor in order to regain cost competitiveness. Both these forces—declining demand for European goods and increasing automation—typically throw still more people out of work, which increases joblessness and once again raises the burden of social costs, thus closing the circle.

This simple model does not take into account a further reinforcing factor: the increasing use of early retirement programs as a tool to "combat" unemployment, an approach that again reduces the working population and increases social charges as the early retirees draw on their pensions.

It should be possible to break out of the vicious circle by maintaining or lowering the cost of labor per unit of output through superior (innovative) automation, lower average wages, reduced social charges, or some combination of the three. In practice, however, the regulations, costs, and underlying attitudes associated with Europe’s social policies have limited the ability of European corporations to pursue any of these routes to improved productivity. For example, operating capital-intensive, high-tech production lines around the clock requires special permits, as work on Sundays or in three shifts is generally prohibited.

The German worker is off work for 61 days each year—more than double the rate in the US and Japan

The handicap under which European corporations have been operating is difficult to measure when it manifests itself in reduced motivation on the part of individuals either to seek work at a lower wage than they previously enjoyed or to accept and devise more productive ways of performing their jobs. It is more obvious when it acts directly to reduce business competitiveness—for example, through shorter working hours, higher absenteeism, longer paid vacations, or rigid wage differentials. The average German manufacturing worker is off work on vacations and public holidays for 42 days a year and misses an additional 19 days on sick leave. All told, the German worker is off for 61 days each year—more than double the rate in the US and Japan, even before maternity leave and days lost through strikes are included. Non-wage labor costs account for roughly half the total cost of manpower in Germany, Italy, and France. In contrast, social charges in the US and Japan make up only about one-third of the average wage bill.

Differences in competitiveness have a direct influence on the fortunes of major European industries

These differences in competitiveness are neither trivial nor without practical effect. They have a direct influence on the fortunes of major European industries. In automobiles—still the world’s largest manufacturing activity—European companies face a huge gap in productivity, quality, and labor cost. MIT’s International Vehicle Program estimated that the average European auto producer took 36 hours to build a standard car. Its US counterpart did the job in 25 hours, and the Japanese in a mere 17. Yet Japanese auto makers had on average only 60 defects per 100 cars, the Americans 82, and the Europeans 97.¹

The coming implosion

Accurately gauging the full weight of the "social cost" contribution to the competitiveness problems facing European industry requires close attention to:

• Scope. All the major factors that exert pressure on a social system must be identified. Spending on health and pensions, for example, will rocket during the coming years, but education and family allowances will decline. Any analysis of the impact of social costs should identify all elements of social expenditure and combine them in a single integrated model. Both economic and social perspectives need to be taken into account.
• Interrelationships. Once all elements have been identified, it is vital to recognize the interrelationships among different variables, as well as built-in feedback mechanisms. As an example, prolonged levels of high unemployment diminish the revenues generated from taxes, and payroll contributions decline. This, in turn, makes the funding of today’s defined benefit, pay-as-you-go pension schemes far more difficult.
• Time horizon. The impact of different factors must also be assessed over the medium and long term. A burst of immigration may, for instance, rejuvenate a country’s labor force in the short term, but store up pressures on the social system that will be released when these workers retire.

With these three organizing principles in mind, we can begin to estimate the magnitude of the challenges facing European societies, using a simple simulation model based on the demographic changes driving most social costs. The results are indeed sobering.

Health and pension costs for the elderly account for approximately half of all social expenditures

Official forecasts show that the total population will actually decline in some OECD countries during the next thirty years, and that the ratio of elderly people to the working-age group will rise steeply nearly everywhere. For social spending it is this ratio that is of the greatest significance: health and pension costs for the elderly account for approximately half of all social expenditures.

At the same time, for a nation’s standard of living and its ability to bear the burden of social costs, it is the size of the workforce relative to the total population, combined with the rate of productivity growth, that matters. When the "baby boom" generation starts to retire, it will become an enormous dependent group. At the same time, the "baby bust" will be cutting heavily into the workforce, depressing economic growth per capita. Indeed, it will be well past the middle of the twenty-first century before the majority of European countries return to a more "balanced" population structure. Meanwhile, major changes in both public and private policy will be needed to cope with the effects of the skewed population pyramids that will be experienced in the interim.²

The official forecasts for Germany assume a very low level of net immigration and little increase in life expectancy.³ Even so, they predict that by the year 2000, nearly one quarter of the population will be over 60, compared to less than 20 percent today. By 2030 the number will stand at 40 percent. These forecasts also show total population declining rapidly after 1999.

If immigration, fertility, and life expectancy turn out to be higher than the conservative official estimates, the total population in Germany will peak a few years later and then decline more gently. Nevertheless, by the year 2030, fully 34 percent of all Germans will still be over 60. Exacerbating the problem, only about 3 percent of Germans over 65 do any paid work, compared to 11 percent in the United States and 26 percent in Japan. If such behavior does not change, there will be roughly one pensioner for every worker by 2030—double the present ratio.

Taking these forecasts as our base, we have calculated the growth of social costs if current programs are maintained, as well as the burden they will impose on society. Our conclusions relate both to economic and social facts that are already in play, and to their probable medium-term outcomes—"probable" because the people who will have the greatest impact on the country’s demography in the years up to 2030 have already been born.

If current trends in Germany continue, public social expenditures will increase in real terms by one quarter during the 1990s, and by over 100 percent up to the year 2030

If current trends in Germany continue, public social expenditures will increase in real terms by one-quarter during the 1990s, and by over 100 percent up to the year 2030. Assuming there is no fundamental change in prevailing policies, this would lead automatically to an increase in the share of GDP devoted to the government’s social budget—on top of other items paid for out of the public coffers—from approximately 33 percent today (already one of the highest percentages of any country) to close to 50 percent in 2030 (see Exhibit 4).

A rise on this scale would precipitate a fiscal disaster. If the government chose not to raise taxes or contribution rates but to finance this additional cost by increasing debt, the resulting interest burden would quickly become crushing. Alternatively, increasing taxes or contributions would adversely affect labor incentives and further depress GDP.

Room for maneuver?

Underlying trends in longevity and fertility lie beyond the easy reach of policy changes. But there are some relevant factors that can be controlled—or, at least, managed—to make the situation more affordable (see Exhibit 5). Governments can, for example, act directly to reduce future costs by, say, curbing the rise of health spending. Or corporations can increase a country’s ability to fund such costs.

People can work more, thus offsetting the relative decline in working-age population by raising rates of participation in the labor force for women or the elderly, increasing average hours worked, or encouraging immigration. People can also work better, thus improving productivity levels so that each worker generates more value. This would reduce unit labor cost, increase European competitiveness and consequently international demand for European goods and services, and hence make it possible to employ more people. Politicians need the courage to help companies break out of the vicious circle of low productivity, high additional wage costs, flagging competitiveness, dwindling demand, and reduced employment.

Unfortunately, recent forecasts of economic growth are not encouraging. Nor are the reactions. Some politicians in Europe have even called for a halt to productivity increases so as to alleviate rising unemployment. This and other short-sighted nostrums threaten to make things even worse. To move in the right direction, an increase in the German retirement age even of one year would, for example, significantly reduce the ratio of pensioners to workers in the future. Bringing forward the retirement age in order to ease the current jobs market, as some propose, would be doubly lethal, simultaneously reducing the size of the workforce and increasing the ranks of those claiming a pension.

Similarly, an increase of just a few hours in the working week would allow contribution rates to be kept close to today’s levels. But if unions achieve their declared goal of further reducing working hours, it will only store up pressures for the future. The past ten years have already seen deep cuts in both weekly and lifelong work time among Germans. That trend must be reversed, not continued.

Just as ominous, public sentiment in many European countries is turning against immigration. Countries are becoming more inclined to set up barriers against foreigners, trying to close the door on workers they may soon need. This tension is likely to be particularly acute in Germany, and beyond Europe in Japan, because of their unique histories and demographic patterns. Both may choose the alternative solution of exporting their capital, technology, and jobs to countries with younger, cheaper workforces.

Indeed, as western populations shrink and age, one of the most attractive solutions to meeting the needs of their elderly consumers may be to replace the "inter-generational contract" with pensions funded through personal savings and investment in labor-intensive businesses in the world’s young and vibrant economies, for example in Southeast Asia.

Solutions and sacrifices

Policy priorities must change to accommodate new conditions

Policy priorities must change to accommodate new conditions. In aging countries such as Germany, the goal of combating unemployment will, in the coming decades, give way to a need to increase participation rates and raise productivity in order to absorb the additional costs of health and pensions, maintain global competitiveness, and defend the level of real disposable income available for consumption. Such a transformation will require both a fundamental shift in attitudes and a new paradigm capable of guiding policy in a changed economic context.

As each society reviews its social priorities and assumptions, it will have to make hard, long-deferred choices

The inescapable corollary of such a transformation is that Europe’s social systems themselves must be refocused to enhance productivity and competitiveness. To be politically and socially acceptable, however, these adjustments must spread the burden of change evenly. As each society reviews its social priorities and assumptions—benefit levels and eligibility criteria, for example—it will have to make hard, long-deferred choices. Limiting unemployment benefits only to those actively seeking work, and child-care allowances only to those families who genuinely need them will, no doubt, challenge the entitlement mentality that has spread throughout the region’s affluent classes. But such a challenge is long overdue.

Adjustments of this kind can work. Consider the change in sickness benefits, initiated by business and supported by all political parties, introduced in Sweden in 1991. A relatively modest reduction in benefit levels—from 90 to 75 percent of salary during the first four days of absence, then rising again for the genuinely long-term ill—caused a dramatic fall in sick leave. The companies that had lobbied for these changes in order to reduce lost output agreed in exchange to take over from the state payments for the first few days of illness. Following the success of this change, the government has gone even further, cutting out payments altogether for the first day of absence.

More generally, it may be necessary for governments progressively to switch to mixed systems, with minimum state support supplemented by optional private insurance. This would increase choice for individual citizens and reduce current incentives for overconsumption of social goods and services. Business leaders can help: by providing insights into the way various policies would affect industrial competitiveness; by drawing on their standard management tools to quantify the different options available to society at large and to their own organizations; and by pointing out, to governments and the public, where social programs inhibit flexibility—or have perverse consequences for the labor market—without improving welfare provision.

But these strategic choices and adjustments in expectations do not go far enough. Efficiency and productivity in the provision of social services must also be raised in Europe, either within the public sector or by transferring services to private providers. In some cases, the manner in which social objectives are pursued will need to undergo radical change—for example, through the introduction of private pension funds to complement pay-as-you-go public systems.

A further illustration is the ambitious reorganization of the National Health Service in the UK, where a clear separation has been introduced between those who purchase services on behalf of patients and providers who contract to supply a specified set of healthcare services of a given quality for a fixed sum. Similarly, the local administration of the Dutch city of Tilburg has become a model for the use of private-sector methods to raise efficiency in government services.

The urgent need is to raise awareness of the magnitude of the challenge facing society and for all groups to elaborate together both short- and long-term policies designed to reconcile social objectives and economic constraints.

All Triad regions will face the need for reorientation in the years ahead, but Europe, the most ambitious in terms of social inclusiveness, will have the toughest decisions to make. Its dilemma is encapsulated in the debate over Maastricht. Implicit in the treaty is a political desire on the part of certain member states to raise levels of social support and extend minimum regulations on working practices to all members. This is precisely why the British government decided to opt out of the social chapter. However, as the current efforts of some governments—particularly those of Italy and Spain—show, such aspirations have been overtaken by the necessity to reduce budget deficits, and hence social spending, in order to meet the requirements for economic and monetary union.

Increased productivity makes increased welfare possible

There appears to be a growing realism and acceptance that, in the long run, social objectives can be attained only in the context of a healthy economy. Increased productivity makes increased welfare possible. Without it, progress toward a better quality of life will be stillborn. For all its current problems, Europe, with its rich tradition of cooperation, partnership, and inclusiveness, may be particularly well suited to find a creative new balance between economic and social goals. If it succeeds, the lessons of its experience will have relevance to the way governments work and people live all over the world.