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Op-ed

How Europe's Regulations Hold It Back

by Martin Neil Baily, Peterson Institute for International Economics
and Diana Farrell, McKinsey Global Institute

Op-ed in the Financial Times
October 18, 2005

© Financial Times


The fear of change and discontent about Europe's economic performance that led French and Dutch voters to reject the European Union's proposed constitution have contributed to the divided election outcome in Germany. The irony of these votes is that for Europe to preserve its way of life, it must embrace change and reform.

With 18.8 million unemployed and average economic growth of 0.4 percent in the old member states, spurring growth and jobs is urgent—but no one can agree on how. Many Europeans believe market forces are hindering growth and that reform will mean elimination of their social safety net. Their solution is to protect the region against competition, maintain regulations that prevent companies from restructuring and cutting jobs and, perhaps, invest more in research and development.

Such solutions will not work. There is no full-employment economy in the world that is innovative and growing and also maintains rigid regulations and restrictions on competition. Our research on big European economies found that a lack of technology was not the reason for slow growth. Instead, boosting competition, often through regulatory reform, is the impetus that Europe needs to improve productivity.

Such reforms need not come at the expense of all social safety nets. Paradoxically, Europe must restore full employment and generate economic growth if it is to maintain adequate pensions and social insurance, especially as the population ages. While no country has fully liberalized its economy, Denmark, Ireland, Spain, Sweden, and the United Kingdom have undertaken reforms that led to more employment and growth.

There are four areas leaders should act on. First, finish liberalizing the service sector. Service industries constituted roughly 70 percent of Europe's gross domestic product and all of the net job growth during the past five years. Europe's service companies remain shielded from competition by a thicket of regulatory barriers. In Germany, for example, limits on operating hours prevent retailers from providing the better service and higher employment that would result from remaining open longer. Across the continent, small family-run corner shops with low productivity and relatively high prices are protected by tax and planning laws.

Regulations such as these aim to preserve Europe's traditions but they have the effect of limiting prosperity. Fortunately, adjusting the level of regulation to increase competition in service sectors does not mean abandoning all the old traditions. If Germany were to lift restrictions on the hours that stores could remain open, not all consumers would shop around the clock, and small stores offering a unique service would still prosper because a sufficient number of consumers like them.

Second, encourage economies of scale. It is one of the most important ways countries can boost productivity growth; indeed, this was a main reason why Europe created a common market. Policymakers can encourage the efficient use of scale by facilitating mergers and acquisitions. Antitrust regulations rightly seek to prevent mergers that would create monopolies. But regulations that restrict mergers unnecessarily allow inefficient operators to stay in business when newcomers could provide the same services more efficiently. Establishing uniform EU regulations, too, can allow the kind of cross-border expansion that unleashes rapid productivity growth.

Third, increase labor market flexibility. Restrictions on job cuts and high taxes on employment to finance generous social security benefits deter companies from hiring new people. And these benefits, depending on how they are structured, can lower the incentives for people to work.

Countries can encourage people to move into, or return to, the workforce without removing all of the social safety net. Permitting employers to pay lower salaries for some jobs but asking the government to make up the difference with a wage subsidy would encourage people to move off welfare into work, irrespective of the pay.

Finally, end the bias in land-use policies. Within the relatively small confines of Europe's borders lie important historical sites and immense natural beauty, and Europeans understandably want to preserve this heritage. Few people realize, however, the extent to which restrictions on the use of land are discouraging productivity and employment. The high price and lack of available land, as well as other regulatory barriers, make it hard to find new locations for large stores, for example, thus holding back productivity and job creation in the retail sector.

Europe can get its economy moving again without abandoning all the social values it holds dear. But many current regulations are hindering the region's ability to achieve higher productivity in its large domestic service sectors and to compete in global markets. They need a thorough overhaul. Even if Europe does not move forward in unison, the successful reforms already achieved in some industries and countries in Europe point the way to better economic performance for all.


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