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1. Background
In many respects, economic Western Europe looks very different today from what it was in the Cold War years of the early 1980s. In these two eventful decades, the Western European economy underwent radical transformations, with deep structural changes and complex institutional reforms affecting the working of both markets and policy authorities.
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Since the second half of the 1980s, after a long period of sclerosis, an ambitious process of economic integration was launched and successfully implemented. It first took the form of market enlargement in real and financial assets aiming at the perfect mobility of goods and productive factors. The idea of a single European market was significantly reinforced by the decision to introduce a common currency and to design a new set of European institutions and procedures. Consequently, economic convergence within the area increased while, following German reunification, integration with Eastern European countries also proceeded at a very rapid pace. Projects for a further widening and deepening of European integration, ranging from a more complete economic and political union to the Eastward enlargement of membership, are now in an advanced stage of elaboration or just about to be implemented.
The decisive steps toward greater integration were taken under the influence (which occasionally became a threat) of world trade globalization, the new technological revolution, and the generalized liberalization of capital movements. In Europe, accepting these external challenges brought about a decisive retreat of the nation-state from the effective control of a series of domestic policy instruments and the public ownership of industrial concerns. Traditional theories on market failure were replaced by a number of alternative approaches based on incentives and mechanism design. State-owned enterprises have been affected by a massive wave of privatizations, while new procedures to deal with anticompetitive behaviors were elaborated by the European Union. The European Commission has now acquired increasing powers in this respect and some commentators have argued that latecomer Western Europe has one of the most developed antitrust policies in the world.
In this process, regulation was critically scrutinized as a source of market inefficiency and systemic degeneration. Politicians and academic scholars often wondered whether Government intervention had become a powerful obstacle to employment and economic growth. The pressure to have common labor legislation and economic regulations going from a harmonization of tax rules to the redefinition of social benefits opened new fields of investigation on the traditional theme of the optimal relationship between markets and authorities.
Major transformation processes such as these often impose heavy adjustment costs on societies or specific groups. Western Europe was no exception to this rule of history. It would probably be an exaggeration to talk of a long recession of the European economy in the 1990s, but it remains true that, in comparative terms, the century closed with a long series of weak economic performances that have not been reversed by the introduction of the new currency. The unwelcome consequence of this rapid transition toward a more integrated and competitive economic system was the upward convergence of unemployment rates and the increase of social inequalities. Double-digit figures were a permanent feature of the European labor market in the 1990s, and remained quite unaffected from cyclical fluctuations in output and investment.
Quite understandably, integration, unemployment, and regulation were among the economic issues that attracted a great deal of intellectual energies. Although the richness of Western European studies in economics is obviously far greater, considerable work was done on these general topics, and this explains the decision to restrict this discussion to them.
2. Integration
Generally speaking, integration in Western Europe has been interpreted as the outcome of sovereign actions of politicians and bureaucrats, rather than a market-induced process (Streit and Mussler 1994). Ever since the Treaty of Rome (1957), a long series of ‘interventions from above’ produced substantial results in the fields of trade policy, agriculture, the monetary system, competition, industrial policy, and social cohesion. The Maastricht Treaty (1992) strictly followed this functional approach, extending the Community powers over new sectors and policies, and establishing a rigid set of criteria for the creation of a monetary union. Policies for redistribution and compensation within the area were also significantly reinforced after Maastricht. Many more recent features (like Sweden’s large majority rejection of the monetary union in September 2003 that strengthened the anti-Euro sentiments of the Northern fringe of Scandinavian countries and Britain) corroborates the view that European integration is an elitist project with rather limited popular support.
Before the approval of the Delors report (1986), agriculture and exchange rates dominated the agenda. The Community Agriculture Policy turned out to be a ‘subsidized folly’ (Petersmann 1993), burdening the European taxpayer and consumer with extremely high costs. It still absorbs most of the Community (modest) financial resources and instead of winning approval it provoked loud protests even among its beneficiaries. It turned out to be a permanent source of conflict, both within and outside the Community, and was particularly detrimental to new trade creation and growth opportunities with Less Developed and Eastern European Countries in transition.
The European Monetary System (EMS) worked as an exchange rate mechanism, which was built on fixed but frequently adjustable parities, enhanced central banks cooperation, and an anti-inflationary bias. Flexibility, new financial facilities, and a strong dollar were the main factors for its first successful stage (1979–87), while rigidities, frictions, a weak dollar, and the economic consequences of German reunification marked its tumultuous end (1992). In terms of a monetary union, the EMS was unsuccessful and steps in that direction (the creation of a European monetary fund and the issue of a ‘parallel’ currency) did not evolve.
However, the actual working of the EMS stimulated fresh analysis on the interaction between monetary arrangements on the one hand and the functioning of real markets and the efficacy of policy decisions on the other. European economists refined such concepts as credibility, reputation, time consistency, or the games between governments and central banks, and applied them as analytical tools to explain the new road to integration. They also showed that asymmetries and rigidities were the result of choice rather than constriction. New theoretical models were framed to speculate on the advantages of ‘tying one’s hands’ in the conduct of domestic monetary policy: the EMS, so it was argued, allowed member states to import credibility and acquire stability from the core country (i.e., Germany) and its central monetary authority. Therefore, by the end of the 1980s, the loss of monetary independence was almost complete, thus easing the way toward greater monetary integration (Giavazzi and Pagano 1988).
The EMS collapsed due to its incapacity to target simultaneously fixed exchange rates and use interest rate policy in pursuit of other domestic economic objectives (i.e., employment growth). While this is possible when capital movements are prohibited, in a global financial market the ‘trinity’ becomes inconsistent. Thus, a monetary union or, conversely, flexible exchange rates, remained the alternate options to overcome the ‘open economy trilemma,’ given the freedom of capital flows. After some discussion and popular reactions, Western European countries decided for the former (Giavazzi and Giovannini 1989).
The European Monetary Union (EMU) remains the world’s most advanced experiment in moving beyond national economic sovereignty. The transition to monetary union was accompanied by wide- spread skepticism and criticism. Particularly, American observers thought that the likely effects of monetary union on macroeconomic fundamentals would be adverse even though they might be somewhat compensated by closer political ties (Feldstein 1997).
Debates on EMU focused on what prerequisites real markets of goods and productive factors ought to possess for monetary integration to generate net welfare gains. The Maastricht schedule of events and convergence criteria, relying on arbitrary quantitative ratios, was attacked for having nothing to do with the economics of optimal currency areas. Requisites for the ‘sustainability’ of EMU were strongly influenced by the prevailing German view and were defined in terms of nominal convergence of inflation and interest rates, monetary independence, and fiscal policy restraints.
Economists emphasized that the real properties for monetary integration simply did not exist in Western Europe: local markets were not efficient enough to guarantee low adjustment costs and offset the loss of exchange rate changes. Mobility, flexibility, and social integration were other indispensable factors that Western Europe did not possess. Common monetary policies with no exchange rate adjustments rendered the absorption of asymmetrical shocks more difficult. The inclusion of restrictions on fiscal policy in a treaty that set the timetable for monetary union was a further source of considerable debate. Many felt that the road to monetary unification needed to be supplemented by some forms of fiscal coordination in order to absorb country-specific shocks and avoid migration of taxpayers. However, while nation-states were all quite reluctant to surrender or harmonize their fiscal stance, Germany imposed stringent rules in order to discipline high deficit countries and avoid negative spillovers that would threaten the dogma of price stability and interest rate convergence. The economic rationale of this ‘stability pact,’ however, was thought to be very weak, particularly if rigidly applied over the business cycle.
On the whole, the (almost) unanimous verdict was that Europe did not constitute a ‘natural’ monetary union, and that imposing a new single currency would be detrimental mainly for cyclical unemployment. On the positive side of the balance sheet, the European countries’ significant degree of openness to mutual trade remained, mainly intraindustry. This feature rendered adjustment through exchange rates less effective and less compelling. Moreover, a single currency was thought to provide further expansion to intra-European trade and investment, because of lower transaction costs, less discrimination, and no currency risks. The ensuing regionalization of the European economy was expected to reduce the likelihood of country-specific asymmetric shocks.
Therefore, within the economics profession, EMU is still receiving favorable support, despite the difficult start of its new currency and widespread manifestations of anti-Euro public opinions. On the one hand, it created a safety net against such outcomes as trade wars, competitive devaluations, and discriminatory practices that are always likely to be implemented as it was experimented in the aftermath of the 1992 EMS crisis. On the other, dynamic efficiency gains might be obtained by integration in terms of more perfect competition, economies of scale, productivity growth, and a more efficient allocation of loanable funds.
Building up on these advantages, new studies show that currency integration is indeed a very dynamic process that cannot be (exclusively) predetermined by some set of exogeneous criteria (whether the Maastricht ones or other more theoretically sound ones). In Europe, the lack of mobility and flexibility is a regional, not national, phenomenon, and there is no reason why monetary integration should make things worse. The classic Mundell criteria have thus been substantially revised. Research efforts have recently been directed to the study of the intertemporal balancing of the benefits against the costs (Padoan 2000). Monetary integration must then be analyzed in an endogeneous growth model. In the process toward more complete integration, public confidence in the system may grow, some new benefits may emerge, and existing benefits may rise; alternatively, expected costs and the occurrence of asymmetric shocks may diminish as integration proceeds.
Recent manifestations of anti-Euro sentiments have been sustained by bad economic performance in the Euro area. At the current stage of European monetary integration, Europe oddly resembles more a multi (rather than an optimal) currency area, while economists have raised serious doubts on whether European policy rules have been efficiently designed and properly managed.
Finally, empirical research has shown that Eastern and Western Europe have integrated faster than it was commonly expected. Eastern European firms are now participating in Western Europe-centered production hubs, and have actively organized cross- bordered corporate networks. Intraindustry trade and input sourcing boomed together with foreign direct investments, just showing the growing complexity and maturity of economic integration between the European Union and the transition economies.
3. Unemployment
Western European unemployment has increased dramatically since the early 1970s, moving up from 2% to more than 10%. Compared to other countries, European unemployment is suffering from higher duration rates (relating to those who are unemployed for one year or more), higher rates of open unemployment (which considers discouraged workers and involuntary part-time jobs), and low participation rates among particular classes of individuals, such as prime-age men, married women, and the elderly. Economists often talk of the existence of a ‘dual’ labor market in Western Europe, one formed by very protected (male) workers (the so-called ‘insiders’), the other by an army of unemployed for which market mechanisms and incentives no longer seem to be functioning (the ‘outsiders’).
Debates on rising European unemployment have focused on three main issues: (i) the effects of globalization with growing imports from low-wage countries; (ii) the effects of the German way to monetary union; and (iii) the effects of a rigidly constrained labor market structure. According to the former, increased international trade from LDCs may have something to do with European unemployment. Although analysts often disagree of the real magnitude of these effects, demand for unskilled labor has been dramatically reduced in developed countries as a consequence of globalization, and changes in the structure of foreign trade provide a plausible explanation (Davis 1998). As to the second argument, meeting the Maastricht criteria for EMU membership has led in some countries to substantial short-term increases in unemployment. This reflected the contraction of aggregate demand due to tight monetary and fiscal policies that all countries implemented in order to meet the deadline. However, the greatest attention has been devoted by far to the study of the labor market, which has been mainly developed in comparative terms. Particularly, the North America versus Europe dichotomy has been featured in a variety of works (Siebert 1997, Nickell 1997, Layard et al. 1991).
Conventional wisdom states that European un- employment is now comparatively higher because of the more powerful interactions between local factor market institutions and global goods markets. In other words, greater openness of the European economy to trade and external competition in the goods market was unaccompanied by greater open-ness and competition in the factor markets, where the downward wage rigidity is the main source of unemployment. Local institutional features (such as the minimum wage, workers immobility, or high firing costs) introduced important asymmetries that affect the level of wages and have a negative impact on labor demand and supply.
The contrast between Western Europe and North America is more complex than this stylized picture. Economists, for instance, have begun to question the description of America as a flexible wage economy and of Europe as a rigidly constrained and overly institutionalized economy. Furthermore, it is quite inconvenient to talk of Western European unemployment since the structure of labor markets is hardly homogeneous, while their performance is even more markedly different (Siebert 1997). European rates of job turnover are quite satisfactory while overall wage flexibility is not dramatically lower compared to North American standards (Nickell 1997). Consequently, economic analysts have been trying to disaggregate the European labor market in order to understand as to what are its main structural weaknesses that generate high unemployment rates. One of the more challenging questions is whether there are any specific institutional features that are more responsible than others and what practical remedies can be introduced.
The review of the empirical evidence shows that Western Europe has strong legislation both on employment protection (relating to the legal frame-work governing hiring and firing) and other aspects of the labor market (from working time to fixed-term contracts and minimum wages). Unemployment benefits are also fairly generous even though, beyond the short term, they tend to adjust toward the lower North American coverage. While extremely variable across countries, nonwage labor costs (which are mainly responsible for the so-called tax wedge) appear extremely burdensome. Hence labor productivity is financing social insurance benefits to a greater extent than in other labor markets. Finally, in most European countries, trade unions play an important role in wage determination and even when union density is quite low the coverage rate is always substantial. One possible generalization from these institutional features is that, in Western Europe, the wage elasticity of labor needs more time to determine the necessary quantitative adjustments, while the long-term response of wages to unemployment is satisfactory and even higher than in other contexts (Siebert 1997).
Among the remedies, together with greater wage flexibility, the high fiscal wedge is considered to be the most important single explanation to European unemployment, regardless of how the tax burden is redistributed. Extension of social insurance is the main reason for the increase in the overall marginal tax wedge, which has particularly depressed the demand for labor. Lowering payroll and income taxes has thus become a very popular recommendation for reducing unemployment. Moreover, there seems to be an increasing awareness that job protection rules must be softened in order to increase firms’ incentives to create new labor opportunities. Serious implications are also associated with unemployment benefits, especially if they have no time limit and are combined with a decreased willingness to search for a new occupation. The so-called ‘reservation wage’ (which guarantees minimum social welfare and unemployment benefits) needs to become more negotiable, thus reducing distortions in the market mechanism that are familiarly indicated under the heading ‘unemployment traps.’ As far as trade unions are concerned, centralization of wage bargaining is thought to increase efficiency if the process is coordinated with strong employer associations and negotiated within the more general macroeconomic compatibilities imposed by policy authorities. However, centralization leads, almost by definition, to less wage differentiation: in Western Europe, equity reasons have again prevailed to market clearing equilibrium, mainly at the expense of low-skilled workers. Finally, increasing investments in education are generally recommended as a remedy against structural unemployment.
4. Regulation
The great claim for perfect competition is that it leads to efficient results in the allocation of resources. From the production side of the economy, a perfectly competitive market solves two problems. First, production is allocated in such a way that desired output is produced at a minimum cost (i.e., efficient cost structure). Second, given that prices are equal to marginal costs, desired output is supplied by a sufficient number of (viable) firms (i.e., efficient price structure). Thus, production efficiency is a desirable objective of public policy.
Unfortunately, the competitive model may fail to be satisfied in the sense that markets are neither always complete (some may even be missing) nor are all markets perfectly competitive. The theory of market failures and the rationale for government intervention have been pioneered by such European economists as Lindahl (1919), Pigou (1920), and Wicksell (1896). Then, starting in the 1930s, in Western Europe the question of how deeply the government should be involved in the national economy has strongly been debated with economists divided between advocates (Robinson 1933) and critics (Hayek 1944) of government intervention. After World War II, market failures together with the difficulties of price controls, subsidies, taxation, and nonprice regulation were the major considerations that, with slight differences across countries, turned out the answer in favor of regulation and/or granting governments ownership and operation of selected activities. Some have argued that the role of government should have been that of acting as a ‘welfare state’ and thus modifying the actions of the market that would not produce vital (or public) goods and services at an acceptable cost (Briggs 1961). In this vein, most Western European countries adopted the so-called public interest view of regulation in which positive theories are based on normative considerations: to improve (maximize) social welfare the government needs to respond to market imperfections, and the extent of its action, subjected to various constraints, varies accordingly with the extent of those imperfections. Moreover, abstracting both from positive and normative rationales, state ownership of certain ‘strategic’ industries like steel, defense, airlines, automobiles, and banks has been perceived as necessary to promote economic growth. However, this interpretation is perhaps too idealistic. As we shall see later, it is often inappropriate to assume that a benevolent government would make decisions solely in the interests of citizens.
From the 1980s, the very idea of a single European market has shifted policy from using regulation and state-owned enterprises (SOEs) to a greater reliance on the market mechanism and on incentive systems to improve consumer welfare as well as pursue industrial and employment goals. The promotion of competition has been one of the pillars of the European Union since the treaty of Rome, and governing bodies of the Union have acquired increasing powers to deal with noncompetitive behavior, both by private firms and public agencies, that distort competition and inhibit integration of markets across Europe. Empirical analysis raised concerns about the cost, price, and quality performance of regulated firms, and the policy arena became increasingly aware of the possibility of regulatory failures. Theory advancements also showed how, although market failures remain an argument for government intervention, the ‘unnecessary’ and/or the ‘wrong’ intervention may worsen the situation.
The existence of market failures, however, is not a sufficient reason to grant government intervention in markets. This insight was provided some 20 years before by Ronald Coase, a British economist working in the US. In the seminal paper ‘The Problem of Social Cost,’ he paved the way for the economic profession to realize that some market failures may be solved by redefining property rights and creating markets. Moreover, in choosing regulatory policies one should take into account the fact that informational limitations may raise the possibility of strategic behavior both by the regulated firm and of the regulator itself. Thus, rather than on command-and-control provisions, regulatory enforcement should be based on incentive mechanisms. This was made clear by a French economist, Dupuit (1844). In his pioneering contribution on marginal cost pricing, he was perhaps the first to take up the problem of how to design incentive-compatible regulatory mechanisms. These issues, which were largely absent in the traditional regulatory theory, have been brought up by developments in the literature on game theory, principal-agent, information economics, and the new institutional economics. The introduction of informational and institutional constraints showed how second-best optimization of social welfare is not straightforward while the set of feasible regulatory instruments is rather limited (an excellent account of most of the issues of the ‘new regulatory economics’ is provided by Laffont and Tirole 1993).
In the last two decades, European Union public policy reform has been mainly concerned with liberalizing prices and access to restricted markets as well as transferring SOEs to the private sector, and/or contracting out activities previously run directly by governments (i.e., privatization). These phenomena have been reinforced by developments in the product and capital markets, changes in the level and structure of demands, and a sharp decline in the cost of certain products and services. Although the pace and extent of liberalization have been quite different across countries, the policy objectives of the European Union can be summarized as follows:
* setting rules that make access to industries possible for a plurality of efficient providers,
* unbundling vertically integrated monopolies, thus creating new markets to replace transactions that previously took place within firms,
* restructuring tariff structures in ways that reflect underlying costs,
* ensuring that noneconomic public interest may be attained in a competitive environment,
* designing regulatory mechanisms that reflect the possibility of ‘capture’ by regulated firms or other interest groups,
* replacing regulation through public ownership with arm’s length regulation,
* ensuring independence of the regulator from the executive branch of the government, and
* imposing constraints on regulator’s discretion.
Looking at selected industries, such as services and utilities, makes it possible to highlight some of the features of the reform process.
Regulation of network industries, such as the local loop in telecommunications, electricity distribution, water pipelines, and rail track, has been based on two kinds of market failures: natural monopoly and externalities. In a natural monopoly a single supplier could serve the entire market at a unit cost lower than any industry configuration with two or more firms (Baumol et al. 1982). Hence, the case for natural monopoly is based on the fixed and costly infra- structures needed to deliver services to users. Externalities are effects of jointness of production/ consumption not priced by the market. Here, externalities are mainly related to network effects: the demand for the product or service increases with the increase in the size of the network, since there are benefits in being connected to a larger network.
Restricted entry and extended price regulation have been sought to prevent: (a) that the single unregulated firm would not produce the desired output level, making impossible the fulfillment of social or universal service, (b) unstable prices, and (c) excessive investments. However, as Coase (1960) put it, ‘all solutions have costs, and there is no reason to suppose that governmental regulation is called for simply because the problem is not handled well by the market or the firm.’ Take, for example, the case of telecommunications. Here, the existence of both scale and scope economies has been used to justify vertical integration of the provider of the local service (a true natural monopolist) with potentially competitive activities such as long distance and mobile services. In these multiproduct industries socially optimal second-best (Ramsey) prices, which permit a natural monopoly to break even, resulted in cross-subsidization. In other words, prices of competitive activities (i.e., long-distance calls) higher than those based on ‘stand-alone’ costs subsidized the costs of noncompetitive activities (i.e., local access). Hence, high prices in potentially competitive services prevented consumers from reaping the benefits of technical progress.
Increasingly aware of these pitfalls, the European Union moved toward regulatory reform that involved the privatization of state monopolies, the elimination of entry restrictions, and the adoption of incentive- based regulatory techniques. An example is the so-called ‘Full competition’ directive (96/19), which required the elimination of all remaining legal barriers to entry in telecommunications markets by January 1, 1998.
Where competition within the market is not feasible an alternative competition for the market has been introduced (Demsetz 1968). For example, auctions for the franchise right to operate the mobile telecommunication services have been used in the United Kingdom, Germany, Italy, and the Nether- lands. Provided that (a) inputs are competitive available to all bidders, and (b) there is no collusion among bidders, auctions compel prospective entrants to reveal private information on their services, thus reducing the agency problem that characterizes the relationship between the government and the regulated firm. Regulated firms almost always have superior information concerning costs, demand conditions, products quality, and technological possibilities than the regulator. Indeed, this asymmetric information plagues the whole (multi)principal– (multi)agent relationship of the regulatory problem. Informational constraints limit both the control of the regulator over the firm and the set of feasible instruments to exert such control.
In traditional rate-of-return regulation, prices are set so that the regulated firm can cover its costs plus a reasonable rate of return for capital. Here, the regulator suffers heavily for informational limitations on costs and demands. Thus, where possible, rate-of- return regulation has been displaced by more fruitful incentive-based techniques. For example, to increase the available information, the regulator may make use of external information, such as the performance of other firms as a benchmark by which to compare the performance of the regulated firm (Shleifer 1985). Yardstick competition is increasingly used by European agencies in assessing efficiency and/or evaluating performance. It has strongly been recommended by the European Commission for the regulation of interconnections prices in telecommunications. Another type of incentive-price regulation—one that avoids continuous and detailed information on costs and demands—is price–cap regulation. In price–cap regulation, the regulator fixes caps on the prices that firms can charge for their products (or basket of products) for a given period of time. Then, firms choose to price at or below the caps—that are reviewed over time. Since firms have the incentive to minimize costs, price–cap regulation induces price structures to be more in line with underlying costs than rate-of-return regulation.
Traditionally, in Europe, regulatory objectives such as quality of service, price control, and universal service obligations were thought to be more easily implemented by state-owned firms than through regulatory schemes. However, several European governments—most notably Britain, France, Germany, Italy, and Spain—have launched large privatization programs in the 1990s, which have been widely used to raise revenue and to reduce public debt without raising taxes or cutting other government services. Nevertheless, in some industries, state control through share ownership remains widespread and the dominant role of incumbents (former monopolists) is still an obstacle to full competition.
Positive theory suggests that politicians are reluctant to privatizations because they have to give up their ability to operate SOEs in ways that provide economic benefits for their political constituencies (Shleifer and Vishny 1994). Regulators have the power to generate and redistribute rents across interest groups and/or may use this power to gain, or maintain, support from their political principals. At the same time, regulated firms have incentives to ‘capture’ regulators and influence regulatory out- comes (Stigler 1971). Indeed, the European Union has strongly criticized regulatory agencies of member states for delaying the implementation of its directives aimed at liberalizing markets.
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