04 May 2011

Institutional stability in European welfare states

How should we characterise changes in the welfare state? Originally, orthodox economics suggested that there was an optimal way to organise the economy. As a logical consequence of this, welfare states and the economy in which they are embedded would evolve towards best practice. Indeed, that was also the 'convergence thesis' that standard (pre-new growth) theory would predict. Countries with lower levels of development would have higher returns to capital. Provided that capital markets were free, capital would flow towards high return countries, thereby resulting in a natural tendency for economies to converge.

Adding to this functionalist conception of change, common pressures would accelerate and further promote this dynamic of institutional convergence on a best practice. With open capital markets, higher trade volumes and common regulatory frameworks such as the WTO, the EU, and so on, European countries would inexorably converge to the best suited model, often assumed to be the liberal (UK) model. This could be characterised as a 'race to the bottom' where tax competition together with freedom of movement of capital and people would undercut the welfare state.

These theoretical predictions eventually had to come to grip with the contradicting empirical evidence. Indeed, not only did countries not converge on a liberal model, but institutional arrangements continued to differ widely in Europe. This realisation gave an important impetus to new theories emphasising the clustering of nations in distinct and stable models. European countries could then be seen to belong to different welfare regimes and types of capitalism. 

Distinct historical origins of the welfare states meant they relied on different political compromises among a variety of interests in society. The range of potential changes that could be implemented was highly path dependent: certain changes were made easier by past developments while others were unlikely to take place. For instance, liberalisation of welfare state institutions in the UK and Germany were not as feasible given widely different political and economic systems. This is because the capacity of actors such as trade unions to block change is much higher in Germany than in the UK. 

But it is also because the consequences of these changes in economic terms differs significantly between these two countries. In the UK, the market is the main organising mechanism through economic exchanges take place. General skills of workers, low protection and flexible labour markets and liberalised capital markets ensure that the economy produces efficient outcomes in certain sectors where the UK is specialised. Most often these sectors entail radical innovation. Institutions can then be said to be complementarity in the sense that flexible labour markets allow labour to be quickly reallocated to newly productive companies. This is further facilitated by the general skills of workers that can adapt quickly. Flexible capital markets can similarly allocate capital where it is most required and withdraw from non-performing companies or sectors. By and large this is the standard liberal model which is advocated as best practice by orthodox economics. So what's wrong with transposing features of this model to Germany?
In Germany by contrast, actors such as companies, workers and investors, coordinate their actions through profoundly different non-market mechanisms. The most efficient sector in company is the export oriented production of manufactured goods and machineries. To remain competitive these sectors require incremental innovation, that is improvements at the margin of existing products. As a result of this difference, companies require workers with specific skills and in-depth knowledge of the product.  Thus, the importance of Vocational education is fundamentally different in a liberal system as the UK and in a coordinated system as Germany. 

Similarly, if workers are expected to specialise in firm specific skills, this requires a significant and risky investments on their part. In the event where they are fired - a necessary flexibility in the UK - they lose their firm and skill specific investment and cannot easily find an alternative source of employment. This would then lead to a market failure whereby necessary investments in Human Capital are not undertaken. To address this issue, high employment protection and unemployment benefits protect the investments these workers make. What may make sense in the liberal British system would have negative economic consequences in Germany: Retrenching welfare state benefits and cutting employment protection may undermine the institutions on which the efficiency of the German economic model is based.

There is therefore both a historical and political dimension and an economic rationale for continuing diversity in welfare state arrangements. Two conclusions stem from this discussion. First, by misunderstanding the sources of efficiency in different capitalist systems, orthodox economic policy recommendations and their one-size-fits-all charateristic risks having adverse effect on European Economies. Second, institutional diversity is here to stay and this is not merely because powerful actors such as labour refuse efficiency enhancing changes.
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Hall, P. A. and D. Soskice (2001). Varieties of capitalism the institutional foundations of comparative advantage. Oxford, Oxford University Press

Esping-Andersen, G. (1990). The three worlds of welfare capitalism. Cambridge, Polity.

Scharpf, F. W. and V. A. Schmidt (2000). Welfare and work in the open economy : diverse responses to common challenges. Oxford, New York, Oxford University Press.

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