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Structural Reform in Europe
Two Lessons from History and Looking at the
Current Landscape
Barnaby Wilson, CFA, Director, Portfolio Manager/Analyst
The austerity versus stimulus debate that has permeated the European economic and political environments
since the financial crisis began has clouded a more important driver of economic performance: structural reforms.
Although structural reforms are underway throughout Europe—but more importantly in peripheral countries—many
observers will swiftly point out that the effect of these reforms has not taken shape. Observing representative examples from reform history in Europe (the United Kingdom in the early 1980s and Germany in the period 2002–2005),
we draw attention to the fact that the immediate years after these reforms exhibited slower economic growth, but
emphasise that the long-term effect following this initial period was significantly positive. As the current reforms go
through their short-term, slow growth phase, we believe this could translate into a favourable multi-year outlook for
the region.
For Professional Investors Only
2
For much of her career Angela Merkel has been compared to
Margaret Thatcher. Initially the basis for the comparison appeared
to be little more than that she was a leader who happened to be a
woman with a science degree. Since the global financial crisis, however, Merkel has taken the lead in driving structural reform across
the European Union in a way that reminds us of Thatcher’s reform
program in the United Kingdom in the 1980s. If we are right, the
outlook for growth in Europe over the next decade is materially
better than the current consensus view, therefore, we believe investors should look to take advantage of the current negativity towards
Europe.
In our previous Investment Research paper,1 The Case for Europe
we argued that structural reform was far more important to investors than the austerity versus stimulus debate. In this paper, we aim
to build on that argument. We think that structural reform is a far
more powerful driver of economic performance than many imagine.
We will show that both Thatcher’s reforms in the UK in the 1980s
and Gerhard Schroeder’s reforms in Germany from 2002 led to a
dramatic improvement in economic growth. We will examine some
of the key aspects of those reforms and suggest that the reforms that
Merkel is forcing on the periphery share many of the characteristics
that made those previous efforts so successful.
Before we begin, however, it is important to make one thing very
clear. Thatcher, Schroeder and Merkel remain controversial figures.
While we would argue that their reforms have bought very clear
economic benefits, many others are less complementary about their
social implications. For the purposes of this paper, we do not seek
to answer the debate about whether the actions that have been taken
are moral or fair. While we believe the moral debate is worth having,
this paper is focused on whether or not the changes made have contributed, or will contribute, to faster economic growth.
The first stage of our argument is to analyse the impact of how
Thatcher and Schroeder’s reforms worked.
Exhibit 1 shows the United Kingdom’s GDP growth relative to the
G7 since 1961.
The second example of successful structural reform is Germany
between 2002 and 2005. Exhibit 2 shows the performance of
German GDP relative to the G7. Again we can see a long period
(in grey) from 1992 to 2001 when the German economy was a
consistent underperformer. Over this 10 year period the German
economy grew 1% slower than the G7. Between 2002 and 2005
the Hartz reforms were enacted – and again the initial impact on
growth was negative with the gap to the G7 increasing to 1.7% per
year (red). However, from 2006 onwards the benefits have come
through with the German economy outgrowing the G7 by 0.6% per
year (blue) outperforming in five of seven years.
Exhibit 2
GDP Growth in Germany Relative to the G7, 1992–2012
(%)
3
Hartz Reforms 2002
1
0
Thatcher Elected 1979
-1
2
-2
1
-3
0
-3
As at 31 December 2012
Source: Lazard, OECD
As at 31 December 2012
Source: Lazard, OECD
2012
2009
2006
2003
1997
2000
1994
1991
1988
1985
1982
1976
1979
1973
1970
1967
1964
1961
-4
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
-5
-2
1992
-4
-1
-5
During the period 1961 to 1979, the performance of the UK
economy was poor; GDP grew slower than the G7 every year except
for one. Over that period economic growth in the UK averaged
1.5% per year less than the G7. If the UK economy had matched
G7 growth from 1961 to 1979 it would have been over 30% bigger
in 1979 than it actually was; the grey bars in the chart represent
this period. The red bars represent the period when a significant
portion of the reforms were enacted. During this period, the UK’s
economic performance got worse. In both 1980 and 1981 UK GDP
grew nearly 3% slower than the G7 – and unemployment boomed
to over 10% of the workforce. However, the blue bars show the
economic benefits of Thatcher’s program over the subsequent years.
From 1982 to 2012, the United Kingdom has grown faster than G7
by 0.3% per year (outgrowing the G7 in nearly two thirds of the
individual years2) . Put another way, the UK economy is 65% bigger
today than if it had continued to grow 1.5% a year slower than the
G7.
2
Exhibit 1
GDP Growth in the United Kingdom Relative to the G7,
1961–2012
(%)
3
To explain the chart, the first data point shows that in 1961 the
United Kingdom grew 1.4% slower than the G7 (G7 grew real
GDP at 4.2% and the UK grew 2.8%).
3
We believe these two examples provide significant support for the
view that structural reform can dramatically change the growth
trajectory of an economy, even where that economy appears to be
firmly stuck in the doldrums. Clearly government policy decisions
regarding labour markets, domestic competition and other structural reforms are only one determinant of economic growth rates.
We recognise that monetary policy, global economic conditions and
trade protocols can also influence GDP growth rates. In this paper,
we focus on the policy decisions and how they might have driven
improved economic growth rates. We cannot ascribe precise causality but feel that the anecdotal evidence is supportive of our positive
view of the impact of structural reforms.
Opening markets and enhancing competition
In our view, there are two other important points to make from
these examples. First, the benefits of the reform do not just change
the growth rate for a year or two, as the improvement can be sustained for decades. Second, the initial impact of reforms is negative
for growth. This is important to remember when we think about
Europe today. Moreover, while growth is weaker as the reforms are
being implemented, consensus opinion can become very pessimistic
about the chances of success. Thatcher’s famous “The lady’s not for
turning” speech in 1980 was a direct response to such negativity.
As late as April 2005, six leading German think tanks slashed their
growth forecasts and estimated that trend growth for Germany was
1% - half that of the euro zone and one third that of the US.
Incentives
Having suggested that structural reforms can be more powerful than
many imagine, that the benefits can last longer and that during the
implementation phase their success is likely to be widely doubted,
we now want to examine some of the actions that have been taken.
This is a challenging project as every economy will be starting down
this path from a different point. The issues that dogged the United
Kingdom in the 1960’s and 1970’s are different from those that
dogged Germany in the 1990’s and the peripheral countries today.
The solutions will also be different depending upon the cultures of
the various countries and the ideologies of the politicians in place as
the reforms are implemented. However, in our view, there are three
broad categories that have been present to a greater or lesser extent
in all three cases:
Incentives based reforms
One major issue in all three situations has been the desire to increase
the incentives for individuals to be in work relative to not being in
work. This generally involves either lowering taxes for those working or lowering benefits for those out of work. Often there may be
a combination of both. The corporate tax rate may also be lowered.
One of the key features of successful reforms in these areas is to
remove the “benefits trap”, whereby an individual on benefits will
see their income fall if they start to work.
Improved flexibility for business
Another major issue in all three situations was a high level of regulation of the labour market or very large and influential unions. This
made it harder for employers to alter their workforces in response to
changes in the environment, and as a result were believed to serve as
a strong disincentive to take on new workers. We believe successful
reforms in this area include modifying the impact of unions and
reducing the level of regulation around hiring and firing of employees.
In some cases, there was an issue with closed or monopolistic industries. These tended to be inefficient leading to higher costs for the
rest of the economy for the services provided. Often there would
be a high level of public sector involvement in these industries. The
solutions to these issues often involve opening industries to competition and private capital.
We will now examine the reforms introduced in these three main
areas:
Thatcher
This was a key component of the Thatcher reforms. Individual tax
rates were lowered considerably – particularly at the top end. In her
first budget, the top rate was cut from 83% to 60% while the basic
rate was cut from 33% to 30%. In subsequent years, the base rate
was cut further to 25% while the top rate fell to 40%. To understand the impact on incentives, a higher rate tax payer retained £60
of each extra £100 earned in 1989 compared to just £17 ten years
earlier–three and a half times as much. Corporate tax rates were also
lowered from 52% to 35%.3
At the same time, unemployment benefits were severely reduced.
The link between benefits increases and average earnings growth was
broken. Indeed, in the early years of Thatcher’s government benefits
were increased less than inflation. In addition, the component of
unemployment benefit linked to previous income was reduced and
then abolished. Relative to average earnings, the value of unemployment benefits was reduced by around a quarter between 1979 and
1991.4
Flexibility
A major aspect of the Thatcher reforms was a marked reduction in
employment labour rights. Thatcher introduced a series of measures
that dramatically impacted the unions, which included the outlawing of secondary picketing, ballots being held before strikes could
be called and the government stopping the process of negotiating
both pay and policy, which had been common in the 1970s. By the
end of her time in power less than 40% of the workforce were union
members compared to over 50% in 1979.5 The level of strikes also
fell faster in the UK than in many other countries during the 1980s.
Open markets
During her time in office, Thatcher privatised many industries, most
famously in the telecoms and utilities sectors, but also companies
such as British Airways, Rolls-Royce and Enterprise Oil. She also
oversaw major deregulation in the financial services sector, which
saw the Big Bang reforms of the City of London, and the introduction of private pensions. Selling off council houses also sparked a
major change in the UK property market.
4
Schroeder
Incentives
The Hartz IV reform was the most significant change of the reform
package. Prior to these reforms, unemployment benefits were linked
to previous salary, reaching up to 67% of previous pay for up to
32 months (capped at €4,250 per month) followed by up to 57%
of previous salary without time limit.6 Moreover, on returning to
work unemployment and other benefits were reduced dramatically
giving little incentive to return to the workplace. Following the
reforms, the link between previous salary and benefit was broken
for long-term unemployment with the introduction of a lower,
means-tested flat benefits. In addition, claimants were required to
accept any suitable job offer or face a further reduction in benefits.
Subsidies were also introduced for both employees and employers to
tackle the problem of the benefits trap.
Tax rates were also lowered for both corporates and individuals in a
process that started in 2001. Income tax rates for individuals were
cut from 23%/51% in 2000 to 15%/42% in 2005, a significant
increase in incentives. Corporate tax rates meanwhile fell from 52%
to 39%.7
Flexibility
Increased flexibility was also a major component of the Hartz
reforms. Regulation on temporary work was lowered, making fixed
term or open ended temporary contracts easier for employers to
enter into. Employer flexibility was further enhanced by increased
exemptions from dismissal protection for small employers, and
changes to regulations governing which workers should be released
first during redundancy programs.
Open markets
This was not a major focus for the German government during this
period.
Europe Today
Given the range of countries involved, we now offer some general
thoughts, followed by a more detailed examination of each of the
key peripheral economies. Each country has its own unique set of
challenges. Portugal for instance suffers from a lack of labour mobility due to the structure of its property rental market. However, Italy
has had excessively restricted professional services markets, while
Spain has suffered a great deal of political interference in the banking system.
Generally the easiest areas have been tackled first. We feel there
has been good progress across the region with opening markets,
particularly in the energy, transport and professional services sectors. Measures to enhance the flexibility of businesses have also
been widely adopted, though in Italy some of the new measures
look likely to do the opposite. The weakest performance has been in
enhancing incentives, as this is partly due to the unhelpful focus on
government deficits, which makes tax cuts hard to introduce. That
said, there has also been a failure to tackle benefit systems which can
do little to incentivise work.
In general, the economies that were hit hardest in the crisis look
to have made the biggest changes. Greece and Portugal score well
in all areas. Spain is let down only by their efforts in relation to
incentives; the reform of Spain’s banking system should have very
positive impacts for many years to come. We believe Italy is the
biggest disappointment, progressing well in opening markets, but
arguably moving backwards in the other two categories. Outside of
the periphery, the United Kingdom has made steps to increase the
incentives for work. France’s attempts to increase flexibility so far
look similar to Italy’s, with the potential to have the opposite effect.
However, the French government’s apparent acceptance of the need
for welfare reform could herald a more dramatic change.
Spain
Incentives
Limited progress has been made related to incentives. Some small
reductions to unemployment benefits are planned.
Flexibility
We have observed significant improvement in this dimension.
Companies are now free to negotiate salaries and conditions directly
with their workforces rather than being bound by collective agreements. Compensation for unfair dismissal is reduced from 45 days
per year worked to 33 days per year worked. The maximum cost is
reduced from 42 month’s salary to 24 month’s salary.8 Employers
can impose a one year probationary period on new workers and
receive tax benefits for taking on new staff on permanent contracts.9
Open markets
The major change is in the restructuring of the financial sector. In
particular, the regional/local savings banks known as caja’s have
been forced to consolidate and become more professional. The vast
majority of the institutions are now in private hands, as opposed
to being controlled by local politicians. Other industries, such as
telecoms, residential real estate and some service industries could see
enhanced competition.
Italy
Incentives
Limited progress has been made up to this point. The proposed
reforms seek to increase access to unemployment benefits and
increase the proportion of expected income from work received in
the form of unemployment benefits from 22% to over 33%.10
Flexibility
The process to dismiss/restructure workers has been simplified and
probationary periods of up to a year introduced. However, measures
have also been introduced to discourage fixed contract or temporary
positions, which is inconsistent with flexibility.
Open markets
There has been significant progress in liberalising the service, energy
and transport sectors. Professional services (for example accountancy, law and engineering) in particular were excessively restrictive
with high cost for business and many of these markets have been
liberalised. Corporate cross holdings have been reduced and there
has been significant reform of board practices in the financial sector.
5
Greece
Incentives
Unemployment benefits have been limited to 12 months and the
government has recently added a maximum of 450 days in any four
year period. The payment amount has also been cut by over 20%.11
This amount is a flat rate rather than being related to previous
salary. Public sector salaries have been cut significantly.
Flexibility
Firm level collective bargaining has been given precedence over
industry level. Rights for workers to seek arbitration unilaterally
have been removed and open-ended employment contract extensions restricted. Minimum wages have also been cut severely. The
court system has been reformed to give faster decisions and government bureaucracy has also been reduced.
Open markets
Closed professions have been liberalised. Retail, fuel, transport and
utility markets are being liberalised and there is an ongoing privatisation program.
Portugal
Incentives
Wages in the public sector have been significantly higher than those
in the private sector, reducing the incentive to work for the private
sector. This is being addressed through pay reductions in the public
sector. Unemployment benefits have been capped at 65% of previous salary and the amount payable is now reduced by 10% after 180
days.12 Measures have been introduced to withdraw benefits where
individuals refuse to accept a new job.
Flexibility
How does the comparison between
Merkel and Thatcher stand up to
scrutiny?
Based on our review of the measures being undertaken, it seems
clear to us that most progress has been made in countries which
have had the highest involvement of Germany, with Merkel’s oversight. The two program countries, Greece and Portugal, are leading
the way with Spain following closely behind. Where the Troika has
had less involvement, particularly Italy and France, progress has
been more limited.
This conclusion is supported by data from the World Bank Doing
Business report. Exhibit 3 shows the improvement in the “distance
to frontier”14 score for each of the periphery nations. This score
measures how close each country is to best practice across a range
of measures, and we can see that Portugal, Greece15 and Spain have
seen significantly more improvement than France or Italy.
Germany has dominated the debate within the European Union.
Merkel has been steadfast in pushing the reform agenda and displayed a level of conviction matched by few politicians these days. It
seems fair to award her a large part of the credit for driving through
these programs. From purely an investment perspective, investors
should hope she has the chance to impact the larger economies of
Italy and France in the same manner. If she does, we believe the
outlook for the European economy should be much better than
most people imagine.
Exhibit 3
Improvement in “Distance to Frontier” from World Bank
Doing Business Report
7
Severance payments are being reduced to 12 days per year of service
with one year’s salary as a cap.13 Collective bargaining powers are
also being modified.
6
Open markets
4
There is an active privatisation program. Government involvement
in the real estate sector is being reduced, as rental laws have been
reformed to free up the property market and encourage the movement of labour. The ports and energy sectors are being liberalised,
and the court and judicial systems reformed.
3
Other Countries
0
Incentives
-1
The United Kingdom has moved to further improve in this area.
Benefits are being capped and tax rates–particularly for lower
earners and for businesses–are being reduced. Changes to the way
benefits are withdrawn should make it easier to return to work.
-2
Flexibility
France has enacted measures to make dismissing workers or changing their hours easier. As with Italy, however, the impact may be
offset by increasing the cost of hiring temporary workers.
Portugal
5
Spain
Greece
2
France
Italy
1
2010
As at 31 May 2013
Source: World Bank
2011
2012
2013
6
About the Author
Barnaby Wilson, CFA
Director
Portfolio Manager/Analyst
Lazard Asset Management Limited
Barnaby Wilson is a Portfolio Manager/Analyst on the
European Equity team. He began working in the investment
field in 1998. Prior to joining Lazard in 1999, he worked for
Orbitex Investments. He became a member of the European Equity team in January
2006, graduating from the role of research analyst. Barnaby has a BA (Hons) in
Mathematics and Philosophy from Balliol College, Oxford University.
Notes
1.
Paper available at: http://www.lazardnet.com/lam/global/investment_research.html
2.
Given the length of Thatcher’s period in office and the fact that reforms were being carried out throughout, it is open to debate when one should start to measure the impact of those
reforms. We chose 1982 as by then the first elements of each of the key programs had been started. Had we chosen any year from 1982 to 1992, the range of outcomes for UK GDP
growth relative to the G7 until 2012 would have been +0.2% to +0.5%.
3.
HMRC
4.
Did The Thatcher Reforms Change British Labour Market Performance? David Blanchflower, Richard Freeman (1993)
5.
The impact of industrial relations legislation on British union density, Freeman, R. and J. Pelletier (1992)
6.
Before and After the Hartz Reforms: The Performance of Active Labour Market Policy in Germany, L. Jacobi, J. Kluve (2007)
7.
OECD Tax Database
8.
Spain’s Structural Reform and Economic Policy Programme, Tesoro Publico June 2013
9.
OECD Economic Policy Reforms: Going for growth, 2013
10.
OECD Italy Reviving Growth and Productivity September, 2012
11.
Greek National Reforms Program 2013
12.
European Industrial Relations Observatory
13.
European Commission Staff Working Document, Portugal, May 2013
14.
The World Bank Doing Business Report includes a “Distance to Frontier Score.” This score provides a measure of how close a country is to best practice across a range of indicators of ease of doing business. Scores are between 0 and 100 with 100 being best practice. The chart shows the improvement in the Distance to Frontier Scores for each of the five
countries since 2009—so Portugal, for instance, has improved by 6.6 points, from 68.6 in 2009 to 75.2 in 2013.
15.
Note that Greece’s improvement would be similar to Portugal’s were it not for the dramatic increase in property transfer taxes in 2011.
Important Information
Published on 2 July 2013.
All sources Lazard Asset Management unless otherwise noted.
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