EU needs labour and welfare reform

By Martin Wolf

Financial Times

Published: April 6 2005

European enlargement promises to end the division of the continent, which goes back at least to the second world war. But, as I argued last week, it also creates huge challenges for the continent's richer west. If the west is to cope, it must make big reforms to its labour markets and welfare states.

Integration of two economies generates price and wage convergence. If that convergence is prevented, the gains are thwarted and unemployment results. If wages are pushed too high in the poorer region, as happened during German unification, unemployment will emerge there. If wages are kept too high in the richer region, the unemployment will emerge there, instead, as production shifts to the low-wage region next door.

The implications of this analysis for European integration are evident. As Hans-Werner Sinn of the Ifo Institute for Economic Research in Munich points out, hourly labour costs in the present wave of accession countries were, on average, one-seventh of the west German level in 2003 (see chart)*. When Portugal and Spain joined in the 1980s, their wages were roughly half west German levels.

The incentive for migration then is huge, as is that for moving production in the opposite direction. The Ifo Institute calculates that about 4 to 5 per cent of the population of the accession countries would migrate to the old members if migration were unrestricted. While the numbers do not seem that large (about 4m for the current accession countries), most would probably go to Austria and Germany. Moreover, while migration is curbed for seven years from the date of accession, gaps in wages - and so in incentives to migrate - are certain to remain enormous long after.

Migration creates gains if prices and wages are flexible. But western labour markets and welfare states are designed to prevent such flexibility. In effect, the welfare state sets a minimum cost of labour well above the net earnings of workers in many poorer European regions.

The high minimum wage determines the employment offered in the economy. This then attracts migrants to take the jobs of nationals who are indifferent between work and state support. Between 1970 and 2002, unemployment of domestic workers rose by 3.2m in Germany. Over the same period, the net immigration of working people was about 3.1m. The match is uncanny.

As Prof Sinn notes, however, such migration is economically useless: it reduces output in the country of origin and lowers it in the recipient. Only if countries have flexible labour markets can migration be beneficial: Israel, the US and today's UK come to mind. Germany is in the opposite category.

Such unemployment-generating immigration is not the only danger. Another is that a generous welfare state is a magnet for immigrants and particularly for low-skilled immigrants. The higher the quality of public infrastructure and services, the bigger the attraction. It is for this reason that only after a lengthy period do immigrants pay back the general benefits they receive.

Within an integrated labour market it is impossible for one region to offer much better benefits than others without generating a ruinously costly inflow of benefit seekers. That is what happened to New York in the 1970s. This is why welfare states must work at the level of the entire labour market.

As Germany becomes part of a bigger labour market with hugely divergent welfare standards, it will become a magnet for immigrants. The attractions are evident: west German social aid levels are far higher than the net wage in a number of poorer regions of Europe that lie right next door.

There exist four ways of resolving the dilemma: the free movement of immigrants from other European Union member states could be prohibited until substantial income convergence had been achieved; welfare levels could be harmonised upwards across the EU; welfare states in rich countries could be made substantially less generous; or many non-contributory benefits could be made unavailable to immigrants.

All have drawbacks: the first would violate a fundamental principle of the EU; the second would create east Germanys across central and eastern Europe, at huge cost to the wealthier members; the third would be politically explosive; and the last would create second-class residents.

Similarly, there are two ways of remedying the adverse labour-market impact of migration: elimination of benefits that create a high reservation wage in the recipients; or the transformation of many of those benefits into wage subsidies paid to nationals, but not immigrants.

Not surprisingly, the new constitution, with its nonsense about a "social union", makes the wrong choices. According to Prof Sinn, it seems to mean that "a citizen of the Union may reside where he wants and that he is then entitled to the host country's full social security benefits and social advantages". Moreover, this seems to apply to anybody who moves to another country, not workers alone.

The result must be the harmonisation of welfare across the continent at the level either of the rich countries or the poor ones. The choice would be between economic collapse in the latter and the end of social harmony in the former.

What are the solutions? In the richer countries, wage subsidies, combined with far greater wage flexibility, should largely replace benefits to those out of work. Those subsidies and other non-contributory welfare benefits should be withheld from migrants. Moreover, non-employed people should gain support from their home countries. The motto, as Prof Sinn puts it, is that each EU citizen is welcome but not to receive unearned gifts.

Wage flexibility, wage subsidies for nationals, limits on non-contributory benefits for immigrants and home country support of non-workers are the only way to integrate rich and poor countries without destroying the welfare levels of the former or the economies of the latter. That is not what the designers of the constitution seem to have in mind.

Yet making a mess of the interaction of labour markets with welfare states in an integrating continent will have a devastating impact on Europe's economic, social and political future. The time to get this right is now. There is no tomorrow.

* EU Enlargement, Migration and the New Constitution, CESifo Economic Studies, Vol 50,