Lucas Papademos: Economic performance, institutions, and human values
Speech by Mr Lucas Papademos, Vice-President of the European Central Bank, at the Second
International Symposium on Universal Values: "Science, Technology and Human Values", The
Academy of Athens, Athens, 2 May 2007.
* * *
I. Introduction
This conference focuses on a fundamental and broad topic of relevance to all fields of science and
public policy: the importance of human values. The role of human values in shaping developments in
different fields of science, in assessing the implications of scientific advances and in adopting
appropriate policies is steadily becoming more widely recognised and better understood. This
observation is also true for economic science and public policy.
Over the past half-century, economic science - both theoretical analysis and empirical research -
underwent a profound transformation with the progressive and extensive adoption of mathematical
analysis, statistical methodology and use of computing technology. The "dismal science" has become
more of a true science. However, the vast majority of the significant advances in economic theory and
empirical analysis has placed little emphasis on the role of values as well as institutions in influencing
the behaviour of economic agents, the overall functioning of the economy and the orientation or
conduct of economic policy. This fact may seem rather odd since in previous years the importance of
institutions and underlying values was at the centre of economic and political thought.
The relative de-emphasis of institutions and values since the middle of the 20th century did not reflect
a lack of recognition of their significance in affecting economic behaviour and public policy. I would
argue that it was largely the result of various factors and assumptions: first, that for a given country
institutions and values could be taken as given elements of the broader economic environment that
evolved very gradually over time; second, that their effects on economic behaviour were indirect and
relatively small, compared with the influence of other determining factors of demand and supply; and
third, that their role in explaining market developments and economic relationships would be captured
in terms of two key fundamental market determinants: "productive technology" and "preferences" of
economic agents and authorities.
There are two key questions of scientific and policy relevance. First, what are the underlying factors
and forces that shape preferences, drive scientific and technological advances, foster innovation and
nurture an entrepreneurial spirit that ultimately are encapsulated in the economy's production
processes and the functioning of markets? Second, to what extent does the observed economic
performance of nations reflect these underlying factors and forces, which may be partly captured by
economic institutions and prevailing economic cultures and social models? Since the late 1990s,
increasing attention has been paid by economists and policy-makers to finding answers to these
questions. Recent economic research - both analytical and empirical - is seeking to further explore
how the economy's performance is influenced by institutions and values; and, more generally, how the
economy's functioning may change if we relax some of the simplifying assumptions about (1) the
behaviour of a seemingly "valueless", perfectly rational homo oeconomicus; and (2) the functioning of
markets that are "perfect and complete", characterised by full information, rational expectations and
largely unaffected by cultural and social values.
In my presentation, I will address some of these issues by examining how and to what extent
institutions and values may be affecting the performance of the European economy. To this end, I will
first sketch out a simple conceptual framework indicating how economic performance, the functioning
of markets, institutions and human values relate to each other. Second, I will show how the growth
performance of the European economy - compared to that of the United States - can be accounted
for by differences in the trend growth rates of productivity, labour utilisation and population; and then I
will discuss - on the basis of the empirical evidence available - the role of economic institutions, social
preferences, values and attitudes in explaining, at least partly, these differences. A key issue of
practical and policy relevance is whether European economic performance can, in fact, be improved
without giving up values or preferences that are considered to be quintessentially European. But since
there is no unique "European Social Model", I will then explore how differences in economic
institutions, reflecting different cultural values and social models, may explain the divergence in the
growth performance of European countries. Finally, I will focus on the other important dimension of
economic performance and a central policy objective: price stability. I will demonstrate the crucial role
of the institutional frameworks for central banking and fiscal policy implementation in ensuring the
preservation of price stability and the sustainability of economic growth.
II. Economic performance, markets, institutions and values: a simple conceptual
framework
Before addressing the issues I have raised, it will be useful to define the various concepts more
precisely and to specify a simple framework that describes their likely relationships and potential
effects. Needless to say, the aim is not to formulate a comprehensive theory but to sketch out a
conceptual structure that can help organise our thinking and analysis. This is illustrated in slide 3.
The economic performance of a country or economic area will be measured by its trend rate of
economic growth and its ability to preserve price stability. These indicators of macroeconomic
performance are the aggregate outcome of market mechanisms and forces and of the effects of
economic and monetary policies. Economic institutions, as well as other types of institutions (e.g.
legal) underpin the functioning of product, labour capital and money markets. They establish the
"framework conditions" for the actions of economic agents, and also define the objectives and scope of
public policies. The final - and fundamental - layer of this structure underlying both markets and
institutions is the set of "human values" which potentially influences and interacts with both.
I will use the term "human values", or simply "values" in a broad sense: to include social and cultural
values which are reflected in people's preferences and attitudes and which influence their behaviour,
including their actions as economic agents and market participants. Edmund Phelps (2006), in a very
recent paper, uses the term "economic culture" to describe the set of "cultural values, attitudes, morals
and beliefs". His concept is similar to the one I have defined as "values" and it seems to relate more to
cultural attributes than pertain closely to economic behaviour.
In principle, values can affect markets and economic performance both directly and indirectly, that is
by shaping the features, objectives and functioning of institutions. There can also be interactions and
feedback effects. The history of economic and political thought reminds us that great philosophers and
economists, starting with Aristotle and including the Enlightenment thinkers like Adam Smith, David
Hume, Immanuel Kant, and later on Max Weber (1905) and Joseph Schumpeter (1911), emphasised
the role and influence of a society's values or culture for the functioning and performance of the
economy. Karl Marx's (1867) work also centred on this relationship, but he stressed the reverse
causation: the effect of the economy's structure and markets on society's values and culture.
In recent years, and after a prolonged period of neglect, the role of values or culture as an underlying
determinant of market efficiency and overall economic performance has been emphasised and
explored by, among others, Banfield (1958), Aghion and Howitt (1998, 2005), Eggertson (2005),
Blanchard (2000, 2003, 2004), Layard (2003), Bruni and Porta (2005), Sapir (2004, 2005) and
Edmund Phelps (1973, 2003, 2006), winner of the Nobel Prize in economics last year.
III. Economic growth in Europe and the United States: the contribution of productivity,
labour utilisation and population
Let me now address these issues by examining the growth performance of the European economy. I
will use as a benchmark for comparison and assessment the US economy, which is comparable in
size and degree of development to Europe's and which has experienced high growth rates, especially
since the mid-1990s. Economic growth in Europe over the past decade and a half, and especially
since the mid-1990s, has been below our expectations and unsatisfactory in comparison with the
United States. The average growth rate for the euro area in the period 1990-2005, was 2.0%,
noticeably below the average growth of 2.3% recorded in the 1980s (1980-1989). Moreover, the gap in
real GDP growth between the United States and the euro area widened over the period 1980-2005, as
shown in Chart 1. During the 1980s, aggregate output growth in the euro area was on average about
0.5 percentage point lower than the US rate of growth. Since the early 1990s, this gap has widened.
During the past decade (1996-2005), when the euro area economy expanded on average at a
relatively robust pace of 2.3%, within the range of estimates of its potential growth rate, the US
economy experienced an economic boom driven mainly by advances in information and
communication technologies and grew by an average rate of 3.4%, that is about 1 percentage point
higher than the euro area average rate of growth (see Chart 2). We are currently experiencing a
turnaround in the relative growth performance of the euro area and the US, which I will discuss later
on. But I want first to focus on an examination of some key determinants of long-term growth of the
European economy on the basis of its past performance.
The relative decline in Europe's trend growth since the mid-1990s does not imply that Europe has
become a poorer continent: people's living standards, as measured by real GDP per capita, have risen
significantly over the past decade, especially in some countries including Greece. The European
economy has enjoyed macroeonomic stability; there have been no financial crisis or severe fiscal
imbalances although budgetary policies in a number of countries faced serious challenges. Europe is
home to competitive and globally successful companies; it enjoys comparably efficient and effective
public services; it boasts world-class infrastructure; it maintains advanced education systems and
generates internationally competitive top technology. And, at the same time, the contours of what may
be called the European Social Model have remained intact: a well-developed welfare system provides
a safety net for the needy; income inequality is relatively contained, especially when compared to
other parts of the world.
Nevertheless, in a comparative perspective, in the light of the economic growth rates registered in the
United States - not to speak of the spectacular growth dynamics in some emerging market economies
- the performance of the euro area economy has been rather disappointing. What are the reasons?
Taking a long-term perspective, and looking beyond the short-term fluctuations of the business cycle,
we must examine the fundamental determinants of its potential or long-term economic growth:
demographic trends, developments in labour utilisation and productivity and the variety of underlying
factors that affect the ability of the European economy to achieve increased efficiency and to create
more employment. In order to better understand and assess the relative contribution of these
determining factors, it is useful to express, by employing a growth accounting framework, GDP growth
in terms of the rates of change in productivity, labour utilisation and population.
Table 1 shows the extent to which the rates of change in these three variables have contributed to real
GDP growth in the euro area and in the United States over the period 1996-2005. A number of
interesting conclusions emerge from this decomposition of average economic growth. Since the
mid1990s, euro area real GDP growth has been driven mainly by labour productivity growth as measured
by the rate of change in real GDP per hour worked. However, average productivity growth in the
United States was significantly higher, by almost one percentage point. US output growth also
benefited from faster population growth, which exceeded that of the euro area by 0.7 of a percentage
point. The degree of labour utilisation improved in the euro area and had a positive effect on its
growth. In the United States, by contrast, it remained unchanged on average and thus had no impact
on growth.
The most important determinant of long-term or potential output growth in both the euro area and the
United States is labour productivity. In the euro area, however, productivity growth has declined since
the early 1980s, and it continued to decline further in the more recent period 1996-2005, when it fell,
for the first time, below that of the United States.1 Chart 3 shows the turnaround in the labour
productivity growth performance between the euro area and the United States since the mid-1990s. In
the period from 1996 to 2005, most of the real GDP growth gap (about 80%) between the United
States and the euro area could be attributed to differences in labour productivity growth (measured by
real GDP per hour worked), the remaining gap (about 20%) being explained by the joint effect of
population growth and the rate of change in the degree of labour utilisation.
Labour utilisation, that is, the extent to which labour potentially available in the economy is effectively
utilised, can be defined as hours worked per head of total population. This is the second important
determinant of economic growth. It can be expressed as the sum of four components: average hours
worked per employed person, the unemployment rate, the labour force participation rate and the share
of the working age population in the total population. Let us look at these components one by one. The
contribution to growth of the participation rate and hours worked has been much lower in the more
level
recent past than in the 1960s and 1970s. The lower of the participation rate and significant
reductions in working hours per person employed in the euro area can certainly help explain the
level
widening of the gap in the of output per capita between the euro area and the United States.
Table 2 shows how the rate of change in labour utilisation can be decomposed into the rates of
change of the four variables I referred to. The decomposition is useful because it helps to better
understand the relative contribution of developments and factors affecting labour utilisation. Some of
these factors can be influenced by policies and changes in economic institutions in a way that can
contribute to improving the economy's growth performance. Since the mid-1990s, labour utilisation in
the euro area has increased, also relative to the United States. This has contributed positively to euro
area growth and to narrowing the growth gap with the United States. However, despite this
level
improvement, the of labour utilisation - as opposed to its rate of change - in the euro area
remains much lower than in the United States. This fact reflects a lower labour force participation rate,
a higher unemployment rate, and lower average working hours per person employed in the euro area.
The figures in Table 2 show how labour utilisation, and thus GDP growth, in the euro area have been
supported by an increase in the share of the working age population that is employed (labour force
participation has risen significantly and the unemployment rate has declined somewhat). At the same
time, those employed are working, on average, fewer hours, and this has negatively affected labour
utilisation. Moreover, despite the relative improvement in the unemployment and labour force
participation rates over the past few years, the unemployment rate in the euro area is currently still
around 3 percentage points higher, and the labour force participation rate around 6 percentage points
lower, than the corresponding figures for the United States (see Chart 4). So although significant
progress has been made in raising labour participation and in reducing the unemployment rate, there
is still room for increasing the rate of utilisation of the labour force.
As I stated earlier, euro area growth has been adversely affected by a continued decline in average
hours worked per person employed. Data for the business sector show that in 2005, Europeans
worked, on average, 300 hours less per year than Americans, and less then they did in the early
1980s (see Chart 5). This gap between the United States and the euro area, which has been
widening, reflects the shortening of statutory full-time working weeks and a rise in part-time
employment in the euro area (see Blanchard, 2004).
Finally, the more dynamic demographic developments in the United States account for a substantial
fraction of the real GDP growth gap over the past ten years. Since the mid-1990s, population growth
has been on average about four times higher in the United States than in the euro area. This implies
that living standards in the euro area, in terms of real GDP per capita, continued to improve and
developed more favourably than indicated by relative real GDP growth rates. At the same time, what is
worrisome is that the gap in population growth has been even larger with regard to growth in the
working age population, which manifests that Europe has a more acute problem of population ageing.
IV. Economic growth in Europe: the role of institutions and values
IV.1. Market structures and economic institutions
Policy-makers in Europe have recognised the structural weaknesses of the European economy and
have put together a range of reforms and policy measures seeking to remedy the deficiencies
identified. The revised and refocused Lisbon strategy, which aims at making the EU "the most dynamic
and competitive knowledge-based economy in the world" by 2010, outlines the main areas where
policy action is needed (see European Community (2004) and Sapir et al. (2003)). There are five
broad areas where reforms are urgently needed: first, reforms to improve education (and on-the-job
training), boost research and development, enhance innovation and facilitate the diffusion of
technological advances, so as to fully exploit the potential of an increasingly knowledge-based
economy; second, reforms to increase competition in product and services markets; third, reforms in
labour markets to increase flexibility and adaptability of the workforce; fourth, policies and institutions to
create a more favourable business climate; and fifth, reforms to promote integration, enhance
competition and foster innovation in European financial markets, with a special emphasis on venture
capital.
Time constraints do not permit me to go into detail on the multitude of the necessary reforms that I
mentioned. What I would like to do, in line with the topic of my presentation, is to examine and explain
how and why the necessary adjustments to market structures should be accompanied by fundamental
adaptations of the pertinent economic institutions and changes in social attitudes (which are much
harder to achieve), in order to improve the performance of the European economy.2 To this end, I will
now concentrate my remarks on the labour market. In other recent papers, I have examined the role of
the financial sector and of education in fostering Europe's growth performance.
The importance of institutions for the functioning of labour markets in Europe can hardly be overstated.
In fact, it has been estimated that one half of the dramatic increase in European unemployment from
the golden days of full employment in the 1960s to the high and persistent unemployment levels of the
mid-1990s can be explained by institutional factors (Nickell et al., 2002). Which "institutions" are
particularly relevant? Let me mention three of them: first and foremost, employment protection
legislation. Second, tax-benefit-systems, which determine the so-called tax wedge between workers'
gross and net incomes, the transfers to the unemployed, and the tax burden on the employed. Third,
wage bargaining structures and procedures and the role of trade unions. Let us consider employment
protection legislation.
Workers can be protected against unemployment in various ways: either by strict regulations against
layoffs, or through unemployment benefits, or a combination of both. The two are interrelated: in
theory, employment protection legislation need not be very restrictive if an unemployed worker can
rely on generous benefits, and vice versa. What does the empirical evidence tell us? Generous
protection of "insiders", i.e. those who have a job, seems to have a negative impact on overall
employment, since it affects the probability of employment of the "outsiders", especially women, the
young and the long-term unemployed.3 The validity of this proposition is illustrated in Chart 6 on the
basis of the evidence from European countries. The lower job turnover and hiring also increases both
the duration of unemployment and the proportion of long-term unemployed. The impact of employment
protection legislation may be particularly adverse in industries that are subject to rapid technological
change. In the context of increasing international economic integration, policies that constrain the
reallocation of workers from uncompetitive industries to industries with a comparative advantage can
adversely affect output and employment. To address the challenges of globalisation, institutions have
to be in place to ensure that people are equipped with the right skills to safeguard their employability
(Gordon 2004).
These arguments do not imply that workers cannot be protected against unemployment in an efficient
manner. An alternative approach is "protect the worker, not the job". A less restrictive framework of
employment protection would go hand in hand with better unemployment benefits. Such a combination
of labour market institutions is at the core of the Danish so-called "flexicurity" model, which has
recently received considerable attention. In Denmark, job turnover is also relatively efficient, possibly
as a result of relatively long notification periods which allow displaced workers to search for their next
job in good time, aided by active labour market measures (such a training, etc.). As a result, the rate of
long term unemployment is low.
Another pertinent point, supported by the empirical evidence, is that rigidities in labour markets and
restrictive product market regulations are also closely connected. Recent studies have shown a high
correlation between employment protection legislation and restrictive product market regulations
across OECD countries (Nicoletti and Scarpetta (2005)). This should not come as a surprise, since it is
much easier to sustain a high level of employment protection in an industry if competitors are kept out
of its market. Therefore, amendments to employment protection legislation should be considered in
relation to the implementation of product market reforms to promote competition. Fostering, promoting
competition in product markets will facilitate the implementation of labour market reforms.
These arguments suggest that the envisaged policy actions in line with the Lisbon strategy aimed at
improving the functioning of labour and product markets - and the review of the institutions that
determine their organisation which this reform agenda entails - can be expected to have mutually
reinforcing beneficial effects on the performance of the economy. The improvement in labour utilisation
in the euro area witnessed in recent years partly reflects the favourable effects of past labour market
reforms. However, when looking at the levels of unemployment and labour force participation rates, it is
clear that, despite the progress made, further improvements on both of these labour market fronts are
possible and urgently needed.
IV.2. Values, preferences and economic culture
Institutions that are inappropriately designed are thus at least partly responsible for the unsatisfactory
performance of the European economy. However, we should go one step further and look at the social
values preferences
and that influence the behaviour of economic agents who interact with, and are
affected by, the economic institutions referred to earlier. After all, the various reforms envisaged in the
Lisbon agenda will fail to produce tangible results if they run counter to what many Europeans
perceive to be quintessentially European values, preferences and attitudes. As outlined in the simple
conceptual framework introduced earlier, economic performance and the functioning of markets can
be directly influenced by values and deeply held beliefs - such as self-realisation, fulfilment in life and
other post-materialist values; the relative importance of work, achievement and success; freedom,
competition and cooperation; tradition and religion; family and community; safety and protection, etc.
A number of economists have argued that lower labour force participation rates and shorter working
hours in Europe relative to the US may reflect a preference on the part of Europeans for more leisure
time over additional income.4 In other words, that Europeans seem to place more value on extra
leisure than having a few extra euros in their pockets, while Protestant work ethics and a more
materialistic attitude to life drive Americans to work harder. Other examples of differences in values
are that European women may prefer relatively more to stay at home to look after their children than
pursuing their professional careers in parallel; that older people place greater value on enjoying the
fruits of their working life through early retirement rather than continuing to seek gainful employment
until - or even beyond - the official retirement age.
Nobel Laureate Edmund Phelps has recently investigated and sought to estimate empirically, by
employing econometric techniques, the possible direct effects of deeply held values by people
interviewed for the World Values Survey on some of the key determinants of economic performance
that I discussed earlier: labour participation and productivity. He found, for example, that the lower
number of Europeans, compared to Americans and other nationalities, stating that their job is most
important in their lives is significant in explaining lower labour participation rates and lower
employment in Europe (Phelps 2006). Furthermore, he found that the more people take pride in their
work, the greater is their participation in the labour market, and the larger the reduction in
unemployment. In other words, the evidence suggests that (1) Europeans are not as deeply involved in
their jobs and place relatively lesser importance on work - compared to, say, Americans or Japanese
- and (2) this fact can be directly linked to lower labour participation rates and higher unemployment
rates, and thus to slower economic growth in Europe.
Similar direct effects could be identified in connection with productivity: Phelps found that "acceptance
of competition" by the public has a strong impact on productivity, meaning that in countries where a
majority of people state that competition is helpful rather than harmful, productivity in the economy is
higher. Similarly, the more people value the opportunity to use initiative in their job, the better the
productivity performance of the economy.
Although this is a partial analysis, these findings provide some striking evidence of direct linkages
between values, institutions and economic performance. An understanding of deeply held values,
attitudes and preferences may thus help in explaining some of the differences in productivity and
labour utilisation between Europe and the United States. However, more work is needed to test the
robustness of the empirical results and to better understand conceptually the linkages between values
and the "intermediate" determinants of economic performance such as productivity and labour
within
utilisation. Moreover, differences Europe are significant and need to be taken into account.
V. Economic performance of European countries: the influence of social values and
economic culture
Indeed, Europe is "united in diversity", as a suggested motto of the European Union states. A
comparison of the growth performance of the US and European economies masks considerable
diversity, on both sides of the Atlantic, but especially among European countries, as Chart 7 shows. A
diversity of growth rates among the members of large monetary unions, such as the euro area and the
US, is not unusual. In fact, the dispersion of growth and inflation rates within the euro area since the
introduction of the euro is very similar to that observed across regions and states in the US. What is
persistence
characteristic of Europe, however, is the of the observed dispersion in growth rates. This
persistence may be attributed to a number of factors, such as the stimulative effects of historically low
interest rates, which sustained dynamic growth over recent years, especially in Spain, Ireland and
Greece. Another important factor, which has received increasing attention, is the potential
longerlasting influence of differences in economic institutions and social values, encapsulated in the
socalled social models, of different European countries on their economic performance. As Sapir (2005)
has observed, "the notion of a single "European Social Model" is largely misleading."
The prevailing social models in European countries can be meaningfully grouped into four types, as
shown in Chart 8:
First, there is what could be called the Nordic model, which applies to Scandinavia, Finland
and also includes the Netherlands: in this model, social protection benefits, universal welfare
provision and active labour market policies are highly developed. Public sector employment
is significant by any standards. The associated fiscal expenditures are large, necessitating
comparatively high tax rates. Powerful labour unions ensure that wage disparities remain
limited. This model has contributed to generating high employment rates, in combination of
with a low risk of poverty and relative income equality.
Second, the Anglo-Saxon model, prevailing in the United Kingdom and Ireland: in this model,
the welfare system provides a relatively limited safety net of social protection. Employment
protection legislation is rather weak, recipients of benefits have to be actively searching for
employment and flexibility in labour markets is considerable. Unionisation is low and there is
a rather large dispersion in wages between very low pay and very high salaries. Overall, this
model has a good record of generating growth and employment, but does not appear as
equitable as other models.
Third, in Germany, France, Belgium, Luxembourg and Austria, the Continental model prevails.
Here, the welfare state essentially consists of insurance-based unemployment benefit and
pensions systems, meaning transfers are seen as unconditional entitlements, which
influence the propensity to actively seek work. Trade unions, despite a general weakening
over the past years, are still influential, and income disparity is relatively low. The Continental
model seems to insure people relatively well against poverty but it may do so with less
efficiency and unsustainably: low levels of labour utilisation (in terms of the number of people
employed and hours worked) and a relatively large public sector have put pressure on public
finances.
Mediterranean
Fourth, the model, which can be identified in Greece, Italy, Portugal and Spain.
Strict employment protection legislation and early retirement schemes keep employment
levels below those of other models, because insiders are protected and incentives to take up
work are not adequate. At the same time, a relatively low coverage of unemployment
benefits means that the risk of poverty is comparably high. Rigid wage bargaining structures
in the formal economy generate a highly compressed wage structure. Together with a large
and inefficient public sector, the features of this model may render public finances
increasingly unsustainable.
The differenc