failing to allocate talent in the most efficient manner. The reason? Heightened job insecurity.
Job security is a thorny issue. Free-market economists believe that any labour market regulation that makes firing more difficult makes the economy less efficient and dynamic. To start with, it weakens the incentive for workers to work hard. On top of that, it discourages wealth creation by making employers more reluctant to hire additional people (for fear of not being able to fire them when necessary).
Labour market regulations are bad enough, it is argued, but the welfare state has made things even worse. By providing unemployment benefits, health insurance, free education and even minimum income support, the welfare state has effectively given everyone a guarantee to be hired by the government – as an ‘unemployed worker’, if you like – with a minimum wage. Therefore, workers do not have enough incentive to work hard. To make things worse, these welfare states are financed by taxing the rich, reducing their incentives to work hard, create jobs and generate wealth.
Given this, the reasoning goes, a country with a bigger welfare state is going to be less dynamic – its workers are less compelled to work, while its entrepreneurs are less motivated to create wealth.
This argument has been very influential. In the 1970s, a popular explanation of Britain’s then lacklustre economic performance was that its welfare state had become bloated and its trade unions overly powerful (which is also partly due to the welfare state, insofar as the latter dulls the threat of unemployment). In this reading of British history, Margaret Thatcher saved Britain by putting unions in their place and reducing the welfare state, even though what actually happened is more complicated. Since the 1990s, this view of the welfare state has become even more popular with the (allegedly) superior growth performance of the US to those of other rich countries with bigger welfare states.[2] When governments in other countries try to cut their welfare spending, they frequently cite Mrs Thatcher’s curing of the so-called ‘British Disease’ or the superior dynamism of the US economy.
But is it true that greater job security and a bigger welfare state make an economy less productive and dynamic?
As in our Korean example, a lack of job security can lead youngsters to make conservative choices with their career, favouring secure jobs in medicine or the law. This may be the right choice for them individually, but it leads to a misallocation of talents and thus reduces economic efficiency and dynamism.
The weaker welfare state in the US has been one important reason why trade protectionism is much stronger there than in Europe, despite a greater acceptance of government intervention in the latter. In Europe (of course, I am ignoring national differences in the details), if your industry declines and you lose your job, it is a big blow but not the end of the world. You will still keep your health insurance and public housing (or housing subsidies), while receiving unemployment benefits (up to 80 per cent of your last pay), government-subsidized retraining and government help in your job search. In contrast, if you are a worker in the US, you’d better make sure you hold on to your current job, if necessary through protectionism, because losing your job means losing almost everything. Unemployment insurance coverage is patchy and of shorter duration than in Europe. There is little public help with retraining and job search. More frighteningly, losing your job means losing your health insurance and probably your home, as there is little public housing or public subsidies for your rent. As a result, worker resistance to any industrial restructuring that involves job cuts is much greater in the US than in Europe. Most US workers are unable to put up an organized resistance, but those who can – unionized workers – will, understandably, do everything they can to preserve the current job distribution.
As the above examples show, greater insecurity may make people work harder, but it makes them work harder in the wrong jobs. All those talented Korean youngsters who could be brilliant scientists and engineers are labouring over human anatomy. Many US workers who could – after appropriate retraining – be working in ‘sunrise’ industries (e.g., bio-engineering) are grimly holding on to their jobs in ‘sunset’ industries (e.g., automobiles), only delaying the inevitable.
The point of all the above examples is that, when people know they will have a second (or third or even fourth) chance, they will be much more open to risk-taking when it comes to choosing their first job (as in the Korean example) or letting go of their existing jobs (as in the US– Europe comparison).
Do you find this logic strange? You shouldn’t. Because this is exactly the logic behind bankruptcy law, which most people accept as ‘obvious’.
Before the mid nineteenth century, no country had a bankruptcy law in the modern sense. What was then called bankruptcy law did not give bankrupt businessmen much protection from creditors while they restructured their business – in the US, ‘Chapter 11’ now gives such protection for six months. More importantly, it did not give them a second chance, as they were required to pay back all debts, however long it took, unless the creditors gave them a ‘discharge’ from the duty. This meant that, even if the bankrupt businessman somehow managed to start a new business, he had to use all his new profits to repay the old debts, which hampered the growth of the new business. All this made it extremely risky to start a business venture in the first place.
Over time, people came to realize that the lack of a second chance was hugely discouraging risk-taking by businessmen. Starting with Britain in 1849, countries have introduced modern bankruptcy laws with court-granted protection from creditors during initial restructuring and, more importantly, the power for courts to impose permanent reductions in debts, even against the wishes of the creditors. When combined with institutions like limited liability, which was introduced around the same time (
Insofar as it gives workers second chances, we can say that the welfare state is like a bankruptcy law for them. In the same way that bankruptcy laws encourage risk-taking by entrepreneurs, the welfare state encourages workers to be more open to change (and the resulting risks) in their attitudes. Because they know that there is going to be a second chance, people can be bolder in their initial career choices and more open to changing jobs later in their careers.
What about the evidence? What are the relative economic performances of countries that differ in terms of the sizes of their welfare states? As mentioned, the conventional wisdom is that countries with smaller welfare states are more dynamic. However, the evidence does not support this view.
Until the 1980s, the US grew much more slowly than Europe despite the fact that it had a much smaller welfare state. For example, in 1980, public social expenditure as a share of GDP was only 13.3 per cent in the US, compared to 19.9 per cent for the EU’s fifteen countries. The ratio was as high as 28.6 per cent in Sweden, 24.1 per cent in the Netherlands and 23 per cent in (West) Germany. Despite this, between 1950 and 1987, the US grew more slowly than any European country. Per capita income grew at 3.8 per cent in Germany, 2.7 per cent in Sweden, 2.5 per cent in the Netherlands and 1.9 per cent in the US during this period. Obviously, the size of the welfare state is only one factor in determining a country’s economic performance, but this shows that a large welfare state is not incompatible with high growth.
Even since 1990, when the relative growth performance of the US has improved, some countries with large welfare states have grown faster. For example, between 1990 and 2008, per capita income in the US grew at 1.8 per cent. This is basically the same as in the previous period, but given the slowdown in the European economies, this made the US one of the fastest-growing economies in the ‘core’ OECD group (that is, excluding the not-fully- rich-yet countries, such as Korea and Turkey).
The interesting thing, however, is that the two fastest-growing economies in the core OECD group during the post-1990 period are Finland (2.6 per cent) and Norway (2.5 per cent), both with a large welfare state. In 2003, the share of public social spending in GDP was 22.5 per cent in Finland and 25.1 per cent in Norway, compared to the OECD average of 20.7 per cent and 16.2 per cent in the US. Sweden, which has literally the largest welfare state in the world (31.3 per cent, or twice as large as that of the US), at 1.8 per cent, recorded a growth rate that was only a shade below the US rate. If you count only the 2000s (2000–8), the growth rates of Sweden (2.4 per cent) and Finland (2.8 per cent) were far superior to that of the US (1.8 per cent). Were the free-market economists right about the detrimental effects of the welfare state on work ethic and the incentives for wealth creation, this kind of thing should not happen.
Of course, by all this I am not suggesting that the welfare state is necessarily good. Like all other institutions, it has its upsides and downsides. Especially if it is based on targeted, rather than universal, programmes (as in the US), it can stigmatize welfare recipients. The welfare state raises people’s ‘reservation
