While many European countries have suffered from chronically high unemployment and relatively low economic growth, Denmark’s economy has performed well in recent years. Output growth has been running slightly above 3 percent per annum last year and in the first half of this year, and unemployment fell to about 4.4 per cent this past summer (well below the average of around 8 percent unemployment in the euro area as a whole).
Are the Danes, with their ‘conservative’ government, exemplary Europeans these days? A recent economic study (PDF) by economists from the International Monetary Fund provides some support for that contention, at least in the area of labor market policies. The Danish labor market model is sometimes referred to as “flexicurity” because it appears to deliver simultaneously labor market flexibility and social security. Basically, employers in Denmark are relatively free to hire and fire, which stimulates hiring of workers, and those workers receive generous social security benefits if they lose their jobs. At the same time, active labor market policies ensure that newly unemployed persons are being offered a new job or training within a relatively short time.
Both (1) the flexibility enjoyed by employers and (2) the active labor market policies pursued by government help to reduce structural unemployment (as distinct from cyclical unemployment). At the same time, (3) the third element of the Danish model, i.e. the generous unemployment benefits, tends to increase structural unemployment (by reducing incentives to work and by raising the so-called “reservation wage(s)” (i.e. the wage at which unemployed people are willing to work), while the tax wedge on labor income (necessary to finance labor market programs and welfare benefits) raises unemployment through its negative effect on labor demand and labor supply. On the whole, though, positive effects have clearly outweighed negative ones, and the unemployment rate has significantly declined in Denmark since the early 1990’s, while it did not change much in the euro area as a whole over the same period.
To be fair, bad memories have been stimulating economic reforms for some time now in Denmark, particularly in reaction to the 1980’s, when the economy suffered from high inflation and unemployment, unsustainable budget deficits and large current account deficits (on the external balance of payments). Since 2001, high priority is being given to fiscal consolidation and to increasing (‘activating’) the labor supply in Denmark, to help the country cope with the pressures from an aging population, e.g. through increasing the retirement age.
Should other European countries try to emulate Denmark? The answer is not immediately obvious or straightforward. First, because Denmark itself in the 1980’s could manage to start bringing unemployment down only after tightening unemployment benefits and labor market policies. In other words, under different macroeconomic circumstances, the combination of flexible labor markets with high income protection did then not by itself give good employment results. Second, a comparable country like Sweden has also managed to lower unemployment over the last decade or so while maintaining more rigid labor markets (in terms of protection against dismissal), but perhaps at a cost of lower economic growth. Third, other countries like Ireland and Britain have lowered unemployment significantly through systems characterized by relatively low unemployment protection and low replacement rates. Finally, the Danish ‘flexicurity’ model is very costly to implement. High spending on labor market programs and unemployment benefits amounts to about 5 percent of GDP in Denmark. This makes the model less applicable to countries with existing high unemployment and weak public finances, because a move to the Danish system would require a further widening of the existing tax wedge and that would negatively impact on employment. To illustrate this, and using an econometric model for France, the IMF economists find that the impact there on structural unemployment would be very limited in the first few years.
Nevertheless, the specifics of the Danish flexicurity model deserve careful consideration from other governments. Labor market flexibility is a necessary requirement in order to achieve high economic growth and low unemployment, at least in advanced and diversified economies, and in the European context such flexibility is more likely to be acceptable to the population in combination with a well-functioning social safety net. Such a trade-off also provides a strong argument to maintain ‘strong’ public finances (i.e. avoid wasteful public spending), because that would enable financing for the pursuit of high employment policies.