Does high employment require high social inequality?

Many economists are fond of saying that a country can have relatively high employment or relatively low inequality - but not both.

The argument runs like this. Good employment outcomes can only be achieved through free, competitive markets, with low levels of social regulation, a high degree of wage flexibility, curbs on trade unions and tough welfare-to-work policies. Such policies are bound to widen earnings inequalities - but any attempt to counter this effect through tax-transfer redistribution measures would simply nullify the economic and employment benefits of the market liberalisation measures. Higher inequality is therefore a pre-condition for higher employment.

Economic theory alone cannot prove or disprove this kind of argument. Subject to the usual qualifications, economists start with a strong presumption in favour of free and competitive market economies - but once a high level of market freedom is attained, as is now the case in all Western societies, the profession is far from unanimous about the incremental effects of further market liberalisation on economic performance.

So we need to turn to the empirical literature for guidance. Many economists like to compare “Anglo” countries (the US, UK, NZ and Australia) with those in continental and southern European countries (which I will call “Continentals”). This comparison does lend support to the “trade-off” theory: Anglo countries have generally performed better on employment criteria than the Continentals but worse on income inequality.

The Nordic experience

However the trade-off hypothesis is undermined by the experience of the Scandinavians (Denmark, Norway, Sweden, Iceland and Finland) and countries like Ireland, Netherlands and Austria. These Northern Europeans, whom I will call “Nordics”, have generally been able to deliver low levels of inequality as well as strong employment outcomes.

Some critics refuse to accept this assessment. In particular they challenge the employment statistics put out by Nordic countries. They argue, for example, that while the official Swedish unemployment rate is well under 5 per cent, the “true” jobless rate is closer to 15 per cent because official figures fail to include discouraged workers who have stopped looking for work, young mothers who choose not to work, people on sick leave or on training and employment schemes, and so on.

Economists have always known that official unemployment figures tend to understate the degree of under-utilisation of the workforce and that there is considerable “hidden unemployment”. But this is not something unique to the Nordics. Exactly the same can be said of other countries. For example, in the US and Australia, if one adds on the number of discouraged and under-employed workers to the official rate, the true jobless rate is very much higher than the official rate. The estimates range from 10 to 20 per cent depending on what you include.

The OECD has rightly chosen not to get into these messy complications. It publishes members’ official unemployment figures on a comparable and widely accepted measurement basis. And it tries to give some indication of cross-country differences in the incidence of “hidden unemployment” by publishing figures on the ratio of employment to working age population and labour participation rates. On all these indicators, the Nordic employment performance is quite comparable to that of the Anglos.

So how do we explain the Nordic success? In a forthcoming paper I hope to examine the issues in detail. In this short opinion piece I will, at the risk of over-simplification and over-generalisation, sum up my tentative views on four specific questions.

Why are the Nordics able to deliver social outcomes that are at least as good as the Continentals - yet out-perform them on employment?

I believe the answer lies with the methods of redistribution employed. These differ from the Continentals in three respects. First, Nordic countries rely less on employment protection legislation. In particular, they allow more flexibility on hiring and firing.

Second, the Nordics provide generous benefits for the jobless but the benefits are more tightly linked to work. That is, they reward well those who enter education or training or are actively searching for work but reduce their benefits if they reject these options.