Ifo Viewpoint No. 72:The Next Welfare State

Hans-Werner Sinn
Munich, 2 March 2006

A market economy is efficient, but it is not just. Because wages are determined by the law of scarcity, some people cannot earn enough money to live a decent life.

In Western Europe, the welfare state helps these people. It guarantees a socio-cultural subsistence minimum by paying replacement incomes in the form of social aid, unemployment benefits, or early retirement benefits. If the market does not provide you with a sufficient labor income, the state will provide an income without work for you.

But, as humane as this policy is meant to be, it is largely responsible for the mass unemployment from which Europe now suffers. The reason is simple. Replacement incomes are wages for doing nothing. They establish “reservations wages” or minimum wage demands against the private economy that employers are increasingly unwilling or unable to satisfy.

Employers are not altruists. They employ a domestic worker only if there is a surplus of his contribution over his cost and if this surplus is not smaller than the respective surplus that a rival worker in another country or a robot could generate. And workers are not stupid. They accept a job only if they earn more than the public replacement income. Thus, workers who are not productive enough to justify a wage above the replacement income are bound to become unemployed.

While this is an old problem in Western Europe, it has been dramatically exacerbated by the fall of the Iron Curtain, which, together with China’s opening, has suddenly brought 28% of mankind into the western market system. The integration of the Asian Tigers in the 1970’s and 1980’s was difficult enough. The addition of the ex-communist countries will remain the world’s biggest challenge in the first half of this century.

While the integration of these economies may yield gains from trade for most countries involved, it creates huge problems in the West, stemming from more intense downward pressure on the wages of the unskilled than ever before. Financial capital and direct investment will flow from West to East, the Western economies will be forced to specialize in highly skilled, capital-intensive production that creates fewer jobs, and unskilled immigrants will move to the West.

All of these forces will increase the excess supply of unskilled labor in the West, thereby reducing the equilibrium wage rate. True, the movement towards a new equilibrium will last decades. Most readers of this article will be dead before it is reached. But the process will be enduring and persistent.

If Western labor markets were flexible and gave way to the increasing pressure, employment could be maintained with falling wages for unskilled workers. But, given that the welfare state makes wages “sticky,” an increasing level of mass unemployment is the most likely consequence of globalization.

Politicians in the West react to the downward pressure on wages by making them even more rigid. Germany, for example, plans to impose a legal minimum, as other countries have done in the past. But such measures will merely worsen the situation: specialization in activities in which unskilled workers are not needed intensifies, even more capital will leave the country, and even more people will be attracted from abroad, driving more domestic residents into the welfare system. Mass unemployment in the West will be higher, not lower.

Europe’s welfare system based on replacement incomes and minimum wages will not survive globalization. It may take another decade or two for politicians to understand this, but in the end they will. There is no way to turn back the tide of history.

The real question, then, is whether the European welfare state must die altogether.

A new welfare system that could both preserve Europe’s social values despite the forces of factor price equalization and avoid mass unemployment would have to be based on wage supplements rather than replacement incomes. Everyone would have to work, at whatever wage he finds employment, and the government would then pay a supplemental income to ensure a socially acceptable standard of living.

When governments pay people while they work, rather than only if they do not work, as is the case today, welfare benefits imply no minimum wage demands. Income from labor freely adjusts to forge equilibrium between supply and demand. With lower wages, more jobs are created, because employers find it profitable to realize a larger fraction of the blueprints on their tables and the ideas in their heads. And poverty will be avoided because unskilled workers will have two incomes: one earned by themselves and one provided by the government.

Such a system is expensive, but so is the current system, which pays millions of people 100% of their incomes while they are not working. In the new system, the state pays even more people, but the payments per head are much smaller as they represent a supplementary rather than a full income.

It is a matter of algebra and econometrics to determine which system is cheaper. According to reasonable estimates for Germany by the Ifo Institute, a welfare system based on wage supplements will, indeed, be cheaper. In any case, substituting replacement incomes with wage supplements will not only lead to more employment and higher GDP, but ensure that fewer people are deprived of the dignity that only a responsible working life can offer.

Hans-Werner Sinn
Professor of Economics and Finance
President of the Ifo Institute

Published as “Arbeit für alle”, Die Welt, 1 March, 2006, p. 9; printed also in: Die Presse (Austria), L'Echo (Belgium), Kapital (Bulgaria), Financial Mirror (Cyprus), Ekonom (Czech Republic), Aripaev (Estonia), Taloussanomat (Finland), Vilaggazdasag (Hungary), Diena (Latvia), Diario Economico (Portugal), Dilema Veche (Romania), Danas (Serbia), Sme (Slovakia), L'Agefi (Switzerland), Diario Las Americas (USA), Jordan Times (Jordan), Al Raya (Qatar), Al Eqtisadiah (Saudi Arabia), South China Morning Post (Hong Kong), The Japan Times (Japan), The Korea Herald (South Korea), Daily Times (Pakistan), The Straits Times und Lianhe Zaobao (Singapore), Taipei Times (Taiwan), Les Echos (Mali), Business World (Philippines), AKI-Press (Kyrgyzstan), Optovik (Uzbekistan), El Siglo XXI (Guatemala), Ultima Hora (Paraguay).