Lazard Investment Research: Structural Reform in Europe, Two Lessons from History and Looking at the Current Landscape.
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Lazard Investment Research: Structural Reform in Europe, Two Lessons from History and Looking at the Current Landscape.

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The austerity versus stimulus debate that has permeated the European economic and political environments ...

The austerity versus stimulus debate that has permeated the European economic and political environments
since the financial crisis began has clouded a more important driver of economic performance: structural reforms. Although structural reforms are underway throughout Europe—but more importantly in peripheral countries—many observers will swiftly point out that the effect of these reforms has not taken shape. Observing representative exam- ples from reform history in Europe (the United Kingdom in the early 1980s and Germany in the period 2002–2005), we draw attention to the fact that the immediate years after these reforms exhibited slower economic growth, but emphasise that the long-term effect following this initial period was significantly positive. As the current reforms go through their short-term, slow growth phase, we believe this could translate into a favourable multi-year outlook for the region.

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Lazard Investment Research: Structural Reform in Europe, Two Lessons from History and Looking at the Current Landscape. Lazard Investment Research: Structural Reform in Europe, Two Lessons from History and Looking at the Current Landscape. Document Transcript

  • Investment Research Structural Reform in Europe Two Lessons from History and Looking at the Current Landscape Barnaby Wilson, CFA, Director, Portfolio Manager/Analyst The austerity versus stimulus debate that has permeated the European economic and political environments since the financial crisis began has clouded a more important driver of economic performance: structural reforms. Although structural reforms are underway throughout Europe—but more importantly in peripheral countries—many observers will swiftly point out that the effect of these reforms has not taken shape. Observing representative examples from reform history in Europe (the United Kingdom in the early 1980s and Germany in the period 2002–2005), we draw attention to the fact that the immediate years after these reforms exhibited slower economic growth, but emphasise that the long-term effect following this initial period was significantly positive. As the current reforms go through their short-term, slow growth phase, we believe this could translate into a favourable multi-year outlook for the region. For Professional Investors Only
  • 2 For much of her career Angela Merkel has been compared to Margaret Thatcher. Initially the basis for the comparison appeared to be little more than that she was a leader who happened to be a woman with a science degree. Since the global financial crisis, however, Merkel has taken the lead in driving structural reform across the European Union in a way that reminds us of Thatcher’s reform program in the United Kingdom in the 1980s. If we are right, the outlook for growth in Europe over the next decade is materially better than the current consensus view, therefore, we believe investors should look to take advantage of the current negativity towards Europe. In our previous Investment Research paper,1 The Case for Europe we argued that structural reform was far more important to investors than the austerity versus stimulus debate. In this paper, we aim to build on that argument. We think that structural reform is a far more powerful driver of economic performance than many imagine. We will show that both Thatcher’s reforms in the UK in the 1980s and Gerhard Schroeder’s reforms in Germany from 2002 led to a dramatic improvement in economic growth. We will examine some of the key aspects of those reforms and suggest that the reforms that Merkel is forcing on the periphery share many of the characteristics that made those previous efforts so successful. Before we begin, however, it is important to make one thing very clear. Thatcher, Schroeder and Merkel remain controversial figures. While we would argue that their reforms have bought very clear economic benefits, many others are less complementary about their social implications. For the purposes of this paper, we do not seek to answer the debate about whether the actions that have been taken are moral or fair. While we believe the moral debate is worth having, this paper is focused on whether or not the changes made have contributed, or will contribute, to faster economic growth. The first stage of our argument is to analyse the impact of how Thatcher and Schroeder’s reforms worked. Exhibit 1 shows the United Kingdom’s GDP growth relative to the G7 since 1961. The second example of successful structural reform is Germany between 2002 and 2005. Exhibit 2 shows the performance of German GDP relative to the G7. Again we can see a long period (in grey) from 1992 to 2001 when the German economy was a consistent underperformer. Over this 10 year period the German economy grew 1% slower than the G7. Between 2002 and 2005 the Hartz reforms were enacted – and again the initial impact on growth was negative with the gap to the G7 increasing to 1.7% per year (red). However, from 2006 onwards the benefits have come through with the German economy outgrowing the G7 by 0.6% per year (blue) outperforming in five of seven years. Exhibit 2 GDP Growth in Germany Relative to the G7, 1992–2012 (%) 3 Hartz Reforms 2002 1 0 Thatcher Elected 1979 -1 2 -2 1 -3 0 -3 As at 31 December 2012 Source: Lazard, OECD As at 31 December 2012 Source: Lazard, OECD 2012 2009 2006 2003 1997 2000 1994 1991 1988 1985 1982 1976 1979 1973 1970 1967 1964 1961 -4 2012 2010 2008 2006 2004 2002 2000 1998 1996 1994 -5 -2 1992 -4 -1 -5 During the period 1961 to 1979, the performance of the UK economy was poor; GDP grew slower than the G7 every year except for one. Over that period economic growth in the UK averaged 1.5% per year less than the G7. If the UK economy had matched G7 growth from 1961 to 1979 it would have been over 30% bigger in 1979 than it actually was; the grey bars in the chart represent this period. The red bars represent the period when a significant portion of the reforms were enacted. During this period, the UK’s economic performance got worse. In both 1980 and 1981 UK GDP grew nearly 3% slower than the G7 – and unemployment boomed to over 10% of the workforce. However, the blue bars show the economic benefits of Thatcher’s program over the subsequent years. From 1982 to 2012, the United Kingdom has grown faster than G7 by 0.3% per year (outgrowing the G7 in nearly two thirds of the individual years2) . Put another way, the UK economy is 65% bigger today than if it had continued to grow 1.5% a year slower than the G7. 2 Exhibit 1 GDP Growth in the United Kingdom Relative to the G7, 1961–2012 (%) 3 To explain the chart, the first data point shows that in 1961 the United Kingdom grew 1.4% slower than the G7 (G7 grew real GDP at 4.2% and the UK grew 2.8%).
  • 3 We believe these two examples provide significant support for the view that structural reform can dramatically change the growth trajectory of an economy, even where that economy appears to be firmly stuck in the doldrums. Clearly government policy decisions regarding labour markets, domestic competition and other structural reforms are only one determinant of economic growth rates. We recognise that monetary policy, global economic conditions and trade protocols can also influence GDP growth rates. In this paper, we focus on the policy decisions and how they might have driven improved economic growth rates. We cannot ascribe precise causality but feel that the anecdotal evidence is supportive of our positive view of the impact of structural reforms. Opening markets and enhancing competition In our view, there are two other important points to make from these examples. First, the benefits of the reform do not just change the growth rate for a year or two, as the improvement can be sustained for decades. Second, the initial impact of reforms is negative for growth. This is important to remember when we think about Europe today. Moreover, while growth is weaker as the reforms are being implemented, consensus opinion can become very pessimistic about the chances of success. Thatcher’s famous “The lady’s not for turning” speech in 1980 was a direct response to such negativity. As late as April 2005, six leading German think tanks slashed their growth forecasts and estimated that trend growth for Germany was 1% - half that of the euro zone and one third that of the US. Incentives Having suggested that structural reforms can be more powerful than many imagine, that the benefits can last longer and that during the implementation phase their success is likely to be widely doubted, we now want to examine some of the actions that have been taken. This is a challenging project as every economy will be starting down this path from a different point. The issues that dogged the United Kingdom in the 1960’s and 1970’s are different from those that dogged Germany in the 1990’s and the peripheral countries today. The solutions will also be different depending upon the cultures of the various countries and the ideologies of the politicians in place as the reforms are implemented. However, in our view, there are three broad categories that have been present to a greater or lesser extent in all three cases: Incentives based reforms One major issue in all three situations has been the desire to increase the incentives for individuals to be in work relative to not being in work. This generally involves either lowering taxes for those working or lowering benefits for those out of work. Often there may be a combination of both. The corporate tax rate may also be lowered. One of the key features of successful reforms in these areas is to remove the “benefits trap”, whereby an individual on benefits will see their income fall if they start to work. Improved flexibility for business Another major issue in all three situations was a high level of regulation of the labour market or very large and influential unions. This made it harder for employers to alter their workforces in response to changes in the environment, and as a result were believed to serve as a strong disincentive to take on new workers. We believe successful reforms in this area include modifying the impact of unions and reducing the level of regulation around hiring and firing of employees. In some cases, there was an issue with closed or monopolistic industries. These tended to be inefficient leading to higher costs for the rest of the economy for the services provided. Often there would be a high level of public sector involvement in these industries. The solutions to these issues often involve opening industries to competition and private capital. We will now examine the reforms introduced in these three main areas: Thatcher This was a key component of the Thatcher reforms. Individual tax rates were lowered considerably – particularly at the top end. In her first budget, the top rate was cut from 83% to 60% while the basic rate was cut from 33% to 30%. In subsequent years, the base rate was cut further to 25% while the top rate fell to 40%. To understand the impact on incentives, a higher rate tax payer retained £60 of each extra £100 earned in 1989 compared to just £17 ten years earlier–three and a half times as much. Corporate tax rates were also lowered from 52% to 35%.3 At the same time, unemployment benefits were severely reduced. The link between benefits increases and average earnings growth was broken. Indeed, in the early years of Thatcher’s government benefits were increased less than inflation. In addition, the component of unemployment benefit linked to previous income was reduced and then abolished. Relative to average earnings, the value of unemployment benefits was reduced by around a quarter between 1979 and 1991.4 Flexibility A major aspect of the Thatcher reforms was a marked reduction in employment labour rights. Thatcher introduced a series of measures that dramatically impacted the unions, which included the outlawing of secondary picketing, ballots being held before strikes could be called and the government stopping the process of negotiating both pay and policy, which had been common in the 1970s. By the end of her time in power less than 40% of the workforce were union members compared to over 50% in 1979.5 The level of strikes also fell faster in the UK than in many other countries during the 1980s. Open markets During her time in office, Thatcher privatised many industries, most famously in the telecoms and utilities sectors, but also companies such as British Airways, Rolls-Royce and Enterprise Oil. She also oversaw major deregulation in the financial services sector, which saw the Big Bang reforms of the City of London, and the introduction of private pensions. Selling off council houses also sparked a major change in the UK property market.
  • 4 Schroeder Incentives The Hartz IV reform was the most significant change of the reform package. Prior to these reforms, unemployment benefits were linked to previous salary, reaching up to 67% of previous pay for up to 32 months (capped at €4,250 per month) followed by up to 57% of previous salary without time limit.6 Moreover, on returning to work unemployment and other benefits were reduced dramatically giving little incentive to return to the workplace. Following the reforms, the link between previous salary and benefit was broken for long-term unemployment with the introduction of a lower, means-tested flat benefits. In addition, claimants were required to accept any suitable job offer or face a further reduction in benefits. Subsidies were also introduced for both employees and employers to tackle the problem of the benefits trap. Tax rates were also lowered for both corporates and individuals in a process that started in 2001. Income tax rates for individuals were cut from 23%/51% in 2000 to 15%/42% in 2005, a significant increase in incentives. Corporate tax rates meanwhile fell from 52% to 39%.7 Flexibility Increased flexibility was also a major component of the Hartz reforms. Regulation on temporary work was lowered, making fixed term or open ended temporary contracts easier for employers to enter into. Employer flexibility was further enhanced by increased exemptions from dismissal protection for small employers, and changes to regulations governing which workers should be released first during redundancy programs. Open markets This was not a major focus for the German government during this period. Europe Today Given the range of countries involved, we now offer some general thoughts, followed by a more detailed examination of each of the key peripheral economies. Each country has its own unique set of challenges. Portugal for instance suffers from a lack of labour mobility due to the structure of its property rental market. However, Italy has had excessively restricted professional services markets, while Spain has suffered a great deal of political interference in the banking system. Generally the easiest areas have been tackled first. We feel there has been good progress across the region with opening markets, particularly in the energy, transport and professional services sectors. Measures to enhance the flexibility of businesses have also been widely adopted, though in Italy some of the new measures look likely to do the opposite. The weakest performance has been in enhancing incentives, as this is partly due to the unhelpful focus on government deficits, which makes tax cuts hard to introduce. That said, there has also been a failure to tackle benefit systems which can do little to incentivise work. In general, the economies that were hit hardest in the crisis look to have made the biggest changes. Greece and Portugal score well in all areas. Spain is let down only by their efforts in relation to incentives; the reform of Spain’s banking system should have very positive impacts for many years to come. We believe Italy is the biggest disappointment, progressing well in opening markets, but arguably moving backwards in the other two categories. Outside of the periphery, the United Kingdom has made steps to increase the incentives for work. France’s attempts to increase flexibility so far look similar to Italy’s, with the potential to have the opposite effect. However, the French government’s apparent acceptance of the need for welfare reform could herald a more dramatic change. Spain Incentives Limited progress has been made related to incentives. Some small reductions to unemployment benefits are planned. Flexibility We have observed significant improvement in this dimension. Companies are now free to negotiate salaries and conditions directly with their workforces rather than being bound by collective agreements. Compensation for unfair dismissal is reduced from 45 days per year worked to 33 days per year worked. The maximum cost is reduced from 42 month’s salary to 24 month’s salary.8 Employers can impose a one year probationary period on new workers and receive tax benefits for taking on new staff on permanent contracts.9 Open markets The major change is in the restructuring of the financial sector. In particular, the regional/local savings banks known as caja’s have been forced to consolidate and become more professional. The vast majority of the institutions are now in private hands, as opposed to being controlled by local politicians. Other industries, such as telecoms, residential real estate and some service industries could see enhanced competition. Italy Incentives Limited progress has been made up to this point. The proposed reforms seek to increase access to unemployment benefits and increase the proportion of expected income from work received in the form of unemployment benefits from 22% to over 33%.10 Flexibility The process to dismiss/restructure workers has been simplified and probationary periods of up to a year introduced. However, measures have also been introduced to discourage fixed contract or temporary positions, which is inconsistent with flexibility. Open markets There has been significant progress in liberalising the service, energy and transport sectors. Professional services (for example accountancy, law and engineering) in particular were excessively restrictive with high cost for business and many of these markets have been liberalised. Corporate cross holdings have been reduced and there has been significant reform of board practices in the financial sector.
  • 5 Greece Incentives Unemployment benefits have been limited to 12 months and the government has recently added a maximum of 450 days in any four year period. The payment amount has also been cut by over 20%.11 This amount is a flat rate rather than being related to previous salary. Public sector salaries have been cut significantly. Flexibility Firm level collective bargaining has been given precedence over industry level. Rights for workers to seek arbitration unilaterally have been removed and open-ended employment contract extensions restricted. Minimum wages have also been cut severely. The court system has been reformed to give faster decisions and government bureaucracy has also been reduced. Open markets Closed professions have been liberalised. Retail, fuel, transport and utility markets are being liberalised and there is an ongoing privatisation program. Portugal Incentives Wages in the public sector have been significantly higher than those in the private sector, reducing the incentive to work for the private sector. This is being addressed through pay reductions in the public sector. Unemployment benefits have been capped at 65% of previous salary and the amount payable is now reduced by 10% after 180 days.12 Measures have been introduced to withdraw benefits where individuals refuse to accept a new job. Flexibility How does the comparison between Merkel and Thatcher stand up to scrutiny? Based on our review of the measures being undertaken, it seems clear to us that most progress has been made in countries which have had the highest involvement of Germany, with Merkel’s oversight. The two program countries, Greece and Portugal, are leading the way with Spain following closely behind. Where the Troika has had less involvement, particularly Italy and France, progress has been more limited. This conclusion is supported by data from the World Bank Doing Business report. Exhibit 3 shows the improvement in the “distance to frontier”14 score for each of the periphery nations. This score measures how close each country is to best practice across a range of measures, and we can see that Portugal, Greece15 and Spain have seen significantly more improvement than France or Italy. Germany has dominated the debate within the European Union. Merkel has been steadfast in pushing the reform agenda and displayed a level of conviction matched by few politicians these days. It seems fair to award her a large part of the credit for driving through these programs. From purely an investment perspective, investors should hope she has the chance to impact the larger economies of Italy and France in the same manner. If she does, we believe the outlook for the European economy should be much better than most people imagine. Exhibit 3 Improvement in “Distance to Frontier” from World Bank Doing Business Report 7 Severance payments are being reduced to 12 days per year of service with one year’s salary as a cap.13 Collective bargaining powers are also being modified. 6 Open markets 4 There is an active privatisation program. Government involvement in the real estate sector is being reduced, as rental laws have been reformed to free up the property market and encourage the movement of labour. The ports and energy sectors are being liberalised, and the court and judicial systems reformed. 3 Other Countries 0 Incentives -1 The United Kingdom has moved to further improve in this area. Benefits are being capped and tax rates–particularly for lower earners and for businesses–are being reduced. Changes to the way benefits are withdrawn should make it easier to return to work. -2 Portugal Flexibility France has enacted measures to make dismissing workers or changing their hours easier. As with Italy, however, the impact may be offset by increasing the cost of hiring temporary workers. 5 Spain Greece 2 France Italy 1 2010 As at 31 May 2013 Source: World Bank 2011 2012 2013
  • 6 About the Author Barnaby Wilson, CFA Director Portfolio Manager/Analyst Lazard Asset Management Limited Barnaby Wilson is a Portfolio Manager/Analyst on the European Equity team. He began working in the investment field in 1998. Prior to joining Lazard in 1999, he worked for Orbitex Investments. He became a member of the European Equity team in January 2006, graduating from the role of research analyst. Barnaby has a BA (Hons) in Mathematics and Philosophy from Balliol College, Oxford University. Notes 1. Paper available at: http://www.lazardnet.com/lam/global/investment_research.html 2. Given the length of Thatcher’s period in office and the fact that reforms were being carried out throughout, it is open to debate when one should start to measure the impact of those reforms. We chose 1982 as by then the first elements of each of the key programs had been started. Had we chosen any year from 1982 to 1992, the range of outcomes for UK GDP growth relative to the G7 until 2012 would have been +0.2% to +0.5%. 3. HMRC 4. Did The Thatcher Reforms Change British Labour Market Performance? David Blanchflower, Richard Freeman (1993) 5. The impact of industrial relations legislation on British union density, Freeman, R. and J. Pelletier (1992) 6. Before and After the Hartz Reforms: The Performance of Active Labour Market Policy in Germany, L. Jacobi, J. Kluve (2007) 7. OECD Tax Database 8. Spain’s Structural Reform and Economic Policy Programme, Tesoro Publico June 2013 9. OECD Economic Policy Reforms: Going for growth, 2013 10. OECD Italy Reviving Growth and Productivity September, 2012 11. Greek National Reforms Program 2013 12. European Industrial Relations Observatory 13. European Commission Staff Working Document, Portugal, May 2013 14. The World Bank Doing Business Report includes a “Distance to Frontier Score.” This score provides a measure of how close a country is to best practice across a range of indicators of ease of doing business. Scores are between 0 and 100 with 100 being best practice. The chart shows the improvement in the Distance to Frontier Scores for each of the five countries since 2009—so Portugal, for instance, has improved by 6.6 points, from 68.6 in 2009 to 75.2 in 2013. 15. Note that Greece’s improvement would be similar to Portugal’s were it not for the dramatic increase in property transfer taxes in 2011. Important Information Published on 2 July 2013. All sources Lazard Asset Management unless otherwise noted. This paper is for informational purposes only. It is not intended to, and does not constitute, an offer to enter into any contract or investment agreement in respect of any product offered by Lazard Asset Management and shall not be considered as an offer or solicitation with respect to any product, security or service in any jurisdiction or in any circumstances in which such offer or solicitation is unlawful or unauthorized or otherwise restricted or prohibited. The information and opinions presented do not constitute investment advice and have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All opinions and estimates expressed herein are as of the published date unless otherwise specified, and are subject to change. Past performance is not a reliable indicator of future results. Australia: Issued by Lazard Asset Management Pacific Co., Level 39 Gateway, 1 Macquarie Place, Sydney NSW 2000. Germany: Issued by Lazard Asset Management (Deutschland) GmbH, Neue Mainzer Strasse 75, D-60311 Frankfurt am Main. Japan: Issued by Lazard Japan Asset Management K.K., ATT Annex 7th Floor, 2-11-7 Akasaka, Minato-ku, Tokyo 107-0052. Korea: Issued by Lazard Korea Asset Management Co. Ltd., 10F Seoul Finance Center, Taepyeongno-1ga, Jung-gu, Seoul, 100-768. United Kingdom: For Professional Investors Only. Issued by Lazard Asset Management Ltd., 50 Stratton Street, London W1J 8LL. Registered in England Number 525667. Authorised and regulated by the Financial Conduct Authority (FCA) and is also registered by the Ministry of Industry and Commerce under registration number 69093 and licensed by the Central Bank of Bahrain in the Kingdom of Bahrain as a Representative Office. United States: Issued by Lazard Asset Management LLC, 30 Rockefeller Plaza, New York, NY 10112. LR23199