Welfare, inequality and economic performance

Globalisation poses several challenges to national economies and governments. One of the most important is the consequence on inequality, both within countries and between countries, and its impact on welfare state sustainability (Hay and Wincott, 2012).

During globalisation, inequality increased consistently in most advanced and emerging economies, particularly during the 1990s and the 2000s. A simple look at the Gini coefficients across countries shows the worsening of income distribution within countries. The reasons for this are various (Atkinson, 1999; Milanovic, 1988; Tridico, 2012; Galbraith, 2012).

The debate is very lively, and it has produced two main interpretations of the problem. The first one states that globalisation reduces the share of welfare states because it constitutes a cost for firms. Higher levels of welfare states produce higher income tax levels, social costs and contributions, which reduce profit prospective and increase costs for firms. Firms would be hence pushed to go abroad unless government retrenched welfare state spending and reduced taxes. Hence, in order to maintain higher levels of investments, firms and employment in the country, the welfare state needs to be reduced under the process of globalisation, with bad consequences for inequality. This interpretation is well known as “the efficiency thesis”. This thesis was developed within the neoclassical (or neoliberal) paradigm, and it argues that globalisation has forced (or should force) states to retrench social welfare in order to achieve a market-friendly environment and attract increasingly mobile international capital and competitiveness (Blackmon, 2006; Castells, 2004; Allan and Scruggs, 2004).

The efficiency thesis is contrasted by “the compensation thesis”, which argues that because globalisation increases inequality, welfare states need to increase. In other words, globalisation pressured governments to expand welfare expenditures in order to compensate for the domestic “losers” of the globalisation process (Brady et al., 2005; Rodrik, 1998; Swank, 2002). In a way, it can be also argued following the compensation argument that welfare expansion would allow states to further pursue globalisation. An extensive interpretation would then see welfare expansion not as a result but as a condition of globalisation, so that in order to continue (or to start) with the process of globalisation, policy makers must expand social safety nets.

Figure 5.4 Inequality Source: OECD database

Empirical evidence concerning the relation between globalisation (intensification) and welfare (expansion/retrenchment) is often found to be inconsistent and mixed.

Certainly, with the introduction of outsourcing practices and FDI outflows, globalisation has improved the bargaining position of capital relative to labour in higher-income countries. As Feenstra (1998, p.46) observes, the impact of globalisation on changing the bargaining position of labour and capital has far-reaching consequences. The decline in union power, particularly within trade-oriented industries, may well account for a portion of the increased wage inequality in the United States and in other countries (Borjas and Ramey, 1995). The decision of firms to move capital and production across countries has distributional effects: the position of low-skilled workers in industrial countries is worsened by a combination of 1) globalisation and 2) new technology (Tisdell and Svizzero 2003). The first increases the bargaining power of capital against labour, with the consequence that it is easier for capital to obtain tax reductions and welfare retrenchment. The states are willing to embark on tax competition among them in order to keep investments and production at home. The second has a direct and negative impact on unskilled labour and income distribution without welfare support and social institutions.

In this context, wage shares declines dramatically, with negative consequences on the aggregate demand, as the figure below suggests. The figure reports the average data aggregate by group of countries. Anglo-Saxon economies (later included in the liberal competitive market economy model) and Mediterranean economies suffered the most from the restructuring process that occurred since the 1980s and intensified during the 1990s and 2000s.

As far as socio-economic model classification is concerned, I used a revised and updated version of the approach used by Esping-Andersen (1990) according to whom welfare models can be divided into three groups, Liberal, Continental and Scandinavian models.3 This classification, although methodologically still very relevant, was based on data from before 1990. Therefore, I updated that classification to the new evidence, following in particular the work of Hay and Wincott (2012). Hay and Wincott follow more or less the same methodology as Esping-Andersen (1990), taking into consideration the evolution of these models in the last two decades. They extended this classification to five models: the three models used by Esping-Andersen plus the Mediterranean group and the

Wage share in advanced economies

Figure 5.5 Wage share in advanced economies

Note: The unadjusted wage share is calculated as total labour compensation of employees divided by value added. Source: own elaboration on the ILO (2013)

106 Pasquale Tridico

Welfare expenditure by models

Figure 5.6 Welfare expenditure by models

Source: Own calculation on the OECD database. See also Adema and Ladaique (2009).

Note: Social spending (% of GDP): is the sum of “social benefits in-kind” and “social transfers other than in-kind” as defined as well before (oECD definition). Continental: Belgium, Germany, Luxembourg, the Netherlands, Austria; Scandinavian: Denmark, Finland, Sweden, Norway; Liberal: UK, Ireland, USA, Australia, Canada, New zealand; Mediterranean: Greece, Spain, Italy, Cyprus, Malta, Portugal; CEEC): Czech Republic, Estonia, Latvia, Lithuania, Poland, Slovenia, Slovak Republic, Romania and Bulgaria.

Central and East European Countries (CEEC) group, claiming that a strong difference can be observed among these groups in general patterns. Moreover, since 1990, welfare patterns are diverging even more with the Scandinavian model, which seems to clearly have followed a compensation thesis in order to cope with the challenge of globalisation; the continental model, which maintained stable or increased slightly the level of welfare spending in the same period; and the other three groups, the Liberal, the Mediterranean and the CEEC, which converge among themselves in the sense that they reduced the level of welfare spending clearly following a sort of efficiency thesis during the last two decades of globalisation, as the figure below suggests.

The evolutionary path of welfare models under the condition of globalisation presented a challenge for all countries involved in the process. Some countries, typically the Mediterranean countries, did not manage to increase welfare spending, and they ended up with both higher inequality levels and the worst performance in terms of GDP and labour market performance. The case of Scandinavian economies shows exactly the contrary: the challenges and the threats to income distribution and competitiveness of globalisation could be better coped with by increasing welfare spending.

In fact, once we compare welfare spending data with the economic performance in the years of the crisis (2007-13) we discover interesting results that confirm our hypotheses: countries that had better performance are those that managed not to retrench the welfare state under the process of globalisation and, therefore, reached the eve of the crisis in 2007 better equipped in terms of the welfare state, as Figure 5.7 shows.

In the graph below, I used a so-called Performance Index (PI) that combines GDP growth, “g”, and labour market performances (employment growth “n”, and unemployment levels

The Performance Index

Figure 5.7 The Performance Index

Source: own elaboration on the WEO IMF, and OECD database

Note: The Performance index here is built simply by aggregating GDP and labour market performance in the following way: (Average GDP growth in 2007-13 + Average Employment growth in 2007-13) - Unemployment rate (average 2007-13)

“U”) for the period 2007-2013. The PI allows to avoid biases and to look at the economic performance from a wider perspective: in fact, some countries can have relatively better GDP dynamics but very bad employment performance (and vice versa), in particular during unstable periods like the current one.

The compensation approach seems to have contributed, in these best performing countries, to both maintaining lower levels of inequality and to having better performance in terms of GDP and the labour market. These countries’ comparative economic performance, measured in this paper with the Performance Index since 2007 has been considerably better.

Moreover, if from one side it is true that inequality, as we argued before, increased everywhere during globalisation, from another side there are important differences among countries and models: Scandinavian and Continental models maintain lower levels of inequality, along with higher levels of social spending. On the contrary, the countries of the Liberal and Mediterranean models, which in the last two decades retrenched the welfare state or did not increase it, also experienced increasing inequality.

On the contrary, the efficiency thesis seems to provide an alternative explanation: advanced economies that embarked on globalisation had to reduce their welfare expenditures in order to satisfy firms’ needs and requests and to increase their competitiveness. However, as I will show, this explanation is not appropriate to understand which countries in the end actually had better economic performance. In particular, we will see that countries that reached a relatively higher level of welfare expenditures and where cuts did not occur, or occurred relatively less, had better economic performance during the crisis that started in 2007 and continued until today. On the contrary, countries that at the eve of the crisis were found to have poorer welfare states and cut welfare expenditures more profoundly during the 1990s and 2000s had a worse economic performance. These results will be shown in the following section.

Inequality by welfare models

Figure 5.8 Inequality by welfare models

Note: Because of the lack of historical data, is not possible to reconstruct the variables for the CEEC group. Source: OECD database

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