As this article was being written, the Bureau of Labor Statistics announced a sharp fall in the U.S. unemployment rate. Most economists expect that rate to decline even further, eventually approaching the 5.5 per cent level generally regarded as "full employment." It is also probable, though by no means certain, that within a year or two recovery will begin in Europe and Japan. As growth accelerates and the number of jobless falls, much of the current despondency over the state of the world economy will surely dissipate. Stories about the "jobless recovery" will fade from the press, to be replaced by upbeat tales of business success.
The optimism that is likely then to dominate economic commentary will, however, be misguided--even more misguided than the doom-and-gloom pessimism that prevails today. The fact is that all of the industrially advanced countries are in deep economic trouble. The irregular rhythm of recessions and recoveries sometimes exaggerates their problems, while at other times it masks them; but to anyone who looks behind the business cycle, the disturbing long-term trends are unmistakable. In Europe, in the United States, and increasingly in Japan, it is becoming obvious that something has gone wrong with the promise of economic growth.
The failure of that promise may be summarized by two words: jobs and wages. For a generation after World War II, the economies of the West offered both--that is, there were jobs for the great bulk of those who wanted them, and those jobs paid wages whose purchasing power rose steadily for just about everyone. Since the early 1970s, however, the economies of North America and Western Europe have not delivered that kind of broad prosperity.(1) In the United States, the problem is essentially one of wages: Most people who seek jobs still get them, but an increasing fraction of our workers receive wages that both they and the rest of us regard as poverty-level. In Europe, wages at the bottom have declined less, but in their place long-term unemployment has consistently risen. On both sides of the Atlantic, there is now a growing sense that many people are in effect economically disenfranchised, shut out of the prosperity that one might expect in what are still wealthy societies.
Ironically, the rise of poverty and unemployment in the Western world over the last 20 years has taken place in a time of spectacular technological progress. That progress has not quite resulted in the productivity growth that one might have expected, yet the economies of the advanced countries are by any measure substantially richer and more productive than they were in 1970. The economic troubles of the West therefore present a paradox of growing misery in the face of growing wealth.
What is the source of the paradox? Here is a simple hypothesis: Modern technology in effect mandates much wider disparities in earnings among workers than we have experienced in the past. In the United States, where markets are left relatively untrammeled by concerns about justice or fairness, the result has been a startling polarization of the earnings distribution. In Europe, where collective bargaining and the much heavier hand of the welfare state have limited income inequality, the same forces have manifested themselves instead in growing unemployment.
It is a simple thesis, but by no means an obvious one. Indeed, an unscientific survey of popular writing on the subject suggests that most people who see a long-term crisis at all view it as the result not of broad technological forces but of foreign competition. Thus, an important part of the argument must involve explaining what has not happened, as well as what has.
Perhaps the best way to bring the economic difficulties of the West into relief is to compare our economic situation today with what it was a generation ago, in the late 1960s and early 1970s. Circa 1970 the Western world was by no means without economic problems. In the United States, in particular, broad prosperity had failed to eliminate a hard core of urban poverty. Nonetheless, the dominant picture was one of unprecedented economic good times. Over the previous generation the standard of living had almost doubled in the United States and the United Kingdom, tripled in France, and quadrupled in Italy and West Germany. Unemployment in the United States was low by historical standards, while it was even lower in most of Europe; in West Germany it came to less than 1 per cent of the labor force. Further, that overall economic progress was shared by most people in those countries; indeed, it was accompanied by a trend toward greater equality of income. As a result, economic misery was dramatically reduced. In the 1930s, Franklin Roosevelt had spoken of "one-third of a nation ill-housed, ill-clad, ill-nourished"; by 1970, the standards defining an adequate standard of living had become much higher, yet the fraction of Americans below that poverty line had fallen to one eighth.
In 1970, few doubted that this picture of economic progress would continue. Critics of modern capitalism, like economist John Kenneth Galbraith, argued that Western prosperity was hollow or misguided, that it led to meaningless jobs and pointless mass consumption, but they rarely questioned the system's ability to continue creating jobs and raising real wages. Even the persistent poverty problem in the United States seemed to have more o do with social dysfunction than with economics per se. It would have been a great surprise to almost everyone to learn how badly things would go. In particular, few would have foreseen the picture we now face:
* In the United States, poverty reached a low point in 1973. Since then, the part of the population in poverty has risen, from 11 to 14 per cent. Moreover, that rise has taken place in spite of a substantial increase in federal programs aiding the elderly, who used to make up a large share of the poor. The number of American children living in poverty has grown by 50 per cent.
* In Europe, unemployment rates have risen steadily. Among the 12 countries now making up the European Union, the average unemployment rate in 1970 was less than 3 per cent. In 1993 it was 11 per cent and rising. Nearly half of the jobless Europeans have been without work for at least a year, and many form a class of the more or less permanently unemployed.
What is perhaps most surprising about such trends is that they have taken place in what would seem to have been a highly favorable technological environment, and indeed in spite of considerable economic growth. Few people would assert that the pace of technological change has slowed since 1970: The past generation has witnessed revolutionary changes in communications, information processing, and manufacturing methods. Admittedly, the productivity payoff from those changes has been somewhat disappointing: Productivity growth in all advanced countries slowed considerably after 1970. Nonetheless, while the rate of growth of productivity has been less since 1970 than before, its level has continued to rise. Even in the United States, where productivity growth has been most disappointing, the average business sector worker produces 35 per cent more per hour than he or she did in 1970. As a result, the Western economies are considerably richer in absolute terms than they were in 1970. Between 1970 and 1990, per capita real income rose 38 per cent in the United States and 53 per cent in France.
So here is the puzzle: Western societies are more productive and hence richer than ever before, yet economic misery--in the form of either poverty or persistent unemployment--has shown steady long-term worsening. How is that possible?
The labor market in the United States is very different from that of any other advanced country in that it resembles much more closely the economist's ideal of a freely competitive matching of supply and demand. Only 12 per cent of U.S. private-sector workers belong to unions; thus, collective bargaining plays a minor role in wage determination. The U.S. minimum wage is low compared with average wages and has failed to keep up with inflation. Unemployment compensation in the United States is ungenerous both in size and duration. Workers are under far more pressure to seek jobs, at whatever wages are offered, than their European or Canadian counterparts. From 1980 to 1992 the successive Reagan and Bush administrations were unsympathetic, to say the least, to the complaints of workers who tried to raise or maintain wages through strikes or other disruptive actions.
One may laud U.S. labor markets for their flexibility or regard our "survival of the fittest" system of markets as a sad commentary on our uncaring politics. In any case, the harsh competition that takes place in American labor markets makes them a better place to observe deep underlying trends than the more managed and confined markets of Western Europe.
If one looks at the U.S. labor market since the 1970s, what stands out above all is a striking increase in the inequality of earnings, especially after the late 1970s. Between the late 1970s and the early 1990s the real annual compensation of the average American worker rose between 1 and 6 per cent, depending on which price index is used; but the real wages of low-ranked workers like janitors fell 15 per cent or more, while the real earnings of high-end occupations like doctors and corporate executives rose 50 per cent or more.
Because of the decline in real earnings among the worst-paid, the number of working poor rose sharply. The portion of full-time workers whose earnings were below the poverty line advanced at a startling rate, from 12 per cent in 1979 to 18 per cent in 1990.
In 1970, even liberals tended to think of poverty in America as essentially a problem of those who did not work--single mothers, the elderly, and the urban underclass. The increase in poverty during the 1980s, however, stemmed largely from the growing number of Americans who were working but whose jobs simply did not pay enough to pull them out of poverty.
Poverty is measured according to a fixed standard: The real income required to be above the line was the same in 1990 that it was in 1970. It is therefore remarkable that poverty could have increased so much even while the average real income of Americans was continuing to rise. If one thinks of poverty as measured not simply by absolute income but also by income relative to one's fellow citizens--as one should--then the picture is even worse.
It is an unhappy picture, though with one bright spot: There are still jobs, if not good jobs, for most people who want them. Whatever else may have gone wrong with the U.S. economy, over the past 20 years it has been an impressive engine of job creation. There has, in particular, been no long-term trend toward higher unemployment rates. That stands in great contrast to the dismal employment performance on the other side of the Atlantic.
In the 1960s, European unemployment rates were consistently lower than those in the United States. Indeed, American labor economists often wondered why the United States could not seem to push its unemployment down to European levels--why, for example, the boom generated by Vietnam War spending seemed to dissipate in inflation rather than continue to add jobs once the unemployment rate had dropped below 4 per cent. Over the course of the 1970s, however, the mystery dissolved as European unemployment rates began a sustained upward march. The number of unemployed in what is now the European Union rose every year between 1974 and 1985.
In the early 1980s the problem of European unemployment became an obsession with many European economists, and several of them--notably Sweden's Assar Lindbeck and Germany's Herbert Giersch--converged on a basic diagnosis, which Giersch memorably dubbed "Eurosclerosis." According to that view, high European unemployment was the unintended byproduct of the European welfare state, which reduced the incentives both for firms to offer jobs and for workers to accept them.
The point was not difficult to understand. In virtually all European countries, unemployed workers are assured of a minimal income, no matter how long it has been since they last worked (in contrast to the time-limited U.S. system of unemployment insurance). Further, medical care is a universal right and housing is often subsidized as well. The result is that an unemployed European does not need to search for employment with the desperation of his American counterpart. Meanwhile, all benefits are paid for by a system of contributions from employers that considerably raises the cost of providing employment.
Added to those straightforward disincentives to job creation are subtler ones. For example, it is typically very difficult and costly for European firms to fire workers. So in an uncertain world, European companies are understandably reluctant to hire workers in the first place. Powerful European unions are also more able than their feeble American counterparts to sustain wages in the face of potential competition from the unemployed.
Lindbeck, Giersch, and others therefore argued that high European unemployment was a byproduct of the welfare state--of taxes and regulations that discouraged firms from offering jobs, and of subsidies and income supports that discouraged workers from accepting them. Americans' comparative success in job creation was, of course, the other side of the same coin: It was the payoff for allowing brutal but free competition to prevail in the labor market.
That is a clear and persuasive diagnosis, and it is accepted at least in part by most economists who look at the European situation. Admittedly, a brief period of optimism--dubbed "Europhoria"--did arise during the late 1980s, as hopes for gains from closer European integration helped fuel a business cycle recovery that led to a modest fall in European unemployment rates. Now, however, unemployment is again rising, and the diagnosis of Eurosclerosis once again seems entirely appropriate.
There is, however, one obvious problem with the argument: If the welfare state is so bad for employment, why were European countries able to achieve such low unemployment rates before 1970?
That question remains a source of great controversy, but our discussion of the American situation immediately suggests a possible answer--namely, that the European model began to perform poorly after 1970 for the same reasons that the U.S. economy began to yield such distressing outcomes. In essence, the welfare state may be seen as an effort to soften the harshness of market outcomes, to ensure that income is not too unequally distributed. Before 1970 that goal was broadly consistent with market forces, which were tending to produce greater income equality in any case. Since then, however, the market has in effect been pushing toward a greatly increased inequality of income. In such an environment, unemployment benefits that are tied to the average level of earnings may become a substantial part of what low-paid workers could earn. For example, a minimum wage that keeps pace with average earnings will price an increasing fraction of workers out of the market; an attempt to maintain additional wage differentials will lead to inadequate demand for low-paid workers; and so on.
According to that view, falling wages at the bottom of the U.S. earnings distribution and the rising European unemployment rate may be seen as the responses of two different institutional systems to a common shock: market forces that have powerfully reduced the demand for the less-skilled or less-talented.
But what is the source of these market forces? Why has demand fallen at the bottom and risen at the top?
REWARDING THE FEW
Most people who worry about growing earnings disparities in the United States and rising unemployment in Europe blame those trends on international trade. The pressure of global competition, in particular from newly industrializing countries with their much lower wage rates, is widely believed to be the fundamental cause of the decline in wages and jobs for the less-skilled.
That is an understandable view. In principle, it is entirely possible that increased trade with countries teeming with cheap labor could drive down the real wages of less-skilled workers in the West. It is also true that trade in general, and the manufactured exports of the Third World in particular, have increased rapidly since the 1970s. From that perspective, the hypothesis that international trade is at the heart of the story is highly persuasive.
Unfortunately, it is not true. A number of careful studies have come to the conclusion that international trade explains at best only a small fraction of the rise in earnings inequality in the United States or the employment problems in Europe.(2) The basic point in all these studies is that if international trade reduces an economy's demand for unskilled labor, it does so by changing the industrial mix. That is, if the United States responds to growing world economic integration by producing more skill-intensive goods like aircraft and fewer goods, like garments, that employ primarily unskilled workers, the effect will be to raise the demand for skilled workers while reducing it for unskilled--and hence to bid up the wages of the former and drive down the wages of the latter. In fact, however, very little of the decline in the relative demand for unskilled labor in Western countries has been due to changes in the mix of goods produced. Instead, employment has shifted noticeably toward skilled employment within each industry--including those "nontraded" industries, accounting for about two-thirds of U.S. employment, that are largely insulated from international competition.
The pervasiveness of the shift toward highly skilled labor suggests that the explanation for growing inequality lies not in international trade, which affects labor demand by changing the mix of industries, but in technological changes that have reduced the demand for the worst-paid workers in all industries. That phenomenon is poorly understood, but two observations can be made. First, it seems clear that modern information technology has the effect predicted long ago by Kurt Vonnegut in his 1952 novel Player Piano: It tends to eliminate routine jobs, without (so far) an equal impact on the more complex ones. Numerically controlled machine tools allow manufacturing firms to lay off lathe operators; they do not replace engineers. Personal computers allow companies to get by with fewer typists; they have not yet helped them get by with fewer vice presidents.
Second, the combination of information and computer technology has what Chicago economist Sherwin Rosen, in a prophetic 1981 paper, called the "superstar" effect: In many fields modern technology appears to change the nature of competition into a sort of winner-take-all tournament, in which most of the rewards go to a few exceptionally talented or lucky people. A seemingly trivial example is the performing arts, where the displacement of live performance by recordings and broadcasting has vastly increased the disparity in fortunes between a handful of Madonnas and a multitude of wannabees. It is arguable that similar factors have widened income disparities in many fields. What is certainly true is that the growth of inequality in the United States has a striking "fractal" quality: The pattern of widening gaps between education levels and professions is mirrored in the pattern of increased inequality of earnings within professions. Lawyers make much more in comparison with janitors than they did 15 years ago; but the best-paid lawyers also make much more in comparison with the average lawyer.
Can technological progress really hurt large numbers of people? Yes, it can and it has. Indeed, historians tell us that the original Industrial Revolution in Great Britain was associated at first with a decline in the real wages of most workers, and that the wider benefits of technological progress could not be seen until about 1840, a half-century after large-scale factory production began. Given that experience, we should not find it incredible that the first two decades of the Information Revolution have seen income fall for many workers.
The best guess, then, is that this crisis of the West is largely a result of technological change that has, at least for the time being, evolved in a direction that is hostile to egalitarian ideals. But why is that a crisis? Why can't we simply live with those trends?
THE SOCIAL FACTOR
Let me make a shocking declaration given my profession: The essential reason for caring about the disturbing trends in Europe and America is social, rather than strictly economic.
Consider the position of someone in, say, the top fifth of the income distribution in either the United States or Europe--a description that surely applies to most readers of this article. Does the growth in poverty in America or of mass unemployment constitute any direct threat to the living standards of that individual? The answer in the United States is a clear no: There is no strictly economic reason why we cannot continue to have a growing economy even while a substantial fraction of the population is experiencing declining standards of living. Economic theory suggests no particular connection between equity or justice and growth, and no evidence exists that income inequality has any large effects on the rate of economic growth, positive or negative.
The case in Europe is a little less clear: Benefits for the growing numbers of unemployed are costly and have contributed to large budget deficits. Nonetheless, it is easy to imagine that with a combination of a modest recovery from the recession and some reduction of benefits, most European governments can regain fiscal stability and maintain that stability even while carrying long-term unemployment rates of 10 per cent or more.
So where is the crisis? The answer is that it is in society and ultimately in politics. On both sides of the Atlantic, economic forces are more and more tending to split society in two: into those who have good jobs and whose standards of living continue to rise and those who are faced either with falling incomes or the prospect of a more or less permanent life on the dole. Even an economist can see that such a split demoralizes those on the bottom and coarsens those on the top. The ultimate effect of growing economic disparities on our social and political health may be hard to predict, but it is unlikely to be pleasant.
The real problem may be even worse. So far, we have only looked at absolute income. But if it is social and political consequences that we fear, then it is relative income that is crucial. An American worker who is paid $4 per hour has considerably greater purchasing power than a Chinese worker earning a quarter as much; but working at what he is likely to describe as a demeaning "McJob," he is socially and psychologically part of an underclass in a way that the Chinese worker is not. The social consequences of declining real incomes for many Americans and Europeans are thus probably all the worse because other people's incomes have continued to rise.
The great problem facing the economies of the West, then, is how to deal with the trend toward growing economic disparities--how to get the incomes of low-paid American workers rising again, and how to draw Europe's reserve army of labor back into employment. Some optimistic economic analysts do believe that the problem of jobs and wages can be addressed at its source, with policies that reduce the underlying disparity of earnings. Observers like Secretary of Labor Robert Reich argue for education and worker retraining. In effect, optimists claim that such policies can both reduce the underlying inequality of skill levels and, by making the labor force as a whole more skilled, reduce the market premium on skill.
It is hard to escape the impression, however, that this is wishful thinking. Experience with worker retraining programs has not been encouraging. Raising the quality of basic education is high on everyone's list of priorities for the United States, but it will not even begin to have an impact on labor markets for at least a decade. And even if we do succeed in greatly improving the quality of basic education, the benefits are unclear. After all, many observers hold up France as an example of a Western society that continues to maintain effective classroom discipline and to teach the basics to virtually all students. Yet France has shared fully in Eurosclerosis and currently has an unemployment rate of 12.2 per cent.
Moreover, to the extent that income inequality is being driven by Rosen's "superstar" effect--that is, to the extent that competition is becoming a sort of tournament that only a few can win--boosting the overall level of skill may do little to reduce income disparities. For example, even a sharp improvement in the average quality of American singing would not change the fact that the big rewards go to a handful of big names.
In the long run, of course, the trend toward growing economic disparities is likely to reverse itself even in the absence of any deliberate policy action. The Industrial Revolution created huge inequalities in its first half-century, but eventually produced a middle-class society of unprecedented affluence. The Information Revolution will probably do the same. Unfortunately, the crisis of jobs and wages is here now and will not go away anytime soon.
THE LUCKY FEW
Let me borrow an image from Princeton economist Avinash Dixit and suggest that technological change is turning Western countries into "Sierra Madre" economies. Dixit's phrase comes from the classic film The Treasure of the Sierra Madre, in which the old prospector explains why those who strike gold become rich: It's because they in effect collect the wages of all those who set out into the desert but don't find gold. Similarly, our economies increasingly yield huge rewards to a few, but very little to a growing mass of the less-skilled or less-lucky.
How can one maintain a decent society when the underlying market forces are so unhelpful! Reich's solution is to train everyone to be a better prospector, in the hope that everyone will then be able to find gold. But what if--as is all too likely to be the case--it is just in the nature of the late-twentieth-century advanced economy that gold deposits are rich but rare, and that some people are much better prospectors than others? Then hopeful words about training and education will turn out to be an evasion rather than an answer.
How does one live with a Sierra Madre economy? The United States and Europe have in effect put forward differing solutions. In the United States, especially since Ronald Reagan, we have simply accepted gross inequity as the inevitable consequence of free markets; everyone heads off into the desert in search of gold (that is, gets a job), but a growing number receive very little for their efforts. In Europe, by contrast, the state tries to take care of everyone; but it does so largely by forcing firms to pay large social insurance premiums that bear especially heavily on the lowest paid, and by paying generous amounts to the unemployed. It is like charging an entry fee to the desert and using the proceeds to finance aid to those who stay home. Is it any wonder that many of those who are not exceptionally good prospectors end up not heading off into the desert at all, adding to the growing class of long-term unemployed?
There is no perfect solution to this dilemma. Nobody has yet found a way to raise taxes or provide benefits without reducing incentives. The best that we can hope for is a society that shows more sense of community than the United States, but that does so in ways that exacts less toll on incentives than the European welfare states. Here are some guidelines:
First, we must provide generous social insurance, but structure it so that it helps the working poor as well as the unemployed. As far as possible, that social insurance should avoid creating "notches"--sudden drops In benefits when threshhold criteria are reached that make it actually irrational for individuals to increase their earnings. A minimum step would be to provide basic services like good schools and health care as universal entitlements, so that even poor people get decent education and medical care for their children, but are not faced with the loss of those benefits if they improve their positions. A broader program would supply low-wage earners with income supports that taper off only gradually as earned income rises--some variant on the much-ridiculed, but still sensible, idea of a "negative income tax" for the less-fortunate.
Second, the financing of social insurance should, as far as possible, avoid curbing employment prospects for the less-skilled. In both the United States and Europe much social insurance is in practice funded by contributions determined by a fixed percentage of wages; as in U.S. social security, since those contributions end at some maximum level of earnings, the effect is to place the highest tax rates on employment of precisely those people that the Sierra Madre economy rewards least. Far better to shift the burden to general taxation--income or value-added taxes. Those taxes create disincentives too, but they are not as severe, and they do not bear disproportionately on the employment of the very people a society is trying to help.
There are two corollaries to that proposition. First, trying to raise the incomes of the unlucky by raising minimum wages is at best a crude and double-edged strategy. Some will earn more; others will simply be priced out of the market. Second, new benefits should not be financed by new charges on employment, whether or not they are called taxes. For example, one could hardly do worse than the proposal of the Clinton administration to finance universal health coverage with mandatory employer contributions, which would uniquely discourage the employment of those mostly low wage workers who are not now covered.
In principle, Western countries could go beyond trying to reduce disincentives for employment and actually try to provide incentives. For example, firms might receive subsidies for employing workers, with the rate of subsidy highest for low-wage workers. Or the government itself could become an employer of last resort, both providing jobs and in effect setting a floor for private-sector wages.
The objections to any such government intervention are obvious in an age of cynicism about the public sector. The difficulties were well illustrated by the Swedish experience in the 1980s. Sweden in effect both subsidized employment and provided, under the guise of training, last-resort jobs. The effect was to postpone for a decade the emergence of large-scale unemployment. The program, however, spun out of fiscal control as the government tried to subsidize everything and everyone. In the end, huge budget deficits forced a sharp cut in subsidies and a rise in the unemployment rate to full Eurosclerotic levels.
We will be lucky if America's leaders are wise enough even to adopt a more modest strategy. The goal of building a welfare state that is more generous than America's, but does a better job of maintaining incentives to offer and accept jobs than Europe's, does not sound like too difficult an idea to grasp. But it requires facing up to the realities of our changing economy, rather than resorting to wishful thinking or blaming it all on villainous Asians. So far, wishful thinking has ruled the public discussion--and the blame game has already begun. Meanwhile, the real crisis of wages and jobs deepens.
(1) Japan represents a special case. The combination of rapid growth from a low base, unigue labor market institutions, and a large financial bubble in the 1980s has obscured the trends so visible in other advanced countries. Japan is in fact facing much the same difficulties.
(2) See Lawrence Katz, "Understanding Recent Changes in the Wage Structure," NBER Reporter, Winter 1992/3; Robert Lawrence and Matthew Slaughter, "International Trade and American Wages in the 1980s: Giant Sucking Sound or Small Hiccup?" Brookings Papers on Economic Activity: Microeconomics 1993; and Jorgen Elmeskov, High and Persistent Unemployment: Assessment of the Problem and its Causes, Organization for Economic Cooperation and Development, Paris. 1993.
Originally published, Summer.94