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InvestmentResearch 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 Eur▯ omic and political environments since the financial crisis began has clouded a more import▯ economic performance: structural reforms. Although structural reforms are underway throughout Europe—but▯ portantly in peripheral countries—many observers will swiftly point out that the effect of these r▯ taken shape. Observing representative exam- ples from reform history in Europe (the United Kingdom in th▯ s and Germany in the period 2002–2005), we draw attention to the fact that the immediate years after▯ s exhibited slower economic growth, but emphasise that the long-term effect following this initial▯ nificantly positive. As the current reforms go through their short-term, slow growth phase, we believe this could transl▯ ate 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 To explain the chart, the first data point shows that in 1961 the Margaret Thatcher. Initially the basis for the comparison appeared United Kingdom grew 1.4% slower than the G7 (G7 grew real to be little more than that she was a leader who happened to be a GDP at 4.2% and the UK grew 2.8%). woman with a science degree. Since the global financial crisis, how- During the period 1961 to 1979, the performance of the UK ever, Merkel has taken the lead in driving structural reform across economy was poor; GDP grew slower than the G7 every year except the European Union in a way that reminds us of Thatcher’s reform for one. Over that period economic growth in the UK averaged program in the United Kingdom in the 1980s. If we are right, the outlook for growth in Europe over the next decade is materially 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 better than the current consensus view, therefore, we believe inves- tors should look to take advantage of the current negativity towards in 1979 than it actually was; the grey bars in the chart represent this period. The red bars represent the period when a significant Europe. portion of the reforms were enacted. During this period, the UK’s In our previous Investment Research paper, The Case for Europe economic performance got worse. In both 1980 and 1981 UK GDP we argued that structural reform was far more important to inves- grew nearly 3% slower than the G7 – and unemployment boomed tors than the austerity versus stimulus debate. In this paper, we aim to over 10% of the workforce. However, the blue bars show the to build on that argument. We think that structural reform is a far economic benefits of Thatcher’s program over the subsequent years. more powerful driver of economic performance than many imagine. From 1982 to 2012, the United Kingdom has grown faster than G7 We will show that both Thatcher’s reforms in the UK in the 1980s by 0.3% per year (outgrowing the G7 in nearly two thirds of the 2 and Gerhard Schroeder’s reforms in Germany from 2002 led to a individual years ) . Put another way, the UK economy is 65% bigger dramatic improvement in economic growth. We will examine some today than if it had continued to grow 1.5% a year slower than the of the key aspects of those reforms and suggest that the reforms that G7. Merkel is forcing on the periphery share many of the characteristics that made those previous efforts so successful. The second example of successful structural reform is Germany between 2002 and 2005. Exhibit 2 shows the performance of Before we begin, however, it is important to make one thing very German GDP relative to the G7. Again we can see a long period clear. Thatcher, Schroeder and Merkel remain controversial figures. (in grey) from 1992 to 2001 when the German economy was a While we would argue that their reforms have bought very clear consistent underperformer. Over this 10 year period the German economic benefits, many others are less complementary about their economy grew 1% slower than the G7. Between 2002 and 2005 social implications. For the purposes of this paper, we do not seek the Hartz reforms were enacted – and again the initial impact on to answer the debate about whether the actions that have been taken growth was negative with the gap to the G7 increasing to 1.7% per are moral or fair. While we believe the moral debate is worth having, year (red). However, from 2006 onwards the benefits have come this paper is focused on whether or not the changes made have con- through with the German economy outgrowing the G7 by 0.6% per tributed, or will contribute, to faster economic growth. year (blue) outperforming in five of seven years. The first stage of our argument is to analyse the impact of how Thatcher and Schroeder’s reforms worked. Exhibit 2 GDP Growth in Germany Relative to the G7, 1992–2012 Exhibit 1 shows the United Kingdom’s GDP growth relative to the G7 since 1961. (%) 3 Hartz Reforms 2002 Exhibit 1 2 GDP Growth in the United Kingdom Relative to the G7, 1961–2012 1 (%) 0 3 Thatcher Elected 1979 2 -1 -2 1 0 -3 -4 -1 -5 -2 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 -3 As at 31 December 2012 Source: Lazard, OECD -4 -5 19611964196719701973761979198219851988199119941200020032006200912 As at 31 December 2012 Source: Lazard, OECD 3 We believe these two examples provide significant support for the Opening markets and enhancing competition view that structural reform can dramatically change the growth In some cases, there was an issue with closed or monopolistic indus- trajectory of an economy, even where that economy appears to be tries. These tended to be inefficient leading to higher costs for the firmly stuck in the doldrums. Clearly government policy decisions rest of the economy for the services provided. Often there would regarding labour markets, domestic competition and other struc- be a high level of public sector involvement in these industries. The tural reforms are only one determinant of economic growth rates. solutions to these issues often involve opening industries to compe- We recognise that monetary policy, global economic conditions and trade protocols can also influence GDP growth rates. In this paper, tition and private capital. we focus on the policy decisions and how they might have driven We will now examine the reforms introduced in these three main improved economic growth rates. We cannot ascribe precise causal- areas: ity but feel that the anecdotal evidence is supportive of our positive view of the impact of structural reforms. Thatcher In our view, there are two other important points to make from Incentives these examples. First, the benefits of the reform do not just change This was a key component of the Thatcher reforms. Individual tax the growth rate for a year or two, as the improvement can be sus- tained for decades. Second, the initial impact of reforms is negative 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 for growth. This is important to remember when we think about rate was cut from 33% to 30%. In subsequent years, the base rate Europe today. Moreover, while growth is weaker as the reforms are being implemented, consensus opinion can become very pessimistic was cut further to 25% while the top rate fell to 40%. To under- stand the impact on incentives, a higher rate tax payer retained £60 about the chances of success. Thatcher’s famous “The lady’s not for of each extra £100 earned in 1989 compared to just £17 ten years turning” speech in 1980 was a direct response to such negativity. As late as April 2005, six leading German think tanks slashed their earlier–three and a half times as much. Corporate tax rates were also lowered from 52% to 35%. 3 growth forecasts and estimated that trend growth for Germany was 1% - half that of the euro zone and one third that of the US. At the same time, unemployment benefits were severely reduced. The link between benefits increases and average earnings growth was Having suggested that structural reforms can be more powerful than broken. Indeed, in the early years of Thatcher’s government benefits many imagine, that the benefits can last longer and that during the implementation phase their success is likely to be widely doubted, were increased less than inflation. In addition, the component of unemployment benefit linked to previous income was reduced and we now want to examine some of the actions that have been taken. then abolished. Relative to average earnings, the value of unemploy- This is a challenging project as every economy will be starting down this path from a different point. The issues that dogged the United ment benefits was reduced by around a quarter between 1979 and 1991. 4 Kingdom in the 1960’s and 1970’s are different from those that dogged Germany in the 1990’s and the peripheral countries today. Flexibility The solutions will also be different depending upon the cultures of A major aspect of the Thatcher reforms was a marked reduction in the various countries and the ideologies of the politicians in place as employment labour rights. Thatcher introduced a series of measures the reforms are implemented. However, in our view, there are three broad categories that have been present to a greater or lesser extent that dramatically impacted the unions, which included the outlaw- in all three cases: ing 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 Incentives based reforms One major issue in all three situations has been the desire to increase end of her time in power less than 40% of the workforce were union members compared to over 50% in 1979. The level of strikes also the incentives for individuals to be in work relative to not being in fell faster in the UK than in many other countries during the 1980s. work. This generally involves either lowering taxes for those work- ing or lowering benefits for those out of work. Often there may be Open markets a combination of both. The corporate tax rate may also be lowered. During her time in office, Thatcher privatised many industries, most One of the key features of successful reforms in these areas is to remove the “benefits trap”, whereby an individual on benefits will famously in the telecoms and utilities sectors, but also companies such as British Airways, Rolls-Royce and Enterprise Oil. She also see their income fall if they start to work. oversaw major deregulation in the financial services sector, which Improved flexibility for business saw the Big Bang reforms of the City of London, and the introduc- tion of private pensions. Selling off council houses also sparked a Another major issue in all three situations was a high level of regula- major change in the UK property market. tion 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 employ- ees. 4 incentives; the reform of Spain’s banking system should have very Schroeder positive impacts for many years to come. We believe Italy is the Incentives biggest disappointment, progressing well in opening markets, but The Hartz IV reform was the most significant change of the reform arguably moving backwards in the other two categories. Outside of the periphery, the United Kingdom has made steps to increase the package. Prior to these reforms, unemployment benefits were linked to previous salary, reaching up to 67% of previous pay for up to incentives for work. France’s attempts to increase flexibility so far 32 months (capped at €4,250 per month) followed by up to 57% look similar to Italy’s, with the potential to have the opposite effect. 6 However, the French government’s apparent acceptance of the need of previous salary without time limit. Moreover, on returning to for welfare reform could herald a more dramatic change. 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 Spain for long-term unemployment with the introduction of a lower, Incentives means-tested flat benefits. In addition, claimants were required to accept any suitable job offer or face a further reduction in benefits. Limited progress has been made related to incentives. Some small Subsidies were also introduced for both employees and employers to reductions to unemployment benefits are planned. tackle the problem of the benefits trap. Flexibility Tax rates were also lowered for both corporates and individuals in a We have observed significant improvement in this dimension. process that started in 2001. Income tax rates for individuals were cut from 23%/51% in 2000 to 15%/42% in 2005, a significant Companies are now free to negotiate salaries and conditions directly with their workforces rather than being bound by collective agree- increase in incentives. Corporate tax rates meanwhile fell from 52% ments. Compensation for unfair dismissal is reduced from 45 days to 39%. 7 per year worked to 33 days per year worked. The maximum cost is 8 Flexibility reduced from 42 month’s salary to 24 month’s salary. Employers can impose a one year probationary period on new workers and Increased flexibility was also a major component of the Hartz receive tax benefits for taking on new staff on permanent contracts. reforms. Regulation on temporary work was lowered, making fixed term or open ended temporary contracts easier for employers to Open markets enter into. Employer flexibility was further enhanced by increased The major change is in the restructuring of the financial sector. In exemptions from dismissal protection for small employers, and changes to regulations governing which workers should be released particular, the regional/local savings banks known as caja’s have been forced to consolidate and become more professional. The vast first during redundancy programs. majority of the institutions are now in private hands, as opposed to being controlled by local politicians. Other industries, such as Open markets telecoms, residential real estate and some service industries could see This was not a major focus for the German government during this enhanced competition. period. Italy Europe Today Given the range of countries involved, we now offer some general Incentives Limited progress has been made up to this point. The proposed thoughts, followed by a more detailed examination of each of the key peripheral economies. Each country has its own unique set of reforms seek to increase access to unemployment benefits and challenges. Portugal for instance suffers from a lack of labour mobil- increase the proportion of expected income from work received in ity due to the structure of its property rental market. However, Italy the form of unemployment benefits from 22% to over 33%. 10 has had excessively restricted professional services markets, while Spain has suffered a great deal of political interference in the bank- Flexibility ing system. The process to dismiss/restructure workers has been simplified and Generally the easiest areas have been tackled first. We feel there probationary periods of up to a year introduced. However, measures have also been introduced to discourage fixed contract or temporary has been good progress across the region with opening markets, positions, which is inconsistent with flexibility. particularly in the energy, transport and professional services sec- tors. Measures to enhance the flexibility of businesses have also been widely adopted, though in Italy some of the new measures Open markets There has been significant progress in liberalising the service, energy look likely to do the opposite. The weakest performance has been in and transport sectors. Professional services (for example accoun- enhancing incentives, as this is partly due to the unhelpful focus on government deficits, which makes tax cuts hard to introduce. That tancy, law and engineering) in particular were excessively restrictive with high cost for business and many of these markets have been said, there has also been a failure to tackle benefit systems which can liberalised. Corporate cross holdings have been reduced and there do little to incentivise work. has been significant reform of board practices in the financial sector. 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 5 Greece How does the comparison between Incentives Merkel and Thatcher stand up to Unemployment benefits have been limited to 12 months and the scrutiny? government has recently added a maximum of 450 days in any four Based on our review of the measures being undertaken, it seems 11 year period. The payment amount has also been cut by over 20%. clear to us that most progress has been made in countries which This amount is a flat rate rather than being related to previous have had the highest involvement of Germany, with Merkel’s over- salary. Public sector salaries have been cut significantly. sight. The two program countries, Greece and Portugal, are leading the way with Spain following closely behind. Where the Troika has Flexibility had less involvement, particularly Italy and France, progress has Firm level collective bargaining has been given precedence over been more limited. industry level. Rights for workers to seek arbitration unilaterally have been removed and open-ended employment contract exten- This conclusion is supported by data from the World Bank Doing Business report. Exhibit 3 shows the improvement in the “distance sions restricted. Minimum wages have also been cut severely. The to frontier” score for each of the periphery nations. This score court system has been reformed to give faster decisions and govern- ment bureaucracy has also been reduced. measures how close each country is to best practice across a range of measures, and we can see that Portugal, Greece and Spain have seen significantly more improvement than France or Italy. Open markets Closed professions have been liberalised. Retail, fuel, transport and Germany has dominated the debate within the European Union. utility markets are being liberalised and there is an ongoing privati- Merkel has been steadfast in pushing the reform agenda and dis- sation program. played 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 Portugal these programs. From purely an investment perspective, investors should hope she has the chance to impact the larger economies of Incentives Italy and France in the same manner. If she does, we believe the Wages in the public sector have been significantly higher than those outlook for the European economy should be much better than in the private sector, reducing the incentive to work for the private most people imagine. sector. This is being addressed through pay reductions in the public sector. Unemployment benefits have been capped at 65% of previ- ous salary and the amount payable is now reduced by 10% after 180 Exhibit 3 12 days. Measures have been introduced to withdraw benefits where Improvement in “Distance to Frontier” from World Bank individuals refuse to accept a new job. Doing Business Report 7 Flexibility Portugal Severance payments are being reduced to 12 days per year of service 6 with one year’s salary as a cap. Collective bargaining powers are 5 also being modified. Open markets 4 Spain There is an active privatisation program. Government involvement 3 in the real estate sector is being reduced, as rental laws have been Greece 2 reformed to free up the property market and encourage the move- France ment of labour. The ports and energy sectors are being liberalised, and the court and judicial systems reformed. 1 Italy 0 Other Countries Incentives -1 The United Kingdom has moved to further improve in this area. -2 Benefits are being capped and tax rates–particularly for lower 2010 2011 2012 2013 earners and for businesses–are being reduced. Changes to the way As at 31 May 2013 benefits are withdrawn should make it easier to return to work. Source: World Bank Flexibility France has enacted measures to make dismissing workers or chang- ing their hours easier. As with Italy, however, the impact may be offset by increasing the cost of hiring temporary workers. 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_resear▯ ch.html 2. Given the length of Thatcher’s period in office and the fact tha▯ forms 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 Mark ▯ et Policy in Germany, L. Jacobi, J. Kluve (2007) 7. OECD Tax Database 8. Spain’s Structural Reform and Economic Policy Programme, Tesoro Public ▯ o 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 indica- tors of ease of doing business. Scores are between 0 and 100 with 100 bei▯ ng 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 po▯ ints, 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▯ 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 solici▯ tation 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 restr▯ or prohibited. The information and opinions presented do not constitute investment advic▯ e and have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no represen- tation as to their accuracy or completeness. All opinions and estimate▯ xpressed 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 Gate▯ way, 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 b ▯ y 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 Financ ▯ e 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 8L ▯ L. 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 ▯ nder 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
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