Can the European social contract still be saved? The delivering scenario.

Weakened by the crisis, the European Union is struggling to ward off mounting challenges. And yet there is nothing inevitable about its decline, let alone its disintegration. Europe can remain the master of its own destiny. But that implies rethinking its model – by reinventing social redistribution in response to some major transitions now under way.

A social contract worn down by a decade of crisis

All over Europe, people are voicing – sometimes angrily – their attachment to the “European social contract”, a model based on a significant redistribution of wealth through fiscal transfer, social protection and public services. For over half a century, this model has enabled a very large proportion of Europeans to share in the benefits of growth – what economists refer to as “inclusive growth”.

Those of us who grew up in Europe, who work there, or have lived there for a long time, tend to focus on the imperfections of the European social contract. It is all too easy to forget its advantages. But one need only compare a few indicators. Well-being? The United Nations, for instance, publishes a “Human Development Index” every year: 7 of the top 10 countries are European. Inequality? Far lower in Europe than in the United States: the ratio between the incomes of the top and bottom quintiles of the population is 5.2 - compared to 8.2 in the USA. Life expectancy? Two years higher in Europe than in the USA. With a minimum of objectivity, it soon becomes clear to what extent the European social contract is enviable – and, indeed, often envied by the rest of the world.

But this contract was shaken by the crisis of 2007-2008. Just as European leaders were adopting the Lisbon Treaty, an ambitious reform agenda to stimulate growth, Europe fell into recession. The fiscal imbalances of some of the Eurozone countries had to be resolved as a matter of urgency. In Southern Europe, austerity policies had drastic deflationary effects.

These shocks had serious consequences; only now are we measuring their full impact. For ten years, the incomes of most Europeans stagnated, as the McKinsey Global Institute (MGI) demonstrated in a 2016 research. Intra-country inequalities and poverty increased until 2014, before falling back again as economic conditions improved. What emerges above all, however, from a new report just published by the MGI is that disparities within Europe have widened. Northern, Central and Eastern Europe, and to a lesser extent Continental and Anglo-Saxon Europe, have put the crisis behind them. Incomes have increased for all population quintiles, and trust in institutions has regained some lost ground. In Southern Europe, by contrast, incomes are still below pre-crisis levels, and trust in national or European institutions remains in tatters.

This situation is all the more worrying in that new storm clouds are gathering.

Powerful centrifugal forces, and a strong risk of disintegration

The MGI report identifies six megatrends, each with its own specific features, which will pile further pressure on the European social contract in the coming years. Failure by Europe to respond to these trends would lead to a deepening of inequalities, and to populist reactions that could eventually result in European disunion.

Let's start with the demographic megatrend. Europe’s population is expected to stagnate, with 518 million inhabitants by 2030, compared to 511 million at present. In some of the larger countries, such as Germany and Spain, the population will even decline. Combined with ageing, the falling birth rate will lead to a 5% decline in the working population, with negative consequences for productivity and the funding of pensions and health care.

Immigration – another of the megatrends examined in our report – could partly compensate for Europe's weak demographic dynamics. But its effects depend on migrants’ levels of qualification and, above all, on the effectiveness of integration policies.

Next comes increased global competition. Overall, Europe has a positive trade balance, and therefore has no interest in promoting protectionist policies. However, in the MGI baseline scenario, increased competition from emerging countries in manufacturing, and from the United States in digital products and services, would result in a loss of 0.3 per-capita GDP points – as well as an increase in inequalities.

Comparable effects will be induced by a fourth megatrend, caused by climate change and the depletion of natural resources. Even if, in the long term, the ecological transition may have a positive impact (principally with the circular economy), it will require massive investment in the years ahead. And since energy costs, in proportional terms, weigh more heavily on lower-income households, there is, once more, a likelihood of greater inequalities.

The fifth source of tension analyzed by the MGI is the rise in geopolitical risks. For Europe, this will mainly entail a need to invest more in defense and cyber-security.

The final trend – digital transition – will potentially have a greater impact than all the others combined. It encompasses digitization, artificial intelligence and automation, big data, etc. The extensive research on this topic conducted by McKinsey has shown that the digital transition, despite the fears it raises, has a positive overall impact. But at the same time, since digital tools increase the productivity of the most skilled workers, while partially automating some functions, they also exacerbate income disparities. Ultimately, the impact of the digital transition on Europe by 2030 is expected to be considerable: if the human skills are available to implement it, then the boost it would deliver to the economy would be equivalent to double the stimulus generated by electrification. It would then, on its own, be able to offset all the adverse trends – demographic ageing, global competition, climate change, etc. – while increasing average per-capita income in Europe by 15%. The other side of the coin is that, yet again, an increase in inequalities by about 19% would be the price to pay.

Only one way out: accelerating transitions…

By aggregating these six mega-trends, the McKinsey Global Institute points to two scenarios.

In the first one, the countries of Europe go for “denial”: unable to align, they implement ineffective policies to respond to these threats. In this case, our models suggest that average growth would fall to 0.3% a year for Europe as a whole, and would even go negative in both Southern and Continental Europe. Social costs would increase by an average of 9% (+ €1,350 per capita) – inevitably raising the question of how much longer the social model could be sustained.

In the second scenario, described as “delivering”, Europe's member states tackle the identified challenges head-on. They implement reforms to strengthen the labor force (for example, by doing more to integrate women and migrants into the labor market, and by raising the retirement age). They invest massively in the transition to a circular economy, to mitigate the negative effects of climate change and resource depletion. Above all, they actively promote the dissemination of digital technologies and artificial intelligence (see this earlier post on this topic). Under this scenario, economic growth would be robust (1.9% per year on average) and the per-capita income gain would be considerable: €9,000 more per person by 2030 than in the denial scenario. Nor would the gains be solely economic: they would also take the form of a reduction in greenhouse gas emissions, or an increase in labor participation. The only fly in the ointment – but it’s a big one – is that in this scenario, inequalities would increase still further… at least before redistribution. This would be the case both for inequalities within each European country, as well as between Member States.

To sum up: Europe is at a crossroads. One of the paths ahead leads straight to the breakdown of its social contract and, it is to be feared, to the disintegration of Europe as a political entity. The other would preserve the benefits of its model, but at the cost of a rise in inequalities before redistribution. We must therefore take the second path, but remaining mindful of the risk, and endeavoring to manage it proactively. The issue of inequalitites will be key. Redistribution will be essential, but how can it be done effectively?

… while cushioning their social impact in intelligent ways

If Europe adopts a proactive scenario of adapting to the megatrends, it gives itself a chance of preserving its social contract, while escaping the trap of sluggish growth. But inequalities before redistribution will increase sharply, particularly as a result of digital technologies.

To contain inequalities at their current level, the MGI estimates that about €1,200 per person would need to be transferred from the first to the last income quintile. That might well be a rational policy decision, but implementing it is no walk in the park. It is already obvious that the issue of redistribution sparks vigorous reactions. This is the case within countries, where there is much debate about consent to taxation and about the validity of helping certain categories of the population. And even more so between European countries: the countries of Northern and Continental Europe are less than enamored with the idea of transfers to the so-called “Club Med” countries of the South, which, they feel, should first of all implement more stringent reforms.

The debate must therefore address this question: which forms of redistribution would be effective in achieving Europe's transformation objectives, and at the same time acceptable to public opinion in Northern Europe, as well as to the segments of the population within each country most favored by the digital economy?

The economist Branko Milanovic, a specialist in inequalities, suggests in his book Global Inequality: A New Approach for the Age of Globalization that, in the digital age, the most effective redistribution levers are, firstly, ensuring the spread of technologies by tackling economic rents, and secondly, improving the quality of education. This may not be the only path, but it does look like a promising one. On the one hand, it would revive the debate, at the European level, on the economic contribution made by digital businesses – a debate that is currently stuck on the issue of taxation. On the other, it would open up new possibilities for fiscal transfer between European countries. One could imagine, for example, the Northern European member states supporting digital training initiatives in their Southern and Eastern counterparts, in the form of “social impact bonds”. This would, at one stroke, ensure their acceptability in the issuing countries and their effectiveness in the recipient countries.

Such a strategy would probably require even greater European fiscal, monetary and economic governance integration, and a massive increase in the level of European investment in innovation and technology.

In parallel, the other question that remains for all of us to explore in the short term is how we can leverage technology as an opportunity, and make it contribute positively to bringing about a positive “deliver” scenario, in addition to its economic impact on productivity and wealth creation, through actions in the fields of education, diversity, and others.

I look forward to reading your reactions and suggestions on this vital topic of the socio-economic equilibrium in Europe in the digital age.