C. Maxwell Watson

The striking turnaround in the Netherlands' economic performance over the past decade and a half has attracted widespread attention. Emerging from deep recession and high unemployment in the early 1980s, the economy shifted to a pace of growth more rapid than that in neighboring economies, and posted a rise in employment close to that in the United States. Even adjusted for an increase in part-time work, job creation in the Netherlands has compared favorably with the experience elsewhere in Europe.

This impressive performance was rooted in policy reforms that included a firm monetary anchor, tight control over public expenditure, and reduced intervention in the economy. With notable wage moderation, and broad "ownership," the reforms have been sustained over an extended period, exercising mutually reinforcing effects.

Economic reform in the Netherlands is far from complete--with major challenges remaining in the area, among others, of long-term and low-skill unemployment. Nonetheless, this experience deserves to be studied in order to distill elements that may be relevant to other countries--and indeed to the task of improving further the performance of the Dutch economy.

The Reform Package

In 1982, a worsening economic crisis triggered major changes in policies and wage behavior in the Netherlands. A deep recession was under way, with real GDP declining for the second year in succession, GDP per capita falling below the level of 1978, business firms barely profitable, and registered unemployment reaching 8 1/2 percent--a rise of 5 percentage points in three years. The fiscal deficit, on a broad definition, had risen to 9 1/2 percent of GDP.

In this setting, the authorities and the social partners recognized that, to address the serious macroeconomic and structural problems, a fundamental change in policy approach was needed:

• Fiscal consolidation became a centerpiece of the reform effort. Public spending declined from two-thirds of GDP in 1983 to just over half in 1997. During the same period, the broad fiscal deficit was cut from 10 percent of GDP to 1 percent, and the revenue ratio was reduced from 57 percent of GDP to 50 percent.

• Monetary policy, from 1983, was based resolutely on the peg to the deutsche mark.

• Among the measures to stimulate labor demand were major cuts in real minimum wages for adults, and even deeper cuts for youths, as well as lower social contributions, particularly for the low-skilled. For the long-term unemployed with low skills, employers' contributions were virtually eliminated.

• Labor market and social security reforms focused also on strengthening labor supply by lowering benefit replacement rates, reducing the duration of unemployment benefits, tightening or privatizing other benefits, and cutting the personal tax burden.

• A sea change in labor union philosophy paralleled the reforms: in the face of mounting unemployment, an enduring consensus on wage moderation emerged--helping to restore the profitability of firms and thus setting the stage for economic revival.

• In recent years, product market deregulation has been accelerated, with measures to extend shopping hours, toughen the anticartel law, and lower entry barriers. The aim is to increase domestic competition, business creation, and jobs--notably in services--and thereby provide a crucial complement to continuing labor market reform.

A Model for Others--Or a Unique Experience?

The reforms, as outlined, were orthodox. A credible monetary anchor; expenditure-based fiscal consolidation, allowing cuts in the tax burden as well as the fiscal deficit; demand and supply side reforms in the labor market--on the face of it, they were more of a textbook cure than a "Dutch miracle." What, then, were the ingredients that have proved elusive for many other economies?

First, the interaction of key policies, and their mutually reinforcing impact, emerge as critical:

• the reform of social benefits contributed to spending restraint, thus facilitating both fiscal consolidation and a cut in the tax wedge;

• tax cuts and benefit reforms both favored wage moderation;

• together with real reductions in the minimum wage, particularly for youths, wage moderation helped strengthen the demand for labor and also played an important role in underpinning the exchange rate peg; and

• in turn, buoyant employment boosted the tax base, setting in motion a virtuous circle in the labor market and the public finances.

Second was the consultative style of the authorities and the cooperation of the social partners, which were also critical for effective reform. Consultation was a key feature of the authorities' approach, and the social partners responded in a spirit of cooperation--although consensus proved elusive at times and some measures provoked strikes. Nevertheless, the reforms became broadly owned, which explains how it was possible to sustain them over a long period. Moreover, the clear strategic commitment of the labor unions provided a setting in which firms felt confident to develop medium-term business plans, expanding investment and employment.

Third was the role of fiscal and labor market reforms in sustaining the change in labor market behavior. The government in effect changed the rules of the game in the labor market: it offered income gains through tax cuts under a new fiscal strategy--but it also pressed through measures that provoked strong negative reactions, such as cuts in the real value of social benefits and minimum wages. There was acceptance, overall, because these new rules delivered growth, jobs, and core social protection.

On all these counts, the evidence speaks to a powerful chemistry at work in the design and implementation of the reforms. Chemistry, but no alchemy. The interaction of reforms--for example, the trade-off of tax cuts for wage moderation--reflected careful design. The results were promised up front, as a fruit of cooperation, and by and large they were delivered. Equally, the shift in labor union attitudes displayed a statesmanship that commanded wide respect, but it was not exogenous: it corresponded closely to a shift in economic fundamentals and to announced changes in official policies.

For those who would transpose this approach to other economies, particularly where constraints in the design of social protection systems are similar, the key arguments lie in the fundamental orthodoxy of the reforms, their complementary nature, and the benefits of wide ownership and sustained implementation. By contrast, the most important caveats lie in the uniqueness of certain starting conditions in the Netherlands:

• The depth of the crisis, including the rapid rise in unemployment, provided both a trigger for consensus and a low bar against which to measure success: the recent employment gains can be viewed in part as a catch-up with neighboring countries from a very unfavorable starting situation.

• With the labor share of income exceedingly high at the outset (profits after interest were negligible in the early 1980s), the scope to price workers into jobs by a combination of wage moderation and cuts in the tax wedge was so ample as to be almost unique.

• A young and growing population, and initially very low female participation, provided an untapped reservoir of labor--including for flexible, part-time work.

This difference, moreover, has strong relevance to the situation in which the Netherlands now finds itself. In a nutshell, few of the long-term unemployed in the Netherlands have returned to work, and job creation has not benefited the low skilled. In the future, as the population begins to age, it will be crucial to ensure that the share of the inactive in the population is progressively reduced and that approaches to training, labor costs, and benefit design promote higher employment among the low skilled.

An Agenda for the Future

A number of important problems remain to be tackled to further strengthen economic performance in the Netherlands. Continuing fiscal and structural reforms are needed to impart a flexibility to the economy that will allow it to benefit fully from the European Economic and Monetary Union (EMU). At the same time, the levels of labor force participation and employment must be raised further, reducing the number of persons on welfare programs.

To achieve these goals, key reform priorities include the following:

• Firm efforts to balance the public finances over the medium term. Achieving this will not only allow fiscal stabilizers full play, but will also be appropriate for the long-term: the debt ratio and interest burden need to be cut substantially before the aging of the population begins in earnest in a decade's time. Even though pensions are partly funded, the demographic shift in the Netherlands is set to be particularly sharp, and--even with entitlement reforms--the shift will entail a significant increase in public spending.

• To be able to cut both the fiscal deficit and the tax burden, a new generation of structural expenditure reforms. In health care, stronger incentives are needed to promote efficient use of resources. In social transfers, recent measures increasing firms' incentives to manage benefits effectively at the "point of entry" are encouraging but need to be monitored closely, and strengthened as necessary.

• In the labor market, stronger incentives and opportunities to reduce the level of long-term unemployment, disability, and welfare recipients. Current experiments in integrating benefit, job search, and training services, with private sector participation, may help secure a breakthrough, but such changes need to be implemented in ways that ensure sufficiently strong incentives for benefit recipients to actively seek work or training. This implies a further re-orienting of benefit administration around the challenge of reintegrating the unemployed into the labor force, rather than simply providing social protection.

• Tax reform, which also can help improve the supply side of the labor market. An important aim should be a further widening of the gap between net salary and net benefit income--notably at levels close to the minimum wage.

• In product markets, a renewed emphasis on fostering entrepreneurship. One key goal should be to remove regulatory and financial obstacles to start-up companies and thus help bolster economic flexibility. In addition, the introduction of market forces in sectors such as transportation needs to be pressed through firmly.

The reform process, in sum, is as yet incomplete, and the advent of EMU calls for efforts to be renewed. Measures are needed that, as in the past, will exercise a mutually reinforcing impact on the functioning of markets and the strength of the public finances--thus extending the impressive performance of growth and employment creation in recent years.