The judicious pursuit of social justice appeared consistent with the achievement of sustained growth and high employment in the welfare state economies of Western Europe until the early 1970s. Many economists have attributed the large rises in unemployment they have experienced in the last 20 years to `Eurosclerosis', as generous income support has reduced both the pressure on `outsiders' to seek work and the constraints on the wage demands of employed `insiders', while employment protection measures have reduced labour demand. Critics of European welfare states often point to the example of the US, which intervenes much less in income distribution and has proved much more successful in creating employment.

In Discussion Paper No. 867, Research Fellow Paul Krugman notes that income distribution in the US is much less equal than in the European countries and its income inequality has increased substantially since 1973; the proportion of US families living below the poverty line has increased considerably despite the rise in average family income. Krugman maintains that these two experiences reflect the responses of different institutional systems to a common shock, as technological changes have pushed towards greater earnings inequality.

Krugman's simple model involves an explicit trade-off between equity and efficiency, as higher rates of taxes and transfers discourage work effort. The government sets their levels in a framework of political competition which maximizes the welfare of the median voter. A laissez-faire economy will then allow a rise in inequality to lead to a corresponding change in incomes, leaving the labour supply unchanged. A welfare state, in contrast, will seek to mitigate the growth in inequality, which causes the overall number of hours worked to decline. While the US has essentially given market forces free rein, and thus maintained its strong employment performance while allowing poverty to increase as the rich have become richer, European countries have leant against such inequality and thereby increasingly distorted incentives in a manner which has reduced equilibrium employment levels.

Inequality and the Political Economy of Eurosclerosis
Paul Krugman

Discussion Paper No. 867, November 1993 (IT)