2016 EEAG Report
Denmark – Too good to be true?
Torben M. Andersen, Giuseppe Bertola, John Driffill, Harold James, Hans-Werner Sinn, Jan-Egbert Sturm and Branko Uroševic
The Danish welfare state and flexicurity labour market model have a reputation for functioning efficiently, but is this assessment justified? How can the strong economic performance of a small, open economy be reconciled with a large public sector and a high tax burden? And how can such an economy cope with challenges like ageing and migration?
Denmark has both a high level and a relatively equal distribution of income. Both of these facts stand out in international comparisons and have attracted attention not least because Denmark has a very large public sector, and thus a high tax burden, is a small and open economy, and has successfully pursued a fixed exchange rate policy.
The Danish experience may thus seem paradoxical to some, or an exceptional recipe circumventing usual policy dilemmas to others. The relatively favourable performance of the Danish economy is not the result of a quick fix, but rather the outcome of a long string of reforms addressing structural problems and very explicitly taking into account the constraints faced by a small and open economy. The latter is immediately clear from the fixed exchange rate policy and Denmark's need to ensure its credibility. This has passed a market test since the interest spread vis-à-vis the Euro area has been very small for years, and even occasionally negative.
Economic performance and a large public sector
The Danish case shows that policy choices are possible, even in an era of globalization. The public sector plays a larger role than in most other countries. The interesting lesson is how the welfare state has been designed to balance concerns for economic performance on the one hand with the public provision of welfare services and the pursuit of egalitarian outcomes on the other hand. Two points are particularly important. Firstly, while the public sector is large, the private sector is very liberal in Denmark. The Danish model is thus not "politics against markets". Secondly, the welfare arrangements have a strong active focus on supporting labour market participation and human capital acquisition. Since the financial viability of the welfare model ultimately depends on maintaining a high employment level in the private sector, the conflict between welfare state objectives and economic performance is not as stark at it may appear at first.
Testing the flexicurity model
Denmark's specific policy choices do not make its economy proof to crisis, neither of domestic nor of foreign origin, as seen during the recent financial crisis. What stands out is that Denmark's labour market has maintained its high degree of flexibility, and although unemployment has increased due to the financial crisis, it remains low in comparative perspective, and unemployment spells remain short. It is a result of the high level of turnover in the labour market that youth and long-term unemployment are low by international comparison. High turnover rates thus effectively work as an implicit work sharing mechanism. Equal burden sharing is important from a distributional perspective, but it is also of structural importance. The alternative would be longer unemployment spells concentrated on a smaller group of individuals, a higher number of long-term unemployed and a corresponding depreciation of human and social capital. In short, the high turnover rates reduce the negative structural implications of high unemployment.
Sustaining the welfare model
Looking to the future, a sequence of reforms has been implemented to ensure the financial viability of the welfare model. The main focus here is also on how to strengthen labour supply and private sector employment. An important element is step increases in statutory retirement ages, and eventually an indexation to developments in longevity. These reforms ensure that the conditions for fiscal sustainability are satisfied.
From a forward-looking perspective, migration is a particularly difficult issue for a country with extensive welfare arrangements. Even if welfare arrangements are not magnets attracting migrants, the financial viability of the welfare model rests on a high employment level. Egalitarian objectives imply high entry requirements in the form of qualifications for jobs (to qualify for high minimum wages), as well as generous social transfers. This causes a very tight relation between the employment rate and how public finances are affected by immigration. This leaves a difficult trilemma: enforcing extremely strict immigration rules (their scope constrained by international treaties and EU rules), lowering minimum wages or giving up on universal social rights. All three avenues challenge the basic objectives of the welfare state. The first and third avenues have mainly been pursued to date, but how far is it possible to proceed in these directions?
While challenges remain, the political focus on medium- and long-run issues is notable. If anything in these developments stands out, it is in the political economy of establishing consensus across a broad political spectrum, leading to support for reforms, as well as continuity and consistency in policies. This has been possible despite the fact that most governments have been minority governments in the past (and usually coalitions among several parties); and that there have been frequent shifts in government.