Germany and France: Confronting the costs of social policies

A new study establishes the case for improving productivity. It’s time to recognize that regulation has not preserved incomes, provided access to services, or prevented job losses. An analysis of six industries: automotive, housing construction, telecom, retail banking, retail, and computer software.

West Germany and France have both enjoyed decades of steadily rising prosperity. Today, however, they are afflicted by sluggish growth, mounting social costs, and high unemployment. Within the populations, young and low-skilled workers have been hit particularly hard. More and more French and German citizens are coming to believe that their economic and social systems are in urgent need of reform.

To provide a fact base for this reform, the McKinsey Global Institute compared productivity, employment, and output in France and Germany with global best practice, and investigated the causes of differences in performance.¹ Like earlier studies, this project examined performance both at the economy level and at the level of several key industries: automotive, housing construction, telecom, retail banking, retail, and computer software. It then considered what governments and corporations could do to close gaps in productivity and job creation while maintaining social policy objectives.

• Weaknesses in economic performance. Comparisons with global benchmarks using purchasing power parity reveal that West Germany produces 30 percent fewer goods and services per capita than the benchmark country and has 20 percent lower labor productivity and 15 percent less employment per capita across the industries studied. France lags the benchmark for these three critical measures by 40 percent, 20 percent, and 25 percent respectively (Exhibit 1).
• World-class productivity and strong employment performance can go hand in hand. The productivity leader also enjoys higher employment levels than France and Germany in five out of the six industries studied.
• Sector-specific product market regulations are the main barriers to growth. They constrain competition and limit exposure to the world's best companies, thus inhibiting productivity. Together with inefficiencies in governance structures, they hinder innovation and the introduction of more efficient processes, which in turn restrict productivity and overall growth.
• Comparatively high minimum wages and restrictive product market regulations such as zoning laws stifle output and employment performance in both countries.
• Better economic and social performance could be achieved by separating economic policies from those with a social goal. Income tax policy could be amended to alleviate the adverse social impact of deregulation, for example.

These findings are true of both countries, although France is suffering more than Germany, especially in terms of output and employment.

Economic performance

Both the individual industry case studies and the aggregate survey show that France and West Germany trail global benchmarks in output and employment (Exhibit 2). The differences in output can be traced primarily to the non-manufacturing sectors, and specifically market services. In 1970, the United States, France, and Germany had similar levels of employment in these sectors. Since then, however, the amount of work done in France and Germany has declined by around 20 percent, while the United States has seen its labor input rise by almost 40 percentThe six industries studied, which together cover roughly 20 percent of the market economy, suggest that France and Germany trail the global benchmark by 20 percent. However, when the aggregate numbers for each country are compared with the total for the United States, Germany appears to hold a slight lead. We believe that the industry results give a more accurate picture than the aggregate figures, because the service and convenience components of service output are often inadequately considered at the aggregate level. Moreover, many low-value jobs that reduce overall labor productivity in the United States and that are particularly important in, for example, personal services cannot exist in France and Germany because of higher minimum wages. The absence of these low-value jobs increases unemployment and simultaneously raises average labor productivity for existing employees.


While it is always better to create high-value, well-paid jobs, low-value jobs do allow people with limited skills to work, which may help them avoid social exclusion and give them a chance of moving up the income ladder. The United States has created a huge number of such jobs. In retailing, for example, it employs about 50 percent more people per capita than France and Germany. On the other hand, low minimum wages have led to greater inequalities in income distribution in the United States. In pursuit of social goals, however, governments have it in their power to create appropriate mechanisms for redistributing income.

Job creation need not be confined to low-value work. More than 80 percent of the new jobs created in services in the United States from 1990 to 1995 were in categories with better than median wage levels: managers, analysts, marketing executives, computer scientists, social workers, and lawyers, among others. In computer software, for instance, where income is well above the average, the United States employs around 50 percent more people per capita than France or Germany.

Barriers to improvement

Our analysis revealed that differences in economic performance were produced by barriers that inhibit productivity and barriers that directly stifle output and employment. The removal of these barriers would not only improve performance in the sectors affected but also create positive spillover effects in the economy as a whole.

Barriers to productivity

The removal of the barriers to increased productivity was identified by the study as the primary means of fostering growth and economic renewal in France and Germany. This may surprise those who believe that productivity improvements come only from downsizing and bring job destruction and higher unemployment in their wake. On the contrary; raising productivity by introducing more valuable products and services emerged from the industry cases as the most important way of increasing output and creating high-value jobs at the same time. In every industry except automotive, the global productivity leader was also the employment leader.

Improving process efficiency across the board and relaxing constraints on product and service innovation (including new business formation) appear to be the only route to world-class economic performance. They mirror the broader process of economic evolution in which employment shifts first from the agricultural sector into industry and services, and then from industry into services (Exhibit 4). Over the past century, many countries, including France and Germany, have found that vast improvements in productivity can be accomplished without any long-term rise in unemployment.

As this evolution takes place, some of today's jobs will be lost as more efficient processes release resources. However, the development of new products and services should create new jobs for these displaced workers, as well as for some of those currently unemployed

n the six industries studied, lower productivity in France and Germany appeared to derive from both a lack of innovation and the use of less efficient processes (Exhibit 6). Product market regulation and, to a lesser extent, inefficiencies in governance structures seemed to weaken the competitive and shareholder pressures that normally spur companies to innovate and improve process efficiency. Neither labor market regulations nor differences in fiscal and macroeconomic environments appeared to affect productivity performance.

In the automotive industry, overt or implicit barriers to trade and foreign direct investment shielded German and especially French manufacturers from Japanese best practice, contributing to 30 percent and 45 percent productivity gaps respectively.

Foreign and specialized players in French retail banking have been discouraged by product market regulations that determine the pricing and distribution of mortgages and deposits. These regulations prevented product differentiation and created inequitable competitive conditions.

The French and West German governments failed to provide appropriate incentives for telecom companies to price local calls at their true economic rate. Overpricing led to underutilization of the phone networks; on average, the French and Germans communicate by phone less than half as much as Americans.

In housing construction, a major constraint on productivity is the fact that local communities do not designate large enough areas of land for major construction programs to allow developers to exploit economies of scale.

Barriers to output and employment

High minimum wages have hit output and employment directly, particularly in retailing. In exactly the same store formats, Toys 'R' Us employs 30 percent fewer people in France than in the United States, for instance. With fewer staff at their disposal, retail managers are forced to reduce the level of service they offer their customers.

In 1995, US minimum wages were only about 55 percent of the French level, and less than 50 percent of the collectively agreed rate for low-skilled retail work in Hamburg, for instance (no overall minimum wage exists in Germany). Around 26 percent of US labor is employed at below the official French minimum wage costs to employers.

Stringent zoning laws that lead to higher land costs also hurt retail output. Overall, the higher costs of land and labor have prevented the development of many innovative, high-service retail formats in France and Germany.

Spillover effects in the wider economy

The output and employment performance of any industry will also suffer from barriers to higher productivity or output in other sectors of the economy. The French and German computer software industries, for example, are constrained by the lack of a vibrant service sector in their local markets. Consider the financial services sector, where external IT spending per capita in the United States is almost twice the French and almost three times the German level. In the economy as a whole, the United States has close to 40 percent higher IT spending per unit of output and uses almost twice as much software per capita overall as France or Germany.
The positive spillover effects in the economy that would result from the removal of barriers in other sectors emerged from our industry case studies as being critical to output and employment growth. They include the additional income that would be generated by the redeployment of resources from mature to growing sectors: for instance, from automotive to construction, banking, and retailing. To maximize these effects, governments must ensure the flexibility of labor and capital markets.

Improving economic and social performance

Most of the regulations that stifle output and job growth have been put in place to meet social objectives, such as preserving income levels (high minimum wages), providing universal access to key infrastructure (low telecom subscription fees), and preventing job losses (trade barriers in the auto industry). But as well as impairing economic performance, these measures often create secondary effects that thwart the original social objectives. Instead of guaranteeing a reasonable standard of living, high minimum wages keep low-skilled individuals out of the workforce. Instead of giving everyone access to an effective telecom infrastructure, low subscription fees, combined with artificially high call charges, limit usage, especially for the poor. Attempts to protect domestic auto industries will eventually cost more jobs than they save when the European market is opened up.
Yet it is possible for governments to introduce practical reforms that will align economic and social objectives. Increased flexibility in product, capital, and labor markets aimed at promoting economic growth could be accompanied by need-based social policies such as negative income tax to compensate for lower minimum wages and telecom subsidies to the poor to compensate for higher subscription fees. Such measures should allow France and Germany to improve their economic performance and achieve social objectives at the same time.

In each of the industries we studied, we found many artificial barriers to higher growth and employment. To remove such barriers across the board—or at least to revise them with an eye to their economic implications—would bring tremendous benefits to the economies of France and Germany.