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A Danish Lesson for Germany

How did Denmark successfully reform its labor market?

January 26, 2005

How did Denmark successfully reform its labor market?

In 1993, the unemployment rate in Denmark stood at 11% percent. By 2000, it was down to 5% — and has remained at roughly that same level ever since.

Simultaneously, the percentage of the population that was in the labor force increased from 72% to 76% — a level more commonly associated with the U.S. economy, rather than European ones.

Despite the steep drop in unemployment, Denmark today retains very high tax rates and an extensive welfare state. How did this happen? How did Denmark manage to replicate the performance of the U.S. job machine in the 1990s — without imitating its much less comprehensive social safety net?

The short answer is that the Danish government woke up and started demanding something from its welfare state beneficiaries — rather than simply providing free handouts.

A longer answer is, of course, required when considering whether the Danish experience is relevant or not for other particular European countries, such as Germany or France.

The key to Denmark's reforms was a careful realignment of the incentives faced by different actors in the labor market — unions, employers, the unemployed, politicians and administrators.

One of the key steps taken by the Danish government was to cut the duration of unemployment benefits in half, to four years.

Surprisingly to many perhaps, the benefits themselves were not cut. Rather, they remain at a very generous 90% of previously earned wages — an OECD high.

However, Danish unemployment benefits are capped at a maximum of about $500 (Dkr 3,203) per week. This means that people with higher wages who become unemployed do not get anywhere near 90% of previously earned wages.

In other words, the system favors lower income individuals and thus strongly reflects the egalitarian norm in Danish society.

Since the mid-1990s, this generosity has come with strong strings attached, as Denmark simultaneously expanded its use of active labor market programs (ALMPs) and training.

The unemployment benefit system in Denmark now functions by an axiom of "Right and Duty." Any unemployed person has the right to both benefits and participation in job training, skill upgrading or other active labor market programs.

But as the same time, any unemployed person also has the duty to participate in such programs.

If they do not, they will forfeit their rights immediately — and be punished economically by being put on a much lower social benefit and/or perhaps sent to "clean beaches" or other similar types of "social tasks.”

Tough love, indeed. But the duality of generous unemployment benefits and forfeitable extensive worker retraining options has ensured that all actors in the labor market have had an interest in seeing the system succeed.

Labor unions — which in Denmark tend to be progressive rather than seeking to maintain the status quo — are heavily involved in managing and directing ALMPs and training centers.

Employers have the benefit of access to a gradually more skilled labor force — and a direct say in what types of skills are needed in the local area.

The unemployed get a meaningful chance to upgrade their skills and thereby improve their chances of getting a job. They also have direct financial incentives to participate in training.

Politicians — and it must be stressed that the Danish government at substantial costs (at around 5% of GDP) directly or indirectly pays for this system — have been quick to embrace the labor market reforms, since everybody loves success stories.

A key factor in the success of the reforms was that the new system appealed to politicians on both sides of the aisle.
Leftist parties — the reform was implemented by a left-leaning government — can point to the strengthening of opportunities for the unemployed, while still maintaining good benefits.

Meanwhile, the more business-oriented conservative parties emphasize the improvement of the skills-base and the requirement for the individual unemployed to earn his or her benefits.

Under those circumstances, it has not been particularly difficult to maintain the political consensus for the labor mark reform — and the related expenses.

There is one more ingredient in Denmark's successful labor market reforms. It is all very well for policymakers to come up with great concepts.

But none of those would amount to much if the street-level administrators — the ones who deal with the individual unemployed person — do not act in the spirit of the law. Those that carry the stick must be willing to wield it.

Harsh as that may sound, the very strong egalitarian norms in Danish society play an important role.

Usually, most public servants in Denmark are left-leaning voters — and therefore more sympathetic to the unemployed person than, say, a government that simply cut unemployment benefits to balance the budget.

In such circumstances, the full force of the law would be unlikely to be brought to bear upon the unemployed to induce the wanted change in behavior — that is, from a passive stance focused on receiving benefits to an active one focused on improving skills and searching for a job.

Fortunately, there is a solid consensus in Denmark that receiving generous benefits requires the active participation of the unemployed — he or she has to pull their weight, too. If not, the unemployed can be punished by the public administrator for a violation of the society's spirit of meaningful solidarity.

In other words, laziness can be punished — and since the sanction is highly credible, if provides an effective incentive to changing the behavior of the unemployed.

They know that if they do not participate in training and are available to take the jobs offered to them, their benefits will be immediately cut.

So the lesson from Denmark to neighboring Germany and all the other high-unemployment countries in the EU is this: A welfare state need not be dismantled to provide the right incentives for its beneficiaries — but it does need a big and credible stick.