Can Europe copy the land of the free?

One of the most important areas of economic competition in the next century looks like being in the quality of regulation. After all, in so many other areas countries are becoming more and more alike. They have similar plants owned by multinationals; similar access to the world capital markets; similar levels of inflation; even similar macro- economic policies, imposed by the world financial markets.

So what can governments do to differentiate one country from another? Much of the answer must lie in micro-economic policies, and regulation in particular. Deregulation was one of the great global themes of the 1980s and early 1990s, and has often been cited as the reason for the improved relative economic performance of the United States and the UK. Countries like Germany and Japan are now cutting regulation on matters as diverse as shop hours, telecommunications and securities trading in an effort to stimulate their economies.

There is a lot of momentum behind this process. This is a good thing, for in some cases there is a long way to go, particularly in continental Europe and Japan. But, naturally, whenever deregulation takes place there are some losers - some people whose life is made less comfortable. So, although the vast majority benefit, deregulation inevitably arouses opposition.

Enthusiasts for the process, convinced by the intellectual arguments in favour, too often neglect the pressure groups opposing it and fail to explain the scale of the potential benefits and the dangers if deregulation comes to halt.

People who believe excessive regulation is strangling the French and German economies will find much useful support from a new study, Removing Barriers to Growth and Employment in France and Germany, by McKinsey Global Institute of Washington DC. McKinsey decided to look at the issue because of the deteriorating economic performance of France and Germany in recent years, and because it felt that a growing number of French and Germans believe their countries must reform their economic and social systems.

Rising unemployment has given a new hard edge to the debate about what Europe should do - that is the emergency. But this is only one manifestation of a wider problem, which is shown in the graphs.

The gap in gross domestic product per head between the three countries has remained pretty steady since the 1970s. Germany has moved up from just under 80 per cent of US GDP per head to about 84 per cent (the figures are for West Germany, not the reunified country), while France has remained in the middle 80s. But progress in industrial productivity has been much greater, with both countries coming up from around 70 per cent of US levels to about 90 per cent.

So why hasn't the gap in gross national product closed further? The two right-hand graphs explain why. Employment of people of working age has risen in the US, but fallen in France and Germany; and the number of hours worked has fallen only slowly in the US but plunged in France and Germany. So while there are more jobless in France and Germany than in the US, that is only one measure of the difference in the labour markets.

Does this mean that America is creating more "low-paid" jobs? To some extent the answer must be yes. McKinsey has looked at comparable shops in the US and in France and Germany, and has found that in the US the same chains employ many more people to staff identical stores. The reason? High minimum wages in France and Germany make it uneconomic to employ so many people. The US now employs 50 per cent more people per capita in retailing than France or Germany, which is presumably why the US offers higher service standards.

But not all job creation in the US is in low-paid jobs. More than 80 per cent of new jobs in the US between 1990 and 1995 offered above-median wages. In computer software, a highly paid activity, the US again has 50 per cent more jobs per head than in France and Germany.

What are the barriers to job creation in France and Germany compared with the US? Aside from the higher minimum wage, it seems that the problem is not labour market regulations but product market regulations.

Thus in cars, one of the reasons why the French motor industry in particular has much lower productivity is the barriers against imports from Japan and the rest of East Asia. In telecommunications, regulations have led to over-priced services, so French and German people use their phones less than half as often as Americans. In retail banking, controls have inhibited the development of new products. (McKinsey does not make the point that in France, banking regulation has failed to stop the state- owned bank, Credit Lyonnais, costing the taxpayer something like pounds 20bn in bail-outs.)

However, there is a silver lining in these clouds. It is that the poor French and German economic performance is self-imposed and the pay-off if policy is reversed could be considerable. The problem can be fixed by structural reform, bringing both economic and social advantages.

"Most of the regulations that stifle output and job growth have been put in place to meet social objectives," the report says. "However, in addition to having a negative effect on economic performance, they often lead to secondary effects which actually thwart the social objectives sought in the first place."

So it is a potential win-win situation. Get rid of the barriers, push through reform and then tackle the social problems which these regulations were supposed to solve (but failed to) with alternative and more targeted measures. "Removing such barriers across the board, or at least revising them with an eye toward their economic implications, will have a tremendous positive impact on the economies of France and Germany," the report concludes.

It is a view which will have some impact on European policy-makers, as McKinsey is almost certainly right in the judgement that there is now real appetite for structural reform in France and Germany. But in a way, assuming you do have the political will to carry reform through, sweeping away restrictive regulations is the easy part. Britain has done a lot of that. The harder part is constructing effective ways of coping with the social consequences of deregulation.

In some areas there is a blue-print. Take telecommunications. Privatisation has been coupled with regulation in every country that has privatised its telecoms industry, resulting in better service. But that is relatively easy because it is a rapidly expanding industry and most of the regulator's role is to balance natural monopoly by encouraging competition. It is much harder to counter the adverse effects on, say, the motor industry from an increase in imports, if the industry has been relying on home demand for its main market.

This last point applies particularly in France, where Japanese imports are tiny. France is at last restructuring its industry, but cutting the workforce at Renault does not create new jobs in, say, software. Even if it did, the jobs would go to different people.

Looking ahead at the prospects for structural reform in Europe, there are three roadblocks. One is political will - although even if it is missing, eventually the economic pressures become so great that reform is inevitable.

The second is the difficulty of creating a culture of regulation which is appropriate to each - very different - industry. It is easy to set a goal of light but effective regulation. But it is difficult to acknowledge that the regulators are bound, from time to time, to fail.

And the third is that lifting barriers to enterprise may not be enough. From a US perspective, McKinsey may be right in emphasising the opportunities, but these probably require French and German people to behave more like Americans. And maybe they won't want to do that.