Testing resilience of Europe’s inclusive growth

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Europe’s inclusive growth model and the European Union’s (EU) welfare-based social contract appear to be under threat amid limited growth in median income in recent years, falling trust in institutions (both EU and national), discomfort about mass migration, worries about security as well as the resilience of global agreements, and a rise in populist politics that challenges the status quo.

Europe now needs to respond to six global — and interacting — megatrends that could push inequality higher within EU member states and among them and increase social and economic divergence, placing the inclusive growth part of the EU social contract in even more peril.

Given these trends, Europe needs to be proactive about testing new ways in which the social contract might work in the case of the future of work, low-carbon lifestyles and technology ethics, for instance. Overall, however, we find that Europe may be able to preserve the essence of its welfare-style social contract, if it delivers superbly on all its current initiatives that are linked to, and aim to respond to, the megatrends.

Among initiatives with the best outcomes for inclusive growth, the EU and European countries might have to scale up green and technological innovation and develop new skills.
While inequality will likely grow as new social policies unfold, these new approaches might be financed by the returns on those policies and, in the process, mitigate rising inequality, and helping to head off anti-EU sentiment. Social divergence within member countries is likely to persist and must be tackled with the EU complementing the actions of member states.

New McKinsey Global Institute (MGI) research, Testing the resilience of Europe’s inclusive growth model (PDF-839KB), focuses on prospects for inclusive growth in the period to 2030 — possibly the largest driver of citizens’ life satisfaction. It simulates the challenges and opportunities ahead in several scenarios and focuses on the impact of the six megatrends.

Much of Europe has returned to growth, but its inclusiveness remains under pressure
The European Union has long strived to reinforce a vision of an inclusive Europe for its member states. However, when the European Union’s focus started to shift from the completion of the Single Market to the strategic vision of “smart, sustainable and inclusive growth” that was a major theme of the Treaty of Lisbon, the timing was unfortunate. The treaty came into force on 1 December 2009, a year when the eurozone and the EU-28 were in a severe recession. Fiscal austerity reigned after 2010 and the sovereign-debt crisis, fueling debate about the institutional setup of the eurozone. Investment rates have not recovered to pre-crisis level, trust in national governments is still falling in one-third of European countries and populist parties have won greater shares of the vote.

It is evident that rising social tension and falling trust in institutions do not happen in a vacuum; citizens’ perceptions of their economic well-being are key. There is a clear and established link between the momentum of economic growth, and strength in social cohesion, citizens’ satisfaction and trust in institutions and politicians.

On average, Europe has performed solidly in terms of GDP growth and had reduced income inequality in the 15 years before the crisis hit in 2007. After the crisis, inequality in parts of Europe rose — in market income by 5 percent between 2007 to 2013 for the working-age population, and in terms of disposable income by 3 percent.

Incomes, particularly at the bottom of the income distribution, stagnated or even fell. MGI research has shown that market and disposable incomes did not advance for the majority of the population in the post-crisis years from 2005 to 2014. So far, Europe has failed to meet its laudable goal of lifting 20 million of EU-27 citizens out of poverty between 2008 and 2020. Indeed, since 2008, an additional 1.6 million have become at risk. There has been a growing perception that younger generations are destined to be poorer than their parents in some European countries.

Today, the pressure on Europe’s social model appears to have receded somewhat as the economic recovery has gathered a measure of momentum, but is far from having disappeared.

On the bright side, the number of people at risk of poverty declined by close to five million between 2012 and 2015 in the EU-28. Mean and median income growth resumed in most of Europe. In general, our analysis in the period to 2016 suggests that all quintiles and deciles experienced an increase in their disposable income, while the ratio of top to bottom 20 percent disposable income earners stabilized or fell slightly, mostly as a result of top 10 percent earners increasing their disposable income at a lower rate than any other decile.

On the dark side, however, populism has continued its inroads in many parts of Europe — witness the emergence of social protests in France, for instance — and trust in institutions remains low.

The average picture may mask cracks in Europe’s inclusive growth that bear watching. Looking at regions (or clusters) within Europe, there have been distinct differences. Nordic countries have achieved the largest income growth, but in Southern Europe, all income quintiles have lost between 1 to 3 percent a year of disposable household income, with those on the lowest incomes experiencing the largest losses (Exhibit 1).

Six megatrends could test the resilience of Europe’s inclusive growth model.

The resilience of Europe’s social contract may be tested by six global megatrends: aging; digital technology, automation and artificial intelligence (AI); increased global competition; migration; climate change and shifting geopolitics.

MGI has simulated the likely long-term evolution of inclusive growth in the European Union and its social clusters in light of these six megatrends. There is a great deal of uncertainty about each trend and the interconnections among them and the simulation is therefore intended to give a rough “dimensionalization” of the challenges and opportunities ahead in several scenarios rather than precision and point forecasts.

Our model suggests that, overall, the six megatrends may put more pressure on inequality and institutional trust in the next decade rather than being a cause for relief. The trends will have different impact depending on whether Europe responds to them vigorously or passively. All six play a role, but sometimes asymmetrically. Our analysis suggests that technology will be the largest swing factor, and further large impact will come from aging and globalization.

The megatrends may mean that Europe faces higher inequality and more social divergence
To gauge the impact of the six megatrends, we have developed two contrasting long-term scenarios from today to 2030.

The first is a “denial” scenario in which Europe takes no action to mitigate the impact of the trends. If this (unlikely) scenario were to unfold, Europe would, for instance, not counteract aging demographics and would block progress on digitization and AI, risking losing competitiveness vis-à-vis China and the United States, the world’s digital and AI leaders. It could also find itself at the mercy of significant economic risk linked to climate change and pollution, for instance. In this scenario, Europe could face prolonged economic stagnation, rising inequality and growth in welfare costs outstripping gross income growth.

The average outcome of our various simulations suggests that the strength of the headwinds induced by the megatrends could be sufficiently large to reduce baseline income growth from an average of 1.6 percent per year to 0.3 percent (an 85 percent drop), not accounting for the likely depressive effect of rising inequality on income growth.

In this scenario, not only would growth come under challenge, but the inclusivity of growth would decline, increasing social tensions. The level of unemployment might rise further by 4 to 5 points by 2030 than today, and the quintile income ratio could increase by 10 percent compared with today, creating rising inequality. Last but not least, extra costs required to finance pensions, healthcare, and increased unemployment could be in the range of 1,350 per capita or 9 percent higher than today in real terms. On average, this would be more than the amount of additional extra gross income generated by anemic growth. There would, therefore, clearly be questions about where the funding would come from, underlining the risk to the welfare-like social contract in Europe.

The second is a “deliver” scenario where European countries, for instance, invest at the same pace in the circular economy and continue their path to decarbonization according to the Paris Agreement. The EU implements its objectives for the Digital Single Market and starts to diffuse AI technologies, achieving success in line with its existing progress in innovation, education and digitization. In this scenario, our results suggest that annual per capita income growth could be between 1.2 and 2.5 percent a year, with a European average of 1.9 percent per year.

Such a scenario may limit the risk of unemployment, and prosperity might continue. Total social funding in real terms (and excluding healthcare costs) could be around 1,000 per capita by 2030, or less than about a 1 percent increase in the social budget a year. This would be a relatively small hurdle considering the increase in funding would be half as much as expected income growth.

Even in a deliver scenario, the larger risk may be social. Europe could face rising inequality — within as well as among countries. Digitization and AI, as well as global competition, could amplify skills premiums and put pressure on wages of routine jobs, superstar effects among firms and cities could continue and aging as well as migration could further increase the wedge between top- and bottom-income households.

In our simulation and for the average European country, some additional 1,200 transfer income per capita for the bottom quintile would have to be made to stabilize within-country income quintile ratios at current levels. Adding this to the social funding needed to see Europe through the transition, the burden may not be financed through normal redistribution channels. Governments would need to reallocate among priorities and be more effective (Exhibit 2).

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