European labour-market reform

John Driffill 08 March 2013

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Unemployment continues to rise in the Eurozone and is increasingly drawing attention to its sluggish labour markets. There is a lingering suspicion that these markets are not flexible enough; that wage growth (real and in money terms) does not respond sufficiently to unemployment. Labour-market reform has featured prominently in the bailout agreements reached between the Troika and Greece, Portugal, and Ireland. Reform is surely a good thing. But what is it meant to achieve? What should and can be done? Is the time now ripe for reform?

It may be argued that the troubled Eurozone periphery is not constrained by aggregate supply, but by a severe shortage of aggregate demand. In these circumstances improving the supply side of the economy need not be a high priority. Recent European Commission estimates of structural unemployment rates in 2013 are 6% for Germany and Denmark, 8% for Italy, 13% for Portugal, 15% for Ireland, and 18% for Spain (Orlandi 2012); versus actual unemployment of 5.4% in Germany (November 2012), 7.9% in Denmark, 11.1% in Italy, 16.3% in Portugal, 14.6% in Ireland and 26.6% in Spain. The most recent unemployment figure for Greece was 26% in September 2012. The estimated structural rates are obtained by smoothing the actual unemployment rate series, so they have followed the recent rises to some extent, and may exaggerate the structural component and under-represent the demand-deficient component. In fact, it would seem that not only is demand in the doldrums but the structural unemployment rate is also very high in many countries.

Stimulating demand

The only way for these countries to stimulate demand at present is for them to cut production costs relative to the rest of the Eurozone; principally Germany, the Netherlands, Austria, Belgium and Finland. Lower production costs constitute a necessary part of the rebalancing that will eventually enable full employment throughout the Eurozone. Labour-market reform might speed up this process, providing a long-term supply side, as well as a short-term macroeconomic case for it.

Cutting public borrowing

Many of the reforms implemented to date have been driven by the simple and pressing need to cut public borrowing. Ireland, Greece and Portugal have all drastically downsized their numbers of public employees and reduced their salaries. Even the UK is implementing public-sector pay restraint and job cuts. Many supply side-friendly reforms save public money: cutting unemployment benefits offers a source of savings and a supply-side boost.

Academic commentators and policymakers widely agree on their diagnosis of the problem and their prescription for a cure. Excessively strong employment-protection legislation insulates the insiders – well-established employed workers on permanent contracts – from labour-market pressures, while the outsiders fill a succession of temporary, unprotected jobs and bear the brunt of business-cycle shocks: employment-protection legislation needs to be reformed to remove the sharp divide between workers on different types of contracts, and to lower the cost to employers of making severances. Bentolila, Dolado and Jimeno (2012) have made this case forcefully on this website. To reduce the divide:

  • Unemployment benefits need to be kept at modest levels and should be of limited duration;
  • Minimum wages may have positive effects, providing they are not too high;
  • Active labour-market policies need to be improved to help the unemployed back into work;
  • The automatic extension of union pay bargains to all firms in an industry with tight restrictions on minimum hours of work and rates of pay has reinforced the power of workers in regular jobs, reduced the influence of unemployment on wage growth, and slowed adjustment; it should be reined in;
  • Meanwhile, broadly supported social pacts between unions, employers and government can help to restrain wages (Ireland provides a successful example, having negotiated a series of such pacts both before and after the financial crisis).

‘Flexicurity’

This consensus view, emerging from the OECD and from many VoxEU.org commentators, among other things, promotes a Danish-style ‘flexicurity’ model with a variable architecture to suit local preferences. While there is much to recommend such a model, it is not without its weaknesses. Danish unemployment has shot up from 3.2% (June 2008) to 7.9% (Nov 2012), though in the United-Kingdom with a more extreme form of flexicurity – all flexibility, no security – the rise has been surprisingly modest, from 5% (November 2007) to 7.8% (September 2012). While this prescription may raise long-term employment rates, it may do so at the cost of greater inequality, as in Germany, for example. However, the picture is mixed. Looking across European countries and comparing Denmark with Spain, for instance, there is a tendency for higher employment rates to go hand in hand with lower inequality (EEAG Report 2013, see Chapter 3). These effects set policies like flexicurity against the aims of the European social model.

The European social model

One may, of course, question whether the European social model is still alive. ECB President Mario Draghi pronounced it dead in a February 2012 blog for The Wall Street Journal (2012): “The European social model has already gone when we see the youth unemployment rates prevailing in some countries”. Though he later resurrected it in Die Zeit, “Competition and labour markets have to be reinvigorated. Banks have to conform to the highest regulatory standards and focus on serving the real economy. This is not the end, but the renewal of the European social model” (Draghi 2012).

Reform

Reforms are being made under external pressure. Is now the right time? Is this a good time to reduce employment protection, or would it only add to unemployment in the depths of a recession, enabling employers to cut staff, rather than encouraging them to hire more in the belief that future severances, should they be needed, will be easier? Employers may doubt the durability of such reforms. Arguably it may be better to make a credible commitment to cutting firing costs in the future. However, the problem with such ingenious solutions is that the time is never ripe: no pressure, no reform. When recovery comes, and public finances strengthen, there will be no pressure, and therefore no immediate need to reform.

The difficulty in proposing a programme of reforms to labour markets is that of striking the right balance. We are operating in world of the second best. How far should reforms go in the direction of liberalisation? What are the trade-offs between – and what is the right combination of – security for the employed, income inequality and higher average real incomes?

Problems in labour markets

Notwithstanding such issues, the 2013 European Economic Advisory Group (EEAG) Report on the European Economy makes a number of specific proposals to address what seem to be three clear problems in labour markets:

  • There is a strong case for taking steps to cut the costs and uncertainty faced by firms when making collective severances, often due to very slow court proceedings, taking years in some countries;

The problem is not the use of the courts per se, but the fact that the legal process is very slow, expensive and highly uncertain. Although courts are used to resolve employment disputes in the Netherlands, for example, resolution takes a matter of days or a few weeks, whereas in Portugal it takes months or years. Similar issues arise in Italy, Spain and Greece. There may be a role for setting up dedicated employment tribunals to speed up the process.

  • In countries where unions play an important role in wage setting, social pacts may be very useful, as they have proven in Ireland and the Baltic states, in restraining wages and maintaining harmonious industrial relations;

Such results may be harder to achieve in bigger and less cohesive countries, of course. However – in contrast – the automatic extension of pay bargains from heavily unionised firms across entire industries or sectors, with little or no local flexibility, as has been the practice in Greece, Spain and Portugal, has clearly had negative effects. It allows one group of workers to set pay for many who are not represented and may face very different circumstances. The heavily protected are able to raise the wages of temporary workers on the brink of unemployment. Such pay bargains also reduce the effect of unemployment on wages. There is a strong case for restricting the automatic, legally binding, industry-wide extension of bargains, and introducing more local flexibility.

  • Youth unemployment has reached alarming levels in Greece, Spain, and Portugal and also remains high in several other countries;

Provision of vocational education and training needs attention. Germany (and Austria and Switzerland, which share many common features) remains a shining example of an effective apprenticeship system, which succeeds thanks to wide support from and the involvement of social partners – unions, employers, local chambers of commerce, local and central government, and educational institutions. Hilary Steedman details the myriad failures of alternative structures in the UK, France and Sweden (2012). Similar criticisms are even more appropriate to Greece, Spain and Portugal. A common feature of many failed models around Europe has been a lack of employers’ involvement. The German system may be too rigid for other countries, the United-Kingdom, for example. Nevertheless, it offers lessons that might be applied elsewhere. In the UK, further education (which provides vocational education and training) has been the Cinderella of the educational world. Some of the resources devoted to the expansion of higher education throughout Europe may have been better used to develop more effective vocational education and training.

Author’s note: This column is based on EEAG (2013), The EEAG Report on the European Economy, “Labour Market Reforms and Youth Unemployment”, CESifo, Munich 2013, pp. 73-94 (http://www.cesifo.org/eeag). The EEAG members are Jan-Egbert Sturm (KOF Swiss Economic Institute, ETH Zurich; Chairman), Giuseppe Bertola (EDHEC Business School), John Driffill (Birkbeck College), Harold James (Princeton University), Hans-Werner Sinn (Ifo Institute and LMU University of Munich) and Akos Valentinyi (Cardiff Business School). They are collectively responsible for each chapter in the report. The authors participate on a personal basis and do not necessarily represent the views of the organisations they are affiliated with.

References

Bentolila, Samuel, Juan Dolado and Juan Francisco Jimeno (2012), “The Spanish labour market: A very costly insider-outsider divide”, VoxEU.org, 20 January.

Draghi, Mario (2012), “The future of the euro: stability through change”, European Central Bank, published in Die Zeit, 29 August.

EEAG (2013), EEAG Annual Report on the European Economy, Munich, CESifo.

Orlandi, Fabrice (2012), “Structural unemployment and its determinants in the EU countries”, European Economy, Economic Papers, 455, May.

Steedman, Hilary (2012), “Apprenticeship policy in England: Increasing skills versus boosting young people’s job prospects”, VoxEU.org, 6 October.

The Wall Street Journal (2012), “Q&A: ECB President Mario Draghi”, 23 February 2013.

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Topics:  Europe's nations and regions Labour markets

Tags:  Europe, unemployment, EU

John Driffill

Professor of Economics, Department of Economics, Mathematics and Statistics, Birkbeck University of London