Labour Market Deregulation and Europe’s Employment Problems

Andrew Glyn Corpus Christi College Oxford OX1 4JF (andrew.glyn@ccc.ox.ac.uk)

Prepared for Panel on “Recession, Inflation and the Prospects for Equitable Growth “

AEA/URPE session Washington January 2003. Thanks to Wendy Carlin for comments and to Dean Baker, David Howell John Schmitt and Wiemer Salverda for collaborative work on the issues

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Labour Market Deregulation and Europe’s Employment Problems Introduction The belief that Europe’s employment problems are the result of the inflexibilities in its labour markets was forcefully articulated in OECD’s Jobs Report (OECD 1994) and has been reiterated in countless official publications and academic discussions (see Siebert (1997) and Heckman 2002 ). The first section of this paper outlines the variety of recent European employment experiences. The cross-country evidence that rigidity-inducing institutions are responsible for joblessness is surveyed next, using “over-generous” benefits as an example. A central idea in the deregulationists’ case is that joblessness reflects a lack of flexibility in relative wages and section (c) examines whether those countries where wage dispersion have increased most have faced less serious employment problems for the least qualified. Finally the link between labour market deregulation in the 1990s and changes in structural unemployment is examined more directly, using both cross country evidence and the experience of two European countries where unemployment has fallen most. (a) European Joblessness As often pointed out (Nickell 1997) European labour market experience has been far from uniform. In 2001 9 European countries had lower unemployment than the USA. This group also had a lower average structural unemployment rate (the NAIRU as estimated by the OECD) than the USA (table 1 below). Their employment rate on average was similar to that of the USA, though it increased somewhat less over the last two decades as a fall in the employment rate in a couple of star performers (Sweden and Austria) partially offset some spectacular employment increases (notably Ireland the Netherlands). Much attention has been devoted in the last decade to the problems of the least qualified and it is amongst these workers that the problems caused by the policies and institutions of the labour market would be most severely felt. The final column of the table shows the most recent available figures for the employment rate for the least educated quartile of the population, which seems the best indicator of joblessness at the bottom end of the labour market (Glyn and Salverda 2000). The low unemployment countries have only slightly higher joblessness for the least qualified than does the USA, and this comparison is slightly flattering as the US figures exclude the very large prison population, most of which will be in lowest educational quartile1 The high unemployment group of seven countries has considerably higher unemployment than the USA and an employment rate 11 % points lower with no increase over the past 20 years and the least qualified have employment rates some 18 % points below that of

1 It is arguable that the employment rate for the least educated males is a better cross country indicator as labour force participation amongst the least educated (and often older) women has such strong social influences. The rates for men are 76.0% for the USA, and 75.8% for the 9 low unemployment European countries. Adjusting for the prison population would put the USA several percentage points below this group of countries in terms of joblessness for the least qualified quartile of men (see Katz 2002). Juhn et al (2002) provides a comprehensive analysis of the rise of inactivity amongst US males.

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the USA (slightly more for the least qualified men). So the worst of Europe’s employment problems are concentrated in a relatively small number of countries – France, Italy, Germany, Spain, Greece and Finland and Belgium -unfortunately most of them quite populous. It is possible to list “special factors”– German unification, the Mezzogiorno, the collapse of the USSR, decline of large agricultural sectors in Southern Europe - which have made things unusually difficult for (most of) these countries. But even so, labour market flexibility is supposed to allow such problems to be overcome. The next section looks briefly at whether the poor performers are characterised by particularly strong institutions of labour market regulation and the welfare state. Table 1 European Employment Unemploy-

ment 2002

NAIRU 2002

Employment/ Population 2001

Change in Emp/Pop 1980-82 to 2001

Employment Rate Least Educated Quartile 2001

USA 5.8 5.1 71.6 7.9 67.4 EU 7.6 7.4 63.9 3,3 55.6 7 High U Europe

9.1 8.7 60.5 0.2 49.4

France 9.0 9.2 62.0 0.6 54.2 Germany 7.8 7.0 65.9 4.6 56.2 Italy 9.2 9.0 54.9 -1.8 35.1 9 Low U Europe

4.2 4.3 72.2 4.4 64.2

Sweden 4.0 5.1 73.8 -5.0 71.7 Netherlands 2.7 3.5 74.1 11.5 57.7 UK 5.2 5.3 69.9 4.4 60.5 Ireland 4.4 5.9 65.0 10.9 50.5 Column 1 OECD Economic Outlook October 2002 High U group include Spain, Greece, Finland and Belgium. Low U group includes Norway, Denmark, Austria , Switzerland and Portugal (Norway and Switzerland are not EU members). Figures for these groups are simple averages of country figures Column 2 Economic Outlook June 2002 table 23. OECD’s estimate of Structural Unemployment Column 3 Employment Outlook July 2002 table B. Figures for USA, UK, Sweden, Spain and Norway have been roughly adjusted to make age coverage comparable to that in the rest (15-64) Column 4 Economic Outlook June 2002 table 21 Column 5 Author’s calculations from background data for OECD Education at a Glance kindly supplied by OECD. For Austria, Belgium, Netherlands and Norway data is for 2000. Data refer to those aged 25-64.

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(a) The impact on Unemployment of Labour Market Regulations The question is not whether the institutions of labour market regulation have any effect on employment but whether these are substantial and predictable enough to underpin the case for deregulation. Taking the case of unemployment benefits as an example, three pieces of evidence suggest great caution. First a simple cross section comparison of the OECD’s measures of structural unemployment with the unemployment benefit replacement ratio show no evidence whatever of the presumed trade off (figure 1). The figure uses the OECD’s series for the net replacement ratio (taking account of taxation and benefits) and is measured for the first month of benefits for a worker on two thirds of the average wage (on the grounds that such workers are most likely to be affected by disincentive effects from high replacement). It is clear from the figure that a number of countries with very high benefits have very low unemployment and if anything the pattern is the opposite of that expected – high benefits goes along with low unemployment (just significant at the 10% level!) . There are other dimensions of the benefit system (duration, work tests etc) and such simple bivariate plots cannot be decisive anyway. But conversely replacement ratios are correlated with other aspects of the welfare state and if the presumption of benefit disincentives having major effects was justified something should be expected even from such a simple comparison2.

Figure 1 Structural Unemployment and Unemployment Benefits

NA

IRU

in 2

000

%

Net Replacement Ratio 1999 %40 60 80 100

3

6

9

12

Australi

Austria

BelgiumCanada

Denmark

Finland

France

Germany

Greece

Ireland

Italy

Japan

Netherla

New Zeal

Norway Portugal

Spain

Sweden

Switzerl

United K

United S

2 Thus Heckman (2002) writes “As the generosity of benefits increases, so does the incentive not to work, Germans like all people respond to these incentives” (p 16).

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The applied work on comparative unemployment has gone far beyond such bivariate plots to assess, with increasingly sophisticated econometrics, the impact of a whole group of labour market institutions (including benefit duration, employment protection, union density, and bargaining co-ordination) together with a range of macroeconomic controls (Nickell 1997, Nickell et al 2002, Fitoussi et al 2000, Belot and Van Ours 2002, Elmeskov et at 1998, Blanchard and Wolfers 1999, ). A review of this literature (Baker et al 2002) shows a range of estimates of the impact of replacement ratios on unemployment from statistically insignificant (Bertola et al) to substantial (Nickell et al 2002 suggest a 10 percentage point cut in the replacement ratio would reduce unemployment by around 1%). A number of the authors themselves point to the lack of robustness in their estimates to changes in variable definition, a point confirmed by Baker et al’s own results. The lesson from this cross section evidence is that the quantitative impact of benefit cuts on unemployment is quite unclear. Finally such effects of welfare benefits on unemployment as there are may very well not be working in the desired way. The general argument for labour market deregulation is that it will reduce the unemployment numbers by encouraging more people into work. So high benefits should be associated with low employment as well as high unemployment. But the studies which have looked at employment directly as well as unemployment (Nickell 1997 and Nickell et al 2001) found that significant effects of replacement ratios on unemployment rates were not repeated when employment rates were used instead. The implication is that high unemployment benefits encourage labour force participation and this was exactly the finding of a little quoted study by two OECD economists (Blondal and Pearson 1995). So paring back the welfare state could lead to detachment from the formal labour market and thus greater economic inactivity rather than the intended rise in employment. Unemployment benefits are just one of the targets for deregulation but similar uncertainties about their quantitative impact on employment apply to employment protection, reduction of minimum wages and so forth. . (b) Wage Inequality and Employment Performance At the core of the argument for labour market deregulation is the view that, under contemporary conditions , the least qualified can only find employment if they accept declines in their relative pay. The effect of unemployment benefits, minimum wages and strong trade unions is then to reduce such relative wage flexibility and thus lower employment amongst the least qualified. One would expect to see, therefore, a strong relationship between (higher) wage inequality and (less) employment disadvantage suffered by the least qualified. However a simple comparison of wage dispersion and employment for the least qualified finds no such relationship (see OECD 1996, Glyn and Salverda 2000).

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Given the potential importance of country effects such as different skill dispersions across countries, a stronger test is to look at how wage inequa lity and employment disadvantage have evolved over time. Figure 2 below (taken from Glyn 2001) plots changes in the employment shortfall of the least qualified against changes in wage inequality. Employment disadvantage is measured by the difference between the employment rate of the least educated quartile as compared to the middle two quartiles; wage inequality is measured as the ratio of wages at the median compared to the bottom decile (the measure most relevant to employment at the bottom end of the labour market). Separate data points are shown for the 1980s and 1990s where available. The presumed trade-off (countries where wage inequality has risen most should have shown the least decline in job opportunities for the least qualified) is just not there. One should not conclude that wages are irrelevant – an unlikely story with employment determined by profit. However, and contrary to what is widely presumed , the degree to which wage inequality has risen has not been the dominating influence on employment outcomes at the bottom end of the labour market 3. This is confirmed in the much more detailed comparisons between US employment rates with those in France and Canada (Card et al 1999) and in France (Krueger and Pishke 1997).

3 Howell and Huebler (2002) show that there is no relationship between unemployment rates across countries and wage inequality ( both in levels and changes).

Figure 2 Employment v Wage Inequalities 1980s & 1990s

%

pa c

hange in

Q23/Q

1 e

mplo

ym

ent

% pa change in d5/d1 wages-1 -.5 0 .5 1

-2

-1

0

1

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3

AUS8AUS9

NZ8

NZ9

CAN89

USA8

USA9

FIN9FRA8

FRA9

GER8

GER9

ITA9

NETHS8

NETHS9

SWE89

UK8UK9

SWI9

IRE9

NOR8

DEN8

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c) Labour Market Deregulation and Structural Unemployment4 The previous two sections have queried the strength and predictability of the relationships which underpin the case for structural reform. This section examines the “bottom line” of labour market deregulation more directly by examining whether it can explain employment outcomes over the past decade. We look first at the overall picture across the OECD economies, followed by a very brief discussion of the “employment miracles” of Ireland and the Netherlands (see table 1). The OECD (1999) claimed a strong link between labor market deregulation and the extent to which structural unemployment (the NAIRU) fell in the 1990s. Following the Jobs Report the OECD set out, in its country surveys, a list of policy prescriptions for labour market reform (such as the reduction of replacement ratios) which they believed had priority for the country concerned. In its 1999 report on Implementing the Jobs Study OECD calculated the degree to which individual countries had followed their prescriptions and used this as their indicator of labour market reform. Such a measure of the “degree of compliance” with the OECD’s suggestions is interesting. However countries varied enormously in the number of reforms recommended – those with less regulated labour markets received fewer suggestions from the OECD implying that there was less scope for deregulation to reduce the NAIRU. A more appropriate measure of the amount of reform, and thus presumed impact on the NAIRU, would take account both of the degree of compliance and the number of reforms suggested. Such an index of the extent of labour marker deregulation can be constructed from the OECD's listing of their reform proposals, their weighting of the comparative importance of different policies, and their tabulation of the extent to which each reform suggestion had been followed (OECD 1999). We confined the index to the core labour market deregulation proposals concerning employment protection, unemployment benefits and wage determination (leaving aside taxation levels and ALMP). Figure 3 plots this index of labour market deregulation (which in effect covers the 1990s) against the OECD’s of changes in the NAIRU in the decade up to 2001 (some lag in the unemployment measure to the policy changes seems appropriate). Although the cases of Spain and the Netherlands look promising for the deregulationist argument there is no significant relation overall between the extent to which countries took policy actions to reduce labour market regulation and shifts in the NAIRU5. This result reinforces that of Elmeskov et al who looked at the extent to which declines in the NAIRU in the 1990s were associated with declines in benefit levels and duration, increased employment protection, stronger unions and so forth and reported that “an important fraction of the structural change in unemployment cannot be accounted for by changes in the explanatory variables included in our analysis” (p11).

4 This section is drawn from Baker et al 2002 and Glyn 2002 5 If Ireland was excluded the relation would be close to significance at the 10% level – but why should Ireland be excluded?.

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Figure 3: Change in the NAIRU and Labor Market Deregulation for 20 Countries in the 1990s

chan

ge in

NA

IRU

199

0-92

to 2

001

Index of Measures to Deregulate Labour Market 1990-99-.02 0 .05 .1 .15

-8

-4

0

2

Australi

Austria

BelgiumCanada

Denmark

France

Finland

Germany

Greece

Ireland

Italy

Japan

Netherla

NZNorway

Portugal

Spain

Sweden

Switz

UK

USA

Source: change in NAIRU: OECD Economic Outlook June 2002; the index of deregulation measures author’s calculation based on measures listed & weightings in OECD (1999) Appendices. Note: the measures considered cover unemployment benefits, wage formation and EPL and working time arrangements.

Overall then labour market deregulation across the OECD countries does not appear to have been the central factor responsible for differential employment performance in the 1990s. Ireland with the most spectacular decline in the NAIRU is a good case in point. Although the OECD reported a study ascribing 5% points of the rise in Irish structural unemployment in the 1980s to the benefit system , the subsequent drastic fall in unemployment occurred without major benefit changes. Moreover long-term unemployment (singled out by OECD as being bolstered by benefits of long duration) fell more than total unemployment. Eligibility criteria were tightened somewhat in the later 1990s, but this was part of an anti-fraud drive (people were seen as having work and claiming benefits rather than not having work because of the availability of benefits). Irish employment protection legislation has been consistently very light; the OECD’s recent ranking puts Ireland near the bottom of the regulation league (with only the USA, Canada and UK below). Most importantly there were no significant declines in the strictness of employment protection since the period of high unemployment in the late 1980s in any of the 18 indicators of the degree of the regulation of permanent temporary employment assembled by the OECD (1999b table 2.2 and 2.3) . The one significant change in labour market institutions which could have cont ributed to the unemployment decline in Ireland was the co-ordination of wage bargaining through a

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series of three-year “Social Partnership” agreements beginning in 1987 and involving the government, trade unions and the employers. The trade unions accepted relatively modest increases in money wages in the range 2-3% (increased to about 5% pa in the latest agreement). Overall this allowed hourly compensation for production workers in manufacturing to grow by 81% in Ireland between 1985 and 1999, virtually the same rate as in Germany (76%) and slower than in the UK (111%). With a relatively stable effective exchange rate after 1990, a very rapid rise in manufacturing productivity in Ireland brought an enormously favourable trend in relative labour costs pe r unit of output. These halved against the OECD as a whole between 1986 and 1998. The result has been a doubling of Ireland’s share of export markets. In a country with exports at around 60% of GDP in 1990 the impact on the growth of demand and thus employment has been huge. OECD has been characteristically grudging in its evaluation of the impact of the wage agreements, initially arguing that slowing wage increases reflected rising unemployment and complaining of induced rigidity in relative wages. Their chapter on “Implementing the Jobs Strategy” in Ireland (OECD 1997) did admit that “The central wage agreements have helped to reduce industrial unrest; the number of days lost to labour disputes was the lowest since 1923. Moreover they may have had a positive effect in moderating pay settlements during a period of rapid growth” (p91) and suggested that the cuts in tax agreed with the government as part of the wage deal did bring restraint to wage increases. However, their 2001 report reverted to the line that the agreements did not have a measurable effect (see also Fitzgerald 1999) . It is hard to believe that the agreements played no role in restraining wages in the Irish boom. The OECD itself offers no explanation for the very large fall in the NAIRU that they estimated, no explanation of why wage bargaining was so restrained in the face of the enormous fall in unemployment. An unusual growth of real wages, exceeding workers’ expectations for rising living standards, could have been the explanation. However productivity growth (more than 3% per year in the 1990s) was not translated into real wages. The growth of real hourly wages in manufacturing was only 1.1% over the period 1990-99. On the contrary the bargaining really was extremely restrained in real as well as in nominal terms leading to rising profitability and cementing the heightened international competitiveness. This played a central role in sustaining the employment boom6. Space forbids more than a few remarks about the Netherlands, the other employment “miracle” noted in table 1. As shown in figure 3 there was a considerable amount of action in the area of labour market reforms there in the 1990s. However the same was true in Germany and apparently brought no decline in the NAIRU at all. Moreover a detailed comparison of German and Dutch labour markets (Schettkat 2002) shows convincingly that the Netherlands is still if anything more regulated than that of Germany. However another important development not included in the Deregulation

6 This conclusion is consistent with the extensive analysis of the Irish expansion by Honahan and Walsh (2002) and with Blanchard’s comment on their paper.

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Index constructed for figure 3, because it never forms part of the OECD’s labour market reform proposals, was the series of centralised wage agreements initiated at Wassenaar in 1982. A 20% rise in labour cost competitiveness followed over the next 7 years and this improvement was held over the whole of the 1990s despite the very low unemployment compared to neighbour ing competitors. In their study of UK and Dutch labour market performance Nickell and Van Ours (2000) attribute 2.5% of a 4. 5% fall in structural unemployment to increased wage co-ordination, another 1% to active labour market policy leaving only 0.5% to reform of the benefit system. Blanchard (2000) concluded that wage moderation in Netherlands was due in large part to the social pacts. Schettkat (2002) also emphasises that the tripartite economic policy discussions in the Netherlands extend beyond wage bargaining and facilitate a high level of co-ordination between wage bargaining, fiscal and monetary policy, in contrast to the policy inconsistencies in Germany. Conclusion The case for labour market deregulation in Europe is that it would have a major effect on European joblessness. This paper has argued that the cross country evidence does not bear this out. Moreover the benefits of labour market regulation and welfare state measures in terms of a wage floor , income security, job security and conditions at work are frequently ignored. Where they are recognised, these benefits are often dismissed as accruing only to “insiders”. If the insiders were few in number and the regulations led to many excluded “outsiders” this would be a powerful argument. But the insider -outsider metaphor does not apply to many of these policies (if high unemployment benefit did raise unemployment the unemployed who are supposed to prefer the benefits are hardly outsiders). Where the argument might apply (employment protection for example) the insiders are typically very numerous and the evidence is weak about outsiders excluded from jobs. If compressed wages brought joblessness, then the wage distribution, by excluding those with zero earnings , would give a false impression of the degree of income equality (as Heckman. 2002 argues). But since countries with compressed wages also tended to have generous welfare states, and the evidence for strong adverse employment effects is very weak anyway, it is not surprising that such countries have much more equal distributions of family income as well (see O’Reardon 1999). The call for comprehens ive labour market deregulation in Europe lacks empirical justification in terms of large and predictable effects on employment and thus a more egalitarian distribution of welfare.

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