Europe’s labor market: toward feasible reform

Gayle Allard. Professor. Instituto de Empresa

22 February 2004

After two decades of historically high unemployment figures, hardly anyone questions the need for labor reform in Europe anymore. But how can we make it happen?

Reform does not mean total liberalization. Each country has chosen a labor-market model for cultural, social or political reasons, and reforming does not mean all must use the same formula. Attempts are frequently made to paralyze the debate in Europe by arguing that Europeans do not want an American-style labor market. Americans have adopted a relatively deregulated model, given their own cultural, social or political norms, and it works for them. Europeans, with different social realities, have opted for another, more interventionist approach. There is no reason why both should fit the same mold. Reforming Europe’s labor market is not synonymous with deregulation.

Many reforms could change the labor market. People often talk as though labor reform means only relaxing laws on contracts and layoffs. In fact, these laws – though rigid in Spain compared with almost all other EU countries, and especially so when compared with other O.E.C.D. countries – do not have great impact on labor-market performance. They have more effect on stimulating other types of employment - more precarious and less desirable for workers – than on increasing unemployment. Social resistance to these reforms tends to be strong. Many other policies could help reduce the unemployment rate in Spain, and their social costs would be less while their impact on job creation would be greater.

Barriers to growth

One example is the unemployment benefit system. As it stands today, it generates unemployment and destroys jobs. Not only does it make being unemployed an easier option, but it puts pressure on the wages of the whole economy. Fewer people are willing to accept low-paid jobs since they have a more attractive alternative. Unemployment benefits thus increase unemployment, directly and indirectly. There is ample evidence to prove this point.

Another policy that destroys jobs and increases unemployment is the fiscal wedge. This is the difference between what a company pays for a worker and the net wage that worker takes home. This wedge varies greatly within the O.E.C.D., but it generally tends to be higher in Europe, particularly in the northern countries. A broader fiscal wedge puts pressure on labor costs and destroys jobs. Therefore, it too helps raise unemployment, and can form part of the solution.

The same can be said for early retirement schemes. It sounds contradictory, but separating people from their jobs before the normal retirement age puts pressure on the wages of the whole economy, in the same way that unemployment benefits do. More people have a desirable alternative to low-paid work. Early retirement likewise increases pension costs, which boosts fiscal pressure, and, ultimately, the final labor cost figure. Studies of O.E.C.D. labor markets demonstrate that early retirement is partly to blame for high European unemployment figures. As this is not sustainable, and would lead to a pension-system crisis, reducing access to early retirement should be an easy sell to the general public.

How can these policies be modified to bring about reform? A package of incremental, politically acceptable reforms could be designed that would have considerable impact on unemployment, and bring big fiscal benefits besides. Using a simulation model, I have estimated what the impact of partial and feasible reforms would be. This model is based on coefficients obtained from a study of labor-market policies and their impact on employment and unemployment in the O.E.C.D. for the period 1960-2000. The data below shows how unemployment could be cut over three years.


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**Proposed reform unemployment rate in 3 years as result of reform (with current rate at 11%)

:: Require unemployed to prove each week they are actively seeking work to continue receiving benefit: 10.1%

:: Require unemployed to accept any work offered or lose their right to benefit: 9.7%

:: Reduce percentage of men aged 60-64 taking early retirement to 54% from current figure of 64%: 7%

:: Reduce fiscal wedge from current 37% to 31% (U.K. level): 9.5%

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Of course, these numbers are an approximation, and assume that the numerous other factors influencing the labor market remain unchanged. Nonetheless, they show that a large part of the debate on labor reform has been misguided. Reforms exist that are feasible, acceptable and not antisocial. They could move countries like Spain or France closer to a more reasonable unemployment rate, and reduce cost of the welfare state. This in turn would target public spending more effectively towards those who really need assistance. It is a reasonable, effective and politically correct goal. Garnering support for this kind of reform should be possible.

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