Introduction
Labour Market Reform in Europe
Because of political constraints, the margin of manoeuvre for governments to combat unemployment with institutional reforms is typically quite narrow. Later we analyse alternative ways of labour market reform that can reduce unemployment, perhaps less efficiently, but which would encounter less opposition. Furthermore, it is argued that present circumstances in Europe could make more radical reforms possible in the near future, pointing out several reasons why governments have become more ambitious in this area.
An important complement to labour market reform is product market liberalisation. Increasing competition in product markets can have a strong beneficial effect on the equilibrium rate of unemployment. This is because increased competition raises firms’ productivity and imposes discipline on pay setting, since it reduces monopoly rents that are available to workers. In Sweden, for example, aggressive product market deregulation in the 1990s may have contributed to the significant fall in unemployment.
A second approach consists in eliminating inefficiencies in the welfare system without radical changes in its basic structure. Relevant measures include the suggestion that dismissal costs are made more efficient in many countries by replacing the current system of legal procedures with a simple “firing tax”, which would be paid to the worker as severance payment.
Alternatively, as discussed above, incentives to work could be increased by replacing means-tested welfare payments with in-work benefits such as earned-income tax credits. Finally, search activity of the unemployed should be tightly monitored, with sanctions in the form of reduced benefits if search is not active. However, an open issue in this respect is how to make sure that the unemployment insurance administration engages in effective monitoring and applies sanctions.
Third, there are specific institutions or reforms that may enhance convergence of the interests of employees (who do not profit from many reforms) and firms (who gain from reforms). An important example is provided by “profit sharing” and the promotion of stock ownership among workers. These can make policies of wage moderation, which boost profitability and job creation, more acceptable to workers. If adopted on a large scale, they can be an efficient means of reducing equilibrium unemployment. A second example is provided by recent reforms liberalising temporary employment contracts, which have increased labour market flexibility in many European countries.
These reforms have met with much criticism. For instance, it has been pointed out that the reforms may increase the protection of permanent workers. Yet, there has been substantial mobility from temporary to permanent contracts in many countries, and firms value temporary contracts as a way to test the quality of new workers. The experiences of the United Kingdom and, to a lesser extent, Spain suggest that in situations perceived as “crisis”, government can be more ambitious in pushing reforms directly targeted at the labour market. In principle, a critical point has also been reached in a number of European countries, not so much because of overall macroeconomic performance, but because of budgetary problems and the feeling that “globalisation” is making the burden of labour rigidities unbearable. We give a list of further main factors that could promote, or delay, reforms in the next few years.
One of these factors could, paradoxically, be the very effort made by governments to combat unemployment. Some of the policies might make it an even bigger problem, as they tend to increase social spending per unemployed worker. Active labour market policies in France and Sweden require considerable spending per recipient. But in France they have failed to produce a reduction in unemployment, and in Sweden their efficiency has been questioned. One view is that they may have succeeded in reducing registered unemployment, but at the cost of lowering regular employment. Similarly, when high persistent unemployment is erroneously fought using fiscal and monetary policies, this can lead to excess deficits and/or inflation, which in the end create the need for more drastic structural reforms.
Furthermore, financial problems in other politically sensitive areas, such as pensions and health care, raise the social value of high employment rates. The recent drive for labour market reform in Germany stems from a more general crisis of the welfare state, with the recognition that the pre reform state commitments in this area are unsustainable. Opposition to the removal of labour market rigidities weakened as it became clear that failing to reform the labour market would increase the need for reductions in pension and health insurance benefits that are more valuable than the gains from existing rigidities.
Changes in the international economic environment may also raise the cost of labour market rigidities. Increasing openness reduces producers’ ability to transfer changes in their labour costs to prices. Since a faster pace of technical progress raises the need for labour turnover, it penalises those societies that impose a tax on turnover in the form of employment protection provisions. New technologies may increase the demand for skilled workers and reduce the demand for unskilled workers, thus reducing the real wages and/or employment of the latter.
The reform package called “Agenda 2010” recently adopted in Germany is a good illustration of these effects. The reform was pushed forward because it had become clear to the political elite of the country that the welfare state in Germany was no longer affordable and proved incompatible with the degree of wage flexibility required by globalisation. In addition to a large number of minor reforms, the package abolishes the second-tier unemployment benefit system, which used to pay roughly 60 percent of the worker’s last net wage until retirement age. While Agenda 2010 falls short of reforming the welfare system and the system of wage bargaining, where major reasons for the inflexibility of the German labour market can be sought, it goes much further than seemed possible only a short while ago.
The German example is therefore a good illustration of how a severe crisis and a sense of urgency enhance reform possibilities and help to implement fundamental changes that are otherwise politically doomed.
