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European labour market rigidity not a constraint to growth

UNECE releases its first 2001 Economic Survey of Europe

Published: 04 May 2001

Whenever suggestions are made for faster growth in western Europe official discussions invariably stress that this will only be possible if further supply-side improvements are made. But is it true that labour markets are a constraint to raising western Europe’s growth? Is European labour market rigidity a real problem? Those are some of the questions answered in the latest release of the Economic Survey of Europe 2001, No. 1 just published by the United Nations Economic Commission for Europe (UNECE).

United States labour market is much more "flexible" than those in Europe: a flawed "story"The pessimism about the potential for growth in Europe is particularly focused on the alleged lack of flexibility of European labour markets. This leads to the conclusion that any aggressive lowering of euro interest rates would simply renew inflation rather than promote growth. For a decade or more unfavourable comparisons have been made between the United States and the European economies in their ability to generate employment and lower unemployment rates: in the United States, the average unemployment rate was only 4 per cent in 2000, down from a peak of 7.4 per cent in 1992. In contrast, in western Europe, unemployment was nearly twice as high at 7.9 per cent in 2000, but down from a peak of 10.5 per cent in 1994. Employment rose by some 15 per cent in the United States between 1991 (the cyclical trough) and 2000 (the cyclical peak). Over the same period, there was only a meagre increase in west European employment, by 5¼ per cent, although this is influenced by the difference in cyclical positions. Compared with the cyclical low point in 1993, employment was some 8 per cent higher in 2000.The standard explanation for these differences is that the United States labour market is much more "flexible" than those in Europe. In the United States hiring and firing is not hampered by "excessive" rules and regulations, whereas in Europe social protection and an array of various labour market institutions create rigidities and resistance to necessary adjustments to market forces and changes in the global economy. In Europe gains in productivity quickly translate into higher wages for those already with jobs at the expense of profits, investment and increased employment for those unemployed. According to this view, which is shared by most of the international economic institutions, the problem in Europe is not one of macroeconomic policy but of supply-side rigidities, not only but especially in the labour market. Hence the stress in official briefings at the recent Stockholm Summit of EU leaders on the urgency for European countries to "bite the bullet of reform"."Although this "story" about the differences between the United States and Europe is endlessly and confidently repeated," says Paul Rayment, Acting Deputy Executive Secretary of the United Nations Economic Commission for Europe, "it is badly flawed because it appears to be at variance with a number of key facts." In the first place, it is misleading to treat western Europe as a homogeneous whole. Labour market performance varies considerably and there are several smaller economies (e.g. Denmark, Finland, Ireland, the Netherlands, Portugal) which have performed as well or even better than the United States in the second half of the 1990s. Indeed these economies (among others) have also outperformed the "new economy" of the United States in terms of labour productivity and multi-factor productivity growth in the business sector.

Secondly, labour market institutions are also very heterogeneous (including among the countries just mentioned). Although some of these arrangements are associated with higher levels of unemployment – for example, high levels of benefit paid indefinitely and with no pressure on recipients to seek work or high levels of unionization with no coordinated wage bargaining – many of the institutions and practices blamed for higher unemployment turn out to have little effect either way and in some cases may even have a positive effect. Thirdly, there is little evidence in Europe that productivity gains have been captured by employed workers in the form of higher wages. In fact wages in Europe, as in the United States, have lagged behind the growth of productivity in the 1990s. As is shown in chapter 2 of the Survey, the share of wages in national output has fallen in favour of gross profits on both sides of the Atlantic, but whereas the falling share in the United States has been associated with falling unemployment, in Europe the reverse has been the case.

Growth, a problem of investment policy more than labourWhy should a falling wage share be associated with large increases in employment and falling unemployment in the United States and with only marginal improvements in Europe? A plausible explanation is that the stance of macroeconomic policy in the United States has provided a more supportive environment for the growth of domestic demand, and especially of fixed investment. Confident expectations of sustained output growth created a virtuous circle of rising investment and productivity which in turn led to rising levels of real wages, profits and employment. Part of the gains in productivity was also distributed to consumers via price reductions (or smaller price increases than might otherwise have occurred). In western Europe, in contrast, much of the 1990s were marked by fairly restrictive macroeconomic policies: fiscal policy was tight as the future members of the EMU strove to meet the Maastricht convergence criteria and real long-term interest rates were also relatively high, falling below those in the United States only in 1997. Fixed investment did occur in Europe but it was very weak in comparison with the United States and much of it was focused on rationalization rather than capacity expansion (or employment creation). The gains from productivity that did occur in western Europe, which in terms of GDP per head were not very different from those in the United States (around 13-14 per cent between 1991 and 1999), went to profits (either retained by enterprises or distributed to shareholders) or to consumers in the form of lower prices (or smaller price increases than might have otherwise occurred).

The "defensive" nature of much European investment in the 1990s is understandable given the disappointment of expectations in the early years of the decade – when the Single Market programme was forecast to deliver an average annual rate of growth of 3 per cent over the decade – and continuing uncertainty as to whether a faster rate of growth would be cut short by an excessive concern with short-run fluctuations in the inflation rate. A key difference between the performance of the United States and that of Europe therefore lies both in the stronger rate of growth of domestic demand in the United States and greater confidence that the Federal Reserve would not bring it to a premature halt.

Economic flexibility also a problem of investment

The need for increased "flexibility" and structural change is often presented, in both western and eastern Europe, as an institutional or behavioural problem which must be solved as a pre-condition for faster rates of output growth and employment. But this approach ignores three important points. The first is that a crucial requirement for a flexible economy and a fast rate of structural change is a high rate of fixed investment. At any given time the structure of output and employment is fixed by the existing capital stock; the rate of structural change thus depends on rates of fixed investment in new equipment sufficient to employ in new sectors the labour released by declining industries or activities, to maintain reduced numbers in the latter, and to provide jobs for new entrants to the labour force. In an open, global economy there will anyway be pressure on traditional industries to "downsize" and release labour, but without investment in new activities there will be a rise in unemployment (an example of passive or negative structural change). Second, the movement of labour into new jobs will also depend on the skills (human capital) of those who are forced to move or who are entering the labour market for the first time. Weak educational levels are recognized as a significant feature of European labour markets, but this is more a failure of government policies and insufficient spending on education than a labour market rigidity per se. The admission of a serious shortage of IT skills in western Europe alongside a youth (under 25 years) unemployment rate in the EU of 16.4 per cent only serves to underline the deficiencies in European education systems. And thirdly, economic growth and rising levels of GDP per head are, in themselves, powerful solvents of traditional rigidities and modes of behaviour. It is in periods of slow growth and uncertain prospects that attachment to existing practice is greatest – what is criticised by the policy maker as a rigidity is seen by those fearful of losing their jobs as perhaps their only chance for some hope of security.

Creating a more civilized working environment

High rates of unemployment alter the balance of power in favour of employers (corporations and shareholders) and this affects not only functional income shares but also working conditions and the way most people live. Both anecdotal and survey evidence point to increasing hours of work, increasing levels of stress, more disruption of family life and leisure, and other welfare reducing features, as a result of the increasingly liberalized economies of the 1990s. Most of these changes were made under the duress of the high unemployment of the 1980s and the increased sense of insecurity of those still in work. The spread of a more aggressive management culture in Europe has not led to better economic performance than in the period before 1973, although it has produced large returns to shareholders and very large salaries for the leaders of business and those engaged in financial intermediation. At the same time many of the social programmes and legislation introduced by governments in the 1990s are basically a response to high unemployment and an attempt to compensate for the relatively weak power of labour. However, their effect is limited when employees fear for their jobs because the prospects of getting another one is low. "The best way to empower employees is to make enterprises compete for their services – without the pressure of full employment," concludes Paul Rayment, "employers will resist or evade concessions on greater flexibility in working hours and leisure, in providing support for working mothers, in reducing onerous working hours and conditions, and in general creating a more civilized working environment. In such circumstances, employees can thus do much to improve their own working conditions without the need for excessive help and legislation (and expenditure) from the state. Tight labour markets can also stimulate enterprises to increase fixed investment and, as has been happening in parts of the United States, to train not only their existing staff but also the young unemployed."

For further information please contact:

Economic Analysis Division

United Nations Economic Commission for Europe (UNECE)
    Palais des Nations
    CH - 1211 Geneva 10, Switzerland
    Tel: (+41 22) 917 27 78
    Fax: (+41 22) 917 03 09
    E-mail: paul.rayment@unece.org
    Website: www.unece.org/ead/ead_h.htm

Ref: ECE/GEN/01/07


United Nations Economic Commission for Europe

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