Labour Market flexibility

ECN 218 Assignment “While labor market institutions can potentially explain cross-country differences today, they do not appear able to explain the general evolution of unemployment over time.” (Blanchard, O. and Wolfers, J. (2000).)
Throughout this essay I will analyze this quote and the various arguments towards, and against, the effects of labor market flexibility on the unemployment rate over the medium term. I will examine in detail the evidence for this before and after ‘The Great Recession’ of 2008, and compare many different European countries unemployment results with the USA’s. I will also differentiate the role of economic shocks with labor market institutions, to come to a conclusion on what the real cause of unemployment is, and hence, discover whether there is Euro-Sclerosis existent, and if so, how to control it through labor reforms. Labor market flexibility is defined by how far and quickly wages adjust to clear labor markets, and thus, I will analyze how effective various mechanisms are in shifting labor from various declining industries to expanding ones. Labor market policies are set by the government to improve these various factors.
Throughout the 1980’s-90’s, economists maintained the theory that high oil price shocks were the cause of high European unemployment rates, however, since then the unemployment have remained high, which led them to believe that labor market rigidities were the main cause of the high unemployment rates.
To understand the concept of this piece, you must understand, the basics of the Non-Accelerating Inflation Rate of Unemployment (NAIRU), and a very brief history of unemployment in Europe, and the United States of America. The NAIRU is the amount of unemployment that is required to prevent the inflation from rising. Some arguments of high unemployment come from the idea that, during the late 1960’s, Europe had an unsustainably low unemployment rate, it was called the “unemployment miracle” of which Blanchard, O. (2004) stated in his article. This came to an end in the 1970’s when the unemployment rate increased due to shocking rise in oil prices, leading to decreased investments and output hence, decreased aggregate supply, some say that the fall in demand resulting from this caused hysteresis in Europe, as the aggregate demand fell massively, so did the investment and capital to labor ratio, and hence, the natural rate of unemployment rose massively, leaving people unemployed for long periods, with skills inappropriate for the labor forces demanded, hence, causing structural unemployment. Two more recessions hit in 1980 and 1990 through oil price shocks, the USA responded to the shocks much better from more flexible labor markets, and achieved a lower unemployment rate than Europe in 1984, and from then on, remained lower up until The Great Recession of 2008.
In figure 1, we compare the EU 4’s unemployment (Germany, France, Italy and Spain), with the USA’s. From this, we can see that despite the recession causing EU unemployment to rocket, the EU 4 remain constantly around two percentage points above the US from the mid 1990’s, therefore, economists have persistently been trying to find the main cause of this high unemployment rate within Europe.
FIGURE 1- US and EU4 Unemployment rate (1970-2006) Source- (2010). Macroeconomics, A European Perspective.
The reason for choosing to compare just the EU4 with the USA is down to the heterogeneity between the European countries. Through adding more countries our results would be very different, this is because of the large differences in unemployment rates between the European countries in the present day, which therefore would provide us with very misleading results, therefore when we talk about Europe, we must do so in a relaxed manor as a resemblance of certain European countries; for example, the UK remained at an unemployment rate of 4.8%, in comparison to Germany’s rate at 11.3% in 2005, whilst the EU as a whole averaged at 9.2% according to Eurostat’s sources.
Figure 2 – European unemployment rate (2001-2012) Eurostat – 2013 –accessed 20/11/13 http://epp.eurostat.ec.europa.eu/statistics_explained/index.php?title=File:Unemployment_rate,_2001-2012_(%25).png&filetimestamp=20130627102805 When looking at the causes of unemployment, there are two major streams, they are, market institutions, and economic shocks. The key differences between the EU and the USA are in the different government policies used to control the labor market institutions. In comparison to the EU, the USA embraces low employment insurance related to the wage levels, very short term benefits, a relatively low minimum wage, a greater wage differentiation, less legal restriction on employing and discharging workers, a smaller density of trade unions, and a lower income-tax wedge. All these factors provide a flexible wage level, strong incentive to work, and restrict wages to a low equilibrium level, reducing the amount of involuntary employment, and providing people with a large amount of low paid jobs, helping the unemployment rate stay low, and also helping the labor market respond to shocks much more rapidly in comparison to Europe, for example, “The average duration of unemployment is now slightly more than one year in Europe compared to around four months in the USA.” (Blanchard, O, Amighini, A, and Giavazzi, F 2010).
To back this Lorenzo E. Bernal-Verdugo, Davide Furceri, and Dominique Guillaume (2012) concluded through their various tests and regressions that “Increases in the flexibility of labor market regulations and institutions have a statistically significant negative impact both on the level and the change of unemployment outcomes”.
However, although It looks as though that these labour market rigidities must be the persistent causes of high unemployment rates, Stephen Nickell (1997) and Robert Solow (2000) refuted this theory, and argued that, firstly, “In the 1960s the unemployment rankings across countries were completely different but . . . the labor market institutions were the same. So how can the labor market institutions have anything to do with unemployment?” Secondly, “One of the two big increases in unemployment took place in the early 1980s, although there was no change in labor-market regulation to account for it.” Hence, labor market institutions cannot be the main reason for high unemployment within Europe in previous years, especially as the countries with the most labor market regulations such as Sweden have maintained the lowest unemployment, hence, it must be an external factor creating the unemployment, such as aggregate demand. Robert Jackman (1997) backed this point in stating that, “The United States experienced a substantial fiscal boost in the early 1980s resulting from the Reagan tax cut initiative and the deficits which followed it. By contrast, most European countries followed orthodox fiscal and monetary policies and demand was held back, and even reduced sharply in some countries such as the UK.”

Despite all of this, the arguments on the cause of unemployment seem to be somewhat merged together; there is no outright cause of unemployment, or, way of maintaining low unemployment, it is a contribution of a number of factors. Economic shocks such as rising oil prices have inflatory effects on prices, forcing the cost of production up, and forcing firms to make a percentage of their workforce redundant. The unemployment that it causes can last a varied length of time, of which, is dependent on the flexibility of the labor force and the wages in returning back to the natural rate, and preventing large increases in unemployment.
Stephen Nickell, Luca Nunziata and Wolfgang Ochel (2005) found evidence to show that “Changes in labour market institutions explain around 55% of the rise in European unemployment from the 1960s to the first half of the 1990s, much of the remainder being due to the deep recession ruling in the latter period.” Hence, reiterating my conclusion, labour market flexibilities help to control the extent and the duration of how long unemployment persists after a shock before it drops to its natural rate, but they cannot maintain low and stable unemployment in the medium run due to the external supply and demand shocks. There are differences also between the medium and the short run, in the short run, labour market institutions such as trade unions or employment protection help reduce the unemployment rate, however in the medium to long run, it increases the wage bargaining powers of workers, hence wages are forced up, this forces firms to lay off workers who may have still been happy to work at the smaller wage, thus, there is an increase in involuntary unemployment in the medium to long run from labour market institutions. Since the ‘Great Recession’ of 2008, when using Europe as an example as a whole, there is little evidence as of yet, as to whether labour market flexibilities are central to low unemployment rates in the medium term, however, there is evidence of certain countries, such as Germany, who have coped extremely well during the ‘Great Recession’ due to their flexible labour market. Germany, in 2011, “actually reached the highest level of employment since reunification.” (Werner eichhorst, 2013 p.19) Germany benefited through the use of flexitime, rather than decreasing their labour force, they kept them on to save money, and offered them flexible working hours. Germany benefitted through this, as they maintained a low unemployment rate through the great, however, it would be hard for these policies to be transferred to other countries without the modifications of which Germany hold, “it relies on a specific combination of labour market and social policies on the one hand, and on wage and working hour flexibility on the other” (Werner eichhorst, 2013 p.25) Hence, Germany are a one off case, and I think that the developments since the onset of the ‘Great Recession’ are consistent with the view that labour market flexibility is important, but only maintains low unemployment up to a certain extent. References
Blanchard, O. Amighini, A. Giavazzi ,F. (2010). Macroeconomics, A European Perspective. Essex: Pearson education limited. 5.
Blanchard, O. Amighini, A. Giavazzi ,F. (2010). Macroeconomics, A European Perspective. Essex: Pearson education limited. 141.
Blanchard, O. and Wolfers, J. (2000). ‘The role of shocks and institutions in the rise of European unemployment: the aggregate evidence’, Economic Journal (Conference Papers), vol. 110, pp. C1–33.
Blanchard, O. (2004). Explaining European Unemployment.Unemployment, Shocks, and Institutions. [online] http://www.nber.org/reporter/summer04/blanchard.html [19/11/13] Eichhorst, W (2013). The European Labour Market Success through flexibility and mobility . Berlin: Konrad-Adenauer-Stiftung. 19, 25.
Jackman, R. "European Unemployment: Why Is It So High and What Should Be Done About It?" RBA Annual Conference Volume: Reserve Bank of Australia, 1998.
Lorenzo E. Bernal-Verdugo, Davide Furceri, and Dominique Guillaume . (2012). Labor Market Flexibility and Unemployment: New Empirical Evidence of Static and Dynamic Effects . Available: http://www.imf.org/external/pubs/ft/wp/2012/wp1264.pdf. Last accessed 21st November 2013.

Nickell, S. (1997). Unemployment and Labor Market Rigidities: Europe versus North America. Journal of Economic Perspectives. 11 (3), 55-74.

Solow, R. (2000). UNEMPLOYMENT IN THE UNITED STATES AND IN EUROPE A CONTRAST AND THE REASONS. CESifo Working Paper Series. Working Paper No. 231 (1), 5.

References: Blanchard, O. Amighini, A. Giavazzi ,F. (2010). Macroeconomics, A European Perspective. Essex: Pearson education limited. 5. Blanchard, O. Amighini, A. Giavazzi ,F. (2010). Macroeconomics, A European Perspective. Essex: Pearson education limited. 141. Blanchard, O. and Wolfers, J. (2000). ‘The role of shocks and institutions in the rise of European unemployment: the aggregate evidence’, Economic Journal (Conference Papers), vol. 110, pp. C1–33. Blanchard, O. (2004). Explaining European Unemployment.Unemployment, Shocks, and Institutions. [online] http://www.nber.org/reporter/summer04/blanchard.html [19/11/13] Eichhorst, W (2013). The European Labour Market Success through flexibility and mobility . Berlin: Konrad-Adenauer-Stiftung. 19, 25. Jackman, R. "European Unemployment: Why Is It So High and What Should Be Done About It?" RBA Annual Conference Volume: Reserve Bank of Australia, 1998. Lorenzo E. Bernal-Verdugo, Davide Furceri, and Dominique Guillaume . (2012). Labor Market Flexibility and Unemployment: New Empirical Evidence of Static and Dynamic Effects . Available: http://www.imf.org/external/pubs/ft/wp/2012/wp1264.pdf. Last accessed 21st November 2013. Nickell, S. (1997). Unemployment and Labor Market Rigidities: Europe versus North America. Journal of Economic Perspectives. 11 (3), 55-74. Solow, R. (2000). UNEMPLOYMENT IN THE UNITED STATES AND IN EUROPE A CONTRAST AND THE REASONS. CESifo Working Paper Series. Working Paper No. 231 (1), 5.