Labour Market Flexibility – Impact on the Economy

There is a widespread consensus among mainstream economists that more labour market flexibility (like in the US) is more likely to be associated with better economic performance because of the more fertile ground for innovation and productivity compared to the welfare states of Europe where labour market has a stricter feature (See Chart 1). As Sapir noted: “The stricter the employment protection legislation of a model, the lower its employment rate.” (Sapir, 2005:8).
As we emphasised in our paper, Kovacs (2013:135), unnecessarily strict employment protection could be problematic, if for no other reason than because employers planning to innovate rely to a large extent on the opportunity to rapidly hire or fire employees before and after the planned innovation. If the innovation proved profitable, the outcome could potentially be beneficial for both employer and employees. But, if the innovation proved futile, the employer could be forced to reduce employment costs. Firing employees is much more difficult in Europe – where the flexibility of labour markets differs significantly across countries – than for example in the US. Accordingly, the opportunity for experimentation is more flexible in the US marketplace than in Europe.
Germany, Belgium, the Netherlands, Latvia, France, Italy, Luxembourg, Portugal, Slovenia and the Czech Republic can be regarded as those of having relatively stricter employment protection legislations in Europe; while Finland, Switzerland have less strict legislation. Additionally, Canada and the United States have the lowest strictness of labour market protection legislation. Consequently, European ones having stricter regulation should behave in a more sluggish way when it comes to recovery, for instance in regaining the employment rate of 2007 (the last peace year).
Chart 1. Protection of permanent workers against individual and collective dismissals, 2013

Source: index established by OECD

Nevertheless, the reality does not seem to confirm this theoretically and empirically documented assumption. As it is discernible on Chart 2, ten countries were able to regain their pre-crisis level employment rate by 2013 among the listed countries, such as Malta, Turkey, Germany, Poland, Luxembourg, Austria, Switzerland, Hungary, the Czech Republic and Sweden (Chart 2). France and Belgium, all the more, could almost reach their pre-crisis levels despite their observable strictness in labour market protection legislations. Moreover, United States for instance lags behind even though it has one of the lowest levels of employment protection legislation.
Chart 2. Regeneration of employment aged 20 to 64? In 2013 relative to 2007 (Index=100)

Source: Eurostat, Bureau of Labour Statistics US

At first blush, this is a puzzling controversary, which conveys us at least four key messages.
First, the conventional wisdom can and should not be treated as a guiding principle in all cases across space and time simply because the nexus between labour market flexibility and better economic performance, which is measured for instance in terms of employment rate, depends very much on other context-specific framework conditions and nuances (e.g. quality of formal and informal institutions, good governance, level of corruption, capacity of the state to absorp unemployment in a sustainable way, strenghtness of bankruptcy law, SMEs’ share in total employment; share of knowledge and skilled workers etc.). Structurally ailing economies like Greece and Portugal and to some extent Spain, having disproportionately huge share of unskilled people are not providing opportunities for extensive experimentation (innovation) for SMEs which typically employ the majority of labour force.
Second, the nexus presumably applies in the longer run, which can be underpinned by taking glimpse into the performance of countries, having less stringent labour market regulation, in terms of productivity and innovation. It is demonstrated with impeccable clarity by the World Competitiveness Reports, Global Innovation Index, IMD World Competitiveness Yearbooks). Innovation Union Scoreboard 2010 also lends support to this argument, demonstrating that Mediterranean countries, which traditionally have stricter employment protection legislation, lag the EU27 in two respects: „Employment in knowledge-intensive activities” and in „Knowledge-intensive services exports”. Consequently, the more protective the labour policy, the lower productivity levels remain in the longer run (Bartelsman et al. 2010). In addition, if one looks at the trend of multifactor productivity (which is to capture innovation and R&D and the knowledge on which along they are carried out), countries like United States, Denmark, Finland that have relatively lower level of employment protection perform better over time.
Third, the welfare states can ostensibly better manage employment situation by extending public employment (as the case of Hungary exemplifies where the biggest increase in employment was registered in the fields of public administration and defense; compulsory social security between 2008 and 2013, more than 78,000 people were absorbed by these fields, See: Hungarian Central Statistical Office).
Fourth, it seems that the success of a society in regaining employment level for instance, cannot be analysed and judged in isolation. Poland and Germany could increase its employment levels not only because of the initiated labour market reforms (the German 2002-05 Hartz reforms), but also becasuse of the inflowing labour force coming from abroad. Without a peradventure, the Spanish economy suffers from a surpassing level of unemployment (even young unemployment), but hundreds of immigrants have left the country by going either back to their mothercountry (especially Poland) or to another one. In this way, Poland could regain and outdo its pre-crisis level of employment level relatively fast. Let us add immediately, Polish rate of employment was infinitesimally low in the European perspective, its „sustainability” was therefore in the cards.
To sum up, it seems that at the core of all successful societies are the framework conditions and economic policy engineering pursued for unfolding the advancement of creative and innovative people. In principle, it embraces micro and macro level flexibility issues regarding labour market from the point of view of economic policy. By micro level labour flexibility we mean the firms’ ability to reallocate workers to places offering more innovative way of working (increasing productivity). By macro labour market flexibility we mean that all time government has the discretionary opportunity to intervene and refine the fundamental institutional framework of the labour market (bankruptcy law, collective wage bargaining, public sector innovation related to public sector employment etc.).
One of the central issues that should be incorporated when it comes to labour market deregulation and liberalisation is that wage, ultimately income inequality is in „blossom” in countries where there is a greatest flexibility of labour markets, like the United States. As a corollary, we join to the line of thinking of Richard Freeman, who once emphasised that regulations seeking to protect labour rights provide lower inequality – without imposing significant losses in terms of output and employment (Freeman, 2008). Lower inequality is of key importance today, because impoverishment which can arise along that can easily undermine the trust infrastructure and thus, exacerbating the democratic deficit advanced countries face today.
Bartelsman, E. – de Wind, J. – Gautier, P. (2010): Employment Protection, Technology Choice, and Worker Allocation. CEPR Discussion Paper No. 7806
Freeman, R. B. (2007): Labor Market Institutions Around the World. NBER Working Paper No. 13242
Kovács, O. (2013): Black Swans or Creeping Normalcy? – An Attempt to a Holistic Crisis Analysis. Eastern Journal of European Studies, Vol. 4., No. 1 pp. 127-143
Sapir, A. (2005): Globalisation and the Reform of European Social Models. Background document for the presentation at ECOFIN Informal Meeting in Manchester, 9 September 2005