A joint Initiative of Ludwig-Maximilians-Universität and Ifo Institute for Economic Research
Area Conference on Employment and
Social Protection
CESifo Conference Centre, Munich
23-24 May 2003
National Labor Market Institutions and the
EU Integration Process
Giuseppe Bertola
CESifo
Poschingerstr. 5, 81679 Munich, Germany
Phone: +49 (89) 9224-1410 - Fax: +49 (89) 9224-1409
E-mail: [email protected]
Internet: http://www.cesifo.de
National Labor Market Institutions
and the EU Integration Process
*
Giuseppe Bertola
(Università di Torino and EUI)
May 15, 2003
This paper offers a review of theoretical insights and empirical indicators
regarding the motivation and effects of labor market institutions as observed in
European countries’ historical experience. From a long-run perspective, each
institution needs to be evaluated on the basis of its broad economic and
distributional implications, which in turn depend on the structure of markets and
on the details of policy implementation. The resulting conceptual framework is
brought to bear on a discussion of how the status quo institutional and policy
decision-making landscape of European labor markets may cope with the new
challenges and opportunities of Economic and Monetary Union.
*
Background paper for a ‘keynote lecture’ at a CESifo area conference on "Employment and
social protection" (Munich, May 23-24 2003). It reviews, organizes, and extends the author’s
own and joint work in the field; this explains and perhaps justifies the many self-citations.
1
1. Introduction
Labor markets are more or less tightly regulated in all industrialized countries. The
relevant institutional features aim at protecting workers’ consumption opportunities in
the presence of limited opportunities to obtain insurance against adverse human capital
shocks, and at increasing their share of aggregate income at the expense of that of other
social groups. The character and effectiveness of such regulation depends importantly
on the economic environment. Labor market institutions that protect workers against
“unfair” market developments reduce the intensity of competition, and trade-off lower
productive efficiency against distributional concerns. And less competition may tend to
privilege subsets of the market’s labor force, preventing others from successfully
bidding for ex post available employment opportunities.
The effectiveness and desirability of the relevant policies depend on the extent
and character of competition, and on the extent to which distributional concerns may be
addressed by other means. Not only the ability of financial markets to protect workers’
consumption from undesirable fluctuations, but also implementation of other public
redistribution schemes and the intensity of product and labor market competition bear
on the extent and character of interference with labor markets’ laissez faire mechanics.
To the extent that labor market institutions are at least partly meant to restrict
competition for jobs, it is far from surprising that wage and quantity constraints
imposed on market interactions are generally blamed for the poor employment
performance of many European labor markets. It is important, however, to recognize
that institutional constraints must fulfill a useful purpose from the point of view of at
least some economic agents. Otherwise, it would be quite difficult to understand why
they were introduced in the first place, and why they fail to be reformed when they
appear to decrease aggregate welfare. From this point of view, one would advocate and
expect labor market reformed when the negative effects of existing institutions
outweigh the advantages foreseen at the time of their introduction.
Section 2 below reviews the character of labor market regulation and labor
market outcomes in industrialized countries. Section 3 discusses how regulation may be
rationalized in light of theoretical insights, depending on the extent and character of
financial market imperfections. Section 4 discusses its negative effects on employment
and productive efficiency, which depend on the intensity of competition and other
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structural economic features which have experienced important changes in the last few
decades.
Section 5 reviews the reform tensions introduced by economic integration on the
status quo configuration of European welfare and labor market systems. Enhanced
competition may on the one hand make protection more desirable, if it increases the
intensity of uninsurable labor market shocks; on the other hand, it may make it more
difficult to provide, as producers need to react more efficiently to market signals. In
practice, and not surprisingly, labor market institutions are quite stable within each
member country. But they are also quite different across the EU, and differently subject
to reform pressures from economic integration forces.
While a detailed analysis of the relevant politico-economic interactions lies
outside the scope of this paper, the concluding Section 6 outlines how tensions within
the current EU policy framework in the relevant area may be addressed by co-ordination
processes and reform patterns of labor regulation focused on the challenges and
opportunities of EMU labor market interactions.
2. Labor market regulation and labor income stability
Labor services are exchanged in a very special market. First, because the commodity
being exchanged can change its own behavior in ways that can hardly be controlled by
standard pricing mechanisms. Asymmetric information leaves much room for moral
hazard, and makes it difficult if not impossible for financial markets to offer insurance
against unfavorable labor market developments. Second, because the non-standardized
character of most labor services makes information peculiarly important. Highly
relevant static and dynamic heterogeneity, makes it unusually hard for supply and
demand to meet - resulting in more information-gathering search, and residual
mismatch, than in more standard markets. And third because, while strongly
asymmetric and scarce information surely damage laissez faire interactions in many
other markets and may be so sever as to rule them out of existence, labor markets must
function. Workers’ very livelihood is at stake, and modern economies need foster
reliable intertemporal relationships between firms and their employees. Perhaps only the
market for medical services and pharmaceutical products compares to the labor market
in terms of the importance and complexity of trading outcomes for the individuals
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involved, and it is therefore far from surprising to see that labor market interactions are
both imperfect and heavily mediated by institutions.
In all industrialized countries, employment relationships are regulated, to
varying degrees, in both their price (wage) and quantity (hiring and firing) dimensions.
To assess the desirability of the resulting configurations, it is important to keep in mind
that consumption and leisure are both “good,” that higher employment (lower leisure) is
only a means to the end of higher production (rather than a goal in itself), and that the
crucial tradeoff between higher wages and higher employment is in general perceived
differently by workers and by employers. And it is also important to recognize that
economic agents do try to optimize along the tradeoffs offered by the economic
system’s structure, both at the individual and collective (political) levels: decentralized
labor market interactions and their institutional structure aim at fostering efficiency, but
in doing so face heavier informational and decision-making constraints, and more
dramatic distributional conflicts, than those featured by simple textbook models.
2.1 Collective wage-setting and labor taxes
Figure 1 illustrates the standard union-based collective wage setting framework (a more
general bargaining structure would deliver a qualitatively similar message, as long as
employment is on the labor demand schedule). Workers faced by a downward-sloping
labor demand relationship between wages and employment are collectively better off if
the wage is set at a level higher than that which equates supply and demand. Some
workers are involuntarily unemployed in that case. But the unhappiness inflicted on
those among them who fall back on the outside opportunity represented by the labor
supply schedule rather than earn the laissez faire wage is more than compensated, from
the collective point of view, by the higher wage earned by the workers who remain
employed.
Of course, since ex post some workers are unemployed and would rather be
working, the collective wage-setting outcome illustrated by the Figure would unravel to
the competitive outcome if individual workers were allowed to bid for employment. A
legal prohibition to do so, as implied by many countries’ administrative extension to all
workers of collective wage agreements, supports the outcome that is the workers’
collective interest, eliminating the externality (from the point of view of workers as a
group) entailed by an individual worker’s incentive to bid for another’s job. And it is
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also obvious that for the union-preferred outcome to be agreeable to all workers there
must exist channels through which the higher wage enjoyed by workers who are still
employed can be partly distributed to those who are ex-post unemployed. Such
redistribution is perhaps most obvious when the two groups of workers are members of
the same family (the unemployed are sons and daughters of the employed). It is also
important, however, to note that outcomes with larger wage bill and lower employment
(and profits) may be supported not only by legislative rather than contractual wage
floors but also by a system of payroll taxation used to fund non-employment subsidies,
such as pensions or unemployment benefits or other welfare transfers, or to offer publicsector employment opportunities at favorable wage/effort ratios. All such policies
essentially serve the same purpose as an explicit wage floor: rather than by prohibiting
workers from bidding down other workers’ wages, alternative income-support sources
eliminate
the
need
to
bid
for
employment
(the
phenomenon
dubbed
“decommodification” of the labor market in related political science studies: see e.g.
Esping-Andersen, 1990). In either case, as illustrated in Figure 1, higher wages and
lower employment are the result of a positive wedge between labor demand and labor
supply: but contractual or legislative lower bounds on wages result in unemployment,
and taxation in a smaller labor force.
In different countries and different periods, such different policies are
implemented differently, and more or less incisively. But in all cases interference with
the laissez faire outcome of the labor market is motivated by a distributional conflict
which takes place under structural constraints (represented by the downward slope of
the labor demand function) and is mediated by institutions. Not only the ease of union
organization and the ability to enforce collectively-agreed wages on all workers, but
also the ability to use non-market instruments to redistribute the wage bill from highwage employed workers to unemployed workers matter for the feasibility and
sustainability of the outcome illustrated in Figure 1, and for the character of
redistribution across labor and other factors of production as well as across individuals.
2.2 Quantity rigidities in the labor market
Employment protection legislation reduces the flexibility of labor markets in reacting to
firm-specific and aggregate labor demand shocks. Typically, EPL requires that
termination of individual employees be motivated and/or that workers be given
5
reasonable notice or financial compensation in lieu of notice, and grants workers a right
to appeal against termination, sometimes stipulating reinstatement with back pay when
the appeal is successful. To the extent that such a right may not be lawfully overridden
by contractual provisions, employment protection legislation interferes purposefully
with individual contractual freedom as regards dynamic aspects of employment
protection, just like administrative extension of collective agreements similarly
interferes with individual wage-contracting freedom. Further, legislation often mandates
administrative procedures, involving formal negotiations with workers' organizations
and with local or national authorities, when large employers wish to proceed to
collective dismissals of plant closures.
Most theoretical work on the implications of EPL models both workers' and
employers' dynamic polices as aimed at maximizing the expected present discounted
value of profit and labor-income streams. The effects of EPL are easily characterized in
that standard framework. For given labor demand and wage dynamics, more stringent
EPL obviously reduces the incentives for firms to shed labor. It is perhaps a little less
intuitive, but also quite obvious, that EPL also reduces incentives to hire: if employers
anticipate that layoffs will be difficult or costly, in fact, they should try and reduce the
amount of labor shedding called for by future labor demand downturns or wage upturns.
Hence, EPL should smooth adjustment dynamics, but aggregate employment and
unemployment should depend on average wages and average labor demand. Its
contrasting effects on employers’ propensity to hire and fire imply that the impact of
EPL on average employment for given wage, or on average wages for given (e.g., full)
employment, is in general ambiguous. In fact, “firing costs” are quite different from
other labor costs, such as wages and social security contributions, that indeed tend to
reduce labor demand. While employers must pay wages to employ labor, and reduce
employment in the face of higher wages if labor demand is downward-sloping, they can
avoid paying firing costs by optimally choosing a stable employment path around a
level that may be slightly lower or even higher on average than what would obtain, for
the same wage and contributions level, in the absence of job security provisions.
Constrained optimality, of course, does not imply happiness: whenever firms are
prevented from equate wages to labor’s marginal revenue product, they earn lower
profits. In this sense, it is quite sensible to think of employment security as imposing a
6
“cost” on employers. Still, EPL reduces efficiency and profits does not reduce profits
through lower average employment levels, but rather through poor synchronization of
productivity and wages around roughly unchanged average levels. The implications of
this are more similar to those of a tax on capital income than to those of labor taxes and
other ongoing labor costs, and are discussed further below.
Empirical work on such partial-equilibrium implications can exploit the wide
variation of EPL stringency across countries, sectors, and time. Only some EPL aspects,
such as the number of months' notice required for individual and collective
redundancies, are readily measured quantitatively. Others aspects are more difficult to
measure precisely, for example the willingness of labor courts to entertain appeals by
fired workers and the interpretation placed by judges on the notion of "just cause" for
termination. When available EPL indicators are positively correlated with each other,
however, it is possible to form qualitatively unambiguous cross-country rankings of
EPL, and to relate such rankings to (also qualitative) indicators of labor market
performance, in light of theoretical implications. The evidence reviewed by Bertola
(1999) and its references suggests that more stringent EPL is indeed associated with
more stable aggregate employment paths.
2.3 Disaggregated wage and turnover outcomes
While Figure 1 illustrates a labor market that clears (or fails to clear) at a single wage
level, in reality wages are of course different across both workers and jobs’
characteristics. The overall degree of wage heterogeneity is different across countries
and, interestingly, the same countries featuring high EPL also display more
concentrated wage distributions (see Figure 2).
Low wage dispersion may of course reflect different degrees of labor force
heterogeneity. If unregulated wages were allowed to reflect individual productivity, they
would of course tend to be more dispersed in countries where high- and lowproductivity workers coexist. The economic structure of industrialized countries,
however, is sufficiently homogeneous to suggest that the very different degree of wage
dispersion largely reflects institutional wage-setting constraints, such as centralized
bargaining and binding minimum wages.
Theory suggests that even identical workers could earn different wages when they
hold different jobs and mobility across jobs is costly for workers (rather than for firms).
7
Think, for examples, of residents in different regions within a potentially integrated
labor markets. At a point in time, geographic wage differentials may be observed if the
labor mobility that would arbitrage them away is costly. Residents of Southern Italy, for
example, need not be enticed to move to the tighter Northern Italian labor markets by
earnings differentials when mobility entails substantial economic and non-economic
costs. And the observed wage differentials across jobs held by similar workers can be
very large, even when mobility costs are small, when they are temporary. Would-be
migrants faced by volatile labor demand, in fact, need to weigh the advantages of higher
wages in the near future against not only mobility costs, but also the value of waiting for
local labor market conditions to improve.
From this perspective, it is not surprising that relative wage variation should be
heavily constrained in the same markets where EPL is most stringent. Quantitative
firing restrictions, in fact, could hardly be binding if wage fluctuations were completely
unrestrained: in response to the labor demand shocks that EPL are meant to protect
workers against, wages could fall so as to make stable employment profitable, or to
induce voluntary quits. Hence, limiting the freedom offered to employers and workers
in setting wages gives force to quantity constraints. To the extent that job security
provisions explicitly require, or implicitly encourage, payments from the firing firm to
departing employees, more stringent EPL implies that mobility costs are at least partly
borne by firms, rather than by workers, and should be associated with smaller wage
differentials in situations where voluntary mobility across jobs is observed.
In practice, “rigid” labor market configurations appear quite effective in
sheltering workers from idiosyncratic labor-income fluctuations. The OECD index of
EPL stringency is not surprisingly strongly associated with average tenure lengths
(Figure 3) and also with wage stability indicators (Figure 4). In rigid labor markets,
workers who are indeed employed tend to remain employed, and their wage remains
stable over time. Stability of labor income for such workers is valuable in protecting
their (and their families’) consumption from otherwise uninsurable fluctuations but, to
the extent that employment is overall lowered, unemployment, and other forms of nonemployment, are concentrated at the beginning and at the end of individual working
careers, as well as in the female segment of the potential labor force.
8
3. The benefits of labor market interference…
From the workers’ collective point of view, the benefits of the high-wage, lowemployment configuration discussed in Section 2.1 above are obvious, since it is
supposed to reflect optimization on their representative’s part. Redistribution motivates
that outcome, which is of course inefficient from the aggregate point of view in that lost
producer surplus more than compensates the higher wage bill
From the perspective outlined in the introduction, however, it is important to
note that a smaller pie (with a larger share for labor) is supported by the fact that
workers are allowed to choose the wage and by their disregard for lower profits. This
can indeed be rational if workers, as a group, do not have access to the financial markets
where claims to employers’ profits are traded, and therefore the economy features a
classical distributional conflict between different ‘classes’ of individuals. Perfect capital
and financial markets would internalize aggregate efficiency concerns and, in principle,
address distributional concerns by lump-sum instruments.
Financial market imperfections can also rationalize some forms of employment
protection legislation. While standard partial-equilibrium models prove useful in
interpreting the effects of EPL, they cannot explain why it should be introduced. From a
general-equilibrium perspective, risk-neutral behavior in the labor market relies on the
existence of perfect and complete financial markets. But job “security” could hardly be
valuable if perfect insurance were already available, and if intertemporal statecontingent contracts were complete then mandatory redundancy payments to dismissed
workers could and should be offset by properly adjusting contractual payments (Lazear,
1989). Since third-party payments cannot be offset by contracts between employers and
employees, when EPL entails notification and certification procedures rather than
redundancy payments to dismissed employees it can have real effects under risk
neutrality but, again, it can hardly be rationalized. EPL can also induce deadweight
costs in individual employment relationships when it mandates administrative or legal
procedures, or severance taxes are paid to a central revenue pool. This can be beneficial
to workers as a group if their share of the lower welfare pie is sufficiently increased by
distorted hiring-and-firing patterns. In perfect and complete financial markets, however,
redistribution should in principle be achieved by lump-sum rather than distorsive
9
instruments, and contracts should circumvent legal restrictions whenever they entail
individual deadweight losses.
In summary, for models based on risk-neutral labor market behavior it is quite
hard to explain why EPL should have real effects in equilibria where wages are allowed
to adjust. And since the efficiency impact of EPL, if any, is negative, it is even harder
for such models to explain why EPL should ever be introduced in the first place. Bertola
(2003) discusses the implications of EPL in a model where workers cannot access
financial markets in order to smooth their consumption pattern in the face of
idiosyncratic, yet uninsurable shocks, and shows that redundancy payments can be
welfare-enhancing in that setting. In reality, of course, imperfect information prevents
laissez faire economic interactions from supplying insurance against the risk of
becoming or remaining unemployed. Workers’ unobservable behavior would not be as
strongly oriented towards avoiding job loss if they were covered against the negative
consequences of that event. And setting the same premium for all workers when some
of them know that their unemployment risk is particularly high would make the scheme
unprofitable for insurance providers, and/or unattractive to workers with lower risk.
Hence, one can understand why collective action would try and remedy the ex-post
inequitable or “unfair” labor market treatment of workers who, lacking insurance,
become or remain unemployed despite their best efforts.
Indeed, regulation and legislation aimed at protecting workers from “unfair”
labor market shocks have a long history, and one that largely proceeds apace with the
development of modern industrial modes of production. The industrial revolution led to
increasingly impersonal economic interactions, and reduced the role of informal
insurance arrangements at the family or village level at the same time as it concentrated
economic power in the hands of employers. Thus, it is hardly surprising that national
policymaking authorities (notably in Bismarck’s Germany, but also in most other
Continental European countries) would introduce legislation aimed at protecting
workers from the health, unemployment, and old-age hazards of their trade, whether via
regulation aimed at shifting the laissez faire balance of costs and benefits across
employees and employers, of via explicit tax and subsidy schemes. And it is even less
surprising that workers would try and organize unions, so as to offset the bargaining
power of their employers in the determination of average wages, as well as to induce
10
wage compression. The wage equalization induced by union bargaining, in fact, can
provide ex post insurance (Agell and Lommerud, 1992) and risk averse workers can find
it appealing ex ante, before knowing how their laissez faire wage will be affected by
labor demand shocks.
In general, it is the difficulties encountered by redistribute via market or tax
instruments that can rationalize collective wage setting and labor market regulation,
such as EPL, with the intuitive empirical effects outlined in Section 2. Labor market
institutions such as EPL and relative-wage rigidity may be rationalized by market
imperfections that lead freely contracting parties to misjudge the ultimate consequences
of arrangements that might appear optimal at a particular moment (with, for example,
detrimental effects on human-capital investments in training), or by “equal pay for equal
work” egalitarian principles. Empirically, the combination of wage and quantity
rigidities appears successful in these respects, and more regulated labor markets deliver
compressed wage distribution, stable earnings, and longer tenure lengths.
4. … and its costs
At the same time as they increase or leave unchanged the wage bill, and stabilize labor
income, wedges introduced between demand and supply (as in Figure 1) and the lower
productivity of labor along potential hiring-and-firing cycles smoothed by EPL both
reduce total production, and “profits” (the excess of production over the wage bill).
Lower “profits” may have only distributional consequences if the firm enjoys
rents, but of course make less resource available for remuneration of factors of
production other than labor, such as capital. Of course, many other features of firms’
economic environment determine their incentives to operate and invest. The
attractiveness to business of a given country’s economic system depends importantly on
many aspects pertaining to public or collective action, perhaps most importantly on the
enforcement of property rights, and most directly on the scope of character of market
access. As outlined in more detail below, the tendency of countries to regulate wage
rates is related to their financial market’s structure. And the reduction in capital’s
profitability (at any level of capital intensity) induced by more stringent job security is
akin to that which might be induced by a tax on capital. Taxing capital income does
imply lower net profits and lower welfare for a hypothetical representative individual,
11
but need not decrease employment at given wages (or the wages consistent with a given
level of employment).
Still, labor market interference that introduces wedges between supply and
demand does reduce efficiency, and profits; and it also reduces employment, if it
increases wages. The size of all these effects of labor market regulation of course
depends importantly on difficulties encountered by employers (and ex-post
unemployed) workers in circumventing them. Substituting labor with other factors, or
with unregulated labor hired under non-standard forms of employment (or in countries
with less regulation, towards which production is moved areas), employers can reduce
the profit implications of regulation, and magnify its employment implications.
Price and quantity rigidities are in fact associated with high real wages and
unsatisfactory aggregate employment performances. It is important again to keep in
mind that there are many ways to achieve high-wage, low-employment labor market
configurations that, in the absence of the complete set of markets that would make
efficiency (rather than distribution) the only objective of market interactions, benefit
workers as a group at the same time as they reduce efficiency from a hypothetical
representative agent’s point of view. One sees in Figure 5 that lower employment is
related to more incisive poverty-reducing redistribution across countries.
This is unsurprising if one recalls that less work is a good thing for workers (as
long as their total income does not decline), and notes that the same policies that
provide income support for the poor also reduce incentives to work. In fact, provision
of insurance in the presence of asymmetric information unavoidably decreases
productive efficiency. Information problems plague not only private contracts but also
public intervention in both its efficiency-seeking and equity-seeking dimensions.
Workers have no less incentive to decrease their job-seeking effort when covered by
social rather than private insurance, and protection from “unfair” developments
unavoidably decreases the labor market’s speed of adjustment. Such efficiency losses
are not easily affordable for developing countries, but are not a major concern for rich
and more stable societies. Hence, it is not surprising that Europe’s unprecedented fast
and stable growth after World War II would, by the late 1960s and early 1970s, lead to
an extensive array of protective labor legislation and to equally extensive co-decision
power by unions in all matters regarding the conditions of employment.
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From a time-series perspective, however, it is very important to realize that poor
employment performance used not to be a European problem. Only since the late 1970s
has Continental European countries’ employment performance been disappointing
enough to spur much interest in the labor-market implications of “protective” legislation
and regulation. As suggested by Blanchard and Wolfers (2000), new exogenous
developments or “shocks” played an important role in shaping observed developments.
But exogenous changes have also likely change the dynamic outlook (as well as the
point-in-time realizations) facing workers, employers, and the institutional environment
in which they interact. And the tradeoff between wage inequality and unemployment
appears to become more dramatic over time. As Figure 6 illustrates, and as discussed in
more detail by Bertola, Blau, and Kahn (2002a), in the 1970s it was empirically easier
than in more recent periods for each country to obtain low unemployment for a given
level of wage inequality. Over the last 30 years the changing structure of labor markets
has forced sharper choices (in the direction of more wage inequality or more
unemployment) on their institutional framework.
In terms of the scheme outlined above, the oil shocks and disinflation efforts may
have led to a the new scenario of slower and unsteady growth, where the desirable
“fairness” benefits of European labor markets’ institutional configuration may well be
outweighed by their undesirable effects on wage and employment adjustment. To
understand why, note that relative-wage constraints may also, by preventing
underbidding by the unemployed, enforce monopolistic wage-setting practices by
organized labor. As noted above, firing costs do not generally reduce average
employment at given wages. Symmetrically, EPL per se need not increase the
bargaining power of “insiders” relative to outsiders, since outsiders could and should in
principle be able to bid down wages so as to “buy” themselves a job. If contractual
arrangements made it possible to do so, competitive pressure on equilibrium wage and
employment patterns should make turnover costs next to irrelevant in wage
determination in a dynamic labor demand model with ongoing fluctuations. The
combination of institutional wage compression and job security provisions is a powerful
source of bargaining power, however, and their apparent association in the data with
high wages and low employment is far from surprising.
13
The balance of desirable and undesirable effects of labor market regulation, like
that of any other cultural and political features of a society’s organization, depends on
the level of economic development, and does so for largely economic reasons. The
benefits in terms of protection and insurance of interference with laissez faire labor
market outcomes are of course less apparent when consumption smoothing may be
achieved by other market or non-market means. And their costs in terms of employment
and productive efficiency are more apparent when employers can more readily react to
high labor costs – for example, by moving production elsewhere. It is not difficult, in
fact, to see that in Figure 1 above a flatter labor demand curve implies that a given
wedge between labor demand and supply will lead to more dramatic employment
losses, and smaller wage gains.
Labor market reforms, however, remain rare and usually far from incisive,
despite large differences in comparative labor market performance (in both aggregate
and disaggregated respects) and important structural changes over time. Of course the
status quo configuration’s balance of cost and benefits can become unfavorable as more
intense competition makes its employment costs larger, and its wage benefits smaller.
But institutions are meant to be stable, and increasing dissatisfaction with the
performance of rigid institutional structures should not lead one to dismiss the original
motivation of collective regulatory activity in the labor market. “Protection” from
“unfair” labor market risk is clearly something that European workers and policymakers
are not willing to forsake easily, even when its costs increase.
Institutional stability is further enhanced by the fact that employment rates of
politically influential prime-age males are less adversely affected by labor market
rigidity. For reasons explored in detail by Bertola, Blau, and Kahn (2002b), it is optimal
for labor market institutions to concentrate employment losses on the younger, older,
and female population segments with more elastic labor supply. The negative effects on
“social cohesion” of such population groups’ increasing disemployment, or increasing
and increasingly long-term unemployment, can be buffered by within-family and
fiscal/pension income transfers. This escape route and institutional rigidities prevented
European wage inequality from increasing as much as in the unregulated American
labor market, and still plays an important role in reducing the perceived need for reform
in Europe.
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5. Challenges for Europe
The need to reconsider systems of social protection and reconcile them with
employment objectives is particularly pressing in Europe, where political interactions
make it difficult to renounce equity concerns even as changed economic conditions
appear to make existing policies obsolete. Failing to confront the trade-off in its entirety
may dangerously lead researchers (and, potentially, EU policy interactions) to
unwittingly neglect one or the other side of it.
Labor market performance is not homogeneous across EU countries, and the
extent and character of ‘social’ policy interventions is also heterogeneous. As is
apparent from the various empirical correlations displayed in the figures above,
European countries implement different labor market policies, and experiment different
labor market outcomes. As is clear from the correlation between per-capita income and
a summary indicator of social expenditure (in Figure 7), the different countries’ levels
of economic development explain much of Europe’s heterogeneity. To the extent that
interfering with the laissez faire configuration of labor supply and demand decreases
efficiency, the resulting improvement in equality is less affordable for poorer countries.
But Figure 7 also confirms that European countries tend to perform more sociallyminded redistribution than the United States, which are as rich as the richest countries
of the EU but only spend in the relevant area a fraction of income comparable to that of
the average EU countries.
Disappointment with the performance of European labor markets has been high
and growing for more than 20 years. The United States’ better employment performance
and lower degree of interference with labor markets may of course reflect either less
concern for inequality, or better developed ways to deliver equality through other
means. But is Europe ready to reform its labor markets, and perhaps do so in ways that
would make them more similar to their American counterparts?
In Europe, policy interventions in the relevant area face two interrelated
problems (Bertola et al, 2001). First, there are many reasons why welfare systems
designed decades ago need to be redesigned in light of new demographic and
technological trends, and of changes in the structure of market and non-market
economic interactions. From a European perspective, however, it is important to
emphasize that while the relevant changes are broadly similar in all industrialized
15
economies, their impact an implications are quantitatively and qualitatively different
across EU member countries. This reflects both their heterogeneous economic and
social structure and, more crucially, the different configuration of their systems of social
protection, summarized by the distinction between Scandinavian, Anglo-Saxon,
Continental, and Southern European Welfare States (see Bertola et al, 2001, for details
and references). Budget problems are the most pressing cause of distress for the publicemployment-based Scandinavian Welfare State. The United Kingdom (like many nonEuropean Anglo-Saxon countries) faces increasing social exclusion in the form of
permanent “working poor” status. The Continental countries are troubled by low
employment rates. Last, but not least, the Southern European countries also find it
increasingly difficult to target poverty as their family- and pension-oriented social
policies are challenged by demographic and labor-market trends.
Second, and not surprisingly in light of the heterogeneous configuration of
National policy frameworks, the EU policymaking framework in the relevant area is
much less well developed than (for example) in the area of monetary and fiscal policy.
Article 2 of the Treaty on European Union states as the EU’s first objective the
promotion of “economic and social progress and a high level of employment, [.]
through the creation of an area without frontiers [.] and the strengthening of economic
and social cohesion.” And “Free movement of persons” is an essential element of the
“creation of an area of security and justice,” another of the objectives to be pursued
within the institutional framework of “subsidiarity” as defined in Article 5 of the Treaty
Establishing the European Union: in areas which do not fall under its exclusive
competence, the Community shall take action “[.] only if and insofar as the objectives
of the proposed action cannot be sufficiently achieved by the Member States.” As
employment stands firm at disappointingly low levels in many of the Member
Countries, the Treaty’s policy statements appear quite wishful. EU-level institutions
have successfully dismantled protective barriers to free and efficient mobility of goods,
services, and factors of production, thus indeed creating an area without economic
frontiers. In the area of social policy, such a process of “negative integration” tends to
enforce deregulation whenever existing policies conflict with desirable economic
efficiency.
16
Even though the scope of economic interactions spans across the National
boundaries of the economically integrated European Union, the social and labor market
policy action advocated by the Treaty is almost completely subsidiary, left to
intergovernmental negotiation, and subject to explicit unanimity requirements. Thus,
official EU documents hopefully envision desirable social-policy convergence and coordination as the automatic result of European countries’ sharing a common social
model faced by common challenges at each national level, rather than of a process of
“positive integration” through explicit collective agreement.
5.1 Policy inconsistency
The two issues highlighted above identify a source of policy inconsistency. Just like
uncoordinated macroeconomic policies, fixed exchange rate, and free trade with capital
mobility before Economic and Monetary Union, free mobility of goods and/or factors,
local decision-making powers in the labor-market and social protection area, and social
inclusion coexist uneasily. And, as in that case, the relevant issues are most clearly seen
in terms of an ‘inconsistent trio’ (see Padoa-Schioppa, 1994, for such reasoning in the
monetary and fiscal policy area) of policy characteristics and goals: pursuing two of the
three to the limit necessarily implies forsaking the third.
Consider first the implications of completely unrestrained economic competition
among constituencies with completely independent social policy-making authority. This
situation cannot foster social inclusion: economic competition leads local constituencies
to forego social objectives, and social policies are theoretically predicted to enter a “race
to the bottom” downward spiral. The pursuit of equity always needs to be traded off
decreased economic efficiency, and from the point of view of local policy makers the
trade-off is clearly worse when, for example, more generous subsidies and higher tax
rates lead to relocation of production rather than lower labor supply, and economic
integration makes it easier for individuals to opt out of supposedly mandatory
redistributive schemes. Foregoing the “protection” afforded by barriers to trade and
labor mobility reduces the effectiveness of social policies and increases their cost, and
theory predicts that as each decision maker privileges economic competitiveness over
the pursuit of social inclusion uncoordinated policy choices by local constituencies
should trigger race-to-the-bottom tensions.
17
Thus, the EU can have complete economic integration and subsidiary social
policies, but only by accepting much levels of social protection. The far from
satisfactory performance of many member countries’ social and labor market policies
may lead some to favour such an outcome, but the resulting caricature of the US system
(local social policies without any Federal competence in the area) is not politically
feasible. Economic integration and subsidiary policy are not likely to be the chosen
members of the inconsistent trio at the cost of social exclusion. In most European
countries, social policies are politically stable and resistant to reform. Such stability is
often read as evidence that “race to the bottom” fears are unjustified. But it can also be
read as evidence that the extent of economic integration (especially as regards labor
mobility) is not yet as full as would be necessary in order to reap its full specialization
and flexibility benefits.
To some extent, the pre-EMU situation of strongly limited international
economic competition and personal mobility and strong National redistributive and
regulatory policy (which in terms of the trio forsakes competition, but preserves local
decision-making powers and local social inclusion) is closer to the political consensus
of European countries, and much of the resistance encountered by dismantlement of
international economic barriers appears dangerously related to such social and political
feelings.
The third possible extreme configuration of the inconsistent trio, namely
unrestrained competition and effective social policy intervention at the cost of local
decision-making power in the area, also presents obvious problems. It would require
EU-level competence in social and labor market policy but, given the high degree of
heterogeneity in the status quo illustrated by Figure 7, would very much be in danger of
replicating at the continental level the current configuration of large and heterogeneous
member countries like Italy, Germany, or Spain, where homogeneous national
institutions tend to reduce the intensity of interregional and inter-occupational
competition at the cost of generating pockets of persistently high unemployment in the
relatively less developed areas (Bertola, 2000). And, as in those countries, it would
require substantial fiscal transfers from the richer regions, whose political sustainability
is very much dubious in the absence of pan-European solidarity feelings – but can
hardly be ruled out completely, to the extent that national political decision processes do
18
often appear to privilege protection over economic efficiency at the cost of substantial
economic and fiscal costs.
6. Tensions and possible resolutions
The EU system of labor market and social policies faces two interrelated challenges.
The first tension is that generated by increasing pressure of international competition
(both within the EU, and at the global level) on the status-quo configuration of each
member country. As discussed in more detail by Bertola and Boeri (2002), the benefits
in terms of high wages and social cohesion of current policies tend to be outweighed by
their efficiency and employment costs when a more competitive environment implies a
flatter labor demand schedule. This would suggest a reconfiguration in the direction of
more flexibility and less protection but, to the extent that workers’ demand for
protection increases in the face of new competition and les effective policy instruments,
reforms are not easy. The interplay of stronger demand for and more expensive supply
of protection is complex, and it is far from surprising to see that no race to the bottom
materializes. Social expenditure remains high in all European countries. Taxes and
expenditures do not fall, and selective tax exemptions (Tanzi, 2002) remain pervasive.
Regulation, a popular way to address market shortcomings without direct budgetary
costs, remains stringent. And in some countries reforms actually yield to demand for
more protection, and move the system in the direction of more rigidity rather than more
flexibility.
The second tension is that generated by the mutual inconsistency of national
policy making authorities, EU-level deregulation of international barriers to trade and
mobility, and pervasive welfare policy concern. As discussed in more detail by Bertola
et al (2001), intergovernmental documents offer a plethora of strongly worded
statements as regards social cohesion as a European Union objective. But little or no
policy action is visible in all relevant fields. The result is insufficient support for
efficiency-enhancing economic integration, and increasingly different views across
countries (whose systems of welfare provision differ considerably) as to the desirability
and character of reforms, and as to the role EU institutions should play in coordinating
them.
These tensions could potentially precipitate a crisis of country-specific
employment and social outcomes and/or of the EU economic integration process. In
19
light of the theoretical insights and empirical evidence discussed above, however, it is
possible to identify how politically and economically appropriate reform processes
might resolve them in smooth and welfare-improving fashion.
The first focal point for reform is the fact that an efficient combination of
equity-motivated social policy and efficiency-enhancing competition calls national and
supranational policymaking authorities to face explicitly the challenges posed to their
current of social and labor market policies by Economic and Monetary Union. Reform
is needed, and needs to be targeted at the collective level as it will not result from
automatic convergence mechanisms. In general, policies should become more
employment- and efficiency-oriented in an environment where competition makes it
harder fro employers to provide life-long employment and financial-market
development arguably reduces the desirability of labor-income stability. The fact that
economic interactions now span all of the EU calls from EU-level policy attention to
labor market and social policy aspects, as the absence of such attention and concrete
policy action unavoidably generates resentment towards economic integration and slows
its pace. But, very importantly, policy should be adapted to local realities: to the extent
that the cost and benefits of labor market interference depend on social homogeneity
concerns and information management, and that these differ across countries, it would
be pointless to force the same system on all of them. The ability to monitor behavior
more efficiently in a more homogeneous society can make it possible to provide more
sophisticated social protection, while a well-developed private financial market may
make protection and regulation less necessary. Thus, it would be pointless to advocate
homogeneity of (for example) Scandinavian and Anglo-Saxon policies in the area, as
long as those societies remain differently organized in other respects.
In fact, the related the second key focal point should be recognition that labor
market institutions can serve useful purposes and, if they are a partial substitute for
other market failures, a wider perspective on the assessment of structural and reform
issues is needed. If more flexibility in the labor markets would further constrain
workers' access to consumption smoothing instruments, then it need not improve the
economy's ability to deliver welfare to its citizens unless accompanied by financialmarket reforms. Figure 8 shows that household credit conditions and employmentprotection legislation are quite correlated, and Bertola and Koeniger (2003) propose and
20
solve a model which suggests that this and other empirical correlations between
financial and labor market outcomes can be rationalized in terms of optimal policy
configurations in a second-best situation. Labor market institutions should be updated
when the intensity of competition increases, or when an economy's credit and other
financial markets develop. But it is not surprising to witness heavy resistance to labor
market liberalization in countries in which credit supply remains relatively constrained,
such as Italy, as well as resentment against European product market and monetary
integration in the presence of still limited market access in many countries’ domestic
service markets.
In order to formulate and implement politically acceptable and truly welfareenhancing reforms, Europe’s national and supranational policy makers should not target
labor markets as the only area of policy action. Inconsistencies of the type exemplified
by local cohesion-oriented policymaking in an integrated economic area abound in the
EU’s environment of increased competition across the boundaries of national systems of
redistribution. By improving the efficiency of resource allocation, more intense trade
and factor mobility should enhance efficiency and increase aggregate income, but an
efficient allocation of economic activity need not in general be equitable and politically
acceptable ex post. As emphasized in the discussion of labor market institutions above,
market pressure can be perceived to be unfair when markets are imperfect.
Policymakers should recognize that fostering competition in all areas of economic
interaction is necessary for citizens to recognize that the resulting environment is
socially optimal, and they should realize that tensions arising in all policy areas from
integration of diverse economies should be targeted by forward-looking, growthoriented, and coherent policy frameworks at both national and supranational levels.
21
REFERENCES
Agell, Jonas, and Kjell Erik Lommerud (1992) “Union Egalitarianism as Income Insurance.”
Economica 59(235): 295-310.
Bean, Charles, Samuel Bentolila, Giuseppe Bertola, Juan Dolado (1998) Social Europe: One for
All? London: CEPR,.
Bertola, Giuseppe (1999) "Microeconomic Perspectives on Aggregate Labor Markets," in
O.Ashenfelter and D.Card (eds.), Handbook of Labor Economics vol.3B, Amsterdam:
North-Holland.
Bertola, Giuseppe (2000) "Labor Markets in the European Union," ifo Studien 1/2000, pp.99122.
Bertola, Giuseppe (2003) "A pure theory of Job Security and Labor Income Risk," Review of
Economic Studies, …
Bertola, Giuseppe, and Tito Boeri (2002) "EMU Labor Markets Two Years On: Microeconomic
tensions and institutional evolution" pp.249-280 in M.Buti and A.Sapir (eds.), EMU and
Economic Policy in Europe: The Challenge of the Early Years, Edward Elgar,
Aldershot.
Bertola, Giuseppe, Francine D. Blau and Lawrence M. Kahn (2002a) "Comparative Analysis of
Labor Market Outcomes: Lessons for the US from International Long-Run Evidence"
pp.159-218 in A.B.Krueger and R.Solow (eds.), The Roaring Nineties: Can Full
Employment Be Sustained?, Russell Sage and Century Foundations, New York
Bertola, Giuseppe, Francine D. Blau, and Lawrence M. Kahn (2002b) "Labor Market
Institutions and Demographic Employment Patterns," NBER Working Paper No.
w9043.
Bertola, G., J.F.Jimeno, R.Marimon, C.Pissarides (2001) "Welfare Systems and Labor Markets
in Europe: What convergence before and after EMU?" in G.Bertola, T.Boeri,
G.Nicoletti (eds.), Welfare and Employment in a United Europe, MIT Press.
Bertola, Giuseppe and Winfried Koeniger (2003) “Consumption Smoothing and the Structure of
Labor and Credit Markets,” typescript.
Blanchard, Olivier J., and Justin Wolfers (2000) “The Role of Shocks and Institutions in the
Rise of European Unemployment: The Aggregate Evidence.” The Economic Journal
110(462): C1-33.
Esping-Andersen, Gosta (1990) The Three Worlds of Welfare Capitalism, Polity Press,
Cambridge, UK
Padoa Schioppa, Tommaso (1994) The Road to Monetary Union in Europe, Oxford: Clarendon
Press.
Tanzi, Vito (2002) “Globalization and the Future of Social Protection,” Scottish Journal of
Political Economy 49:1 pp.116-127
22
w
( U)
w
Markup (or tax)
Labor supply
Labor
demand
l
l
Figure 1: Wage and employment effects of union wage markups (or labor taxes).
2.2
Canada
U.S.
Male wage D5/D1, 1993
2
1.8
U.K.
Portugal
Austria
Japan
Italy France
1.6
Australia
Switzerland
Finland
1.4
Germany Belgium
Sweden
1.2
0
5
10
15
EPL rank,1990s
23
20
25
30
Figure 2: Empirical relationship between wage inequality (ratio of the median to the
10th percentile of the male wage distribution) and employment protection
legislation. Data source: OECD.
24
12
Italy
Japan
Belgium
Portugal
Mean tenure, all workers, late 1990s
11
France
Sweden
Finland
Austria
Germany
10
Switzerland
9
CzechR
Ireland
8
Spain
Korea
Netherlands
U.K.Canada
Greece
Denmark
U.S.
7
Australia
6
0
0.5
1
1.5
2
2.5
3
3.5
4
EPL indicator, late 1990s
Figure 3: Empirical relationship between tenure lengths and employment
protection legislation. Data source: OECD.
Earnings correlation, 1986-91
0.85
0.8
Germany
Italy
France
0.75
Sweden
U.K.
0.7
U.S.
Denmark
0.65
0.6
0
2
4
6
8
10
12
14
EPL indicator, late 1980s
Figure 4: Empirical relationship between wage stability (correlation of earnings over a
5-year period for full-time employees) and employment protection legislation.
Data source: OECD.
25
Non-employment rate of working-age households
24.00
Belgium
23.00
22.00
21.00
Denmark
Germany
Netherlands
Ireland France
20.00
Italy
Canada
19.00
18.00
y = 0.3513x + 13.495
2
R = 0.4582
17.00
16.00
Australia
U.S.A.
15.00
5
7
9
11
13
15
17
19
21
23
25
difference between pre- and post-tax/transfer poverty rates, circa 1991
Figure 5: Empirical association of redistribution and employment. Source: Bertola et al
(2001).
.1
unemployment, dev. from country
95
.05
95
95
90
90
0
70
75
70
90
85
8580
95
80 90
9090
95
90
80
85
95
95
95
90
75
85
85
90
809095 858080
95
85
758595
90
90
85
90
80
80
85
75
75 85
85
75
80
85
95
75
70
-.05
70
-.1
-.05
0
.05
.1
log 50-10 wdiff, dev from countr
.15
deviations from country means
Figure 6: The moving trade-off between unemployment and wage inequality (male log
wage differential between median and 10th percentile of male wage distribution);
country-specific means are subtracted from both. Source: Bertola, Blau. Kahn
26
(2002a).
27
Social Prot. Expenditure per capita in 1996
(PPS, logs)
9
Denmark
8.8
Germany
Sweden
Austria, Belgium
Netherlands
France
Finland
8.6
United Kingdom
Italy
8.4
United States
8.2
Spain
Ireland
8
Greece
Portugal
7.8
7.6
9.3
9.4
9.5
9.6
9.7
9.8
9.9
10
10.1
10.2
10.3
GDP per capita in 1996
(PPS, logs)
Figure 7: Social protection heterogeneity and per-capita income across the UE and the
US. Source: Bertola et al (2001).
4
Greece
Portugal
Italy
overall EPL indicator, 1989
Spain
3
Korea
France
Germany Norway
Belgium
Netherlands
Finland
Austria
Japan
2
Sweden
Denmark
Australia
Ireland
New Zealand
U.K.
Canada
U.S.
1
0
30
40
50
60
70
80
90
100
Loan-to-value ratio in mortgage market 1981-87
Figure 8: Empirical association between employment protection and credit market
development indicators. Sources and definitions: see Bertola and Koeniger
(2003).
28