Behind the Numbers: The Misdiagnosis of Eurosclerosis

For two decades, virtually every western European nation

has faced high and persistent unemployment. Many Europeans now

look to the United States as a model of labor market flexibility.

It is argued that Europe's "rigid" policies, encumbering

payrolls with benefit costs, giving workers social rights, and

making them hard to fire, deters European industry from creating

jobs. Conversely, it is said that America, with its lesser levels

of social protection, is a job-creation machine.

The United States, however, displays rising wage inequality not

mirrored in Europe. This has lead some observers to argue that

labor markets on both continents share common pathologies, reflecting

the common influence of slow growth, globalization, and technological

change. Europe simply chooses to take its slower growth in the

form of higher unemployment, while the United States has chosen

more jobs but greater inequality.

It is wrong to assume a simple trade-off between social protections

and labor market problems. Both the United States and Europe are

experiencing problems in their labor markets. To address these

problems, good policy choices will require mixing some of the

best aspects of labor market flexibility with well-run activist

labor market and social protection policies.

The stakes, of course, are not just economic. The high unemployment

(in Europe) and rising inequality (in the United States) have

social and political ramifications. They threaten a country's

social cohesion. Those who have lost economically over the past

few decades—either because of extended unemployment or because

of falling wages—are likely to be risk-averse and prone to seek

scapegoats. Various forms of right-wing violence and opposition

to immigrants are on the rise in both the United States and Europe.

As the gap between winners and losers widens, the sense of a common

political community erodes.


Concurrent with the OPEC oil price shocks, worldwide recession

and stagflation, growth faltered in the mid-1970s in both the

United States and Europe. But rather than recovering in the 1980s,

unemployment in many European nations got worse. Rates of long-term

unemployment (the share of the unemployed out of work 12 months

or more) soared to between 30 and 50 percent in many nations,

while part-time employment also rose. Problems were especially

severe among younger workers.

Initial attempts to explain this high unemployment focused on

Europe's extensive labor market regulation and generous social

assistance programs. Despite an uncertain economy, it was argued,

wages stayed high because of protective legislation and rigid

union rules. Employers refused to hire these high-cost workers,

especially since extensive severance protection made it costly

or impossible to lay them off. Workers, in turn, were content

to remain out of the workforce because they received generous

and long-term unemployment compensation and other assistance.

Those with jobs presumably had no incentive to allow flexible

wages and severance rules, hence "insiders" (the employed)

kept firms from adjusting in ways that would allow them to hire

"outsiders" (the unemployed).

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In fact, many European nations have pursued greater flexibility

in their labor markets by weakening protective legislation, but

with little effect on unemployment. Germany, France, the United

Kingdom, and Belgium weakened their dismissal laws. Spain, the

United Kingdom, and the Netherlands decentralized wage bargaining.

Italy eliminated automatic wage indexation. But overall unemployment

did not fall. So it is not clear that Europe's social protections

are the main culprit.

From 1991 to 1993, I headed a research project sponsored by the

Ford Foundation and the National Bureau of Economic Research that

commissioned a group of authors from Europe and the United States

to study the effect of European changes in labor market regulation

and social protection on labor market flexibility. This research

indicated that the effects of these changes were small. For in

stance, changes in severance laws or in public-sector bargaining

created no bursts of job growth or worker mobility. (This work

is published in Social Protection Versus Economic Flexibility:

Is There a Trade-off? University of Chicago Press, 1994.)

These results are consistent with work by other researchers.

Of course, it is possible that the legislative changes enacted

by European nations in the 1980s were too small to make a difference,

and that larger, more dramatic changes are necessary. In Britain,

however, there really were dramatic reductions in labor protections,

and these did not produce a burst of job growth. Britain's unemployment

fell modestly only when Britain devalued the pound.


Through the mid-1980s, the much less regulated labor market in

the United States appeared to provide a successful alternative

model. While unemployment continued to rise in Europe through

the 1980s, it fell dramatically in the United States. By the late

1980s, it was at a low and sustained rate of around 5.5 percent.

The mild recession of 1990-91 pushed unemployment up, but it fell

quickly to its previous low levels by the mid-1990s.

But while unemployment seemed stable at fairly low levels, wage

inequality was rising rapidly. Real wages of less-skilled workers

started to fall in the early 1970s. Between 1979 and 1993, real

wages (wages adjusted for inflation) among men working full-time

without a high school degree fell 22 percent, while full-time

working men with a high school degree experienced a 12 percent

decline in their wages. Over these same years, full-time male

workers with a college degree saw their wages rise by 10 percent.

Female workers have also seen dramatic increases in wage inequality,

although the actual declines among the least skilled are not as

extreme (not a very reassuring statement, given how low wages

for less-skilled women have always been).

By the time growing wage inequality in the U.S. was widely recognized,

the claim that flexible American labor markets were obviously

superior to Eurosclerotic ones had become so imbedded in the

public discussion that few people stopped to reassess whether

that flexibility came at too high a price.

Rising inequality in the United States and high unemployment

in Europe very likely reflect the same changing global economic

forces. For instance, changing patterns of international trade

and changing technologies will increase the demand for some groups

(especially more-skilled workers), while decreasing the demand

for other groups (especially less-skilled workers) in all industrialized

nations. In the more open U.S. labor markets, it is not surprising

that these changes produce shifts in relative wages. The more

regulated European labor markets have historically maintained

more rigid wage structures, forcing employers to adjust to these

economic changes by changing their hiring and firing behavior,

leading to increased unemployment. A priori, it is not clear whether

the United States or the European model is preferable. They are

simply different, adjusting to these international economic changes

in different ways, with different effects on various groups of



The best evidence in support of this "unified theory"

is simply the timing of events. Continuing high unemployment in

Europe became a puzzle as the world economy started to recover

in the late 1970s. This is exactly the same time that wage inequality

started to rise rapidly in the United States.

Other empirical evidence for the unified theory is admittedly

mixed. The theory implies a trade-off between wage inequality

and high unemployment, where countries with inflexible labor markets

experience the highest unemployment rates but show little evidence

of rising wage inequality, and vice versa. The United States has

experienced the strongest increase in wage inequality, and little

long-term increase in unemployment rates over the past 15 years,

consistent with the theory. Similarly, some European countries

with high unemployment show no change in wage inequality. But

some European countries, most notably the United Kingdom, have

experienced both problems. So we should not imagine a static choice

of high unemployment or high inequality; public policy can influence

the terms of trade-off.

Further evidence might be found by investigating which group of

workers is experiencing the biggest decline in relative wages

in the United States, and asking whether this same group of workers

is most affected by rising unemployment in European countries.

In the United States, it is clearly the less skilled who have

seen the biggest wage declines, although wage inequality is rising

within higher-skill categories as well. In Europe, unemployment

rates are highest among the least skilled, but it is not clear

that the relative unemployment rate of low-skilled workers has

risen over time. In fact, only France and Sweden show big rises

in unemployment among the least skilled relative to more skilled

workers. In other countries, unemployment among all groups has

risen, so relative unemployment rates by skill remain largely

constant. In general, European unemployment seems more focused

by age than by skill level. Younger workers have experienced the

biggest increases in unemployment. But this does not necessarily

contradict the unified theory. Labor market protections that make

it harder to fire older workers in Europe may have pushed an undue

burden of unemployment onto younger workers of all skill levels,

as companies try to cope with changing competition and changing

product demand.

While there is much we still don't understand about the

extent to which U.S. and European labor market changes are linked,

one can draw three tentative conclusions:

  1. There appears to have been a series of shifts in the demand

    for workers that have affected many of the most industrialized

    nations. Differences in how labor markets in these nations have

    responded depends upon their institutional structure. Less-regulated

    labor markets, particularly the United States and the United Kingdom,

    have experienced much greater changes in relative wages. (It is

    worth noting that only in the United States have there been actual

    declines in real wages among workers. In other countries where

    inequality has grown, it is because the wages of more-skilled

    workers have risen faster than the wages of those at the bottom

    of the wage distribution.) Countries with centralized labor bargaining

    have been most effective in maintaining an unchanged relative

    wage structure, but a number of these economies have instead faced

    very high and sustained unemployment problems.

  2. The demographics of different nations also appear to matter

    for these labor market changes. Some of the differences across

    countries can be explained by different age patterns in the population,

    as well as by different patterns of labor force entry and exit

    among younger and older workers and among female workers. For

    instance, in some countries women and older workers leave the

    labor force entirely as high unemployment rates make the benefits

    of staying in the labor market less attractive. This exodus of

    women and older workers from the labor force lowers the overall

    level of unemployment (because there are fewer total people in

    the labor market), but concentrates unemployment among the workers—such

    as the young—who remain.

  3. Social protection programs have played a key role in offsetting

    the effect of labor market changes on workers' income and well-being.

    Countries with more redistributive programs have spread the economic

    costs of these changes more broadly within the economy. In fact,

    there is some evidence that countries with more extensive social

    assistance programs are exactly those countries where the increases

    in unemployment are also spread more broadly across workers of

    different skill levels. This suggests that these countries may

    have distributional norms that affect corporate and public behavior,

    beyond the explicit transfer systems that are in place. One piece

    of evidence in support of this is the rising level of CEO salaries

    relative to other workers within firms in the United States over

    the 1980s, a pattern not mirrored in European firms. Within the

    United States, the costs of these economic changes have been much

    more highly concentrated on a particular group of workers, with

    less relief provided by public transfer programs.

Every industrialized country has clearly faced its own unique

set of economic and social forces over the past two decades, which

have shaped economic reality for its workers. Some countries have

chosen to pursue contractionary macroeconomic policies to fight

inflation, and this has affected their unemployment rates and

their wage rates. Other countries have faced significant immigration

changes, which have affected unemployment and changed the distribution

of jobs and wages. Robert Solow has argued that most of Europe's

problem is macroeconomic and not due to "rigid" labor

market institutions. These institutions have been in place for

decades; it is the slower growth (due in part to tight monetary

policies) of these economies that has driven higher unemployment.


The fundamental economic changes roiling labor markets are unlikely

to reverse themselves in the foreseeable future. To the extent

that part of the problem is due to growing global economic competition

(particularly from rapidly developing nations), this competition

will only continue and even accelerate. To the extent that part

of the problem is due to the growth of "smart" technologies

that privilege more-skilled workers, these technological shifts

are still underway in most industries.

One response is to try to insulate a country's economy from these

economic changes, through higher trade barriers or by trying to

regulate labor market changes and slow down the adoption of new

technologies. Fortunately, few countries have chosen this route,

although a vocal political minority in all industrialized countries

continue to advocate this. As economists are famous for pointing

out (often with annoying frequency), creating barriers to trade

and barriers to economic change can produce very negative long-run

effects. But given that active labor market policies must be limited,

a reasonable social safety net needs to remain in place. If this

does not happen, countries will face very real long-term consequences,

such as increases in the size of their underground economies,

increasing crime, drug use, family fragmentation, and increasing

civic disconnection and disorder—frequent outcomes when a share

of the population is excluded from mainstream labor markets.

Such income supplementation can occur through traditional unemployment

and public assistance subsidies, or can occur in more novel ways.

The earned income tax credit in the United States subsidizes wages

of low-wage workers and has been shown to increase labor force

participation among those out of the labor market. Public-sector

job programs are a way of supplementing income while still encouraging

labor market activity. Part-time unemployment subsidies are used

in some European countries, and subsidize involuntary part-time

workers with partial unemployment payments.

Because of perceived overwhelming demand on their unemployment

and public assistance budgets, most industrialized countries have

cut income transfers to some extent in recent years. The United

States has been in the midst of a debate about whether its social

assistance programs are too generous (particularly in the face

of high and sustained caseloads over the early 1990s) for several

years. Other countries have implemented major changes in the unemployment

benefit systems (which traditionally provide far more income support

and redistribution in European countries than in the United States),

as well as some of their social assistance programs.

Setting limits on access to cash support may be a fiscal necessity,

but if at all possible, those limits should coincide with the

provision of active labor market policies. For instance, time

limits on unemployment insurance may usefully coincide with involvement

in job search and training programs.

At present, the United States appears to be in the process of

choosing a route whereby low-income families are cut off even

further from government assistance, in the name of deficit reduction

and budget balancing. The recent welfare reforms aimed at low-income

families emphasize that the labor market is the only way out of

poverty, even as falling wages make full-time work less and less

useful as an escape from poverty. Time limits on public assistance

with no guarantee of employment, as have been recently enacted

in the United States, is wishful-thinking public policy. Given

the realities of low-wage labor markets, many less-skilled parents

who reach the end of public assistance will find economic survival

extremely difficult. The long-term consequences of such policy

changes, when combined with the trends in wages, have the potential

to lead to increases in class conflict, in poverty, and in a lost

sense of opportunity via mainstream employment. Even as Europe

justifiably seeks greater labor market flexibility, it would be

a mistake to follow the United States down this road.

Those who have knee-jerk reactions against all forms of

public intervention into labor markets need to be reminded that

there is not always a conflict between labor market regulation

and employment flexibility. Consider family or maternity leave

laws. There are obviously costs to such provisions. But there

is also evidence that these laws increase worker productivity,

by allowing workers to return to their previous jobs following

the birth of a child or a family emergency without losing their

accumulated training and experience. Public interventions designed

to enhance job matching or relocation may also add to the speed

of retraining or reemployment when workers become unemployed.

In short, labor market interventions can sometimes increase labor

market flexibility.

Those who favor U.S. labor markets as models of flexibility that

adjust quickly to economic change and thereby provide the incentives

for workers to invest in new skills or change jobs and relocate,

must also indicate how they propose to deal with those American

workers who face permanently lower wages and reduced incentives

to participate in mainstream labor markets. Those who favor the

European model that provides more job protection and greater wage

equality must indicate how they propose to deal with the large

number of long-term unemployed in these countries. We should not

view policy as a choice between two opposing models, but rather
try to meld some of the best parts of the flexible U.S. private
labor market with an effective set of active labor market and
social protection policies.

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