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 workers.



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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