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 decadeseither because of extended unemployment or because
of falling wagesare 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.
THE STORY IN EUROPE
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).
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.
THE STORY IN THE UNITED STATES
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 UNIFIED THEORY
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
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:
- 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.
- 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 workerssuch
as the youngwho remain.
- 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 disorderfrequent 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
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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