Assessing the Political Viability of Labor Market Reform: The Case of Employment Protection
Saint-Paul, Gilles, Federal Reserve Bank of St. Louis Review
There is somewhat of a consensus among economists that labor market rigidities are responsible for high unemployment in Europe, and in particular for its most alarming aspects such as its long duration and high incidence on youth. Unemployment benefits lower the incentive for job search and increase wage pressure by insiders. Minimum wages price the least skilled out of the market. Firing costs deter hiring, thus reducing labor demand, and hamper the economy's ability to deal with uncertainty and structural change. This is why experts frequently recommend making the labor market more flexible, as is exemplified by the conclusions of the recent OECD Jobs Study (1995).
But, in practice, few of the remedies economists advocate pass the test of political viability. In 1994, an attempt by the French government to lower the minimum wage for young workers was followed by violent demonstrations, and the government eventually withdrew its reform proposal. In 1995, in order to be elected, a French presidential candidate put on its platform an increase in the minimum wage. In 1994, the Swedish government lost the elections because it had lowered the unemployment benefit replacement ratio from 90 percent to 80 percent. After reunification, the German government gave in to western unions' pressure and allowed eastern wages to converge rapidly to western levels, despite large productivity differentials and the need to restructure the eastern economy, which led to substantially higher unemployment rates in the East than in the West.
In my view, an understanding of the political determinants of labor market institutions is a crucial prerequisite for being able to implement structural reforms that are acceptable to those social groups that potentially may block these reforms.
While we believe that the set of institutions that prevail in many European countries form a coherent whole, given the complexity of the issue it is often more convenient to analyze these institutions separately from each other. In this paper we focus on employment protection legislation (also called "firing costs"). We want to know who gains and who loses from such regulation, and what will be the equilibrium level of employment protection. We abstract from other rigidities - we do not ignore them, but take them as given, ignoring that they, too, are the outcome of the political process.
Why firing costs rather than other institutions? This is partly a matter of taste and I have discussed other institutions elsewhere.(1) But there are several reasons why employment protection is more relevant than other rigidities when one deals with the political economy of reform. First, it is regularly pointed out by employers as one of the most severe constraints on their incentives to create jobs. Second, it is somewhat more renegotiable than minimum wages or unemployment benefits. Some reductions in firing costs have been observed in various countries in the eighties and nineties. We have not seen similar reductions in unemployment compensation or minimum wage laws. Unemployment benefits are seen as part of the "welfare state" and attempts to reduce them often are interpreted as a first blow to the whole welfare state, while the minimum wage is often an untouchable symbol.(2) Third, while firing costs' impact on employment is actually unclear,(3) they clearly increase unemployment duration. If anything, the key difference between Europe and the United States is not so much the former's higher unemployment rate which partly reflects composition effects and a greater incentive to register as unemployed - as Europe's much larger unemployment duration.(4)
Behind the political support for employment protection lies the existence of rents in favor of the employed, which arise due to imperfections in the labor market. We understand firing costs as a device to protect the rents of incumbent employees. The greater these rents, the greater their incentive to support protective measures. …