Labor Market Flexibility: Repetition Doesn't Make It True

Every day the newspapers are filled with the conventional wisdom about the current European economic crisis.  Besides problems with large, persistent governmental budget deficits, commentators typically emphasize the issue of economic growth.  The argument is that growth and increases in productivity are the best way to solve not only the budget issues but also to increase country competitiveness and employee well-being.  And virtually every article, regardless of the political leanings of its source, makes the same claim:  a great way to encourage economic growth and higher levels of employment is to deregulate the labor market so that employees in Europe have about the same protections as they do in the U.S.—basically zero.  This labor market flexibility will supposedly reduce unemployment, stimulate the creation of more permanent jobs, and make Europe more competitive.

There's just one enormous problem with this constant refrain about "Eurosclerosis" and the benefits of labor market flexibility:  there is remarkably little empirical evidence about the effects of deregulated labor markets.  And what evidence there is scarcely supports the level of certainty and passion that seems to characterize many economists and the media in their pleas to remove employee protections.

As to the amount of evidence, two economists noted that given the importance of the issue and the fact that governments have reformed labor market oversight following conventional wisdom, "one would think that there are hundreds of papers studying whether more flexibility does in fact reduce a country's unemployment rate in practice.  Sadly, this is not the case."[1]

And what evidence there is presents a far more complex and equivocal picture than you would get reading or, for that matter, listening to the current discussion.  One review of the available evidence of the effects of labor market flexibility stated that it is "much less persuasive than is commonly believed" and maintained that the economics profession's "faith in the merits of labor market de-regulation is misplaced."[2] A review article on this topic in the Journal of Economic Perspectives[3] makes several important points:

"differences within Europe are much greater than are the differences between the European average and North America" (p. 55).
"the European countries with the lowest unemployment rates…are not noted for the flexibility of their labor markets.  Britain…has always had the most flexible labor market in Europe on standard measures yet has an average unemployment rate higher than half of its European neighbors" (p. 57).
"the contrast between Europe and North America is more complex than is commonly realized" (p. 59).

Even studies that find an effect of European-style labor market regulation often report extremely small effects.  So, for instance, one study of France concluded that if it were to make its labor markets as flexible as those in the U.S., it would increase its employment rate just 1.6%.[4]

Labor market protections provide real benefits to employees.  Before we get excited and throw all of this out, it would be nice to actually look at the evidence.  And public policy makers and commentators would do well to acknowledge the complexity of the issues and to stop repeating the same misinformation.  Real people suffer the consequences of policy based on ideology rather than evidence.

[1] Rafeal Di Tella and Robert MacCulloch, "The Consequences of Labor Market Flexibility  Panel Evidence Based on Survey Data," European Economic Review, 49 (2005), p. 1226.

[2] P. Gregg and A. Manning, "Labor Market Regulation and Unemployment," In D. Snower and G. de la Dehesa (Eds.), Unemployment Policy, Cambridge, UK:  Cambridge University Press, 1997, p. 395.

[3] Stephen Nickell, "Unemployment and Labor Market Rigidities:  Europe versus North America," Journal of Economic Perspectives, 11 (1997), 55-74.

[4] Di Tella and MacCulloch, op. cit.