Myths and facts of the Euro crisis part 2 – labour regulation and unemployment – an analysis by João Madeira

In Anglo-Saxon countries the Euro seems to be seen in a very negative way. Many look at the Euro as an institution which reduced the vibrancy of the economies that adopted it. Table 1 below dispels this idea. Yes, it is true that until the Great Recession the UK, Iceland and USA grew more than most Euro members, but this was also true before the creation of the Euro.

 

Table 1: Average GDP growth rates in percentage
Table 1

Also, the country which grew most during this period was Ireland, one of the Euro members. The Netherlands, another Euro member also had a good performance. What then explains the lack of dynamism of Euro economies? I think the answer is in excessive regulation which becomes an obstacle to economic growth. A paradigmatic case is the labor market. Table 2 displays the OECD’s Employment Protection Index and appears to confirm the hypothesis of a negative impact on economic growth of excessive labour regulation. The only economies which managed to sustain robust growth rates for a significant period (Greece and Spain were only able to do so for a brief time) were exactly those with less labour regulation (Iceland, Ireland, UK, USA and Netherlands).

 

Table 2: OECD Employment Protection Index
Table 2

Is it coincidence? I think not. Excessive labour regulation limits the growth of productivity (for example, by preventing the relocation of workers to more useful activities) and discourages investment (a private business always has significant risk, a potential investor might decide not to go through with it if he/she knows that later it will be very costly to reduce the workforce).

Besides being a serious obstacle to the long run economic potential of many Euro economies, I believe that excessive labour regulation (and not the Euro) has played a determinant role in the truly tragic situation which many periphery Euro countries face today. Figure 1 shows us how unemployment rates in the periphery countries have increased dramatically after the Great Recession. As we saw in Table 1, Iceland and Ireland suffered as much as Greece in terms of GDP loss. The UK suffered similar output loss to that of Spain, Italy and Portugal. But Figure 1 shows that in terms of unemployment increase the economies of these countries responded in very different ways. In 2011 the unemployment rate of Iceland was 7%, Ireland’s 14% and Greece’s 18%. In the same year, the UK, Spain, Italy and Portugal had unemployment rates of 8%, 22%, 8% and 13% respectively. Is it a coincidence that the two countries (Spain and Greece) which have the more rigid labour markets are precisely those which suffer higher unemployment? On the other hand, of the countries with less regulated labour markets, only Ireland experiences one of the highest unemployment rates (and of the more regulated countries only Italy did not see a dramatic increase). Despite unemployment rates in Iceland and UK having increased, these did not reach the levels seen in the other countries that suffered similar output losses.

 

Figure 1: Unemployment rate
Figure 1

What can explain this? A recent study by Shimer (2012) indicates that increases in unemployment rates are explained mostly by a reduction in hiring and not by increases in firings. That is, excessive labour regulation can contribute to a rise in unemployment in a recession because the negative effects in terms of a reduction in hiring outweigh the positive effects of reduced firings.

Excessive regulation also contributed in another way to the amplification of the effects of the recession in periphery countries (for those interested in anecdotical evidence I suggest the reading of John Cochrane’s blogs here and here which describe some of the difficult situations which businesses face in periphery countries). Let’s look at Table 3 which shows the proportion of enterprises per number of workers in several European countries.

 

Table 3: Enterprises share (in percentage) per number of workers (year of 2005)
Table 3

One can see that except Ireland (and to some extent Portugal), the periphery economies of the Euro have a much smaller share of medium-sized and large-scaled enterprises in comparison to other European countries (this likely indicates, that excessive regulations make it difficult for companies to grow beyond a certain point and/or regulation shields the current large enterprises from new competitors). How can this explain that the Euro periphery has been more intensively affected by the Great Recession? Well, it is precisely small enterprises which are more credit constrained and exhibit higher business cycle volatility (Gertler and Gilchrist, 1994). Economies which have a higher proportion of small firms are therefore more vulnerable to credit contractions. Smaller firms also typically export much less (in the EU only 8% of small and medium-sized enterprises export while 28% of large-scale enterprises do) and therefore reducing the obstacle to the growth of these firms would also help these countries to increase their exports.

 

João Madeira

University of Exeter

 

References:

Data for tables 1, 2 and figure 1 can be obtained from the OECD website: http://stats.oecd.org/

Data for Table 3 can be found at the EC website:

http://ec.europa.eu/enterprise/policies/sme/facts-figures-analysis/sme-observatory/index_en.htm

John Cochrane’s blog can be found here: http://johnhcochrane.blogspot.co.uk/

Gertler, Mark & Gilchrist, Simon (1994). “Monetary Policy, Business Cycles, and the Behavior of Small Manufacturing Firms,” The Quarterly Journal of Economics, vol. 109(2), pages 309-40, May.

Shimer, Robert (2012). “Reassessing the Ins and Outs of Unemployment,” Review of Economic Dynamics, vol. 15(2), pages 127-148, April.

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