Hard Labour

Despite persistently high unemployment in Europe, there seems little support for policies to fight it. Research by Gilles Saint-Paul suggests that this results from the powerful political influence of people who have jobs.

There seems to be a consensus among economists that labour market rigidities are responsible for high unemployment in Europe. In particular, they are blamed for unemployment's most alarming aspects: its frequently long-term nature and its high incidence among young people.

Three institutions stand out as sources of rigidity: unemployment benefits (which lower incentives for job search and increase wage pressure from those in work); minimum wages (which price the least skilled out of the market); and the high costs of firing employees (which deter hiring, thus reducing labour demand and hampering the economy's ability to deal with uncertainty and structural change). Hence the common recommendation that the labour market should be made more flexible, as exemplified in the OECD Jobs Study.

But in practice, few of the remedies economists advocate pass the test of political viability. For example, a 1994 attempt by the French government to lower the minimum wage for young workers was followed by violent demonstrations, eventually leading to withdrawal of the reform proposal. And in 1995, a French presidential candidate advocated an increase in the minimum wage in order to boost his chances of election.

Meanwhile, the Swedish government lost the 1994 election because it had lowered the proportion of people's income replaced by replaced by unemployment benefit from 90% to 80%. And after reunification the German government gave in to western unions' pressure, allowing eastern wages to converge rapidly to western levels despite large productivity differentials and the need to restructure the eastern economy. The result was substantially higher unemployment rates in the East than in the West.

Such phenomena raise a number of questions: what is the coalition of economic agents that benefits from existing labour market institutions? What strategies to reform the labour market are politically viable? And what economic environments are most favourable to economic reform? In a series of recent papers, Gilles Saint-paul has addressed these questions, investigating the mechanisms that account for the persistence of labour rigidities and how they affect the political viability of reform.

One important mechanism is described in what Saint-Paul calls the 'political insider-outsider' model. This refers to circumstances in which, when voting or lobbying in favour of a given institution, incumbent employees take into account its impact on their ability to bid-up wages at the firm level. Labour market rigidities can be thought of as devices that allow incumbent employees indirectly to achieve monopoly power in wage-setting, even though at the firm level the scope for wage increases beyond the level set by competitors is very limited. High unemployment benefits, for example, may provide employees with a credible threat of leaving if their wage demands are not met.

Another mechanism reflects policy complementarities': many channels can be identified through which labour rigidities mutually reinforce each other because the existence of one institution increases support for another. For example by reducing the exposure of employed workers to unemployment, job protection legislation increases the political support for institutions that reduce job creation, such as work rules or generous welfare benefits funded by payroll taxes.

A third mechanism is social cohesion: institutions such as minimum wages and wage ladders typically reduce the dispersion of wages compared to what the free market would generate. But because they create unemployment, they are not an efficient tool to redistribute income to the poorest and may even increase overall inequality.

Nevertheless, Saint-Paul shows, such institutions benefit the middle class by reducing the degree of redistributive conflict between the middle class and lower class. The key mechanism is that those members of the lower class who have jobs are richer and thus less likely to Support redistributive policies. At the same time, the unemployed are poorer but have little impact on political outcomes because they remain a minority.

Saint-Paul has conducted both theoretical and empirical research on these mechanisms. For example, in examining the logic of unemployment benefits, he notes that the traditional way to think about them is as an insurance device. But the political insider-outsider model suggests that unemployment benefits may also benefit incumbent employees by increasing their bargaining power in wage negotiations.

In an article in the latest issue of Economic Policy, Saint-Paul analyses whether insurance or wage bargaining motives are more relevant by looking at the determinants of support for unemployment benefits in a number of countries. He finds little evidence of insurance motives: there is no correlation between the level of unemployment benefits and employed people's exposure to unemployment.

At the same time, economies where employment is less reactive to wages - implying a greater scope for wage increases for insiders and less chance of their facing unemployment - seem to have more generous unemployment benefits. This suggests that the wage-setting motive is playing a role: benefits are being used by employed people to achieve higher wages.

Saint-Paul's article also examines the reform of employment protection legislation in such countries as France, Germany and Spain. In the 1980s, many European governments have attempted to boost job creation by reducing firing costs. Saint-Paul argues that both the design of these reforms and the economic environment in which they were implemented were important determinants of their success.

First, many of these reforms to the costs of firing employees were designed so as to buy the support of incumbent employees. This was done by using a two-tier system in which insiders maintain their level of job  protection: the new regulations on firing, which make it easier and less costly, only apply to new contracts and there is a limit on the use and renewal of the new contracts. Such a limit reduces the likelihood of 'flexible employees' (those hired under the new 'flexible' system) eventually outnumbering 'rigid employees', and hence threatening their political power.

Second, the two tier reforms to the flexibility of the labour market were implemented at a time of relatively high job destruction. this meant that employed people's greater exposure to unemployment at that time increased their support for measures that create jobs. All of these reforms took place at times of sharply rising unemployment across Europe, and hence found favour among the politically powerful in the labour market.

This article reviews research reported in a series of papers by Gilles Saint-Paul of DELTA Paris. Saint-Paul is a Research Fellow in CEPR's International Macroeconomics programme.