Refuted economic doctrines #8: the superiority of flexible labor markets

According to the latest Eurostat data*, the unemployment rate in the US was equal to that in the EU-15 in March, and is now likely to be higher. Writing in the NY Times, Floyd Norris refers to the conventional wisdom that flexibility inherent in the American system — it is easier to both hire and fire workers than in many European countries implies that unemployment should be lower (at any given point in the business cycle) in the US than in Europe.

Although this is the conventional wisdom, the research on which it was based (by Lazear and others) has long since been qualified or refuted. I looked at this in the context of the Australian debate about unfair dismissal laws a few years back. Although the early research supported the simple view that more flexibility = more jobs, later research yielded the conclusion that employment protection laws lower the variance of employment and unemployment but have no clear effect on the average levels.

When you look at the institutions involved, this is unsurprising. Although Norris refers to restrictions on hiring and firing, the reality is that restrictions on hiring are nowhere very important. Even in the extreme case of Spain, they amount to a few weeks of salary. The big differences are in costs of firing, and it is the anticipation of these costs that acts to constrain hiring in periods of expansion.

Advocates of the US system make much of the deterrent to hiring associated with employment protection laws, but they ignore the other side of the coin. When the economy is contract, employment protection laws do in fact protect employment (if they did not, they would have no adverse effect on hiring either).

On this basis there is nothing surprising in what we are seeing. EU unemployment rates should be higher in expansions and lower in contractions, which is exactly what is required for lower variance.

Which is better? The big problem with strong employment protection is that it tends to create an insider class of well-protected permanent employees and an outsider class who are either unemployed or assigned to some form of semi-permanent “temporary” status (see, for example, the tenure system in universities). But, comparing the EU and US as a whole, the opposite seems to be the case – there is a sharper class divide, and less social mobility in the US than in the EU.

More on this from the Center for Economic Policy Research (h/t Brad DeLong).

* In response to various comments, this is harmonised data adjusted to remove the effects of differences in national definitions. The choice of definition still makes a difference – for example, the harmonised definition refers to the civilian non-institutional population. If prisoners were treated as unemployed, this would raise the US rate by about 1.5 percentage points and the EU rate by about 0.2 percentage points.