The explanation of ‘European sclerosis’

As mentioned above, a predominant opinion concerning the unemployment problem in Germany insists that the high rate of unemployment is due to institutional labor markets rigidities existed there. It is argued that firms are

6 It is the opinion of German council of economic experts, German central bank and the majority view of the leading economic research institutes in Germany.

faced with too strong restrictions such that they are hindered to adapt to changed circumstances. ‘European sclerosis’ is coined to characterize such encrusted labor markets in Europe.

Labor market institutions being considered in the literature are usually regulations that play a more or less direct role in the functioning of the labor market. Following factors are often pointed out as fundamental rigidities in German labor market as compared with U.S. labor market:

(1) Net wages are only a part of the whole labor costs. Income tax, non-wage benefits and social charges are much higher in Germany than in U.S. This surely makes some low-wage workers unemployable.

(2) High dismissal costs will arise if firms want to lay off workers. Due to employment protection legislation against unlawful dismissal and severance pay, complex and protracted legal procedures are necessary only to get dismissal permitted. Although such employment protection regulations could work against unemployment in the short run, the long-run effect of them is to discourage job creation and to strengthen the power of incumbent workers to protect wages at the expense of outsiders seeking employment.

(3) As compared with those in U.S., the greater density and power of trade unions in Germany enable unions to press for high wage settlements and prevent firms from adjusting to changes flexibly.

(4) Unemployment benefit is more generous in Germany than in U.S. It is easier to have a claim to unemployment benefit and the payment lasts also for a longer period of time. The natural consequence is the incentive of unemployed workers to search a new job being reduced.

(5) Minimum wages in Germany are relative high in comparison with the average wage.⁷ Therefore it is unprofitable for firms to hire unskilled workers. In this way, unskilled workers remain unemployed, having neither access to training at workplace nor chance to get themselves qualified.

7 Although Germany does not have legal minimum wages, custom and the large tax wedge must have a similar effect.

This view of ‘European sclerosis’ is based directly on neoclassical labor market theory. With a complete and perfect neoclassical labor market as a standard of reference, unemployment can only arise from market imperfections preventing a market clearing real wage at full employment.

Institutions of collective wage bargaining, labor market regulation and the welfare state are such market imperfections and therefore creators of unemployment.

It is true that labor market institutions affect the nature of unemployment and some of them may indeed generate a high unemployment rate. In fact, explanations based on labor market rigidities have become more popular with the persistence of high unemployment for about three decades. Explanations based solely on institutions run however into both theoretical and empirical problems.

With respect to theory, if models are based on modern labor market theory instead of the traditional neoclassical labor market theory, it becomes difficult to derive unambiguous implications concerning the employment effects of labor market regulations and welfare state institutions.⁸

In terms of empirical research, results from the literature are rather mixed and far from being clear. Since the influential work of Layard et al. (1991) there have been a large number of econometric studies examining the influence of institutional rigidities on unemployment.⁹ However, the empirical work does not provide clear and unambiguous results in favor of the institutional sclerosis view. A considerable part of the unemployment differences over time and across countries can not be explained by differences in the labor market institutions. Time and country specific factors and macroeconomic variables have to be taken into account too. Some of the empirical results supporting the institutional sclerosis view do not seem to be robust.

Finally, many of the cited rigidities were already in existence in Germany in the 1960s when German unemployment rate was still very low. The evolution

8 Once asymmetric information, incomplete contracts and price-setting are taken into account, there are good reasons to question the institutional sclerosis opinion and its political implications.

9 An excellent overview of the more recent econometric studies is provided by Baker et al. (2004).

See also Hein and Truger (2005a) for more details.

of Germany’s labor market and welfare state institutions does not correspond to the unemployment development in Germany.

The variables usually being regarded as indicative of institutional rigidities are indices of labor taxes, employment protection, union density, bargaining coordination, the benefit replacement ratio and benefit duration. Table 3.3 gives changes in these institutional indicators in Germany from the 1960s to 2000. According to Table 3.3, Germany exhibits some increase in labor taxes during the period of 1960-1995 and since then labor tax rate has been reduced a little till 2000. Index of employment protection shows employment protection has been much stricter since the 1960s.¹⁰ As regards wage determination, union density hovered between 31% and 35% during the 1960 to 1995 period and declined to some degree from 1996 to 1998. Index of bargaining coordination has remained constant during the whole period.

Unemployment benefit replacement ratios have decreased while unemployment benefit duration has lengthened during the period of 1960-1999.

To conclude, during the 1970s and the early 1980s, some of the labor market rigidities were indeed aggravated to some extent. But it is hardly plausible that these modest changes alone could have resulted in the dramatic rise in unemployment during this period. In addition, German labor market seems to have been more flexible from the late 1980s onwards. In fact, many of the rigidities are nowadays less pronounced than they were ten years ago.

The coincidence of the rise in unemployment after 1990 with the labor market deregulation is in sharp contrast to the institutional sclerosis view.¹¹

If the argument is correct that rigidities in the labor market are responsible for the rise in the German unemployment rate, it must be that the effects of these rigidities on unemployment have become more significant, even though the institutional regulations themselves have not deteriorated.

10 Due to different sources, this series is not completely reliable. See Nickell (2003) for details.

11 The unemployment increase in Germany in 1996-1997 happened at a time of wage moderation.

Table 3.3 Changes in Labor Market Institutions in Germany

1960-64

1965-72

1973-79

1980-87

1988-95

1996-00 Total Taxes on Labor

(%) 43 44 48 50 52 50

Employment

Protection (Index, 0-2) 0.45 1.05 1.65 1.65 1.52 1.30

Union Density (%) 34 32 35 34 31 27

Co-ordination Index

(Range 1-3) 2.5 2.5 2.5 2.5 2.5 2.5

Unemployment Benefit

Replacement Ratios 0.43 0.41 0.39 0.38 0.37 0.37

Unemployment Benefit

Duration Index 0.57 0.57 0.61 0.61 0.61 0.75

Note: 1) Total Tax Rate = Payroll Tax Rate + Income Tax Rate + Consumption Tax Rate;

Union Density = union members as a percentage of employees.

2) Index of Employment Protection (0-2): 0=low, 2=high; Co-ordination Index corresponds to Co-ordination 2 in Nickell (2003) (Range 1-3): 1=low, 3=high.

3) The last number of Employment Protection refers to 1998, of Union Density refers to 1996-98, of Co-ordination Indexrefers to 1995-99, of both Unemployment Benefit indexes refer to 1999.

4) Except for Unemployment Benefit Duration Index: West Germany.

Source: Nickell (2003).

There have seen various macroeconomic shocks hitting German economy since the 1970s: oil price crises, economic growth slowdown, etc.. Taking these factors into consideration, it is possible that rigidities become more important under these changed conditions. In the face of stable demand, firms do not need to lay off workers. Protection against unlawful dismissal presents thus no obstacle for firms. However, if firms in more variable circumstances are forced to make adjustment quickly in order to revive, such rigidities could have disastrous consequences. Although rigidities in German labor market were perhaps reasonable in the 1960s, the same rigidities could prove to be inappropriate now.

Following this logic, the explanation linking rigid labor market institution with the effects of adverse shocks is rather prospective. In such s framework hysteresis mechanism plays a crucial role which is the subject of the next

section. Several economic shocks mentioned in the literature as potential culprits of high unemployment in Germany will be discussed in section 3.4.

Their role in influencing the unemployment development combined with hysteresis effects will be elaborated after that.