The debate on the strategies that would help the Eurozone governments to face off the current public debt crisis and steer their public finances back onto a sustainable path has been raging on. One of the main criticisms that the current EU initiatives have been receiving is that they do not adequately address the issue of growth. After all, cutting public budget deficits is more likely to be sustainable when it relies on high output growth rates rather than on ever-increasing public spending cuts and tax rate rises.
This is a valid criticism but many critics suggest that, to stimulate growth, the EU should push harder for ‘structural reforms’. The term has come to mean reforms in a broad range of areas on the supply-side of the economy with labour market reforms featuring prominently among them. Thus, enforcing fiscal discipline should be concurrently matched with stronger enforcement of, among others, labour market reforms, the argument goes, because labour market reforms will stimulate growth and help the consolidation of public finances.
The menu of the ‘pro-growth’ labour market reforms includes reforming wage bargaining systems so that labour costs grow in line with stable inflation, productivity trends and external competitiveness; more flexible employment protection legislation, especially with regards to firing restrictions on regular contracts; changing tax-benefit systems so that they encourage (presumably inherently lazy and unemployment loving) people to work; and enhancing the skills of the workforce to match better the needs of production.
The underlying assumption of those advocating ‘pro-growth’ labour market reforms is that they would help counteract the adverse demand effects of fiscal contraction in one or more of three ways. First, they would allow wages and other labour costs to adjust downwards so as to make up for the current slump in demand and restart European economies. Secondly, they would increase the active participation of more working-age people in the labour market. Thirdly, they would improve the match between unemployed workers and the existing vacancies so as to make up the most of the current labour demand.
Are these expectations well-founded? No.
To start with, the relationship between collective wage bargaining arrangements and labour cost outcomes that favour higher employment is more complex than often assumed and depends on the interaction of among bargaining, fiscal and monetary policies. Merely decentralizing or deregulating collective wage bargaining will not necessarily lead to more flexible or lower labour costs. In fact, given that the framework for monetary and fiscal policy making in the EMU was designed to follow the philosophy governing these policies in Germany, there should even be a case for explicit wage bargaining coordination at the Eurozone level. To this, one would of course have to add the arguments that reducing labour costs, especially wages at this time of weak demand across Europe would not go far in stimulating domestic or export demand anywhere.
In neoclassical growth model terms, the underlying rationale of reforms aiming at increasing active participation in the labour market is that in the long run, when an economy operates at its full potential, they will increase the labour input used for output production and thereby, boost growth rates. This may be true for some of these measures. For example, labour market reforms that would facilitate the balanced combination of employment and family care responsibilities especially for women or the employment of older people would be certainly welcome, as they would respond to and reflect societal and demographic changes such as the increasing female labour force participation, falling fertility rates and longer lives.
Still, the problem with the currently proposed strategies for public finances consolidation that the ‘pro-growth’ labour market reforms are supposed to remedy, is not that they would not have benign effects in the long run. Instead, the source of concern is the deflationary trajectory in which fiscal contraction is likely to set European economies into in the short- to medium-run. ‘Pro- (long-term) growth’ labour market reforms cannot counteract the short- to medium-term deflationary effects of fiscal contraction.
Lastly, structural reforms aiming at increasing the matching between unemployed workers and vacancies are irrelevant when it comes to stimulating the economy. Once again, the problem is the fact that there are not enough vacancies at the moment, due to weak demand, which fiscal contraction is most likely to make even weaker.
Labour market reforms need favourable demand conditions in order to pay off in terms of employment creation and subsequent demand growth in the short- to medium-term. This is not only true for those measures aiming at increasing active labour market participation and improving the matching of workers with vacancies but even for those aiming at making labour costs more flexible.
To the extent that these reforms cannot jumpstart demand in the economy, they will not facilitate the consolidation of public finances. This will inevitably mean higher tax and social security contributions rates. These in turn create an inflexible component for labour costs. No less importantly, such reforms, especially in tax-benefits systems and employment protection are likely to exacerbate the inequality and poverty effects of the current recession and of fiscal retrenchment.
Enforcing labour market reforms cannot and will not substitute for the absence of meaningful macroeconomic policy coordination that the Eurozone needs right now both to stimulate demand and growth in the short- to medium-run and reduce public debt in a sustainable manner in the longer-run. Whether the current plans on economic governance in the EU are likely to lead to meaningful macroeconomic policy coordination, however, deserves a separate discussion.