Capitalism and Society Volume 2 Issue 1 2007 Article 1 Are Protective Labor Market Institutions at the Root of Unemployment A Critical Review of the Evidence David R Howell Dean Baker Andrew Glyn John Schmitt The New School Center for Economic and Policy Research Oxford University Center for Economic and Policy Research Copyright c 2007 The Berkeley Electronic Press All rights reserved Are Protective Labor Market Institutions at the Root of Unemployment A Critical Review of the Evidence David R Howell Dean Baker Andrew Glyn and John Schmitt Abstract A rapidly expanding empirical literature has addressed the widely accepted claim that employmentunfriendly labor market institutions explain the pattern of unemployment across countries The main culprits are held to be protective institutions namely unemployment benefit entitlements employment protection laws and trade unions Our assessment of the evidence offers little support for this orthodox view The most compelling finding of the cross country regression literature is the generally significant and robust effect of the standard measure of unemployment benefit generosity but there are reasons to doubt both the economic importance of this relationship and the direction of causation The micro evidence on the effects of major changes in benefit generosity on the exit rate out of unemployment has been frequently cited as supportive evidence but these individual level effects vary widely across studies and in any case have no direct implication for changes in the aggregate unemployment rate due to composition and entitlement effects Finally we find little evidence to suggest that 1990s reforms of core protective labor market institutions can explain much of either the success of the success stories or the continued high unemployment of the large continental European countries We conclude that the evidence is consistent with a more complex reality in which a variety of labor market models can be consistent with good employment performance Special thanks to Paul Swaim for data and extensive comments and advice We also thank Bruno Amable Tony Atkinson Andrea Bassanini Romain Duval Donatella Gatti and Bob Pollin for valuable comments Howell thanks the Schwartz Center for Economic Policy Analysis New School the Gould Foundation and CEPREMAP for support Corresponding author is Howell howell newschool edu Howell et al Protective Labor Market Institutions As recently as 1979 among the 20 most developed OECD member countries only Ireland and Portugal reported unemployment rates above 8 percent each at about 8 5 percent Just four years later 11 of these 20 countries posted higher rates and six reached double digit levels ranging from Belgium 10 7 percent to Ireland 14 9 percent This collapse in employment performance persisted throughout the 1980s and 1990s Between 1995 and 1997 as the U S was showing rates between 5 6 to 4 9 percent OECD Europe ranged from 10 1 to 9 7 percent By 2005 the OECD Europe rate had dropped to 8 6 percent but the two largest economies of continental Europe France and Germany had rates of 9 5 percent 1 Much like the response of economists to the Great Depression the dominant explanation for persistent high unemployment has focused on supply side rigidities generated by protective labor market institutions and similarly the proposed solution has been greater downward wage flexibility and stronger work incentives As Fitoussi 2006 has recently put it The reference model in the plea for structural reforms is centered on an economy with perfect competition and rational expectations In such a model full employment is always assured absent rigidities Spurred in particular by the influence of the Layard Nickell and Jackman 1991 and the OECD s Jobs Study 1994 by the late 1990s this orthodox rigidity account thoroughly ruled the field The title of a prominent paper in the Journal of Economic Perspectives aptly summed up the conventional wisdom Labor Market Rigidities At the Root of Unemployment in Europe Siebert 1997 The policy implications of the rigidities view are straightforward and profound As the IMF 2003 p 129 put it leading international institutions the IMF OECD and the European Commission have long argued that the causes of unemployment can be found in labor market institutions Accordingly countries with high unemployment have been repeatedly urged to undertake comprehensive structural reforms to reduce labor market rigidities Their own empirical tests led IMF researchers to conclude that European adoption of welldesigned reforms the U S model could produce output gains of about 5 percent and a fall in the unemployment rate of about 3 percentage points IMF p 129 At the same time the orthodox labor market rigidity view has become so widely accepted that a leading scholar could recently claim in a recent issue of the Journal of Economic Perspectives that evidence supports the traditional view that rigidities that reduce competition in labor markets are typically responsible for high unemployment without citing any peer reviewed research St Paul 2004 p 53 The dominance of the orthodox labor market rigidities explanation of unemployment and the recent focus on macroeconometric testing reflects a striking evolution in mainstream economics As recently as 1994 Charles Bean s influential survey of European unemployment allocated little space to evidence on Published by The Berkeley Electronic Press 2007 1 Capitalism and Society Vol 2 2007 Iss 1 Art 1 the effects of labor market institutions on employment performance finding little compelling empirical support in the literature for any of them 2 Bean concluded with three recommendations for future research the first of which was to discourage further macroeconometric testing There is simply not enough information in the data to give clear signals on the relative merits of the competing hypotheses p 615 Far from heeding this advice the cross country macroeconometric literature has grown dramatically for recent surveys see OECD 2006 Blanchard 2006 Certainly an important part of the explanation for this explosion in crosscountry studies of unemployment was the growing gap in employment performance between the U S and large European countries after the early 1990s which lent at least anecdotal support to the orthodox rigidities explanation It is worth noting that the dominance of the labor market rigidities account for developed country employment performance closely paralleled
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