Institutions

EMPLOYMENT PROTECTION LAWS EXPLAIN MUCH OF THE DIFFERENCE IN NATIONAL UNEMPLOYMENT RATES

Differences in the law that make it more difficult for firms to fire their workers – known as employment protection legislation – account for as much as 40% of the differences in unemployment rates among OECD countries. That is one of the many findings of research by Peter Gal, Alexander Hijzen and Zoltan Wolf, presented at the Royal Economic Society’s 2013 annual conference.

The study looks at data on companies and their employees for 20 OECD countries from the mid-1990s up to 2009. Using information on several hundred thousand companies, it explores the factors that might explain why unemployment has risen so dramatically since the global economic crisis in countries like Spain while staying relatively unchanged in countries like Germany. It finds that:

  • Most of the variation in unemployment – 46% – can be explained by the different changes in economic output. Some countries have seen GDP fall by more than others, leading to a larger fall in jobs.
  • Around 15% of the variation is explained by the fact that some countries specialised in the hardest-hit sectors. The sector most likely to cut jobs was construction, followed by services and then manufacturing. This helps to explain why the US, which had a construction boom before the crisis, experienced a far greater rise in unemployment than Japan, which specialises in manufacturing.
  • Labour market institutions and policies can account for as much as 40% of the cross-country differences. In countries such as the US and the UK, which have relatively weak employment protection legislation, shocks to the economy quickly lead to a fall in jobs as firms fire their workers, whereas stricter regulations lead to slower changes, as in Sweden and the Netherlands.
  • In countries where strict employment protection makes it more costly for businesses to fire workers, companies are more likely to cut costs by reducing the number of hours that their employees work or their wages.

More…

All OECD countries have been severely hit by the global financial crisis starting in 2008. But the labour market effects have been dramatically different. In some countries, much of the adjustment has been in terms of downsizing (for example, Spain and the US). In others, where firms have adjusted by reducing hours (for example, Germany and Japan), employment declined less. To highlight two extreme examples, the unemployment rate in Spain increased from 11% to 18%, whereas in Germany it stayed at 7.5% in 2009, the harshest year of the crisis.

The large variation in the impact of the crisis raises important questions about the role of labour market institutions and policies. Understanding their impact is the main objective of this study. To identify their effects, first, it is necessary to assess the potential role of differences in output shocks, in the types of businesses in terms of their responsiveness or elasticity to shocks, and the possibly different composition of such firm types across countries.

To take account of this heterogeneity, the researchers use a longitudinal, company-level database, ORBIS, for a set of 20 OECD countries and with more than seven million firm-year observations. This research looks at the period starting in the mid-90s and up to 2009, which also captures the bulk of the employment response during the financial crisis.

The results show that a major part, 46%, of the cross-country variation in employment dynamics were due to differences in the size of aggregate output shocks. Further, the differences in the way those shocks were distributed across different types of firms explain an additional 15%.

For example, in Germany and Japan, the bulk of the decline in aggregate demand during the crisis was concentrated in manufacturing, both countries with a comparatively large manufacturing base, whereas the construction sector was hit particularly hard in countries such as the Spain and the US, countries where construction tended to grow rapidly before the crisis as a result of the housing bubble.

Turning to the role of differences in responsiveness across segments of the economy, the microeconomic estimates show significant differences across businesses. Employment in the construction sector reacts most strongly, followed by services and finally manufacturing. The strong reaction of construction thus further exacerbated the employment decline in countries where the housing collapse was an important trigger of the crisis. Also, firm size has an independent, albeit much weaker effect: larger firms tend to be more responsive than small ones.

Having quantified and disentangled the role of all these factors, the researchers find that labour market institutions and policies can still account for a maximum of 40% of the cross-country labour market response during the crisis. Their results also confirm earlier findings: in countries such as the US and the UK, with relatively weak employment protection legislation (EPL), output shocks are more strongly translated into employment changes, whereas stricter regulations make employment adjustment more sluggish, as in Sweden and the Netherlands.

In the second part of the study, to identify the effects of EPL, without the potentially confounding factors such as related policies, the researchers exploit within-country variation in its application and the richness of the firm-level data: some countries exempt small firms from the legislation. As such, the differences in firm behaviour below and above the exemption thresholds, and the information from countries where such exemptions do not exist (‘control-group’) can provide additional useful variation.

By this ‘difference in differences’ methodology, the study provides additional evidence that EPL reduces the employment response to output shocks. It also finds that in countries where strict employment protection makes it more costly for businesses to lay off workers, companies rely more on the ‘intensive margin’ – that is, they allow for a reduction in working hours and compensation (wages and bonuses).

ENDS


Contact:

Peter Gal (gal.peter@gmail.com)

Alexander Hijzen (alexander.hijzen@oecd.org)

Zoltan Wolf (zo.wolf@gmail.com)

RES media consultant Romesh Vaitilingam:
+44 (0) 7768 661095
romesh@vaitilingam.com
@econromesh

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