Do Labor Market Institutions Explain The Crisis?

A main goal of labor market institutions is to respond well to economic shocks. So in a sense, by definition “poor labor market institutions” are a major cause of poor outcomes in economic crisis. But is there some objective sense in which the business agenda of labor market flexibility is an important explanatory variable in explaining what’s happened over the past five years?

I have some doubts. I went to the Fraser Institute’s Economic Freedom in the World site and pulled the “Labor Market Freedom” index numbers for Eurozone countries and then rounded it out without enough other developed countries to end up with twenty.

I think this chart is an important reality check because it’s a reminder that as of five years ago the overwhelming consensus was that Germany belonged in the “bad” basket of overregulated European labor markets not so different from a France or a Spain. It was true that Gerhard Schroder’s government undertook some noteworthy reforms—Fraser rated Germany a measely 2.85 on labor market freedom back in 2000—but these were not seen as having brought the Germans up to the high freedom standard set by the Dutch or the Danes or, indeed, even the Italians. Cyprus was viewed as sounder than France and far sounder than Portugal. Now over the past five years Germany has done well and a lot of this solid performance has been attributed retroactively to those Schroder-era reforms. And maybe that’s correct. But it certainly has a whiff of post hoc ergo propter hoc about it.

The overall case that barriers to firm growth are bad seems sound to me for productivity reasons. And the basic logic that if you make it hard for firms to lay people off in downturns they’ll be reluctant to hire in recovery phases is pretty compelling. But the overall notion of “flexibility” is hard to measure and the relationship to the current crisis is hard for me to see. The clearest case for labor market flexibility I can see in the eurozone is that if you’re going to be a small country yoked to a dysfunctional currency union and saddled with inappropriate demand-side policies, you’re better off with Irish labor market institutions than Portugese ones.