The role of labour rigidity in the euro area's low productivity

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January 8th, 2016

Limited improvement in total factor productivity (TFP)1 is one of the main reasons behind the euro area's low growth.2 A more efficient allocation of input factors (capital and labour) is one of the keys to increasing TFP and something which various economic policies can act on, such as changes in the regulatory framework to help increase competition, reducing the fragmentation of the products and services market and measures to encourage labour market efficiency. This Focus deals with the last of these areas.

Labour legislation and, in particular, the rules governing dismissal is vital to regulate relations between companies and workers. However, excessive labour rigidity makes the hiring and separation of workers less efficient. Firstly, high dismissal costs prevent some companies from hiring workers whose productivity might be greater than their wages, while making it difficult to terminate the contracts of other, less productive workers, which could be counterproductive for gross employment.3 However, an increase in the flexibility of permanent contracts (lower dismissal costs, greater legal security in the process) promotes in- and outflows of the labour market. Reducing the euro area's average degree of protection (2.6) to the level of, for example, the United Kingdom (1.59) would lead to a significant increase in new contracts, both job-to-job and also jobless-to-job. Moreover, in gross terms, job-to-jobless flows would not increase significantly in non-recessionary periods but job-to-job flows would.4 It should also be noted that a strongly two-tier labour market with marked differences between insiders (workers on a permanent contract) and outsiders (workers on a temporary contract orthe unemployed) leads to bigger fluctuations in the unemployment of the second group, while reducing this difference by making permanent contracts more flexible would benefit them.5

Secondly, it is important to point out that the reallocation of factors (both labour and capital) towards more productive sectors is positive for productivity. In the case of employment, greater flexibility leads to the labour factor being allocated more efficiently. Less productive firms destroy more jobs and more productive ones create more jobs, so reallocating labour from the former to the latter increases gross productivity. According to the IMF, the potential of euro area countries to improve their factor reallocation is high and the elimination of distortions preventing such reallocation could increase the rate of growth of TFP, especially if a solution could be found to the poor matching between individuals and jobs,6 which would boost growth considerably. For example, according to the IMF, the rate of growth in Italy and Portugal would increase by 1.8% and by 1.3% annually, respectively, if all such distortions were eliminated. In summary, less protection for permanent workers increases labour mobility and the reallocation of labour at the level of sector, thereby improving productivity.7

Thirdly, rigid legislation governing permanent contracts ends up encouraging labour flexibility based on the repeated use of temporary contracts, as has occurred in most of the countries in the euro area. Replacing permanent jobs with temporary ones is counterproductive because it discourages individuals' investment in human capital and firms' investment in training. This kind of labour flexibility ends up reducing productivity at the level of company and harms those people who, after losing their job, cannot find any better job opportunities (thereby suffering from a reduction in income or worse labour conditions in their next job).8

In conclusion, euro area countries can increase the productivity of their economies via labour legislation that makes permanent contracts more flexible and avoids the abuse of temporary contracts while effectively protecting participants. To achieve this goal, a favourable environment would be that of «flexicurity», combining the labour flexibility required by companies with employee security via stable contracts, unemployment benefits that allow claimants to look for a suitable job and active policies that improve employability.

1. TFP is calculated as the difference between the economy's growth and the contribution to this growth of the labour factor and capital factor.

2. See an analysis of the euro area's low growth in the Focus «Why is the euro area growing less than the US?» in MR12/2015.

3. Lazear (1990), «Job security provisions and employment», The Quarterly Journal of Economics.

4. OECD (2010), «Institutional and Policy Determinants of Labour Market Flows», OECD Employment Outlook 2010, OECD Publishing, Paris.

5. Bentolila et al. (2012), «Two-tier labour markets in the Great Recession: France vs. Spain», Economic Journal, 122.

6. Moreover, individuals will be more inclined to improve their qualifications and acquire more skills if there is a greater chance of them finding a well-matched job.

7. Among others, Autor et al. (2007), «Does employment protection reduce productivity? Evidence from US states», The Economic Journal, 117 (June); Bassanini et al. (2009), «Job protection legislation and productivity growth in OECD countries»; Martin, J. and Scapetta, S. (2011), «Setting it right: employment protection, labour reallocation and productivity», IZA Policy paper no. 27.

8. OECD, op. cit.