Asset management

28 May 2012

Economist Insights Inside out

Recession has pushed up unemployment rates across Europe, but rigid labour markets have sent unemployment rates for the young skyrocketing. Rules that favour insiders who have jobs to the detriment of outsiders create severe social tensions. This is not sustainable, either economically or politically. Unfortunately, reform is easiest when the economy is doing well, but paradoxically this is exactly when nobody is interested in reform. The silver lining for the Eurozone periphery is that the more rigid your labour market is, themore likely reform will bring quick benefits. Joshua McCallum Senior Fixed Income Economist UBS Global Asset Management joshua.mccallum@ubs.com

Gianluca Moretti Fixed Income Economist UBS Global Asset Management gianluca.moretti@ubs.com

If youre not making somebody angry, your policy is probably not effective. This simple rule of thumb should ring true to any experienced policy maker. Someone always benefits from the status quo, usually a special interest group at the expense of the majority. Structural reforms aim to remove this privilege so, unsurprisingly, that minority is likely to complain very loudly. Nowhere is this clearer than in the labour market. Labour market rigidities favour those who have jobs (the insiders) at the expense of those who do not (the outsiders). Rules that make it hard or expensive to fire workers are especially hard on young people. In an economic downturn, firms cannot easily fire the least productive, expensive workers; when the economy picks up again they are reluctantto hire cheaper, younger workers because they would then be stuck with more workers that they cannot fire if business prospects worsen. Young people joining the workforce find it almost impossible to get a job in rigid labour markets. They are also the most likely to be excluded from the labour market if the minimum wage is set too high. The difference between unemployment rates among those aged under 25 and those aged over 25 is a measure of the rigidity of the labour market (see chart). The unemployment rate among the young is always higher, but in more flexible markets such as the US or markets with apprenticeship systems such as Germany the difference during the good times was less than ten percentage points. In rigid economies the difference was half again as big during the good times.

Following the crisis, the real scale of the rigidities becomes evident. In Greece and Spain the differential is now about thirty percentage points higher, with unemployment for the young approaching a socially explosive fifty percent. In contrast, the differential in the US has widened only marginally, and in Germany the differential has actually fallen as unemployment for both young and old fell. It is easy to see why the Germans are so evangelical about the need for reform. The interplay between structural reform, austerity and political support make the challenges even more complex. Eurozone periphery countries will need structural reform in order to grow, but the growth benefits tend to come later and unfortunately can even be bad for near-term growth. The best time to make structural reforms is really during the boom years when it is easier for those who lose out to find new jobs. Reform is also easier when there is public funding available for retraining. Unfortunately, austerity is bad for growth and also means no funds available for retraining.

Reform paradox The relationship of both reform and austerity with political support is paradoxical. In boom years, when both reform and austerity should be easiest, nobody sees the need for change. After all, during the boom years everything is good. When the economy turns bad there is a realisation that change is needed, but this is just when the costs of change are highest. As the costs of reform and austerity build up in terms of higher unemployment and lower incomes, the population can quickly lose its appetite for change. In Europe, Germany is the exception that proves the rule. The reforms initiated by Chancellor Schroeder during the early 2000s significantly improved the flexibility of the German labour market even though there was no overwhelming pressure to do so. In contrast, successive Greek governments used the boom times as an excuse for even more budget profligacy and even more favouritism for special interest groups. Spain never really addressed its excessive labour market rigidities because the impact was disguised by a massive construction boom.
Chart 1: Further outside

The periphery countries will need major structural reforms to improve growth. The silver lining is that the more rigid the system is, the more likely it is that reforms will bring about an improvement in employment in the near term. Even in a weak economy, a very rigid labour market will generate pent up demand for employing younger workers. Labour market reform in these economies will have less of a trade-off against austerity and political support. In more rigid labour markets, such as Spain or even France, job security is thought of as I will still have this job in a year. In more flexible labour markets such as the US or UK, job security is thought of as I will have a job in a year. Right now in the periphery the younger generation, the outsiders in the labour market, would be happy for any job, as soon as possible. The insiders will need to recognise that change is needed urgently or it could end up being forced on them through social unrest.

Unemployment rates for population aged 24 and under and for population aged 25 and over. Shaded bar denotes difference in unemployment rate between younger and older populations.

60 50 40 30 20 13.7 10 0 9.7

Unemployment rate, under 25 years Unemployment rate, 25+ years

52.7

51.1

35.9 30.3 21.7 16.4 7.9 5.3 2006 Now Germany 10.5 6.8 3.6 2006 Now US 14.0 14.0 7.5 9.4 8.6 12.9 3.7 2006 Now Ireland 21.7 22.4 21.8 21.5

36.1 25.2 20.1 19.6 13.5 17.9 21.8

5.8 3.8 2006 Now Netherlands

7.7 8.8 2006 Now France

5.5

7.5

7.2 2006 Now Portugal

7.5 2006 Now Spain

7.3 2006 Now Greece

2006 Now UK

2006 Now Italy

Source: Eurostat, Bureau of Labor Statistics.

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