The euro area isn’t working
Since the crisis started, unemployment has risen by 50% in the euro area as a whole, doubled in Italy, tripled in Greece and Spain, and quadrupled in Portugal. As of May 2013, unemployment rates were at record highs (generally since the mid-1980s) for the euro area (12.2%) and the European Union (11.0%), as well as in Slovenia (10.2%), Italy (12.2%), Cyprus (16.3%), Portugal (17.6%), Greece (26.8%) and Spain (26.9%). By comparison, unemployment in the non-EU OECD stood at 5.7%, having risen by less than 1bp since end-2007. Long-term unemployment and youth unemployment — probably the most economically and socially harmful forms of unemployment — are particularly high in many euro area countries. In 2012, around one-fifth of young persons in Italy, Greece, Spain and Ireland were ‘NEETs’ (not in employment, education or training) and the NEET ratio has risen in all EU countries since 2008.
In addition to the general rise in joblessness, its divergence across euro area countries has been stark. In January 2008, the highest unemployment rate in the euro area (Spain at 9.0%) was less than three times the lowest (Netherlands at 3.2%). In May 2013, unemployment rates ranged from 4.7% in Austria to 26.9% in Spain.
Labour reform has worked in the past, but conditions are not as benign today
Precedents for successful labor market reforms in Europe in recent decades include Ireland, the Netherlands and the UK in the 1980s, Denmark in the 1990s and Germany in the 2000s. These reforms were all implemented from a position of relative weakness of economic performance. All of them involved a moderation in labor costs, achieved by a varying mix of negotiated wage moderation (through collective bargaining), less generous employment benefits, a lower “tax wedge” (the sum of labor income tax and employer and employee social security contributions), and reductions in union power. Virtually all also included an increased emphasis on active labor market policies (ALMPs), and most a reduction in public payroll. Compared with previous reforms, euro area periphery countries today suffer from a lack of social capital, lower skill levels in the workforce and less fiscal flexibility. In addition, all except Ireland are relatively closed economies and the external environment is more challenging.
Meaningful reform efforts in labor markets, benefit systems and pensions have taken place in recent years in the euro area, in particular in the periphery and often mandated by the troika programs for Greece, Ireland and Portugal since 2010 and 2011. Virtually all euro area countries have put in place some ALMPs to support job creation, particularly for the young and low-skilled, and most euro area countries have reviewed their education systems with a view to producing more employable school and university graduates and boosting graduation rates. Finally, all have reformed their pension systems to some extent, generally based on fiscal considerations, but usefully also boosting the prospects of higher labor force participation in the face of adverse demographics.
Labor reform will be tough…
We are cautiously optimistic about the prospect for further labor market reform, even in the absence of troika pressure or financial market pressures, as high unemployment itself will put pressure on governments to act. Even though progress has been achieved in deregulating euro area labor markets, plenty of work remains. Labor cost competitiveness has still only moderately improved (and non-wage labor costs remain very high), and employment protection remains extensive (particularly in terms of the burden of regulation, including legal reviews and challenges leading to costly delays, rather than levels of severance pay and notice periods, per se). Minimum wages are also quite high, and labor market duality remains a major problem.
One of the major problems in many economically weak euro area countries is that the mismatch between the skills available in the labor force and those appropriate to profitable employment is quite wide, and that the average skill level in the labor force is too low. Low employability of parts of the workforce, particularly in euro area periphery countries, and little hope of raising skill levels quickly probably mean that labor costs for these low-skilled workers have to fall substantially if they are to find sustainable employment in the private sector. A low-wage sector and probably extensive and long-lasting ALMPs may be necessary to get low-skilled workers back into jobs, but fiscally weak euro area countries would struggle to pay for these ALMPs.
Even in the countries that have legislated quite substantial reforms to date, much remains to be done. In those countries, implementation of already-decided reforms remains a big concern, as is the involvement (and slow operation) of the courts in many aspects of the labor market. But a number of other euro area countries are at best just beginning to reform, including Belgium, France and the Netherlands. It is in these countries that labor market rigidities are probably highest in the euro area today. Labor market rigidities also remain substantial in the three countries with the lowest unemployment rates (Austria, Germany and Luxembourg).
…but alone won’t restore growth
Labor market reforms will help — or in the medium term even be necessary for — the euro area to recover. But in the near term they won’t be sufficient to create growth and jobs. For growth, a pickup in (effective) demand is needed.
To the extent that reforms can boost private demand, say by awakening entrepreneurial, corporate and household animal spirits, product market reforms may well offer more promise than labor market reforms. Such reforms include opening closed professions, making it easier to open or operate businesses, improving the ability to collateralize land, property and other private possessions, and completing the single market for services in the European Union. Product market reforms are also being pursued in many euro area countries, but progress lags that made on the labor market side. Structural reforms also take time to show up in output and employment. In fact, labor market reforms often raise unemployment in the short term. In the reform examples noted above employment growth in some cases took years to gain sustainable momentum.
In our view, an excess of debt (public and private), a weak banking sector, continued fiscal austerity and substantial policy uncertainty (domestic and at the euro area level) are larger impediments to growth currently than structural rigidities, particularly in the relatively closed euro area economies. Consequently, debt reduction (public and private), a decisive restructuring of the banking sector and a reduction in policy uncertainty would likely boost demand much more in the euro area in the near term than structural reform could.
Without debt reduction, a fiscal and/or monetary boost to aggregate demand and a reduction in policy uncertainty, the risk rises that structural reforms in fact make things worse in the near term. Structural reforms often ‘work’ in the near term by being deflationary or at least disinflationary, which would make it harder to repay outstanding debt. In principle, this could be compensated by action from the central bank to counteract the disinflationary effect of the reforms, but there is a risk that the European Central Bank will act too timidly. In addition, reforms often increase uncertainty in the minds of households and enterprises, and raise precautionary saving and/or reduce investment as a result.
A cautious outlook: High unemployment to persist and several risks to rise
History provides little reason to be optimistic about the prospects for euro area unemployment. For instance, in all recessions in Italy, Portugal and Spain since the 1970s, the earliest unemployment peaked was 5 quarters after real GDP growth turned positive and much later in some cases.
We believe unemployment in the euro area will peak in 2014 versus estimates by the European Commission expecting the peak to probably come at some time this year. But the point is not so much whether unemployment will peak this year, next year or in 2015. Rather, the issue is that unemployment will likely stay high for a long time. Some simple calculations are instructive (and sobering). The evolution of unemployment can be derived from the change in the ‘output gap’ (i.e. the difference between output growth and potential output) and the effect of falling output gaps on (un)employment. The latter is usually referred to as ‘Okun’s law’. Estimates exist for both.
The European Central Bank (ECB) estimates the Okun’s law coefficient for the euro area to be 0.3, meaning that a 1 percentage point reduction in the output gap would lower the unemployment rate by 0.3 percentage points. The International Monetary Fund (IMF) also produces forecasts for the output gap which imply that the euro area output gap would fall by roughly 0.5 percentage points each year in 2015-18. If we put the two together, the implication is that unemployment in the euro area would only fall by less than 1 percentage point until the end of the decade.
There is some reason to believe that this is probably a little too pessimistic and that employment may react more strongly to output than historically — this is where the labor market reforms and more flexibility would presumably make a difference — and emigration could also help. In fact, the IMF’s actual forecasts imply that unemployment would be three times as responsive to changes in the output gap. Although that implies that unemployment should fall faster if and when (above-potential) output growth resumes (the IMF thinks in 2014, we think it might be a year later), it still expects unemployment to be above 10% in the euro area even in 2018.
The risks with continued unemployment are high
One risk is that reform efforts will run out of steam before euro area economies have become competitive, so that even these forecasts prove optimistic. An even more worrying risk is that continued high unemployment will raise the prospects of widespread social unrest. Even if the more extreme reflections of public dissatisfaction are avoided, these factors will likely have a significant impact on political decisions and outcomes, and on growth prospects. ‘Austerity fatigue’ is often closely related to ‘unemployment fatigue’ and before long could become ‘debt service fatigue’. These considerations all play a major role in our assessment that sovereign debt restructuring will be a material risk for a number of euro area economies with high public debt.
