The Law and the Labour Market

Putting Square Pegs into Round Holes:
The Contract of Employment as a Mechanism for Labour Market Re-Regulation

Graham Smith

Thank you very much for inviting me back to this, my second, H R Nicholls Society Conference. I really did enjoy my last encounter which, as you may remember, was on the topic "Should there be a freedom to strike?"

Since that occasion I have come across a piece of unique Australian writing on the question of strikes and I could not resist the temptation to bring it to your attention at this conference. I came across it as I was reading to my children that great Australian classic by May Gibbs called Snugglepot and Cuddlepie (Angus & Robertson, 1946). In the story Snugglepot and Winky have just arrived in a new land having been taken there by a big bad banksia man. And the story goes like this.

So they rested and looked about them. They were in a broad road with large houses on either side. Presently the sun rose and, as they sat warming, there came a large crowd of nuts down the road, holding up flags, and singing. "It's a strike procession," explained Winky. "How? What?" asked Snugglepot. "It's a new way of making money," said Winky. "Everybody strikes in Big Bad, and the one who hits the hardest gets the most". "Bully Ant!" said Snugglepot. "And who gets hit?" "Everybody," said Winky.

No doubt, members of your Society would take the view that Big Bad and Australia are one and the same!

With the rapid changes enveloping institutional industrial relations in Australia, your Society and its objectives---once considered far to the right---are now becoming mainstream. You might think it now appropriate to soften that once hard-line image. Perhaps you could jettison your relationship with that ignominious man H R Nicholls and adopt a softer name for your society. Why not the Snugglepot and Cuddlepie Society!

I will now turn to more serious issues and more particularly to the stated topic for my talk.

The winds of change are certainly sweeping our industrial relations system rapidly away from the H B Higgins legacy of a centralised monolithic system of award regulation. The Coalition's voluntary agreements policy Ä perceived by most prior to the last election as pure ideological fantasy---is now moving close to reality in Australia. Those who said it could not happen now look nervously over their shoulder at New Zealand, hoping that the Employment Contracts Act will fail to take root in that country. The same people have also seen the failure to halt Troubleshooters and other forms of contract hire arrangements as a sign that fantasy is about to become reality.

If we look at the core justification for the introduction of individual contracting as the primary mechanism for conducting industrial relations in Australia, it becomes immediately apparent that there are two key justifications. Firstly, it is a mechanism for directly introducing market forces to bear upon industrial relationships. In other words, it is hoped that the law will facilitate and indeed create the conditions under which the laws of economics will prevail. After all, industrial awards and arbitration commissions are all about modifying these markets forces in order to achieve wage justice in an economic society in which there is perceived to be inequality of bargaining power between individual employees and monolithic employers.

The other principal justification for focusing on the contract of employment or individual contracting is to undermine the power of unions and, in particular, their power through concerted collective action to undermine market forces.

The focus of my talk today is on the first of these justifications and I will consider whether the assumptions underlying that justification are valid. My argument, put at its simplest, is that the legal construct, known as the contract of employment, is an inappropriate legal mechanism for bringing about a genuinely free market in labour. I am even prepared to assume--- though I do not in reality accept this assumption--- that there is equality of bargaining power between employers and employees. To put the argument into perspective, it is appropriate to begin by considering what I call the "Higgins legacy".

The Higgins Legacy:

There is no doubt that the best means of attacking the Higgins legacy in Australia is by use of individual contracting in place of, or alongside, the award system. If you accept the individual contracting model then there is no doubt that John Howard was right during the 1990 Federal Election campaign to say that "without the voluntary agreement, in effect taking centre stage, then you won't bring about the [necessary] change in the whole atmosphere of industrial relations" (Australian, 19 April 1990). In fact the Higgins legacy---the whole system of arbitration that we have developed in this country since 1904---is founded upon a rejection of the contract model. A cursory glance at Higgins' early article "A New Province for Law and Order" published in the Harvard Law Review ((1915-16) 29 pp. l3-39) reveals a great deal about the philosophical and economic foundations of our present, but crumbling, system of compulsory arbitration.

What is immediately apparent is that the whole system is designed to ameliorate market forces in order to buy industrial peace. The core, unproven, assumption is that the economic and social benefits of having industrial peace and industrial justice through arbitration, outweigh the costs of industrial chaos resulting from an unregulated, "market forces", system of industrial relations. There is also an assumption that an arbitration system will have a neutral economic impact, and that it will be accepted by the parties as such. It also assumes that minimum wage justice can be matched with a successful outlawing of strikes and lockouts. The system is clearly premised on collectivism rather than individualism --- it is based on unionism to ensure wage equity and so on. But Higgins also adds that unionism---when coupled with arbitration Ä will engender industrial peace. In his view, individualism and individual bargaining promote conflict in the workplace (see p. 23). The whole notion of freedom of contract is rejected.

In his justification of the 1904 Conciliation and Arbitration Act, Higgins states that in addition to its aim of securing industrial peace it is aimed to benefit employees. To "secure for them something they could not get through individual bargaining" (see p 14). And he shows that the Court of Conciliation and Arbitration's approach to its regulatory tasks was undoubtedly an attempt to modify market forces for the purpose of both industrial justice and industrial peace, with only limited scope for bargaining. For instance he says:

"The basic wage ... rests on Walt Whitman's 'divine average' and the secondary wage is remuneration for any exceptional gifts or qualifications, not of the individual employee, but gifts or qualifications necessary for the performance of the function" (pp 16-17, emphasis added, footnote omitted).

And if a business operates at a competitive disadvantage, wages cannot be lowered to allow it to stay in business: "The Court cannot endanger industrial peace in order to keep unprofitable mines going" (p 17). Moreover, minimum wage differentials on grounds of comparative productivity were not countenanced: "Discrimination on such grounds is neither safe nor sound". If an employer "desires to secure the services of an exceptional workman, he is free to do so. The payment of higher rates is left to the play of bargaining" (p 18).

Higgins' rejection of freedom of contract as a form of industrial regulation is perhaps most clearly articulated by the following passage:

"The imposition of a minimum wage, a wage below which an employer must not go in employing a worker of a given character implies, of course, an admission of the truth of the doctrine of modern economists, of all schools I think, that freedom of contract is a misnomer as applied to the contract between an employer and an ordinary individual employee. The strategic position of the employer in a contest as to wages is much stronger than that of the individual employee. "The power of the employer to withhold bread is a much more effective weapon than the power of the employee to refuse to labour." Low wages are bad in the workers' eyes, but unemployment, with starvation in the background, is worse. The position was put luminously once, as well as with unconscious humour, by an employer on whom a plaint was served for settlement of a dispute by the Court. In place of filing an answer, he wrote a letter to the registrar, denying that he was a party to any dispute. "I have never," said he, "quarrelled or disputed with a labourer of any kind. ... If we cannot agree, well, we will part: that ends the whole. ...Love is the power which will end all struggles, not legislation." Other respondents pin their faith, not to "love", but to the sterner "law of supply and demand". They treat this law as being, in the matter of wages, more inexorable and inevitable than even the law of gravitation, as not being subject, as laws of nature are, to counteraction, to control, to direction." (pp 25-6, footnotes omitted)

Of course the Higgins system failed dismally to stem the tide of strikes, and the ban on strikes in the 1904 legislation was subsequently removed. But what of the Higgins legacy in terms of achieving industrial justice? And at what cost? In this company it would probably be regarded as a gross understatement to say that what has resulted is of course a complex and often rigid centrally regulated system of industrial relations. The award system has, on the other hand, delivered to the bulk of the Australian workforce a floor of rights which form an essential part of the core of the egalitarian social fabric of our society. The notion of 'a fair go all round ' in the application of unfair dismissal clauses in awards, uniform award rights to sick leave, annual leave, parental leave and long service leave are illustrative examples.

Yet the system has increasingly become regarded as being far too rigid---smothering necessary change and productivity growth. But it is less well understood that the major reason for this stultifying over regulation is that industrial justice has been largely lost sight of. Indeed, as Bill Kelty recently observed, Barry Maddern has become something of a Fidel Castro of the Australian wages system. But of course this role that the Commission has assumed does not stem from any sense of Christian social justice. No longer is industrial justice and the prevention of strikes the key aim of the system---the goal now is primarily one of economic stability. In this sense there is merely a new province for controlled order---not a new province for law and order. An illustration of this chameleon-like change in the nature of the system is that Higgins' view that an award should only ever be a minimum has been subverted by the charade known as the wage fixing principles. These have made awards a maximum and---despite recent modifications Ä stultify the freedom of workers and employers to develop more flexible packages relevant to their own workplaces and enterprises. Higgins himself would see the irony in the fact that it is often the highly regulated nature of the system itself which is a cause of industrial action---demarcation disputes, disputes about relativities, the excessive rigidity of the wage fixing principles---they are all common causes of industrial disputes.

So the Higgins legacy---even if it is not now the creature he once envisaged---has itself created the very momentum towards the re-introduction of the market paradigm which Higgins himself so vehemently rejected.

In the circumstances, it is hardly surprising that the rejection of the centralised-collectivist model of industrial relations exemplified by the Higgins legacy, is the starting point for many modern proponents of individual contracting. Penny Brook in her recent book Freedom At Work: The Case For Reforming Labour Law in New Zealand (OUP 1990), typifies this approach. According to Brook, the notion that governmental agencies can regulate industrial relations to effect socially just outcomes is fundamentally flawed. As she says: "The ability of central planners to improve on the outcome of voluntary processes is severely hampered by their sheer incapacity to gather and utilise information about individual varying needs, preferences and circumstances." (p viii).

At the core of Brook's argument is the view that individual autonomy and freedom, accompanied by voluntary market exchanges, will lead to positive sum games for the participants. Even better, there are benefits for all in society. There is a more efficient use of labour resources, greater productivity, and an empowering of individual workers. Wages will more readily reflect their true value, be higher overall, and unemployment will be reduced. Proponents of the individual contract model thus rely to some extent (although not always acknowledged) on the equilibrium price-auction model.

I am no economist but my understanding is that the model goes something like this:

In the standard price-auction model, the labour market is treated as if it were like any other market in which price (wage) is the short-run market-clearing mechanism. Individuals buy and sell skills and raw labour (time) in a bidding framework in which equilibrium prices clear markets leaving no unsatisfied buyers or sellers. (Lester Thurow, Dangerous Currents: The State of Economics, OUP, 1983 p. 181).

According to the model, if it were not for market imperfections, unemployment is due to informational mistakes (individual workers think that they are worth more than the market thinks they are) and anyone can get a job by knocking on the door of some employer and offering to work for less than those already employed. This bidding mechanism is the method for driving market wages back down to their equilibrium level.

But the theory does have its flaws. In Dangerous Currents Thurow states:

[W]hat would happen if you confronted the employer of your choice with a willingness to work for less than his existing employees are getting? According to the model, he should fire some of them (or force them to take a wage cut), take advantage of your lower wage rate, and increase his profits. We all know that in the real world any employer would think that you were a nut if you really expected him to accept your offer... That the real labour market ignores the theory is often blamed on the market imperfections created by minimum wages or unions. But that explains very little. Most large firms have minimum wages that are far higher than the officially mandated legal minimum wage. Every firm has a self imposed minimum wage rate, and offers to work for less than that are no more accepted at non-union firms such as IBM than they are at union firms such as General Motors. What about the costs of hiring and firing? This might explain why slightly lower wage bids are not accepted, but cannot be advanced to explain the absence of the bidding process entirely. Even the university professors who write about competitive labour markets work in institutions where no one gets fired because job applicants have announced that they will work for less. If they were hired, think of the carnage of wage reductions that would occur in fields such as English Literature. Vast numbers of qualified teachers and scholars of English exist and most would jump at the chance to bid in an auction market for a teaching job. So academic tenure can be regarded as a market imperfection (although I notice few, if any, economics professors campaigning for its elimination), but it is not an aberration or a market imperfection. The protection of tenure or its equivalent (seniority hiring and firing offers to work for less rejected) seems to exist almost everywhere in the labour market. (Ap.191-192)

But let's put aside these criticisms and even assume that the equilibrium price auction theory works in the labour market in the long run.

The Contract of Employment as a Mechanism for Voluntary Market Exchange:

The proponents of voluntary market exchange in the labour market admit that to be successful the transaction Ä the mechanism for exchange---must be neutral. Otherwise the symmetry of the exchange and the relationship will be compromised. Furthermore, the autonomy and freedom so necessary for the positive sum game outcome will be vitiated, we will be back to the alienation and loss of incentive characteristic of the centralist-collectivist model.

Proponents of voluntary market exchange in labour markets such as Richard Epstein (see eg: "The Common Law and the Labour Market" in The Law and The Right to Strike, H R Nicholls Society, 1991 pp. 3-13) and Brook place great reliance on the contract of employment as an appropriate vehicle for the practical implementation of their model. This philosophy underpins the New Zealand Employment Contracts Act.

Brook, Epstein and others argue that voluntary exchange is best achieved through private law---exemplified for many by the English common law system. It is "seen as having inherent advantages over statutory law in the governance of many day to day relationships". (Brook p.97) Its "ability to deliver 'efficient', welfare-enhancing decisions is seen as resting on its basic respect for the autonomy of individuals". Moreover its reliance on rules that tell individuals not what to do but how to do things---its emphasis on process not outcomes Ä makes it a more efficient mechanism for voluntary market exchange. Moreover, "pursuit of social justice in this context is seen as at best meaningless" (Brook, p.98).

All of this of course sounds wonderful and if it were true it would be even better. But the difficulty is that economists like Brook, while waxing lyrical about the English common law, seem largely ignorant of its content, operation and history. And this ignorance leads to fundamental error in the advocacy of the use of the contract of employment in New Zealand and Australia as a mechanism for labour market regulation. Before I outline these flaws, I should say that one reason why Brook has misconceived the contract of employment is that she has relied heavily on the analysis of Epstein which itself is premised upon the US common law contract as a species of law. In the context of the contract of employment in our English common law heritage, this reliance is misplaced.

I have divided, for the sake of analysis, the flaws in Brook's approach into three broad categories.

1. First of all, Brook assumes that the contract of employment as it exists in New Zealand (and there is not a great deal of difference between New Zealand and Australia in this respect) is the same in its content and application, as other forms of contract. Brook, as I have said, relies heavily on the work of Epstein in making this assumption and Epstein's recent address to this Society is littered with assertions that the contract of employment is just like any other contract. He says for instance "the common law rules on transfer do not treat labour relations as something distinctive or special. When I studied law initially at Oxford, there was no separate branch of the common lawgoverning labour relationships." (p.4)
I do not know what Epstein read while he was a student at Oxford, but he could not have read any of tbe English cases on the contract of employment (see Diamond,A S. The Law of Master and Servant, (2nd ed) Stevens, 1946; Friedman, G H L The Modern Law of Employment, Sweet & Maxwel, 1963 and Freedland M R The Contract of Employment, OUP, 1976, nor could he have read William Holdsworth's classic work History of English Law where in Vol.4 (in the 1924 edition) p. 386 he said:

"In truth, until political economists of the earlier half of the 19th century converted the legislature to the belief that freedom of contract was the cure for all social ills, no one ever imagined that wages and prices could be settled merely at the will and pleasure of the parties to each particular bargain: or that the contract between employer and workperson could be regarded as precisely similar to any other contract.
The truth is that in our legal system, the common law contract of employment is fundamentally different to other forms of contract. It contains far more terms which are implied automatically by operation of law than any other form of contract. These are court imposed terms. And these terms are balanced heavily in favour of employers. No other form of contract imports a term Ä and in employment law we call these terms not inappropriately "duties"---that one party and one type of party only must obey the orders of the other. To this we could add the duty of good faith, the duty of care and competence and even arguably a duty of co-operation. These of course are all owed only by employees to employers. The principal terms or duties implied by law which bind employers are much more limited and specific duties such as the duty to pay wages in return for work. The common law does not even impose a duty upon an employer to provide work during the duration of a work contract."

This all makes a mockery of Epstein's statement made to this Society in 1990 that "In analysing contractual validity, then, the legal system did not speak about one set of rules for employers and another for employees." (p.4) This fundamental asymmetry should not of course come as any surprise to anybody who knows anything about the history of the common law contract of employment. The contract of employment grew out of the law of master and servant which itself directly formed part of the law of domestic relations along with marriage and parenthood. The law of master and servant was all about obligation and subordination. It was in many ways alien to contract. So when certain forms of master-servant relationship were called contracts they retained a special status in the law founded in the distinctive right of one party to exercise authority over another. Most of the terms were implied by law rather than set by mutual agreement. With the growth of the concept of the free market and with it freedom of contract, in the 19th Century the employment relationship came to be seen as more contractual in essence. Necessarily, many of the master-servant obligations waned, especially those which impeded the freedom of capitalist employers to dispense with labour. The parties could agree upon terms, and the old presumptions of yearly hiring gave way to the idea of a contract of definite duration. The old master and servant doctrines which would allow termination of the relationship of master and servant only on grounds of wilful disobedience, gross moral misconduct or habitual neglect, were dissipated.

But the English common law through the notion of terms implied by operation of law---rather than by "contract"---has retained many of the old obligations which existed in the law of master and servant. The British and Australian judiciary---not to be denied Ä have greatly expanded and enhanced these "non-contractual" terms or duties. The contract has become in effect a status contract and the Courts are extremely reluctant to find that even an express written term, agreed between the parties, will oust one of these court imposed terms. It should also be noted that some of these terms implied by law in fact evolved out of a failure of contracting Ä in other words the courts sought to impose a term simply because the parties messed up their contract. An example is Harmer v. Cornelius (1858) 5 CB NS 236 where an employer engaged two scene painters to paint a set for a play. The employer engaged the painters for a fixed term but due to his own default, failed to properly assess whether they were any good at painting. When it turned out that they weren't he wanted to avoid the contract. So he asked the Court to find, and the Court did find, that there was a general duty on the part of all employees that they are "of a skill reasonably competent to the task" they undertake to do. And if they were not they could be summarily dismissed. In other cases where the parties failed to agree about the hours of work, the courts were quite ready to hold that "the law will imply that the party hired shall work at all reasonable hours when required" (see R v St. John Devizes (1829) 9 B&C 896).

A good recent illustration of the reluctance of the Courts to permit an expressly agreed term to override a court imposed term is Johnstone v. Bloomsbury Health Authority [1991] 2 All E R 66. Johnstone was a junior hospital doctor whose contract of employment expressly required him to work a basic 40 hour week and to be available on call for up to a further 48 hours per week on average. He claimed that he was required to work intolerable hours with such sleep deprivation as to damage his health (one week he had to work more than 100 hours, one weekend 49 hours continuously). He relied upon a term 'implied by law' that every employer has a duty to take reasonable care for the safety of his employees. The health authority not unreasonably argued that he had expressly agreed to work the hours in question and that an expressly agreed term should not be cut down by any implied term. But Dr Johnstone succeeded. The Court rejected the argument that if a doctor thought that he could not perform the hours required he should not have taken the job, or as it was put more colourfully in the case that "If you cannot stand the heat in the kitchen you should get out, or not go in".

2. The second flaw in the arguments of proponents of the use of the contract of employment, is that having deified the contract of employment and the common law judges who created it, they then turn around and criticise it in its modern form. They worry about 20th Century common law judges corrupting their sacred common law. The criticism is of the judiciary imposing equitable notions of unconscionability, due process and so on upon the common law rules. Thus Brook says:

"There is increasing evidence throughout the Western world of "judge made law" moving far beyond the prerogatives of traditional common law courts. In particular, there is increasing judicial involvement in assessing the fairness of outcomes and dictating acceptable outcomes Ä a role not unlike that assumed by collectivist governments, and potentially as damaging. In the context of employment relationships, a significant development is the increasing role of the Courts in unjust dismissal cases. More generally there is an increasing assumption by the Courts of their right to provide a running commentary on contractual relationships, teasing out satisfying solutions and pronouncing on fairness; bearing the banner of social justice, discovering ever-new and alienable rights and, in the process, weakening or confusing the principles that traditionally made the common law an effective means of protecting individual rights and promoting socially beneficial relationships". (p.100)

It is indicative of Brook's ignorance of the common law contract of employment that she gives as an example of this weakening of traditional principles by the Courts, the "periodic flirtations with the notion of defining employment as a matter of status based purely on rights and duties---not unlike a master-servant relationship---rather than as contractual relationship". (p 100). Her example is, of course, an accurate description of the contract of employment as it was in the 19th Century---and indeed as it is now.

What all of this goes to show, is that it is a fundamental mistake to rely upon the common law to find the solution to our late 20th Century ills. To worship the l9th Century common law and then to seek to freeze some misconception of it, is to live in a false reality. What is needed is a statutory code which incorporates the best features of the common law so as to facilitate the most desired model of voluntary market exchange. The need for a code rather than a misty eyed harking back to past mythologies is exemplified by my third and final criticism of proponents of the contract of employment model.

3. The greatest degree of asymmetry in the traditional contract of employment model is in the area of remedies. The common law denies to a wrongfully dismissed employee damages which would be available for wrongful termination of many other forms of contract. In particular, the common law denies compensation for humiliation, loss of dignity, injury to feelings and loss of the prospect of obtaining another job, for employees who have been dismissed unlawfully and oppressively. Their only remedy is damages equivalent to wages in lieu of proper notice. This allows employers to dismiss in circumstances which are harsh or oppressive with impunity. It is interesting to note that the New Zealand Law Commission (see Report No.18) recently recommended that the law in New Zealand be changed to permit the award of such damages. They recommended that such amendments be incorporated into the Employment Contracts Act. The Law Commission believed that a change in the law was necessary to restore the symmetry of the contract of employment if it is to become the major mechanism for labour market regulation.

The second difficulty with remedies is the traditional common law rule that the courts will not order specific performance (or reinstatement) of a contract of employment. While the common law continues to put few, if any, brakes on the power of an employer to unilaterally dismiss employees, but retains a rule of law that it will not redress by reinstatement wrongful or unfair use of the power of dismissal by employers, the law can hardly be said to operate equally. The voluntary market exchange---the entering into of a contract of employment---immediately results in an unequal contract. Brook, Epstein and others valiantly try to argue that from an economic point of view an employer cannot afford to arbitrarily, and in an irrational manner, dismiss employees. They say it will affect its commercial reputation, its reputation with remaining employees and there will also be the negative costs of finding and training a replacement. But in the end we are forced I suggest to accept St. Antoine's criticism of Epstein stating that:

"His analysis admits of no living, breathing human beings, who develop irrational antagonisms or exercise poor judgment, on the one hand, or who suffer the psychological as well as the economic devastation of losing a job, on the other." (quoted in Brook, p. 106)

Contrast this with Epstein's statement that the precarious nature of the termination at will doctrine provides both sides with a secured obligation. He goes on to say that "before quitting or firing, one has to make a hard decision of whether the benefit forgone is worth the labour or the wages, as the case may be, that can now be retained. But once that decision to settle the arrangement is made, the security on the other side is instantly realised, without the formalities and delay of foreclosure proceedings. The worker instantly recovers her labour, and employer his cash" (p. 11). I have yet to hear of a sacked worker exclaiming the recovery of her labour!

Again it is interesting to note that the New Zealand Employment Contracts Act retains a power for grievance committees to direct the reinstatement of employees who have been unjustifiably dismissed, unless the individually negotiated contract excludes this right.


My conclusions can be very briefly stated. Proponents of the use of the contract of employment as a mechanism for labour market regulation need to look again at their fundamental assumptions and their basis of knowledge. The contract of employment as it exists in Australia is clearly inappropriate to achieve voluntary market exchanges in the manner desired. Freedom of contract when applied to the contract of employment is a misnomer. It is freedom to enter into a status and into a state of subordination. What is being advocated is rather like trying to put square pegs into round holes--- or playing with a loaded dice on an uneven playing field.

Why HR Nicholls?