The Changing Paradigm: Freedom, Jobs, Prosperity
Employment Protection Laws and Worker Welfare
In recent years, economists throughout
the world have devoted much effort in an attempt to better understand
the functioning of labour markets, especially the reasons for
persistently high unemployment in many countries including, of
course, Australia. Part of this research has focused on the consequences
of employment protection laws (EPL) or, alternatively, job security
provisions, for the welfare of people of working age. This research
has created a debate about EPL which, in broad terms, has two
- the effects of EPL on labour market "flexibility" and, ultimately, on employment
and unemployment; and
- the relationships between labour market flexibility and productivity,
economic growth and living standards.
This paper outlines arguments, based on this research, which
challenge the view that employment protection laws serve the interests
of workers. In particular, there are reasons for believing that
EPL contribute substantially to the persistently high rates of
unemployment that have plagued most OECD countries over the last
two decades-or-so, and especially to the problem of long-term
unemployment. EPL also tend to reduce rates of productivity improvement,
thereby reducing rates of increase of real incomes of workers,
and eroding living standards generally. The paper also outlines
the reasons for believing that EPL processes systematically produce
labour market outcomes that are not consistent with generally
accepted tenets of fairness.
Employment Protection Laws
Roughly speaking, Employment Protection Laws (EPL) are:
- the laws, regulations and administrative decisions that constrain
the contractual conditions under which a worker can be dismissed;
- the laws and regulations relating to the compensation an
employer is obliged to pay when a worker is dismissed; and
- the laws and regulations determining remedies for wrongful
or unfair dismissal.
Laws and regulations determining eligibility for unemployment
benefits and unemployment insurance payments might also be considered
part of EPL, because of their interaction with other components
of EPL. However, there is only passing reference to these in the
Employment protection laws and the processes for administering
them vary widely across countries. At one extreme is the US, where
many workers are employed on the basis of "at-will contracts"
which permit employers to discharge employees for "good reason,
bad reason or no reason at all". Even in the US, however,
many states have one or more of three main restrictions on at-will
- laws which prohibit employers from dismissing employees who
refuse to act contrary to public policy;
- court-defined "implied terms" and requirements
for "fair dealing" in employment contracts; and
- scope for tort action for wrongful discharge.
These restrictions are becoming more pervasive and severe over
time---especially the last two, which provide wide scope for court
"construction". Towards the other extreme are the countries
of continental Western Europe (for example, France, Germany, Italy
and Spain) where grounds for dismissal are difficult to establish,
procedures are costly, and compensation and penalties are generally
severe. Australia, Canada, New Zealand and the UK sit between
these groups, with (perhaps surprisingly), the UK probably considerably
less restrictive than Australia. Note, however, that because there
are so many dimensions to job security measures and because the
rigorousness of enforcement is difficult to assess, ranking countries
according to degree of severity of EPL is difficult and such rankings
are likely to exhibit some inconsistencies. Recognition that EPL
may contribute to persistent unemployment has led some European
countries over the last 15 years-or-so to relax some measures,
but the UK and New Zealand (prior to the current government) aside,
the reforms fall well short of "radical". For example,
some countries have relaxed restrictions on forming fixed term
and temporary employment contracts.
Two other points should be noted:.
- in most countries, if not all, employees can and do quit
an employment relationship "for good reason, bad reason,
or no reason at all"; and
- in most countries, if not all, there are contractual arrangements
that allow parties in labour supply relationships to escape EPL
restrictions (for example, initial review periods; fixed-term
contracts; independent contracting; the black market; and so
on). In many cases, however, resorting to these escape routes
imposes costs of various kinds on contracting parties.
Job Security and the demand for EPL
The growth of market economies is driven both by innovation
in products, and innovation in techniques and organisation of
production, combined with competitive selection of those enterprises
which deliver the best value for dollar---in Joseph Schumpeter's
immortal phrase "creative destruction". The expansion,
contraction and reorganization of enterprises that this inevitably
entails implies continual reallocation of people to jobs. In addition,
young people are continually entering the workforce, while others
are leaving, either temporarily or permanently (retirement). Characteristically,
those in the early stages of their working lives tend to change
jobs frequently to acquire information that will help to match
their abilities and aptitudes with the characteristics of jobs
they move to later in their working lives. Similarly, many hirings
and firings are manifestations of attempts by both parties to
employment relationships to increase the values of those relationships
by improving matches between job requirements and the abilities
and aptitudes of job holders.
People are aware of these processes in a general way, but until
the publication, in 1996, of a pioneering study by US economists
Steven Davis, John Haltiwanger and Scott Schuh , Job Creation
and Job Destruction, most had little appreciation of what
"creative destruction" entails in practice. A few pieces
of data from a recent US Bureau of Labor Market study (Pivetz
et al. 2001)---one of the vary large number of recent publications
inspired by the work of Davis et al.---help to provide
a perspective on creative destruction in practice.
- More than one in seven jobs in the US were either created
or destroyed over the year between September 1999 and December
The following US data (rounded to the nearest whole number)
refer to just one quarter in the US---the fourth quarter
- Employment in the retail industry grew by 4 per cent during
the quarter. However, this was the net result of creation of
11 per cent of the jobs existing at the end of the quarter and
destruction of 7 per cent of the jobs existing at the beginning
of the quarter. In the same quarter, 36 per cent of retail trade
establishments expanded or opened during the quarter (that is,
took on extra workers) while 30 per cent contracted or closed.
- During the quarter, a net change of minus 3 per cent in employment
in the construction industry was the result of an 11 per cent
job-creation rate and a 14 per cent job-destruction rate.
- During the quarter, 31 per cent of establishments in the
construction industry expanded or opened, while 35 per cent contracted
- Manufacturing had the lowest rates of job creation and destruction---4
per cent and 5 per cent respectively. And of all 10 industry
groups, manufacturing had the lowest quarterly opening and closing
rates (both 3.3 per cent).
We can gauge the relative importance in job creation and destruction
of establishment openings and closings versus establishment
expansions and contractions by looking at the following data
for 1999 Q4.
- The proportion of jobs created by establishment openings
ranged from 13 per cent in manufacturing to 24 per cent in agriculture.
- The proportion of jobs destroyed by establishment
closings ranged from 15 per cent in manufacturing to 25
per cent in the retail trade.
In short, job creation and destruction are dominated by enterprise
contractions and expansions, but establishment openings and closings
are also substantial contributors.
High rates of job creation and destruction are not peculiar
to the US.
- Research shows that rates of job creation and destruction
in Australia are similar to those in the US.
- Job creation and destruction rates in the "sclerotic"
major European economies are about the same as those in the US,
but this should not be interpreted as showing that European sclerosis
is a myth---far from it.
- Over the course of a business cycle, job destruction rates
exhibit greater variation than job creation rates.
In considering the labour market
processes underlying creative destruction, it is helpful to consider
the reasons why people change jobs. Australian data show the following.
- Of the 9.25 million people in Australia who were employed
at some time in the year to February 1998, 21 per cent (1.98
million people) gave up a job within that year. (Roughly 700,000
of these were people who changed the location of their job but
not their employer; people retrenched from, or who left, temporary
jobs; and people who lost their jobs because of ill health or
- Of the remaining 1.3 million who gave up a job (for reasons
other than those listed above) in the year, almost a million
(69 per cent) quit their jobs voluntarily compared with 400,000
(31 per cent) who were retrenched. Thus, quits outnumbered
redundancies/dismissals by more than two to one.
- Of the 0.92 million who left their jobs voluntarily, 20 per
cent (about 185,000) left because they regarded their work conditions
Similar data from other countries show that volumes of employment
flows in all OECD economies are high. As emphasised by Arnold
Harberger in his 1998 Presidential address to the American Economic
Association, the processes of creative destruction which underlie
economic growth are such that, even in booming industries, there
are both insolvencies and contractions and, conversely, in declining
industries, some firms expand and new firms enter. (Harberger,
Implications of labour flows for EPL
High rates of job mobility are the inevitable consequence of
three central features which are the essence of economic growth
and improvements in living standards within modern economies.
- First; continuous changes in patterns of demand for goods
and services resulting from rising household incomes; development
of innovative goods and services, and goods and services with
superior price/quality characteristics; the phasing out of goods
and services that can no longer be produced profitably; and changes
in demographic structures and migration.
- Second; continuous innovation in production techniques and
in the organization of production processes; and
- Third; the continuous process of searching for information
needed to better match people and jobs thereby forming more productive
and higher-valued employee--employer relationships.
One obvious limitation of legislating
to prevent job losses in economies characterised by creative destruction
is that it is somewhat akin to legislating to prevent tides from
rising---job destruction is the essence of a growing economy.
Excluding those who leave seasonal and temporary jobs, in any
given year probably something like 5 per cent of the workforce
lose "their" jobs because establishments close or contract
in response to changes in the economic environment (that is, for
what are referred to as "economic reasons").
The numbers of employees terminated by their employers for
"economic reasons" probably exceed those terminated
for other reasons, such as unsatisfactory performance, by a substantial
margin. Although many countries make explicit provisions that
permit employment contracts to be terminated for economic reasons,
the often futile attempts to distinguish between economic and
other reasons for termination tend to be costly and unsatisfactory.
Nevertheless, since losing a job often (but not always) entails
an unexpected loss of wealth, there is a natural demand for insurance
against it---just as there is demand for insurance against fires
and vehicle collision. Accordingly, satisfying the demand for
unemployment insurance is desirable, provided it can be done without
creating negative side-effects that outweigh the benefits. Commercial
insurers cannot profitably provide unemployment insurance, because
the problems of moral hazard and adverse selection (roughly, insurance
fraud) are insurmountable. Much employment protection regulation
seems to derive from attempts to satisfy workers' demands for
unemployment insurance. The problem is that, like so much other
ad hoc regulation cobbled together to meet the exigencies
of particular circumstances, EPL measures in many countries appear
not only to have failed to deliver effective unemployment insurance,
but also to have produced negative side-effects which outweigh
any benefits they might confer.
Finally, it should be obvious that a very effective way of
ameliorating the problem of losses of wealth associated with job
loss is to reduce the size of the losses by adopting policies
that minimise unemployment (i.e. reduce the average time taken
for a dismissed worker to find a new job).
Negative consequences of EPL
Research shows three broad kinds of negative effects of EPL
on the welfare of workers and living standards generally.
1. EPL, employment and unemployment
For many years, people have argued that heavy-handed EPL and
other regulations have contributed to the persistently high unemployment
rates experienced in many continental European countries over
the last two decades or so. Probably the main reason why this
argument was not widely accepted was that the regulations which
were supposed to cause the problem were in place many years before
unemployment levels rose. A related reason is that some countries
with strong EPL have not experienced persistently high rates of
unemployment (for instance, Austria, Norway). And, there are other
respectable theoretical arguments why EPL should not cause higher
Over the last 5 years, however,
a growing body of theory and evidence has been developed, based
on international studies, which greatly strengthens the argument
that EPL has been a substantial cause of the persistently high
rates of unemployment in continental Europe. Most of this has
been produced by a new generation of continental European economists,
although US and UK economists have also contributed. Briefly,
the broad argument is that industrialized countries have been
subject to a series of macroeconomic shocks since the early 1970s,
including a marked slowing of the rate of technological progress,
as measured by Total Factor Productivity (TFP); two large increases
in oil prices; high real interest rates since the early 1980s;
and an apparent reduction in the demand for labour relative to
supply, especially unskilled labour.
The research points to the interaction between these shocks
and economic "institutions" (labour market regulations,
including EPL and wage-setting procedures; welfare payments, product
market regulations) as the cause of persistently high unemployment
in much of Western Europe. With economic conditions much less
turbulent, the relatively minor adjustments needed to maintain
full employment in the 1950s and 1960s could be accommodated within
these restrictive institutions.
To sketch the flavour of the arguments, wage increments more
appropriate for the 1950s and 1960s continued to be granted in
the regulated labour markets of Europe in the 1970s and 1980s
because the wage-setters, failed (not unreasonably) to take proper
account of the marked slowdown in rates of increase in Total Factor
:Productivity TFP. Consequently, real wages in the later period
rose faster than was consistent with maintaining full employment.
This contrasts with the US, where wage changes depend on the capacity
of firms to pay and must inevitably reflect the underlying changes
in TFP. However, since the slowdown in TFP did not become obvious
in official data for a decade or more, the Europeans continued
blithely granting wage increases, assuming the earlier TFP increases
were being maintained. Importantly, EPL contributed to the problem
of excessive real wages in Europe by strengthening pressures on
regulators to grant wage increases for the majority of employees---whose
jobs were protected by regulations---(that is, regulations that
raised firing costs).
Apart from raising real wages above market clearing levels
(and thereby causing higher unemployment) institutional factors
have contributed to the related problem of creating a division
in the workforce between "insiders" (those with secure,
well-paid jobs, well represented in wage-setting processes) and
outsiders (the unemployed and those filling the insecure and relatively
low-paid jobs). Half-baked "regulatory reforms" exacerbated
this division by giving employers more scope and incentives to
hire people for temporary and fixed-term jobs that were less costly
to create. Also, there are convincing arguments and evidence that
EPL increase the proportions of unemployed people experiencing
long-duration unemployment (spells of unemployment exceeding,
say, a year).
In contrast to continental Europe, the more flexible US labour
market has permitted the real wage adjustments needed to accommodate
the macroeconomic shocks of the 1970s and 1980s with relatively
small and temporary effects on unemployment rates, albeit with
a fall in real wages for unskilled workers over an extended period,
and a widening dispersion of income. (In recent years, for predictable
reasons, real wages at the lower end of the US labour market have
again shown substantial, steady increases over time.)
In summary, the argument, supported by a substantial and growing
body of evidence (albeit not yet conclusive evidence) is that
EPL, interacting with other labour market institutions and macroeconomic
shocks, has been a factor contributing to:
- persistently high unemployment in Europe;
- the large numbers of people experiencing long-duration unemployment
in Europe, to which should probably be added the large numbers
who chose premature retirement;
- the increasingly wide gap between pay and conditions for
labour-market insiders and labour-market outsiders.
The issue of whether these negative effects on employment will
be ameliorated in the longer term by market processes or whether
they are more permanent is a controversial one.
2. EPL, productivity and living standards
To the extent that EPL reduce employment (as argued in the
preceding sub-section), it reduces aggregate production of goods
and services relative to potential output, thereby eroding living
standards for all in society, including those workers who have
jobs. Beyond this, the research shows that EPL, especially unfair
dismissal laws, can be expected to impede productivity growth
and living standards generally by:
- impeding the job-matching process (the matching of workers'
skills and aptitudes with job requirements);
- constraining employers and employees from negotiating terms
of contracts that are conducive to greater productivity; and
- encouraging shirking (defined as opportunistic reductions
of physical and mental effort to assigned tasks).
3. EPL and fairness
There are several reasons for reasons for believing that EPL
processes systematically produce labour market outcomes that are
inconsistent with generally accepted tenets of fairness. First,
since employers cannot easily detect shirkers and may be prevented
from discriminating against them, the various costs associated
with increased scope for shirking created by EPL tend to be passed
on to the more conscientious workers. Second, unfair dismissal
laws tend to create scope for other forms of opportunistic behaviour
that are costly to deal with (for example, pilfering) and, again,
these costs tend to be passed on to more conscientious workers
in the form of wages lower than would otherwise be the case. Third,
in a world of creative destruction, substantial numbers of workers
will be forced out of jobs for economic reasons. EPL cannot reduce
these job losses without damaging productivity. Fourth, unfair
dismissal processes have inherent defects which systematically
produce unfair outcomes.
One reason for this is that employment contracts, like marriage
contracts, are relational contracts that are based largely on
implicit terms and understandings. Since performance in relation
to such contractual terms cannot be monitored reliably by a third
party, those responsible for implementing EPL simply cannot obtain
the information required to adjudicate disputes fairly. This is
reflected in the emphasis on procedures leading to a disputed
dismissal rather than on the substance of the reasons for the
dismissal in unfair dismissal cases. This problem seems to be
exacerbated by a tendency for adjudicators to give the employees
the benefit of any doubt about performance in relation to contractual
terms. The problem of dispensing "fairness" is compounded
by the impossibility of taking into account the effects of judicial
decisions in unfair dismissal cases on third parties. Dismissing
an underperforming employee does not destroy a job but rather
creates an opening for another person who might well be better
suited to the job and, indeed, might be more needy than the dismissed
employee. However, such considerations simply cannot be taken
into account in decisions to reinstate a dismissed employee, despite
the obvious implications for the overall fairness of labour market
It is worth noting that because of similar difficulties in
evaluating contractual performance, regulators no longer attempt
to determine the fairness or otherwise of dissolution of marriage
relationships. Thus, either party to a marriage relationship is
permitted to "dismiss" the other "for good reason,
bad reason or no reason at all" and, in the process, to inflict
wealth losses that frequently far exceed the expected wealth loss
inflicted by an employer on a dismissed employee. Another asymmetry
between regulators' attitudes to the breakdown of marriage relationships
and the breakdown of employment relationships is that, whereas
an employee is free to dissolve an employment relationship "for
good reason, bad reason or no reason at all", an employer
is not. Such considerations are central to the case for exempting
small businesses from EPL. The owner of a small business may spend
more waking hours with her employees than with her spouse. Given
this, even if friction in the personal relationship between the
employer and an employee does not erode the economic value of
the employment relationship (which it very often does) it is far
from clear that preventing the employer from breaking the relationship
is consistent with fairness.
Finally, there are undoubtedly bosses who treat employees unfairly,
just as there are spouses who are treated unfairly by their partners.
Since a low unemployment rate reduces the expected cost to workers
of moving to another job, and consequently raises the expected
cost of mistreating employees, labour-market policies that keep
unemployment rates low are likely to be an effective way of curbing
bosses who behave badly. To the extent that EPL contribute to
higher rates of unemployment (as discussed above) it has the unfortunate
consequence of tending to work against itself.
Recent overseas research has produced an increasingly convincing
body of research showing, as many have long suspected, that institutions
of EPL adversely affect the welfare of workers in several ways.
This research provides theoretical arguments supported by empirical
evidence that in an increasingly turbulent world economy and in
conjunction with other labour market institutions:
- EPL impede the creative destruction that improves productivity
and living standards for all people in an economy;
- EPL impede the process of job matching which helps to give
workers productive and fulfilling lives and higher real wages;
- EPL contribute to widening the welfare gap between insiders
and outsiders; and
- EPL increase unemployment rates and the duration of unemployment,
thereby forcing the heavy costs of adjusting to shocks onto a
relatively few, essentially disenfranchised people of working
The nature of the employment relationship makes it extremely
difficult for third parties to determine the fairness or otherwise
of a dismissal through unfair dismissal (or any other) procedures.
The result is that EPL increase the cost of controlling various
forms of shirking by opportunistic employees, and these extra
costs tend to be passed on to more conscientious workers. Likewise,
the costs of opportunistically negotiated redundancy payments
tend to be passed on to more conscientious workers.
In a world of creative destruction
the notion of "employment protection" seems somehow
peculiarly inappropriate---thinking in terms of unemployment insurance
is more helpful. In this respect, a recent piece of unpublished
research by Daniel Cohen of the University of Paris-Sorbonne has
come up with what may turn out to be the ultimate irony: despite
the vast volume of EPL and generous unemployment benefits in France
and the relative absence of EPL in the US, the average loss of
wealth suffered by a person who became unemployed in France in
the early 1990s (13 months' wages) was greater than the corresponding
wealth loss for a person who became unemployed in the US at the
corresponding time (9 months' wages).
EPL appears to be a very poor approach to provision of unemployment
Australia's unemployment record is little better than Europe's.
Despite a decade of strong economic growth, the unemployment rate
has remained stubbornly high (around 6 per cent) and some observes
consider that because of "hidden unemployment" the true
unemployment rate may be considerably higher. Although we cannot
be certain that our EPL regulations have contributed to the problem,
the conclusions from overseas research outlined above suggest
that we should be examining carefully their effects on labour-market
processes and labour-market outcomes. It may be tempting to think
that, because Australia's labour market institutions differ substantially
from those of other countries, the results of overseas research
have little relevance for Australia. However, leading US labour
economist Daniel Hamermesh thinks otherwise. In a recent US NBER
paper he argues that it would be foolish for US economists not
to attempt to use information about differences in labour markets
and differences in labour market institutions across economies
to learn more about ways in which differences in institutions
affect the welfare of workers and living standards generally.
Pivetz, Timothy R.; Searson, Michael A.; and Spletzer, James
R., 2001, "Measuring job and establishment flows with BLS
longitudinal microdata", Monthly Labor Review, April,
Davis, Steven J.; Haltiwanger, John C.; and Schuh Scott, 1996,
Job Creation and Job Destructon, Cambridge, Massachusetts:
The MIT Press.
Harberger, Arnold C., 1998, "A vision of the growth process",
American Economic Review, 88(1) 1-32.
market "flexibility" can be thought of as relating to
flow rates of workers between jobs and firms; into and out of
employment and unemployment; and into and out of the workforce.
these data (taken from earlier work) are outdated, there is little
doubt that more recent data would tell essentially the same story.
illusions about the capacity of legislators to "do good"
led King Canute, almost exactly 1000 years ago, to demonstrate
by example reasons for thinking otherwise. Nevertheless, these
days similar illusions seem to have reached epidemic proportions.
attributable to factors such as technological change, increased
trade with developing countries and increased female participation
in paid employment.
the reliability of this research has yet to be tested, 2000 Nobel
Laureate James Heckman apparently considers it good enough to
cite it in a recent talk given in Germany.
Why HR Nicholls?