Saturday, October 24, 2009

U.S. and Europe: The Tale of Two Labor markets

By most measures, the recession in the Eurozone countries has been at least as devastating as in the U.S. In fact, GDP is expected to contract by at least one percentage more in the Euro area in 2009 compared to the point estimate of about -2.5% currently used for the U.S. Still, despite the more severe loss of output, the unemployment rate in the Euro countries has risen much less dramatically than in the U.S.

Since the beginning of the recession in the U.S. in December 2007, the unemployment rate has doubled from 4.9% to 9.8% last month. In the Eurozone, during that period, the unemployment rate rose from 7.3% to 9.6% last month. The explanation for that seeming paradox lies in the vastly different structure of the labor markets in those two major economic entities.

To start with, labor mobility in the Euro countries is much lower compared to the U.S., largely due to cultural differences related to the premium Europeans place on the "quality of life" concept. In other words, a Paris-born and bred employee who recently lost his job is highly unlikely to relocate to a medium-sized, provincial city simply because of a job opportunity there, although staying in Paris would prolong his period of unemployment. This obviously leads to a higher "core" in the unemployment rate in the Euro countries compared to an economy like the U.S. where a high degree of labor mobility is the norm.

More importantly, though, the famous social safety net that countries in the Eurozone provide to their citizens- which is the pride of Europe and often a source of scorn in this country- creates a very different dynamic in the functioning of the labor market there vs. here. Precisely because labor laws are structured to offer a fair degree of protection to employees during periods of hardship, it is more difficult for employers in the Euro area to lay off employees during an economic downturn, as there are significant benefits and other compensation that need to be given to those that are laid off. As a result, it is costlier for employers to fire workers compared to the more bare bone benefits provided to laid off employees in the U.S., and companies in Europe often tend to hang on longer to their under-utilized employees until an economic turnaround occurs.

The flip side of that dynamic is that those same employee-friendly labor laws that make it more difficult and expensive to lay off workers in the Eurozone make companies think long and hard before they proceed with a more aggressive pace of hiring when the economy turns around, as expanding their number of employees during the good times may imply a higher burden when the cycle turns sour again.

The implication of those differences in the structure of the labor markets is that in the down part of a business cycle, the unemployment rate in the U.S can shoot up past that in the Euro area and that is exactly the situation currently. This gap is likely to persist over the next six to twelve months, as the relatively moderate economic recovery in both the U.S. and Eurozone is unlikely to lead to a significant pick up in hiring in either economy. However, over a 2- to 4-year horizon, the unemployment rate in the U.S. will most probably decline faster than that in Europe, confirming the familiar pattern where the Euro countries experience an overall higher rate of unemployment than the U.S. during the more mature phase of the business cycle. (This was also reflected in the 4.9% unemployment rate that the U.S. had just prior to the latest recession vs. a 7.3% unemployment rate that prevailed in the Euro area ta the same time).

Still, it is questionable whether, as this economic expansion unfolds over the next few years, the unemployment rate in the U.S. can move that sharply below that of the Euro zone, as GDP growth in this country may fall behind that of previous economic expansions, therefore failing to reduce the unemployment rate as sharply as in the past. In other words, it is an open question as to whether the U.S.unemployment rate can decline again, over the medium-term, in the 4% to 5% range. If the latter were indeed not to happen again in this new cycle., then the social safety net that protects workers in the Euro zone so much better during the difficult economic times will then also be causing less harm compared to the U.S., when the good times are rolling once again.

Anthony Karydakis