Few predictions are certain in the world of international financial markets. But there is one thing we can be very nearly sure Mario Draghi will say on Thursday when he discusses the European Central Bank’s (ECB) latest interest rate decision (most likely to be a 25 basis point cut to 0.75 percent): The ECB president will, at some point, call for deregulation of the euro zone’s labor markets — as he has for the past three months and on many occasions before that.
Journalists have tended to see the time taken up on this entreaty as an opportunity for a quick and furtive check on what is running on the news agency terminals, rather than diligently recording Draghi’s exact words on the subject. But it would be foolish for anyone to ignore any theme to which a man of the careful language, and sheer power, of Draghi is prone to return persistently. In future months, progress in reforming employment markets may become one of the currency union’s key issues.
If Friday’s breakthrough deal in emergency euro zone funding proves to have marked the turning point of efforts to master the immediate debt crisis — and that is a big if — we will, in the coming months, be onto the next stage: trying to generate sufficient economic growth in the middle and long term to whittle down the large block of accumulated government debt.
The growth question has become all the more apparent in recent months, as policymakers and institutional investors are assailed with increasing doubts about the ability of spending cuts and tax rises to close fiscal gaps on their own — because of their damaging effect on the economy, which hits the tax return.
Key to the growth question is the labor market. At his June conference following the interest rate meeting, Draghi declared that labor reforms would “help foster sustainable growth.” In May he advised that they should be designed to increase flexibility, mobility and equity.
Germany’s disaster-defying ability to keep its economy growing can be credited, partly, to its labor changes since the 2000s, which have boosted employment to 73 percent — almost 10 percentage points above the euro zone average. Incentives to work have grown because of a tightening of welfare provisions. Moreover, German companies have found it easier to keep on existing employees because the unions have accepted flexible working patterns in the interests of preserving job security.
Spain is belatedly trying to achieve its own employment miracle. The government is decentralizing wage-setting — moving it away from bargaining on a national level for entire sectors and into the hands of individual companies. It is also cutting severance pay.
Italy is anxious not to be left out of this reform bonanza. Motivated by the conundrum of how to make a significant dent in its debt when faced with a pitifully low underlying economic growth rate. Over the past ten years, Italy’s annual output growth has never come to more than 2.3 percent. Raising its employment rate — at 57 percent, one of the lowest in the euro zone — could be a solution.
Last week Mario Monti, Italy’s prime minister, won approval for a slew of changes that include making it easier for employers to fire workers for economic reasons.
Ending labor rigidities of this sort should boost long-term growth in several ways. Employers who know they can fire workers relatively easily, and at lower cost, will in normal conditions be more likely to hire them — thus boosting employment. Moreover, weakening the entrenched positions of existing employees will make it easier for companies to swap current unsuitable workers with other workers who may have more appropriate skills. This should increase productivity.
In the long run, these measures are likely to boost euro zone employment rates and therefore member states’ capacity to grow before labor shortages push up inflation and force the ECB to raise the cost of borrowing.
However, some economists are skeptical about whether such deregulation is necessary. They point to the high employment rates in some economically successful European countries with strong employment protection. These include Denmark, at 72 percent, and the Netherlands, which, at 75 percent, is even higher than in Germany.
The biggest worry, however, is the short-term effect of employment deregulation. Given the depressing economic background, employers will be tempted to take step one of their governments’ proposed labor market remedy — firing people — but not step two, which is hiring people.
This fear is heightened by the latest survey of euro zone purchasing managers from Markit Economics, which shows that employers cut their workforces rapidly in June, responding to a continued fall in new orders. Official Monday numbers from the EU show a rise in the euro zone unemployment rate to a euro-era high of 11.1 percent. A more flexible employment market might in the short term exacerbate this trend.
Even those analysts who are not excessively worried that employment reform will make the situation temporarily worse are not expecting it to usher in any imminent improvement.
The tardiness of any positive effect was highlighted by Standard & Poor’s, the credit rating agency, when it downgraded Spain in April. S&P praised the government for “a comprehensive reform of the Spanish labor market, which we believe could significantly reduce many of the existing structural rigidities and improve the flexibility in wage setting.” However, it added: “At the same time, we do not believe the labor market reform measures will create net employment in the near term. As a consequence, the already high unemployment rate — especially among the young — will likely worsen until a sustainable recovery sets in.” At 24.6 percent, Spain’s unemployment rate is the highest in the 34-country Organization for Economic Cooperation and Development.
Sovereign bond investors do give governments credit for long-term reforms. Monti’s busy attempts to deregulate the Italian economy across the board since he came to office in November have knocked Italy off its pedestal as the top villain among euro zone bondholders. But investors also need to know that governments will be able to service their debts in the next few months as well. For this reason, Draghi’s homilies on labor market reform must be supplemented with the promise from policymakers in Frankfurt, Berlin or Brussels of enough financial firepower to save bond markets until such structural changes work their magic.
