European Unemployment: The Age of Ignorance, Part II

“This persistence of high unemployment in the European Community is a major puzzle.”
—Charles R. Bean, “European
Unemployment: A Survey,“ Journal of
Economic Literature, June 1994

“Is This the Age of Ignorance—Or Enlightenment?”, my most controversial column, was published in the June 1994 issue of The Freeman. It revealed how a growing number of well-trained economists plead ignorance on the most fundamental aspects of the budget deficit, taxes, inflation, the stock market, and the business cycle. Those cited included Herbert Stein, Robert J. Barro, and Paul Krugman.

My column was not well received by the profession. None of the economists cited in my column responded, perhaps because they were too embarrassed. But Milton Friedman wrote, “Herbert Stein underestimates his knowledge; you overestimate yours.” Brigham Young University professor Larry Wimmer said, “Ignorance is preferable to arrogance.” So the battle of ideas continues.

Now along comes Charles R. Bean, a bright economist at the London School of Economics, writing in a recent issue of the Journal of Economic Literature. After engaging in 47 pages of citations, graphs, charts, cross-country regression analysis, and econometric studies, he bravely concludes that nobody really knows why unemployment is so high in Europe. None of the numerous technical models works. It’s all a “major puzzle.”

Obviously, if economists can’t explain why a major problem such as European unemployment exists, they can’t be expected to prescribe a policy to rectify the situation. Hence, the growing impotence of the economics profession. It has blunted Occam’s Razor: Complexity is preferable to simplicity. Economists know so much that they now know so little.

Fortunately, not all economists subscribe to this new form of economic nihilism. Some economists see through the clouds of complexity, realizing that econometric modeling often obscures rather than elucidates the real nature of the problem. It’s time to return to basic economic principles.

The Real Cause of Unemployment

For example, Richard K. Vedder and Lowell E. Gallaway, economists at Ohio University, demonstrate quite powerfully that government policies cause widespread and persistent unemployment by raising real wages above equilibrium levels. Labor laws significantly increase labor costs and hence discourage businesses from hiring workers. In addition, the federal government’s inflationary fiscal and monetary policies create a boom-bust business cycle, causing much temporary unemployment of labor and resources. Their important study, Out of Work, applies their thesis to the United States during the twentieth century and concludes that unemployment is primarily due to “government activism.”^[1]

Applying the Thesis to Europe

The unemployment rate has been gradually rising in Europe and now exceeds 11 percent, compared to 6 percent in the United States and 3 percent in Japan. It’s the highest since the oil-shock years of the 1970s. But today there is no oil crisis. Through much of the 1980s, virtually no new jobs were created in the private sector. Fifty percent of the 16 million unemployed in Western Europe are considered long-term unemployed—without work for a year or longer. Only 11 percent of U.S. jobless are long term.

What is the cause of European joblessness? Despite the machinations of econo-metricians, the answer is not that difficult to discover. First, high payroll taxes—personal income tax withholding, social security, and unemployment compensation— discourage businesses from hiring. As Edmund S. Phelps, economics professor at Columbia University, declares, “Nearly every European country has brought much of its unemployment on itself—through its punishing taxation of labor. . . . Big increases in payroll and personal income taxes in most countries have been mass job-killers.”^[2] Last year, in an effort to close the national deficit, France raised income taxes by 10 percent. Not surprisingly, the unemployment rate in France rose by about a point and a half to 12.6 percent.

A second cause of unemployment in Europe is its labor laws and regulations, such as minimum wages, collective bargaining, and labor-management restrictions. Other mandatory benefits, including health care, pensions, unemployment and disability compensation, and paid vacations, raise labor costs.

The minimum wage in Belgium is $7 an hour, compared to $4.25 in the United States. Even now, German labor unions are pushing for a four-day workweek, amounting to an immediate 20 percent increase in real wages. In Italy, an employer must give up to six months notice before dismissal. In order to protect workers from sudden unemployment, Spain passed legislation making it virtually impossible for employers to fire workers. These are disguised methods of raising labor costs. But the actual effect is unemployment: If you can’t fire workers, why hire? Spain’s labor law dealing with employers’ obligations to the work force is 600 pages long. It should come as no surprise that, as a result of this legislation, Spain’s unemployment rate has gradually risen to depression levels, 25 percent. Portugal, on the other hand, has a less encumbered labor market and an unemployment rate of only 5.5 percent.

Third, generous welfare benefits to the unemployed, encourages the jobless to avoid work.

The existence of the European Common Market will undoubtedly force high-cost nations to liberalize their labor laws, or else face a major talent drain. Not surprisingly, many jobless Europeans are headed to other parts of the EC, or to Asia, where jobs are plentiful and labor markets are unfettered.

The answer to Europe’s unemployment problem is simple. Sharply reduce payroll taxes and the rules and regulations governing labor-management relations to allow market forces to work more effectively. This means less mandated job security and fewer government benefits, but more jobs and greater productivity. It is a difficult choice for EC governments to make, but if they don’t, unemployment can only get worse.

1.   Richard K. Vedder and Lowell E. Gallaway, Out of Work (New York: Holmes & Meier, 1993).

2.   Edmund S. Phelps, “Summiteers: Your Taxes Kill Jobs,” The Wall Street Journal, March 14, 1994.