Unemployment and mandated employee benefits: a true trade-off?

Paul Krugman articulates the well-know argument of the trade-offs between requiring employee benefits and unemployment. While as a worker it seems intuitively preferable to compel firms through law to include important benefits such as a retirement plan and health insurance, this analysis makes a faulty assumption, that work will be available. This error stems from the fact that these lofty requirements make it extremely risky for businesses to sign-on new workers. If, to use France as an example, laws make it extremely difficult to fire new workers, firms may be hesitant to hire them at all. It seems safer to make less hires than risk swallowing the costs of an incompetent worker. Krugman explains this phenomenon, “For example, restrictive government policies that make it costly for firms to add employees can raise the NAIRU. Many economists blame such policies for “Eurosclerosis” – the persistent rise in European unemployment rates after 1970” (32). Thus, a worker’s preference for restrictive policies becomes more complex: if she actually gets a job, she will enjoy more benefits benefits, but the fewer jobs available increases the competitiveness of the application process and may prevent her from even finding a paying job.

Europe, starting from the 70s and stretching to the present, provides an excellent framework from which to test this hypothesis. During this era, unemployment rates rose from their incredibly low 2% to as high as 12 %, eventually leaving off at around 7 % in 2008. Different countries with different political approaches to the stagnating economic environment, however, experienced very different unemployment rates. Consider the following figure analyzing Europe’s average unemployment rate (dotted line) compared with Austria, Denmark, the Netherlands, and Sweden’s unemployment rates (solid lines) from 1970 – 2008. The highly similar features of these four countries including size, homogeneity, and policy in the 70s make them ideal subjects for comparison.

As seen above, the Netherlands and Denmark experienced much greater success at lowering NAIRU quickly than either Austria or Sweden. These differences may reflect the different macroeconomic and labor policy approaches taken by the Netherlands and Denmark on one side and Austria and Sweden on the other. One argument developed by the BLS suggests that the Dutch and Danish governments more quickly shifted their policies, which had traditionally embodied strong welfare programs, to increase incentives for finding work and lower barriers to entry. In contrast, Austria and Sweden were more cautious with their political changes, which impeded them from pursuing free-market policies and absorbing more labor into the job market. Thus, Krugman’s analysis of the trade-off between mandated employee benefits and employment appears consistent with history, and it will be interesting to see how Europe responds to its current elevated unemployment levels.