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Saving Southern Europe's 'Lost Generation' of Jobless Youth

Published: May 15, 2012 in Knowledge@Australian School of Business
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In some southern European countries, unemployment is more than 20% -- as high as it was in the U.S. during the Great Depression. The situation is particularly bad for younger workers. In Spain and Greece, more than 50% of 18-to-24 year olds are now out of work. This represents a social and economic disaster that could have devastating consequences for those nations, rippling outward toward the European Union and the world.

Putting young people to work as soon as possible is essential, yet economists at Wharton and other institutions note the obstacles to doing that. The fact that southern European governments are cash-strapped makes stimulus programs difficult to finance. Economic growth seems elusive, at least for now. The only step that could help -- and even then, not for a long time, experts caution -- is to reform one of the underlying causes of unemployment: a highly regulated labor market.

Most economists agree that just as rent control ultimately tends to exacerbate, rather than alleviate, housing shortages, job protection tends to make jobs scarcer over time. In Spain, for instance, such regulations have created a two-tier labor market: older, protected workers who are very difficult to fire and younger workers who lack job security, says Gayle Allard, a professor of managerial economics at IE Business School in Madrid.

Job protection leads companies to put off permanent hiring for as long as possible, knowing that satisfying a short-term spike in demand could lead to an unprofitable long-term obligation. In Spain, for example, workers with permanent contracts must be paid 45 days' salary in severance for each year of service if they are dismissed and a labor board finds their dismissal "unjustified" -- as is almost always the case, according to a March 2012 OECD report on Spanish unemployment.

Such regulations are slowing growth in the most promising sectors. The positions such rules protect "tend to be in existing industries, often declining ones like steel, while the jobs that don't get created [in places where] the anti-dismissal laws are in effect tend more to be in rising sectors, such as electronics. That's bad for economic growth in the long run," notes Peter Lindert, a professor of economics at the University of California at Davis and a specialist in the history of financial inequality.

Policymakers have been aware of this problem for some time. In Spain, for instance, the unemployment rate has topped 20% three times during the past 30 years, according to Allard. Though some workarounds have been attempted, unfortunately the structures designed to alleviate joblessness have also tended to exacerbate the problem. Short-term contracts in Spain were intended to make it easier for younger workers to get hired. However, they have also made it harder for young people to stay employed permanently, she adds. Without an employer incentive to train them, they don't develop the skills they need to perform more advanced work.

Unemployment among Italy's ragazzi (young men) is now 30%. As CENSIS, an Italian think tank, noted in a report released last year, this means "a significant part of society's productive resources appears to have withdrawn from the system (though perhaps not definitively), thus turning their backs on what used to be viewed as an obligatory passage to adulthood and also, in many ways, a genuine social duty.'

Making matters worse is the reluctance of young people in southern Europe to move to the economically stronger northern economies, particularly Germany. Unlike, say, in the U.S., where people will move from a weak regional economy to a stronger one, southern Europeans are closely tied to their cities and their families.

"It's strange, since at least the moderately well-educated Spaniards -- and this applies also to Italians, Greeks and Portuguese -- could easily find jobs in Germany if they speak at least English reasonably well. But they seem to prefer unemployment and staying in the southern sun to moving where the work is and learning German or Dutch," notes Hermann Simon, chairman of Simon-Kucher & Partners, a global consulting firm.

"Young people in Spain are not very mobile," agrees Allard. "They are not even very mobile within the country." Part of this has to do with the Spanish family being very tightly knit. Another factor that tends to decrease mobility is home ownership, which, at 79%, is about 15% higher than in the U.S. and almost twice that of Germany. The collapse of the property bubble has left many families' finances deeply underwater because, unlike many states in the U.S., Spanish laws make it illegal for homeowners to simply mail the keys to the lender and walk away from the debt.

Yet liberalizing the labor market is difficult. Even young people tend not to support reform, fearing that it means that they will be worse off than their parents, according to Allard. With many families supported entirely by older, protected workers, the prospect of losing job security, their one seemingly reliable asset in a brutal economy, is terrifying. And it is not only terrifying for the families: Just as U.S. Social Security has been called "the third rail of American politics," job protection is sacrosanct in southern Europe. In Italy, politicians who have tried to weaken labor protections in the past have even been assassinated, as have two economists advocating labor reform. In addition to the cultural barriers to reform, there is also the challenge of the deep-seated nature of these rules, many of which go back decades, and a social contract that goes back even further. Allard notes that there is a strong correlation between countries that have this kind of structured labor market and countries that had fascist governments in the 1940s, a fact she speculates may stem from a tradition of state paternalism.

Pressing on with Reforms

Despite the difficulties, the Spanish and Italian governments are pressing ahead with some reforms. In Spain, these have been adopted through a royal decree, but in Italy, they are still being discussed in parliament.

Yet, even if labor markets are restructured in southern Europe, change won't come overnight, economists warn. "It's probably better if labor laws are looser, but I don't think this is the magic silver bullet to create economies that can compete with northern European countries, let alone Asian countries such as South Korea and China," says Franklin Allen, a professor of finance at Wharton.

Germany, which liberalized its labor market in 2002, is one possible employment success story in Europe. Today, the country enjoys 6.7% unemployment (the lowest level since reunification in 1990) and 7.8% youth unemployment. Since 2002, German labor productivity has risen by 35%, and its wage costs are now more competitive than wages in the poorer southern countries. "[Germany] still profits from this social reform, which was not really radical but effective in moving people into jobs," notes Simon.

Added to the reforms adopted by Germany in the early 2000s, the mix of goods the country produces is a second reason Germany does well: Much of what Germany sells -- products such as motor vehicles and electronics -- must be purchased sooner or later. "Eventually, the customer needed these products and started buying again as soon as the crisis abated," says Simon. In contrast, the jobs of the last solid growth period in Spain were fueled by a building boom -- a massive, debt-powered investment in holiday homes and apartments that turned out to far exceed demand.

The education level of the idle workers is another challenge not easily remedied. In Spain, young workers with the least education are suffering the most, according to a March 2012 OECD report. In 2009, a quarter of the then-35% unemployed youth lacked a high school certificate. However, life is not all that much better for the educated. The number of young people with a university degree in Spain is now actually higher than the OECD average, but Allard says many have a hard time finding permanent jobs.

"In the U.S., you can hire and fire at will, but if a person is good, if they've got a good degree and they start doing well in a company, they've got a chance to get on," notes Allard. "In Spain, they never have a chance. They are the first out, always." The latest reforms should change that dynamic by making it harder to fire temporary workers but easier to fire long-term workers.

Another source of the problem, says Mauro Guillen, a professor of management at Wharton, is that the nature of collective bargaining tends to be different in southern Europe. Like Spain, Germany is also heavily unionized, but the message has gotten through to union leaders there that gains can only come when the business is growing more productive. Unions now play a constructive role, Guillen notes, helping companies find ways to enhance productivity.

Finally, the euro can exacerbate labor volatility. In boom times, the euro made loans cheaper by giving southern Europe access to the pan-European credit market. In hard times, these countries, which in the past would have devalued their national currency to make their exports more competitive, are locked into the common currency.

Even with labor reforms, things are likely to keep getting worse before they get better for Spain, Allard warns. "One of the bad things about labor market reform is that companies will be laying off more people," she predicts. In other words, unemployment in southern Europe is unlikely to go away any time soon.

There are other challenges, too. Many critics point to excessive taxes of various kinds that employers must pay for their workers. In France, both outgoing President Nicolas Sarkozy and newly elected leader Francois Hollande talk about tax breaks for hiring young workers that could offer at least a small bit of help.

Another possible way to ameliorate the unemployment morass would be to ratchet-down some of the strict austerity measures being imposed on the countries with the most intransigent unemployment levels, at least in the short term. Stretching out austerity goals over a longer period could help economies to grow a little faster, experts say, and economic growth offers the best solution of all to today's employment dead end.

Lately, there has been more willingness to consider softer measures. As many European countries slip back into recession, there are signs of a shift to "those of us who have argued for economic growth first and a gradual fiscal adjustment," Guillen says. "We all hope now that the fiscal hawks realize their strategy is not working." But any meaningful pivot away from austerity and toward more stimulus "will only happen if GDP continues to shrink or grow very slowly. But then, I am not wishing for that."

Guillen adds that the best outcome "would be for governments to commit to fiscal balance over a period of three to four years, giving time for the economy to recover, tax revenue to increase and so on. But the problem is that the markets don't believe the politicians' commitment to fiscal austerity years down the road. They believe that if they reduce the pressure now, the politicians will relax."

And so, for now, the unemployment dilemma looks set to continue for the foreseeable future. And yet the questions remain. With Spanish unemployment overall near 24%, and keeping in mind the 50% youth unemployment level, "one begins to wonder where the political limits are," Allen notes. "Will the politicians be willing to go to 30% or 35% unemployment, and 60% or 70% youth unemployment?"

In the face of planned budget reductions of 5.5% through 2013 in Spain, these devastatingly high unemployment levels "seem quite possible and the potential long-term consequences are very worrying," Allen adds. "What is disheartening is the apparent lack of concern in northern Europe and in Brussels about this economic disaster. There seem to be very few proposals to improve the situation other than austerity and more austerity."

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