The demise of the communist systems in Central and Eastern European countries (CEECs) signalled the beginning of the process of reintegration of the CEECs into Europe, with many consequent actual and potential political and economic benefits. But this ‘return to Europe’ has also had a dark side for the CEECs, in the form of a spectacular rise in unemployment. For all its faults and inefficiencies – which were many and costly – state socialism did provide a regime of full employment through a conscious process of labour hoarding and a remuneration system largely unrelated to individual productivity. Full employment – especially of such dubious character – was not sustainable, however, as a market equilibrium, and within three years of the fall of the Iron Curtain, unemployment rates of around 10% of the labour force had emerged, thus creating a veritable ‘reserve army’ of the jobless. Moreover, more than half of those without jobs typically are in long-term unemployment.

The reasons for and the analytical and policy challenges created by, the transformation processes in CEEC labour markets have been one of the key preoccupations of researchers involved in the Central European Economic Policy Forum, established as part of CEPR’s Economic Policy Initiative, launched jointly in 1995 with the Institute for EastWest Studies. The fourth report compiled by the Forum, and published in February 1998, reflects the findings of this research.

The rise in unemployment is attributable in part to the collapse of aggregate supply and the consequent sharp fall in the derived demand for labour. The most striking common aspect of CEEC labour-market transformations, however, has been the dramatic decline in employment rates, measured as the proportion of the working-age population in work. Since this decline has been as significant in countries where unemployment has risen most sharply as in those in which it has not, it is clear that analysis of labour supply changes is also a necessary element in explaining cross-country differences in the emerging patterns of unemployment.

Falling labour supply has been the result of various policies – including, for example, increases in the effective cost of childcare – that have increased the incentive to stay at home and resort to production for own consumption. Thus outflows from unemployment tend to be dominated by exits from the labour force. This trend has been accelerated by large cuts in benefits, which have failed to lead to significant job creation. In a number of countries, labour supply has declined so precipitously that participation rates have fallen below those in Western Europe. Significantly, however, this overshooting has affected males more severely than females, leading to higher relative participation rates for females in comparison to OECD countries.

These reductions in labour-force participation have been costly. Retirement ages – already low by OECD standards – have plummeted, and systemic dependency ratios have risen sharply, with serious fiscal ramifications: bloated social security budgets, rising tax burdens on employees, and increasing tax evasion which merely aggravates the problem. Indeed, the emergence of a ‘fiscal trap’ is now recognized as a serious risk in CEECs. Moreover, higher labour taxes have helped make labour more expensive than warranted by local living standards and productivity levels.

Although CEEC labour markets are becoming more market-driven, thus increasing the salience of standard analytical tools, they nonetheless will continue to behave differently from OECD markets for at least three reasons. First, a series of exogenous factors – ranging from the collapse of the Soviet Union to inherited fiscal and balance-of-payments problems and wars in the Balkan and Gulf regions – has contributed to the ‘transformation recession’, with continuing adverse consequences for the recovery of labour demand.

Second, job destruction and creation are linked by fiscal policy and the wider policy regime. Endogeneity of the feedback from job destruction to job creation is particularly evident in fiscal interactions, which can induce a ‘high-unemployment trap’ with slow recovery from the initial shock. A rapid rise in unemployment is helpful in that it moderates wage demands, but it also reduces net tax revenues. While slowing down the job-destruction rate puts less strain on the government budget, it also reduces job creation because the wage effects of higher unemployment are mitigated. More aggressive plant closures might bring more new jobs, but would also worsen the budget balance, thereby raising the spectre of the aforementioned ‘fiscal trap’. There is thus an optimal speed of job destruction to be determined.

Third, newly emerging institutions and behavioural patterns will have an important influence on the dynamics of labour demand. This is true not only because of factors inherent in the state-socialist legacy or the nature of the transition process, but also because the increasing importation of Western institutions will expose CEEC labour markets to the consequences of the persistent shocks which now characterize the business-cycle effects on labour markets in market economies.

It is clear, therefore, that the incentive structures in CEEC labour markets do not favour a resolution of the unemployment problem. There is also a risk that, as economic growth picks up, the recovery will prove to be ‘jobless’, with consequent political dangers as expectations prove to be unfulfilled. More generally, the success of the transition will be determined by the outcomes of the accompanying tax-collection and rule-of-law problems. With regard to the taxation issue, the proposed entry of CEEC countries into the EU, with its associated requirement for adoption of similar standards of social security provision, will increase even further the fiscal burden on the active population, unless the ratio of employment to population – and hence the tax base for social policies – increases. The interactions between labour taxes, the underground economy and the social support system, and the resultant possibilities of multiple equilibria, with different outcomes in similar economies, thus place a premium both on understanding the functioning of CEEC labour markets and determining appropriate policies to address the problems.

Against this background, mobilization of this labour supply would appear to be one of the key requirements for ensuring the sustainability of economic recovery in the CEECs and, ultimately, their successful integration into the European Union. A major outcome of the research, therefore, has been the identification of a range of policy measures which, it is hoped, will enhance labour supply in the region. Six broad policy recommendations are put forward.

First, there is need for better integration between unemployment benefits and social assistance provisions and enforcement of work tests throughout the period of benefit receipt. Short duration of unemployment benefits, compared with currently long unemployment durations, has pushed many individuals onto means-tested social assistance, with negative effects on work incentives. Second, there is need for the development of active labour-market programmes. While not a panacea, such policies can serve important flanking functions, in that they force unemployed people to reveal their willingness to work, and either push the inactive into other categories or motivate more search. The Public Employment Services in CEECs should extend their brokerage functions and proactive staffing policies to help monitor workers and provide an efficient flow of job information to credit- (or otherwise-) constrained individuals.

The third recommendation is that any future savings in social policy spending – for example, as a result of future declines in unemployment – should be translated directly into reductions of statutory contribution rates. Rather than letting extra-budgetary funds run surpluses and thereby relieve fiscal pressure elsewhere, policy-makers should strive to reduce the state’s contribution to labour costs wherever possible. Fourth, non-negotiated restrictions on job and labour turnover, via severance benefits or firing costs, must be abolished or, talents and ideas. Since employment security costs generally have significant fixed-cost elements, small firms should be exempted from some of these regulations, such as those creating procedural obstacles to layoffs.

The last two recommendations relate to public
investment policies in education and infrastructural development. Education policy is an excellent example of a public good with large externalities, as well as an investment with high returns which is often difficult to finance. Despite a widespread view to the contrary, enrolment rates in secondary education – notably, general secondary education – are low, because the previous regimes over-invested in narrowly based – and dead-end – curricula, such as those offered under vocational training. Increased spending on general secondary education is therefore strongly indicated. Finally, by improving the transportation network, for example, governments could significantly contribute to enhancing regional labour mobility. Given the small size of most CEECs, it should be possible to achieve significant labour mobility, in response to regional mismatches in the allocation of posts and jobseekers, via commuting without requiring changes in residence.