Labour Markets
Spanish policies

The possible harmonization of labour market regulation is a major issue in Europe's political and monetary union, since labour market rigidities are widely thought to be a key factor in the sustained rise in unemployment experienced by many countries. Many governments have reacted with measures to increase flexibility. Many European countries have introduced `flexible' labour contracts with fixed duration and low firing costs but harmonization of EC labour markets now requires identification of the most promising system for employment.
Such flexible labour contracts were adopted widely in the late 1980s in Spain, which experienced a sharp rise in employment at the same time. In Discussion Paper No. 596, Samuel Bentolila and Research Fellow Gilles Saint-Paul construct a model of such contracts and test it on Spanish data to determine how much extra unemployment was due to the new contracts. Their model distinguishes `rigid' and `flexible' labour, holding permanent and temporary contracts respectively, which also have different productivities and wages. There are many firms, each of which is in a `high' or a `low' state `expansion' or `recession' whose individual behaviour is governed by their probabilities of switching from one state to the other. Aggregate recessions occur when a greater proportion of firms switch from the high to the low state than vice versa; each firm's overall probability of falling into recession depends on the aggregate and firm-specific probabilities of recession. The rigid labour force can be reduced either by firing a number of workers and paying the firing cost or by reducing it progressively and incurring a cost per unit of time.
The authors note four main predictions. First, flexible contracts tend to increase the size of the employment response to cyclical fluctuations. Second, the response of employment to cyclical fluctuations will be faster with flexible than with rigid contracts. Third, the impact on average employment is ambiguous, since it depends on parameter values. Finally, after the introduction of flexible contracts, employment will temporarily overshoot its long-run value. Bentolila and Saint-Paul suggest that the surge in employment following their introduction in Spain may have been due to its stronger response to the world-wide recovery and to such overshooting. Empirical testing of the model on a panel of Spanish firms confirms the model's prediction of larger employment fluctuations along the business cycle, but the data provide no support for its prediction of lower employment persistence. This suggests a need for further empirical research on the transitory dynamics of the introduction of flexible labour contracts.

The Macroeconomic Impact of Flexible Labour Contracts: An Application to Spain
Samuel Bentolila and Gilles Saint-Paul

Discussion Paper No. 596, December 1991 (IM)