European unemployment of 8-10% since the early 1980s has entailed GDP losses comparable to wartime destructions of the capital stock, but governments have devoted only a modest 1% of GDP to active labour market measures. In Discussion Paper No. 803, Research Fellow Gilles Saint-Paul maintains that governments will fight unemployment only if it significantly reduces the welfare of the employed majority, and he identifies the environments in which this may happen.

Legal restrictions on firms' ability to set employment and wage levels benefit the employed. A simplified model with firing costs shows nevertheless that a two-tier system with `flexible' and `rigid' workers can generate a consensus in favour of enhanced flexibility. A gradual rise in the stock of flexible workers may then raise political support for further flexibility to allow a comprehensive reform.

Saint-Paul applies this theory to Spain, which has gone much further than other European countries in adopting flexible contracts. Unions opposed these contracts in principle, but the large-scale restructuring after Franco meant that even insiders felt at risk from the high rate of job destruction while flexible contracts promised to raise the hiring rate. Unions negotiated restrictions on their use, in particular the stipulation that temporary contracts could only be renewed up to three years. Following their introduction in 1984, however, some 95% of new hires were temporary, and the share of total employment on fixed-term contracts quickly rose to 30%. The considerable support for further flexibility is demonstrated by this year's proposals to replace the two-tier system with a unified labour market that is more flexible than the present system of permanent contracts.

Saint-Paul relates these findings to the conventional wisdom that unemployment causes governments to become unpopular and lose elections. If unemployment affects political decision-making through the employed, it should cause concern when the current firing rate is high; his regressions of a measure of `concern' on the level and rate of change of unemployment confirm that the latter is the more significant.

On the Political Economy of Labour Market Flexibility
Gilles Saint-Paul

Discussion Paper No. 803, August 1993 (HR/IM)