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Restrictions On Firing: The Impact On The Creation And Destruction Of Jobs

In the UK, firing a worker is easier than anywhere else in Europe. At the other end of the spectrum, in Portugal, it is very costly and time-consuming. According to new research by Julián Messina and Giovanna Vallanti, such differences in labour market regulation explain the contrasting patterns of job creation and destruction in recessions between the UK/Ireland and most continental European countries.

Are recessions periods of rapid destruction of jobs? Or instead, is it that firms respond to economic downturns keeping the destruction of jobs relatively constant and limiting the opening of new positions? The answer to these questions is complex, and depends on the rules and regulations governing the functioning of the labour market in each country and moment in time.

This study, published in the June 2007 issue of the Economic Journal, shows that the reallocation of jobs across firms is stronger in recessions in countries where the regulation allow layoffs to happen easily. Hence, in countries such as the UK and Ireland, recessions are turbulent times, with rapid creation and destruction of jobs.

In contrast, in most continental European countries, where firing a worker is costly and time-consuming, the reallocation of jobs is smoothed across the business cycle. Neither the creation nor the destruction of jobs vary substantially between recessions and expansions.

The protection of jobs differs enormously across European labour markets. According to recent OECD studies, it is in the UK where firing a worker is easiest in Europe. This is due to relatively cheap severance payments, reduced advance notice periods and lax regulation regarding the use of temporary contracts.

Portugal, closely followed by other Mediterranean countries such as Greece, France and Spain, stands out at the other end of the spectrum. In Portugal, the monetary costs of laying-off redundant workers are substantial, reaching over 20 months pay for workers with more than 20 years of tenure in the firm.

More importantly, firing procedures there involve substantial delays and are coupled with a high degree of uncertainty, inasmuch as workers who feel their firing has been unjustified can take firms to court and often obtain compensations above those contained in the law.

This study shows that such differences in regulation have a large impact on the dynamics of European labour markets. In countries where the regulation of firing is costly and time-consuming for firms, they follow a ”wait and see” strategy. Even if conditions are bad, it might still be optimal for them to hold up a dismissal in the case where economic conditions are expected to improve.

In contrast, in countries where firing workers is less costly, firms react rapidly to economic downturns, increasing the destruction of jobs. At the same time, firms in the UK and Ireland during a recession have a larger pool of unemployed workers to choose from, and hence create more vacancies than in markets where the regulation of firing is stricter.

The welfare consequences of such firing restrictions are hard to evaluate. Economic theory predicts that if markets are perfect, the interference of the legislator in the dynamic adjustment of the labour market is bound to reduce efficiency, and hence aggregate welfare.

But markets are imperfect. It is often difficult to find efficient insurance mechanisms against the risk associated with the probability of losing one”s job. It is in this context where the rationale for firing restrictions can be best understood and may be justified.

”Job Flow Dynamics and Firing Restrictions: Evidence from Europe” by Julián Messina and Giovanna Vallanti is published in the June 2007 issue of the Economic Journal.

Julián Messina

Universitat de Girona and IZA | julianm@iadb.org

Giovanna Vallanti

Università Luiss