Labour market regimes and unemployment in OECD countries

The IMK's working paper -  Labour market regimes and unemployment in OECD countries  - analyses the relationship between external labour market flexibility and internal flexibility showing their different impact on the unemployment. The results are at odds with some conventional assumption. In the Abstract an extract of the study. To download go to 

While much of the empirical literature focuses on interactions between labour market
institutions, OECD (2006: 183-205) follows a different approach. 24 OECD countries are
grouped into four country-clusters according to their institutional labour-market settings at the
early 2000’s. Principal components analysis is used to identify these clusters. When analysing
the labour market performance of these clusters, the findings are that the ‘North European
countries’ are as successful in achieving low unemployment than the ‘English-speaking
countries’, although these two clusters show highly different settings in institutions in almost
every selected area. For example, the generosity of the unemployment benefit system and
union coverage are highest in the North European countries, and lowest in the Englishspeaking
countries. The North European countries also have a high tax wedge, a high union
density, strict employment protection legislation and spend most on active labour market
policy. According to OECD, “[t]his suggests that there is not a single road for achieving good
employment performance.” (2006: 192)

This approach of OECD (2006) is enriching the debate, as it indicates that labour market
institutions are part of a broader institutional model and that different labour market regimes
exist. As is argued in the literature on ‘varieties of capitalism’, institutions are parts of
complex societal and economic arrangements and strategic interactions, and fulfil different
functions in these diverse economic regimes (e.g. Hall and Soskice, 2001; Amable, 2003;
Freeman, 1998, 2000). And indeed, there exists varied evidence suggesting that important
variables are omitted in the ‘standard approach’, when explaining unemployment only with
standard labour market institutions, and that these labour market institutions do not play the
same role in all countries.

First, the ‘standard-approach’ focuses only on indicators for external labour market flexibility.
But, especially in corporatist countries, internal flexibility is as important to adjust production
capacities and costs to actual demand. While with external flexibility this adjustment is
achieved via hirings or dismissals, with internal flexibility the same outcome is obtained
through variations in regular working hours and overtime work, working time accounts, and
 (publicly funded) short-time working schemes.1 Eichhorst et al. (2010) construct a
quantitative indicator for 16 European countries in 2003, which includes measures of internal
flexibility. They also consider information on functional flexibility, which requires a skilled
and flexible labour force, adapting to structural change (external functional flexibility), or a
flexible organisation of the production process (internal functional flexibility). When internal
flexibility is included in their summary flexibility indicator, especially countries typically
described as corporatist – like Austria, Denmark, Finland, Germany, the Netherlands, and
Sweden (see also Appendix 1) – show a much greater overall flexibility than before.
Denmark, Finland, and Germany are even more flexible than the UK. This suggests that
important indicators for flexibility are omitted when focusing only on standard labour market

What’s more, the results of Eichhorst et al. (2010) confirm that there exist different labour
market regimes. The Anglo Saxon countries or liberal market economies are on average
characterised by high external flexibility, but low internal flexibility. The Nordic and central
European countries or corporatist economies show a high degree of internal flexibility and a
low degree of external flexibility. And some southern European countries are below average
in external and internal flexibility measures. This helps to explain why some countries with
very ‘rigid’ labour markets – when focusing on indicators of external flexibility – are as good
in achieving low unemployment as countries with ‘flexible’ labour markets.

Second, the ‘standard-approach’ assumes that wage-moderation, higher work effort and a
smoother adjustment of labour supply and demand is achieved through pressure on unions and
unemployed through the deregulation of labour markets. While this may be a reasonable
approximation for the functioning of labour markets in liberal market economies, it is a very
crude description for the process of wage bargaining and labour market policy in corporatist
countries. In these countries, employer associations, unions and (perhaps even) the
government negotiate together about wages, working time and (perhaps even) labour market
and social policy (see Aidt and Tzannatos (2002) for a survey of the literature). Social
partners consider the situation of the whole economy in decision-making, and may respond to
rising unemployment due to macroeconomic shocks with social pacts and other arrangements
1 The German experience in the ‘Great Recession’, where GDP dropped by 4.7% in 2009 but employment
remained constant, while working hours were reduced drastically, illustrates the importance of internal flexibility
(Möller, 2010; Herzog-Stein et al. 2011) to fight unemployment (e.g. Visser, 1998; Baccaro, 2003).
Therefore, external labour market flexibility plays a less relevant role in achieving low unemployment in corporatist countries.

In the literature on (neo-)corporatism and social partnership, it is further argued that trade
unions are compensated by the government for wage moderation and social peace (Headey,
1970; Schmitter, 1977; Lange and Garrett, 1985; Alvarez et al., 1991). Although this tendency
has probably decreased since the 1970s (Hassel, 2003), it still plays a certain role (Hicks and
Kenworthy, 1998; Hemerijck et al., 2000; Baccaro, 2003; Brandl and Traxler, 2005). This
means that there is some trade-off between internal and external flexibility in corporatist

Third, Estevez-Abe et al. (2001) argue that if employment and income protection is high, as is
particularly the case in corporatist countries, workers are more willing to invest in firm- and
industry-specific skills. In turn this makes it more attractive for firms to invest in skill-intense
production techniques, making the labour market for general skills shrink. Because of the
resulting international institutional comparative advantage of these firms in a particular skillintense
production niche, employment and income protection is favourable for employees and
employers. This in turn is reflected by good labour relations. Related arguments are put
forward by Blanchard and Phillipon (2004) and Feldmann (2006). They find that good labour
relations (which are highly correlated with corporatism; see Appendix 1) decrease
unemployment. Good labour relations increase the probability of concessions of workers to
overcome adverse economic shocks. They further decrease labour turnover, making
employers more willing to invest in human capital, and employees become more motivated to
acquire firm-specific skills and to make proposals for an improvement of production
techniques and work organisation. This results in higher productivity and lower
unemployment. According to these arguments, employment and income protecting
institutions, good labour relations, skill investments of workers and low unemployment are
interrelated in a systematic way in corporatist countries.

To sum up, internal flexibility plays an important role in adapting labour demand to labour
supply especially in corporatist countries. In wage bargaining processes in corporatist
countries (with good relations between the social partners and the state) worker’s
representatives accept increasing internal wage and working time flexibility, but receive some
compensation in the form of job and income security. There exists a (certain) trade-off
between internal and external flexibility as a result of the political economy of wage
bargaining in corporatist countries. These mechanisms are amplified by the impact of good
labour relations and employment and income protection on skill-investments and productivity
of workers. Therefore, external labour market flexibility shows a different impact on
unemployment in corporatist labour market regimes.

Simon Sturn