Labor Reform—The Elixir for the Eurozone’s Woes?

Labor reforms have proven politically unpopular in much of Europe. Do current French, Italian and Spanish leaders have enough political capital to push through needed reforms? Source: Getty Images.

As France,Spain andItaly strive to improve economic competitiveness, labor market reforms seem like low-hanging fruit—a sensible way to improve productivity and reduce unit-labor costs, giving exports a tailwind. EU/IMF/ECB “troika” officials often call them a necessity, citing the impact of Germany’s 2003 – 2005 labor reforms. All three countries would likely benefit to varying degrees, but in my view, investors should temper their enthusiasm—the probability other eurozone nations replicate Germany’s success appears low.

Germany in 2002 did share some similarities with the periphery today. Known as the “sick man of Europe,” Germany lagged eurozone GDP growth, productivity and unit-labor costs and had high-and-rising unemployment. Exports were strong, but they weren’t driving robust growth. Enter a commission led by former Volkswagen executive Peter Hartz, who proposed overhauling labor markets to give firms more flexibility, incentivize entrepreneurship and streamline benefits to boost overall efficiency. Many of the proposals were tough, but German Chancellor Gerhard Schröder controlled both houses of parliament and was willing to spend significant political capital, so the Hartz Concept reforms passed despite their unpopularity. The benefits weren’t immediate—unit-labor costs did fall, but GDP growth continued lagging eurozone peers through 2005 and unemployment peaked in early 2005 at almost 11.5%. In 2006, however, the tide turned: Exports and productivity shot up, labor costs continued easing, GDP growth surpassed eurozone peers and unemployment fell—and Germany continues leading Europe today.

In France, political headwinds lower the likelihood of similar success—though the cabinet approved a broad labor reform package in January, President FranÇois Hollande’s plummeting popularity reduces the likelihood of meaningful change. Proposed reforms were already a tough sell with many in his Socialist Party, and now that he’s lost significant support among his base, he may water down the reforms before submitting to Parliament this summer. Even if reforms do pass, structural obstacles likely offset some of the benefits. Labor reforms likely would help reverse the recent trend of declining productivity and rising labor costs—and boost export growth. But government spending, 56% of France’s GDP, has seemingly crowded out the private sector, limiting the ability of private-sector-oriented reforms to drive economic growth. Businesses are further hampered by high taxes—at 34%, France’s effective business tax rate is the highest among larger eurozone countries.

With an effective business tax rate of 32% and relatively smaller public sector, labor reforms could have more of an impact in Spain, but there’s some evidence firms are getting more competitive on their own. Productivity and unit-labor costs have improved in recent years as the recession forced firms to get leaner, and exports have recovered in recent quarters. A more flexible labor code would be a tailwind, but new domestic policies are seemingly not a government priority. Prime Minister Mariano Rajoy’s government has a 28.1% approval rating (after several tax hikes, ongoing recession and high unemployment), and they’re focusing more on EU-wide reforms than domestic changes.

Italy, which has seen productivity weaken and unit-labor costs rise significantly over the past 20 years, has the most room for improvement, but its government appears to lack the political capital to pass anything substantial. Like early-2000s Germany, Italy is a strong exporter, and higher productivity and lower labor costs would likely help boost exporters’ margins. However, reforms met huge opposition when proposed by former Prime Minister Mario Monti in 2012, and measures were significantly watered down. The current government—an unstable coalition—has even less clout and likely ignores polarizing topics like labor markets in favor of electoral reform.

Labor market reforms wouldn’t be a panacea for the eurozone, but they likely would catalyze higher productivity. Without that, the region likely continues muddling through, but its economic growth likely lags the world. For investors, better opportunities likely exist elsewhere.