Subir Gokarn: French lessons

Critical reforms should not get stalled by resistance that is based on either imperfect understanding or inadequate institutions.

I occasionally draw upon the experience of other countries to argue for or against particular public policies in this column. For the most part, such comparisons have been made with the fast-growing East Asian economies, China in particular. The US has figured once in a while and the odd reference made to Japan and the UK. But, this is the first time that France enters the discussion, although the issue itself is one I have dealt with on several occasions in a variety of contexts: labour market reforms.

Over the last several weeks, world news headlines have been focused on the very widespread and intense anger in France against the government's attempt at what most observers would consider rather limited reform of the domestic labour market. The main provocation is the proposed legislation (it has been passed by Parliament but not been acted upon), titled the "First Job Contract", which allows employers to fire first-time workers with relative ease during the first two years of their employment.

The policy was motivated by the perception that rigid employment protection regulations were a serious deterrent to employers taking on new, particularly young and inexperienced, workers. As a consequence, the unemployment rate amongst potential workers below the age of 26 is as high as 23 per cent, a clearly dangerous socio-political scenario. The underlying premise, one I subscribe to entirely, is that job security requirements add to the effective cost of labour by loading the entire burden of unemployment insurance on to the employer. A higher cost of labour means slower job growth and higher unemployment, particularly amongst new entrants into the labour force, for whom this insurance component is a relatively high proportion of the total cost.

I think we are in an identical situation in India today; sectors (organised manufacturing, mainly) bound by tight job security regulations have shown no growth at all in employment, despite significant growth in production. So, I have argued for a solution close to what is being attempted in France; differential treatment or "grandfathering", which allows for more flexibility in the rules applicable to new employees (which could be extended to new establishments, such as ones being set up in the special economic zones).

From a theoretical perspective, grandfathering has several weaknesses, on the criteria of both efficiency and fairness. However, it does, ostensibly, have the merit of appeasing entrenched interests who benefit from the old regime and thereby, hopefully, reducing political resistance. Let's face it""reform has to be opportunistic to keep moving ahead. And, since it would create new job opportunities for young people with few avenues in the status quo, it should at least earn support from them.

Surprisingly then, the resistance to this politically pragmatic approach in France seems to have come mainly from the very young people it is supposed to benefit. One might have imagined that for a young person, having any job, even one which carried the risk of being fired (in the first two years!), would be preferable to having no job at all. But that is evidently not the case in France. The youth would rather be unemployed than risk being fired.

And, it is not as though France does not have a comprehensive unemployment insurance programme. A worker has to be employed for at least six months to be eligible for benefits, and the maximum duration of the benefits depends on how long the worker was employed in the most recent stint. A worker employed under the new terms, who worked for 14 months before being laid off, could claim unemployment benefits for 23 months. He, of course, cannot claim any benefits if he hasn't worked at all.

The combined forces of individual "rationality" and an effective safety net do not appear to have persuaded the young people of France that the new law is in their interests. Their reactions will undoubtedly provide ammunition to opponents of even incremental labour market reforms to argue that they will be opposed to by the very people they are supposed to benefit.

That would be a pity. First, let's look at the French situation in the broader European context. While Europe, in general, is viewed as having far more restrictive labour regulations than the US, there is, in fact, a relatively wide range of practices prevalent across the continent. The UK, Ireland and the Scandinavian countries, for example, have high degrees of flexibility in the standard employment contract, supported, of course, by comprehensive unemployment benefits.

Second, across the continent, there is a negative correlation between the degree of flexibility in the employment contract and the unemployment rate. Is this correlation robust enough to be universal? We just have to look at our own experience. Services, particularly the sunrise sectors, which have generated the maximum employment over the last several years, have done so in an environment of complete labour market flexibility. In contrast, organised manufacturing, which is most constrained by job security regulations, has seen virtually no growth in employment over a period when production has been growing at rates equal to GDP as a whole.

The economic argument in favour of flexible labour markets, supported by unemployment insurance, is compelling. By spreading the cost of unemployment benefits over the three stakeholders""the employer, the employee and the state""it brings the effective cost of labour closer to the wage rate and therefore induces employers to hire when workers are available in plenty. We could surely do with some of that.

But, let's not dismiss the reaction of the French youth as irrational or obstructionist. We have been stuck in the political debate on labour reforms for a long time without having any sense of what young people think on the issue. Of course, job security would be preferred to a lack of it, but do we know where they stand as a cohort on critical issues of livelihood risk and the institutional mechanisms that can mitigate it? Would a majority, for example, trust a government-run unemployment insurance programme?

Some commentators, particularly in the UK, have criticised the French government's handling of this situation on the communication front. As in the case of most reforms, the costs are immediate and obvious, while the benefits are distant and untested. Much more effort was needed, argue the critics, to educate the impacted stakeholders on the potential benefits. This is certainly one lesson we can take to heart. Let's not allow critical reforms to be stalled by resistance that is based on either imperfect understanding or inadequate institutions.

The author is chief economist, Crisil. The views here are personal