Delivered June 14, 2007
As obvious is this may seem, every analysis of economic policy
at the federal level in the United States must begin with
recognition of the comprehensive, record-setting strength of the
national economy. By almost every indicator, the American economy
is prosperous, but especially so in comparison to other advanced
economies.
-
More Working Americans than Ever Before. In the
latest Employment Situation report from the Labor Department, it is
reported that there are 152.8 million Americans in the labor force
and 145.9 million employed. These numbers are just shy of all-time
records set in the last few months.
-
Eight Million Payroll Jobs in Four Years. I try to remind
myself, given all the gloom in the media, that during a four-year
span, job growth in America has averaged 167,000 every month.
That's 5,559 jobs added to U.S. payrolls every day, or 232 jobs per
hour, or a new job every 16 seconds for four straight years.
-
Extraordinarily Low Unemployment. The rate of
unemployment is just 4.5 percent nationally. In most introductory
economics courses, this is considered a rate that is below the
natural rate of unemployment, and a sign of possible overheating.
By any measure, it is a low rate, far below the average of the
1990s, which itself was a healthy decade economically.
-
Growth in Output and Productivity. The positive growth
rates in gross domestic product (GDP) every quarter since the
attacks of September 11, 2001, are a very powerful symbol of the
resilience of the American economy. Despite the recent slowdown in
the first quarter's preliminary growth estimate, the critical fact
is that the economy is still expanding in a positive direction with
many signals that this growth will continue and even accelerate.
But a more important measure, as you know, is the high GDP per
capita Americans enjoy. By comparison, U.S. GDP per capita is 20
percent higher than income levels in nearly every other country in
the world, particularly the advanced industrial economies of
Europe, as well as Japan.
Economic Freedom and the Institutions
of Growth
I find that the most useful framework for approaching fiscal
economic policy is not what is traditionally known as
macroeconomics, but instead growth economics, particularly the
renewed consensus among economists that institutions are the key to
overall performance. This idea is captured well by Stephen Parente
and Ed Prescott's line of research, Barriers to Riches,[1] which
is also the name of their book. It is also the approach we use in
the Heritage Foundation/Wall Street Journal Index of Economic
Freedom--a systematic, empirical measurement of economic
freedom in countries throughout the world. As the director of the
team that assembles the Index, I should mention that we make
all the material, country scores, and even raw data available for
free on the Internet at www.heritage.org/Index.
Economic theory dating back to the publication of Adam Smith's
The Wealth of Nations in 1776 emphasizes the lesson that
basic institutions that protect the liberty of individuals to
pursue their own economic interests result in greater prosperity
for the larger society. Modern scholars of political economy are
rediscovering the centrality of "free institutions" as fundamental
ingredients for rapid long-term growth. The objective of the
Index is to catalog those economic institutions in a
quantitative and rigorous manner.
The 2007 Index of Economic Freedom measures 157 countries
across 10 specific factors of economic freedom, which include:
-
Business Freedom
-
Trade Freedom
-
Fiscal Freedom
-
Freedom from Government
-
Monetary Freedom
-
Investment Freedom
-
Financial Freedom
-
Property Rights
-
Freedom from Corruption
-
Labor Freedom
The methodology for measuring economic freedom is significantly
upgraded. The new methodology uses a scale of 0-100 rather than the
1-5 brackets of previous years when assessing the 10 component
economic freedoms, which means that the new overall scores are more
refined and therefore more accurate. Second, a new labor freedom
factor has been added, and entrepreneurship is being emphasized in
the business freedom factor. Both of these new categories are based
on data that became available from the World Bank only after
2004.
The methodology has been vetted and endorsed by a new academic
advisory board and should better reflect the details of each
country's economic policies. In order to compare country
performances from past years accurately, scores and rankings for
all previous years dating back to 1995 have been adjusted to
reflect the new methodology.
Economic freedom is strongly related to good economic
performance. The world's freest countries have twice the average
income of the second quintile of countries and over five times the
average income of the fifth quintile of countries. The freest
economies also have lower rates of unemployment and lower
inflation. These relationships hold across each quintile, meaning
that every quintile of less free economies has worse average rates
of inflation and unemployment than the preceding quintile has.
Of the 157 countries graded numerically in the 2007
Index, only seven have very high freedom scores of 80
percent or more, making them what we categorize as "free"
economies. Another 23 are in the 70 percent range, placing them in
the "mostly free" category. This means that less than one-fifth of
all countries have economic freedom scores higher than 70 percent.
The bulk of countries-- 107 economies--have freedom scores of 50
percent-70 percent. Half are "somewhat free" (scores of 60
percent-70 percent), and half are "mostly unfree" (scores of 50
percent-60 percent). Only 20 countries have "repressed economies"
with scores below 50 percent.
The typical country has an economy that is 60.6 percent free,
down slightly from 60.9 percent in 2006. These are the highest
scores ever recorded in the Index, so the overall trend
continues to be positive. Among specific economies during the past
year, the scores of 65 countries are now higher, and the scores of
92 countries are worse.
The variation in freedom among all of these countries declined
again for the sixth year in a row, and the standard deviation among
scores now stands at 11.4, down one-tenth of a percentage point
from last year and down two full points since 1996.
There is a clear relationship between economic freedom and
numerous other cross-country variables, the most prominent being
the strong relationship between the level of freedom and the level
of prosperity in a given country. Previous editions of the
Index have confirmed the tangible benefits of living in
freer societies. Not only is a higher level of economic freedom
clearly associated with a higher level of per capita gross domestic
product, but those higher GDP growth rates seem to create a
virtuous cycle, triggering further improvements in economic
freedom. This can most clearly be understood with the observation
that a 10 point increase in economic freedom corresponds to a
doubling of income per capita.
Generating Policy Change
The reason that I am devoting so much of my testimony to the
topic of economic freedom is because I hope to impress on listeners
the centrality of internally generated policy change as the key to
development. To be blunt, countries control their own
fate--including the U.S.
In the 2007 edition of the Index, one chapter is
dedicated to a cross-country study of labor regulations, which is
the issue of interest in this hearing today. It was written by
Johnny Munkhammer, an economist from Sweden who has a unique and
invaluable perspective. Here is an extended quote from Munkhammer's
chapter, "The Urgent Need for Labor Freedom in Europe and the
World."
For several weeks during the autumn of 2005, riots raged in the
streets of Paris. Every night, hundreds of cars were burned, shops
were vandalized, and violence ruled. French President Jacques
Chirac concluded that his nation was suffering from a profound
"malaise," a word that indeed captures the reality of economic and
social problems in many European countries. After centuries of
economic leadership, Europe must now face the truth that its
governing institutions--especially its labor markets--are deeply
flawed. Those who finally took to the streets, native and immigrant
citizens alike, were severely affected by unemployment.
France may be the most stubborn defender of the so-called
European social model, characterized by vast government
intervention in the economy, but many other governments in Western
Europe are committed to the same philosophy. Presidents and prime
ministers devote speeches to nostalgic messages and promise to
maintain and protect the existing social model. Their rhetoric
translates into policies that are a new kind of protectionism for
traditional jobs, a protectionism that is reflected in the
widespread official resistance to a single European Union (EU)
market in services, disapprovals of business mergers, and an
anxious debate about the "Polish plumber" representing free flows
of labor within the EU.
We Europeans are clearly at a crossroads. Either we look to the
future and learn from successful market-oriented reforms, or we
look back to the past and continue trying to shield old occupations
from international economics. It is a choice between openness and
protectionism, between modernization and nostalgia--indeed, between
government intervention and freedom itself. The problems of Europe
are not born overseas, but are innate to the process of internal
economic development and change. That is why a tighter adherence to
a failing model will only exacerbate current problems and lead to
more unrest in European cities. Rioting and decline is a destiny
that no European wants to face.
Yet there is reason for optimism. Never before have so many
countries been so deeply involved in the global economy, and the
benefits of globalization--economic growth, employment, and
competition--are ever clearer. Never before have so many countries
made successful free-market reforms, which is an inspiration for
others. Almost all European countries can point to at least one
successful reform, and as we copy each other's successes, the
future should rapidly become much brighter.
In my view, of all the areas that are still in need of
substantial reform, the most important is the labor market.
People--especially the young--want jobs and freedom, not dependence
on government.
…
Consider that between 1970 and 2003, employment in the U.S.
increased by 75 percent. In France, Germany, and Italy, it
increased by 26 percent. In 2004, only 13 percent of unemployed
workers in the U.S. were unable to find a new job within 12 months;
in the EU, the figure was 44 percent. In the EU, average youth
unemployment is 17 percent. In the U.S., it is 10 percent.
But the best comparisons can be made within Europe itself.
Denmark has an employment rate of 76 percent, but Poland is far
lower at 53 percent. Youth unemployment is above 20 percent in
Greece, Italy, Sweden, France, Belgium, and Finland and below 8
percent in Ireland, the Netherlands, and Denmark. In the EU's 15
member states, between 1995 and 2004, the development of employment
was also very different between the countries. In Ireland, the
Netherlands, and Spain, the increase in employment was the highest;
in Germany and Austria, it was almost zero.
What were the differences between the successful countries and
the others? First of all, the labor market was substantially freer
in the countries that succeeded in creating new jobs. Second,
payroll and income taxes were more than 10 percentage points lower
in the five best economies (in terms of job creation) compared to
the five worst. Third, the levels of contribution from the state
for unemployment and sick leave were lower in the best
economies.XREF What the successful countries have in common are
freer labor markets, lower taxes, and lower contributions.
A look at the results for various countries in the labor freedom
category in the Index provides further proof of the
connection between labor freedom and employment. Table 1 (in
the Index, Chapter 2) shows all of the nations of
Europe, including their EU affiliations, ranked according to their
labor freedom scores in the 2007 Index.
Countries like Georgia, the U.K., Switzerland, and Denmark enjoy
higher scores in labor freedom and have experienced better
employment outcomes generally. Countries with low scores like
Germany, Italy, Portugal, and Sweden have suffered weak employment
and outright stagnation.
Comparing the 15 countries that were members of the EU in
1995-2004 to EU-25 and non-EU countries is illustrative. In
Britain, the labor market is relatively free and earns a score of
82.7 percent, whereas in Sweden, it is highly regulated and earns a
score of 52 percent, compared to the EU-15 average of 59.7 percent.
The 10 countries that recently joined the EU have raised their
average labor freedom by nearly a full point, but the scores of
non-EU economies average nearly five full percentage points higher.
Yet the average income between 1995 and 2004 grew by 29 percent in
Sweden, 37 percent in EU-15 countries, and 72 percent in Britain.
The income of the poorest 10 percent of the population grew by only
10 percent in Sweden, compared to 59 percent in Britain. The worst
off were better off where the labor market was freer.
The larger lesson is that Europe's more "advanced" economies
have generally created more complex restrictions on labor freedom
in the name of protecting workers. This relative wealth has been a
convenient excuse for stagnant growth and higher unemployment, but
the apology is losing its validity as many Eastern and Middle
European countries experiment successfully with freedom.[2]
Labor Protectionism and
Unemployment
The Summer 1997 issue of the Journal of Economic
Perspectives published two articles discussing labor rigidity
in Europe.[3] Horst Siebert emphasized that the concert
of rigid labor institutions in Europe was clearly driving higher
unemployment rates there, emphasizing the tightening of policies
during 1960s and 1970s. While he observed differences among
European states, he concluded by focusing on one common feature:
"Job protection rules can be considered to be at the core of
continental Europe's policy toward the unemployment problem:
protecting those who have a job is reducing the incentives to
create new jobs." A contrasting opinion was provided in Stephen
Nickell's econometric overview, which reported, "[T]here is no
evidence in our data that high labor standards overall have any
impact on unemployment whatever."
Table 1 presents unemployment rate averages by decade for 10
countries reported by the Bureau of Labor Statistics.
Table 1
After 1980 it is clear that America has continued its
productivity leadership (with higher income distribution
generally), while European countries suffer high unemployment
rates. The "humane" policies of labor protectionism appear to have
backfired, creating a less humane social arrangement.
Nickell emphasized the diversity of European unemployment rate
experiences ("from 1.8 percent in Switzerland to 19.7 percent in
Spain") and policies.[4] Nickell's approach is a good one--he
assembles macroeconomic performance data for 20 Organization for
Economic Co-operation and Development countries, measured over two
periods (1983-88 and 1989-94), and assembles an impressive array of
labor policy measures, which he uses as explanatory variables.
Nickell says at one point that "roughly speaking, labor market
institutions were the same" in the 1960s and 1990s. He concludes
that unemployment rates are dependent on some policies (e.g.,
generous unemployment benefits, high taxes, high minimum wages, and
weak universal education), but not the conventional culprit, labor
market rigidity.
However, Nickell in 1997 has been updated by Nickell in 2005.
His assessment has changed in less than ten years because the
empirical evidence has changed, as he expressed in a paper with
Luca Nonziata and Wolfgang Ochel.[5] The authors find that
"changes in labor market institutions" and rigidities since 1960
have indeed occurred, and these are the root causes, with
employment protection accounting for 19 percent of the rise of
unemployment. I think it is fair to say that the consensus view of
economists today has evolved along the same lines.
A deep new data set published by the World Bank in 2003 and
published in the Quarterly Journal of Economics makes a
definitive case that the "Regulation of Labor" can be harmful to
macroeconomic outcomes.[6] The labor data cover 85 countries over
dozens of labor categories, including the local minimum wage,
strike laws, protections from dismissal, generosity of social
benefits, and so on. The data are coded so that a maximum score of
one represents the most rigid labor rule, while zero represents
perfect flexibility. Importantly, this very deep data set
represents laws during a single year, 1997, which precludes some
uses that would be available with a time series.
Nevertheless, Djankov et al. find that an increase in the
employment laws index is associated with an increase in black
market activity, a reduction in labor force participation, and an
increase in unemployment rates (averaged over the decade). The
econometric tests are not robust and report an R2 of 0.13, with the
labor regulation variable significant at the 5 percent level.
I am hopeful that the excellent new data sets in place will be
improved in years ahead and that, with greater knowledge of how
institutions and outcomes relate to one another, countries will be
even better armed to lower the barriers to riches.
Recommendations for U.S. Policy
Many voices are calling for new policies to address a vulnerable
U.S. workforce, including ideas such as wage insurance, flextime,
and mandatory paid leave. There may be merit to all of these ideas,
and yet they each remain problematic. The premise that the U.S.
workforce is vulnerable is the first problem: Suggestions of
anxiety are simply overblown. Indeed, many of the statistics used
to emphasize new pressures on the workforce are actually evidence
of new flexibility, such as the rising number of temporary jobs. A
second and related problem is that many policy solutions are
defined by government intrusion into an otherwise optimally
functioning private sector.
The two basic rules I would recommend for the formulation of
fiscal policy are first, Do No Harm; and second, Consider the
Incentives. Regarding the first rule, the economy is strong, so an
airtight case must be made for any new rules aimed at fixing a
labor market that is not broken.
And if we are to consider the incentives, the idea of mandatory
paid leave is especially problematic. My colleague James Sherk
recently published a Heritage study, which I quote:
Few oppose allowing workers to take time off work to recover
from illness or allowing parents to tend to sick children. Today,
the vast majority of businesses provide their workers with some
form of paid sick leave: 74 percent of companies provide paid sick
leave, while 82 percent provide other paid vacation days that
workers can use to care for a sick relative.
[The Healthy Families Act as considered in the Senate (HFA, S.
910)] would make this widespread and voluntary practice mandatory.
The legislation would require businesses employing 15 or more
workers to provide at least 7 days of paid sick leave per year and
would prevent companies from disciplining employees who abuse this
leave. This would radically change the current system of
voluntarily provided sick leave by encouraging widespread
misuse.
Like the FMLA [Family and Medical Leave Act], the HFA would make
it difficult for employers to verify that workers taking sick leave
are actually sick. The act would allow workers to take up to 3 days
of leave without any medical certification that the leave is
necessary.
For absences exceeding three consecutive work days, workers
would need a doctor's certification. However, the HFA does not
allow employers to challenge a doctor's certification, even when
they strongly suspect that it is fraudulent. Under the FMLA,
employers have found that workers who are not injured can usually
find a doctor who will certify that they have a chronic condition,
such as back pain, that requires time off work.
Abuse is rampant in countries that require mandatory paid sick
leave. In Sweden, for example, the government pays sick workers 80
percent their salary while on leave for an indefinite period of
time. At any given moment, 10 percent of Sweden's workers are on
sick leave, and over three-fifths tell pollsters that they take the
leave when they have no health problems.[7]
So one core incentive problem is that a new mandatory leave
requirement is subject to abuse by some workers, which is
essentially a penalty on the honest workers.
A larger concern is that any congressional mandate on employers
amounts to a mandatory benefit, which will come at the expense of
take-home pay. It is widely known that earnings have not kept up
with productivity growth in the U.S. It is also widely known that
the reason is that the cost of employee benefits are rising and
soaking up almost all of the compensation growth. Bottom line:
Total compensation for workers is growing at the same pace as
productivity, but there is a divergence between take-home pay
versus benefits. By mandating more benefits in new labor
regulation, Congress will be basically giving American workers a
pay cut.
Third, there will be a new incentive for employers to
discriminate. The good employers will make blind hiring decisions,
but unscrupulous employers will have a powerful incentive to avoid
employees who are most likely to qualify for the newly mandated
benefits. For example, young women who are most likely to take paid
maternity leave will face quiet discrimination. Good employers will
face higher costs, whereas bad employers will get a competitive
advantage. And it all makes economic sense, which is perhaps why
they call mine the dismal science. Nonetheless, the reality of bad
incentives means that mandated labor regulations rewards bad
behavior and so should be avoided.
Those are three strikes against new labor regulations, or at
least three cautions to consider in designing new rules
carefully.
Tim Kane, Ph.D., is Director of
the Center for International Trade and Economics at The Heritage
Foundation. These remarks were delivered before the U.S. Congress
Joint Economic Committee in a hearing entitled "Importing Success:
Why Work-Family Policies from Abroad Make Economic Sense for the
U.S."