Europe's rigid labor markets are an economic death sentence

Why has Europe slowed down relative to the US?

I have my hobby horse about tech regulation and horrible antitrust laws, but I don’t think those are THE biggest reason. Instead, I agree with a recent piece by Pieter Garicano that points to labor market regulations. The timing and the magnitude fit much better than for other theories. See also their podcast discussion of it.

Lots of places have regulations. As the piece points out, California has lots of regulations. Labor regulations—specifically those that generate rigidity, compared to like labor safety regulations—are fundamentally different.

When it’s hard to fire workers, you never hire them in the first place. That’s the big idea. Yes, it’s super simple.

Still, in this newsletter, I want to augment Garicano’s piece a bit by going more explicitly through a basic theory to show the problem with rigid markets. There’s a bit more to it than “don’t hire since you can’t fire.”

Don’t worry; there’s no math this week. But we will work through a model, one that recognizes that workers become a type of “capital” stock. For businesses, stocks are slow to adjust. Worse than that, businesses are very hesitant to adjust their stocks (read labor force) in the face of uncertainty.

The Everything is Housing Theory

To explain the theory, let’s first talk about something a bit more standard first: housing.

When demand for housing rises, both prices and quantity adjust. Prices jump, construction ramps up. That makes sense. The market works the way the textbook says it should.

Now flip it. Demand falls. Prices drop. But quantity? The houses are still there. A wood-frame house left alone takes roughly fifty years to fall apart. Concrete lasts a century. Once the structure exists, the decision isn’t “build or don’t build.” It’s “use it, mothball it, or pay to remove it.” You can’t un-build them. Well, you can, but removal is usually the worst deal.

You can see this asymmetry across cities that experience a bust: the ghosts of demand that vanished, rotting in slow motion.

With a positive demand shock, prices and quantity both rise. But with a negative demand shock, prices fall but quantity can’t really drop. Yes, the flow of new construction can drop, but the stock of housing won’t. When people say “markets will adjust,” they’re imagining supply can move both ways. But if the only fast adjustment is “build less,” you don’t just get up and down, nice and smooth.

The cost of uncertainty isn’t that we could end up being wrong. That’s fine. Any market has risk and people cope. The unique problem here is that, anticipating this inability to un-build, you’re hesitant to build in the first place.

I’m focused on housing, because this is where we see it most explicit. There are something like 75 million single-family homes in the United States. About one million new ones get built each year. The flow of new construction is around a percent or two of the existing stock.

The key is that when demand falls, the market can kill the flow instantly: construction goes to zero. But it can’t kill the stock. Notice that the stock is a backward-looking object. It’s the accumulated result of every building decision made over the past fifty years. Prices crash immediately because they’re forward-looking: they capitalize the bad news right now. But the stock just sits there, because it only knows about the past. The adjustment margin is one-sided.

So you get a lot of unique things about housing, like it has much higher volatility in purchase prices than rental price, or than you get for other goods. This isn’t a housing post. We can dig into that another time.

The strength of this effect depends on how durable the asset is. Housing depreciates at two percent per year, so a negative shock lingers for decades. Software depreciates at thirty percent and a negative shock washes out in three years. The more durable the capital, the more uncertainty depresses investment.

As we’ve argued, chaos freezes economic calculation. This is the most explicit way we see it in a simple setting. It’s not that the calculation isn’t possible in these simple examples, but instead uncertainty is harmful because of irreveribilities. This also is closely related to the ideas. As Josh has written before, there’s an option value to waiting. This means uncertainty raises the bar before anyone pours concrete. People build later and build less. The two mechanisms stack.

Labor force as a rigid stock

Now let’s circle back to Europe and labor markets.

Imagine you run Siemens. To highlight the mechanism, let’s make it extreme. You can hire workers, but you can’t fire them. They can only quit. Let’s make it more extreme: workers only quit when they retire. So a company can only get turnover when workers turn 65. Well, we’re talking about France, so 50ish. Now, for your stock of workers, you’re looking at a turnover/depreciation rate that is more like housing than it is like software.

Now imagine there is a surge for Siemens products. Do you hire a ton of workers to fill that demand? No, you’re worried about having to fire them in the future but being stuck until they retire.

But it’s even worse than that. Suppose you knew demand would stay high forever. You know with certainty, so you aren’t worried about needing to fire them in the future when demand cools. We’ve shut down the simple mechanism that everyone knows about.

Even in this case, hiring is still really costly in the short run.

Where is Siemens getting those workers from? In our hypothetical, you can only hire people entering the labor market for the first time, since no one quits their job early. Not only is it a problem for Siemens that they won’t be able to fire people down the road, the fact that BMW (I really need to be more creative with my European manufacturing companies) doesn’t fire anyone means you can’t hire people.

This is the equivalent of it being extremely costly to increase the housing supply in a short time frame, even if you know demand will be there in the future because of demographics. There aren’t the people out there to hire. The short run supply curve is very steep.

In reality, both are going on. Siemens doesn’t know that demand will stay high forever. They can’t tell how long it will last. So they don’t want to hire because there aren’t the workers and because you will have to keep them forever. That’s the don’t hire because you can’t fire. You can’t un-build a house. You can’t unwind a European factory line. In the US, you can.

This simple mechanism explains how recessions can be so catastrophic for rigid markets. Let’s think about an increase in uncertainty, say coming out of the Euro Crisis. That uncertainty will be scarring; you’ll REALLY do not want to hire new workers, even if they are lying around (high unemployment) if you can’t fire them if it’s a double-dip recession. So the spiral perpetuates. Even if wages fall and you have a bunch of unemployed people, the uncertainty is too drastic in a world where you’re committed to workers.

We can also think about high risk industries. Think VC heavy industries. Suppose you KNOW AI will be a big deal and transform everything. (We almost got through a newsletter without AI.) That’s not the same thing as knowing your AI company will be a big deal. How do you hire? How do you invest? The forces discussed above say you don’t. So, yes, Europe’s issues far predate AI, but it’s going to get even worse for Europe without changes.

The big picture is that turning labor markets into housing markets grinds everything to a halt. And the key to economic competition and growth is that churn, that turnover to more productive firms. That’s not to say the ideal is where everyone is a freelancer. There are real economic gains to certainty and investing in the relationship. But there’s a downside too and when economic uncertainty rises, that downside increases. That’s what Garicano documents so well. As always, it’s basic economics :)

Building can be fast. Un-building must be slow. So volatility reduces the amount of durable capital the economy dares to create. The economy dislikes uncertainty because you can’t un-build a house. Europe has a labor market with the problems of the housing market.