Social Policy Will Be Critical To A Sustainable EMU

Also posted on Social Europe Journal

by Simon Deakin

Listen to the podcast of this blog »

European policy-makers have some vitally important decisions to make in the coming weeks. The June meeting of the European Council is due to consider the role of social policy in the wider context of economic and monetary union ('EMU'). The background to this process consists, firstly, of the adoption in November 2012 of the Blueprint for a deep and genuine EMU which referred to the need for greater policy coordination in the 'field of employment'. Then in May 2013 the Commission Vice-President and Commissioner for Monetary Affairs informed the European Parliament that he was 'working on preparing proposals to strengthen the social dimension of EMU' and on 'finding ways to better integrate the social dimension in the current structures for economic governance', including 'strengthening the surveillance of employment and social developments within the European Semester framework'.

It is clear what this could mean: a renewed effort to impose deregulatory policies on the member states, of the kind put forward by the Troika in its dealings with Greece, Portugal and Ireland. The logic of this approach is that 'structural reforms' in labour markets, by cutting nominal wages and enhancing flexibility in hiring and firing, will restore competitiveness in the states and regions adversely affected by the crisis.

This approach is consistent with the new economic governance which has been developing since 2010 around measures including the 'six pack', the Euro Plus Pact and the Treaty on Stability, Coordination and Governance (TSCG). These measures are based on the premise that if a stricter regime of macroeconomic surveillance had been in place during the 2000s, the fiscal imbalances which threatened the stability of the single currency and the wider Eurozone after 2008 could have been avoided. This is a false premise. Prior to the onset of the crisis, all the Eurozone states with the exception of Greece were in compliance with the convergence criteria.

The problem was that their real economies were far from aligned. The future debtor states were mostly pursuing policies of financially-driven growth which were dependent on an expansion of private credit and on increasing asset prices in the markets for commercial and residential property. Thanks in part to loose arrangements for wage determination, wages in these states rose faster than productivity (Johnston and Hancké, 2009). The future creditor states, by contrast, were mostly following policies of 'endogenous' or industry-led growth which depended on targeted investment in capital goods, public support for training and labour force upgrading, and wage moderation supported by coordinated collective bargaining. They were better placed to deal with the shock induced by the financial crisis when it arrived in 2008, but it must be remembered that their competitive advantage was, in part, the result of policies in the 'core' which were, in effect, exporting wage and price inflation to the faster-growing 'periphery' (Armingeon and Baccaro, 2012).

The policy of enforced austerity, administered at first through the interventions of the Troika and subsequently through the 'new economic governance', does not address these fundamental imbalances. The TSCG, in its attempt to embed a pro-cyclical fiscal policy at the level of constitutional governance, is in danger of becoming a dead letter within months of its implementation. Wage cuts and casualisation of employment are inducing depression-type conditions in the indebted states, but in the absence of productivity improvements they cannot address the underlying causes of the competitiveness gap, as the IMF has recently acknowledged in its assessment of the response to the Greek crisis (IMF, 2013).

The question now facing the European institutions is whether they can demonstrate the flexibility needed to effect a change of course. The debate over the 'social dimension' of EMU is to be welcomed for at least putting the relationship between social policy and monetary policy on the agenda. A 'deep and sustainable EMU' can only be one which promotes sustainable growth and social cohesion. To get to this point, a deepening of efforts at economic and social policy coordination will be needed. But this cannot plausibly take the form of the socially divisive and economically counter-productive policies which have been pursued to this point.

What would a sustainable EMU look like? To begin with, it would acknowledge that the most successful countries and regions within the single currency area during the past decade have been those that combined investment in human capital with strong welfare states and coordinated wage bargaining. Egalitarian policies in labour and social security law, designed to narrow earnings inequalities while promoting labour market access, help to build a stable tax base. Active labour market policies, coupled with legally-mandated vocational training systems, enable economies to adapt to global competitive pressures and the 'creative destruction' associated with technological change. Solidaristic wage bargaining, based on the principle of maintaining a floor to wages and conditions at sectoral and national level, has helps to ensure effective demand for locally produced goods and services in the face of recessionary conditions.

The EU already has in place the institutional mechanisms needed to promote learning around 'what works' in economic and social policy. To this extent, the new economic governance marks a step forward. A shift of emphasis within EMU, towards a growth-orientated and egalitarian form of economic union, does not have to wait for Treaty revisions.

The European institutions have shown a high degree of adaptability in the face of the crisis. This is most clearly so in the case of the ECB, which has overcome supposed limitations on its mandate to become an effective line of defence against the destabilising effects of currency speculation, through its outright market transactions programme. The Court, in the Pringle judgment, also demonstrated flexibility in finding a solution to the constitutional issues surrounding the adoption of the European Stability Mechanism Treaty, at the same time validating the central bank's interventions in the market for sovereign debt.

It is now down to the other institutions to show similar flexibility. The June European Council provides the ideal moment.

References

Armingeon, K. and Baccaro, L. (2012) "Political economy of the sovereign debt crisis: the limits of internal devaluation". Industrial Law Journal, 41: 254-275.

IMF (2013) Greece. Ex-post Evaluation of Exceptional Access under the 2010 Stand-by Agreement (Washington, DC: IMF) available at: http://www.imf.org/external/pubs/ft/scr/2013/cr13153.pdf

Johnston, A. and Hancké, R. (2009) "Wage inflation and labour unions in EMU". Journal of European Public Policy, 16: 601-622.

This article is part of the EU Social Dimension expert sourcing project jointly organised by SEJ, the ETUC, IG Metall, the Hans Böckler Stiftung, the Friedrich-Ebert-Stiftung and Lasaire.

"March of the Makers" - rebalancing our economy needs more push from government

By Michael Kitson, Cambridge University Senior Lecturer in global macroeconomics, Assistant Director of the Centre for Business Research.

You can now read Michael Kitson on compassonline.org.uk

Listen to the podcast of this blog »

If the Chancellor George Osborne is to turn his vision of reinvigorating our manufacturing sector, the so called "march of the makers", he and his government colleagues need to develop a coherent industrial policy.

The public policy debates which focus on austerity, withdrawing from Europe, and on limiting immigration misses the target. These are short term political agendas, that are not good for long term economic growth. We need Europe as a market for our goods and services, 50 per cent of our trade is with our European partners, and we need people coming into the country to boost our talent pool.

The need for an industrial strategy

There are too many piecemeal policies at the moment and there is too much focus on austerity, and reducing the size of public sector deficits and debt. But there is no coherent long term industrial strategy that will successfully rebalance our economy. The need to rebalance our economy is losing momentum when it should be at the centre of the agenda. We have to focus on stopping the "retreat of the makers" before we even get to thinking about the "march of the makers".

The economy is still stagnating. We are still really bouncing along the bottom, this is the worst recession and the worst recovery from recession for over one hundred years. In normal times, an economy recovering from recession should generate annual growth of three to four per cent. Sir Mervyn King, the outgoing Bank of England governor, refers to a "modest recovery" - but a modest recovery is a sign of failure.

When in March 2011 George Osborne called for a "march of the makers" he identified manufacturing as the key growth sector for the economy and announced a series of policy initiatives, such as: extending the export credit guarantee schemes; increased R&D tax credits; and the creation of new enterprise zones. But these policies have failed to generate growth because they do not deal with the fundamental problem which is the lack of demand in the economy.

The myth of the 'invisible hand'

The manufacturing sector has suffered benign neglect from governments of all persuasions from the 1960s and particularly from the 1980s onwards. The manufacturing sector has been allowed to decline based on the argument that markets know best and that the economy can be built on services. Manufacturing has been left to decline, whereas in the USA and Germany it has been supported. For some, the "invisible hand" of the market, will solve all economic problems - a phrase used only once by Adam Smith in "The Wealth of Nations". Markets rely on help from government to help them work more efficiently and become more effective - the role of the State is to support markets. If we just rely on 'market forces', the result is an unbalanced and weak economy.

The need to rebalance

In the UK, there are sectoral imbalances: we have seen a focus on the financial services and the relative decline of manufacturing. There are regional imbalances: London has done very well over the last thirty years while the North West and the North East have not. There are also trade imbalances: we have had a big balance of payments deficit and we are not paying our way; for the last thirty years we have been borrowing from the rest of the world to fund our consumption habit.

These three imbalances - in our sectors, our regions and our balance of payments - cannot continue and we are destined to see much lower growth for ourselves and our children in the future.

Rebalancing is important, geographically for the regions and also for the economy as a whole. It is not just about manufacturing but it is also about giving our high technology services, our creative industries, a much needed push too. We need long term investment in these sectors, and this needs to come from the public sector and the private sector working together.

Openness strengthens the economy

There is also the misplaced focus on reducing immigration. The UK economy has always been open to talent, and that talent has helped our economy grow. We need to be an open economy both to ideas and to people. Europe is one of our major markets if we withdraw from Europe it is going to harm economic growth.

The importance of investment

What we need is a coherent strategy to invest, and although the private sector will help, a lot of that investment will have to come from the public sector and that means increased government expenditure. We must relax the current focus on austerity, and cutting deficits, the main legacy we can leave our children is not the problem of deficits, it is the problem of low economic growth. If we want to get economic growth going we need investment and we need investment now and the public sector has got to be part of that.

"March of the Makers" - Why UK business need funds to grow and global talent to capture new markets

By Michael Kitson, Cambridge University Senior Lecturer in global macroeconomics, Assistant Director of the Centre for Business Research.

Listen to the podcast of this blog »

How can we turn George Osborne’s much used phrase "march of the makers" into reality? We need to rebalance the UK economy: rebalance our industrial sectors; rebalance our regions; and rebalance our balance of payments.

But two years on from when he first promised to deliver that "march" there is still a problem as the financial sector remains seized up, with many small and medium size enterprises unable to access funds to borrow to invest.

The importance of innovation

We also need to look at how our economic system is failing, where are the structural holes and structural flaws in our system? We need to invest more in science and technology and we need to get those ideas into businesses, not just manufacturing but also into the service sector. We need to create the structures that ensure businesses of all sizes can be innovative and are enabled to develop new products and processes. At the moment there is no coherent strategy to do this, just a series of encouraging initiatives, and businesses are failing to innovative because they cannot access funds or ideas. A proper industrial strategy could solve these problems.

We cannot continue to borrow to spend

Crucially if we did allow business to innovate, this would be good for our Balance of Payments, which has been in deficit from the early 1980s. This means that the economy has been spending more than it earns, we are good at consuming and not very good at producing and we need to change that around. We have borrowed to spend and we can no longer rely on the rest of the world funding our consumption habits. We need to pay our way and to pay our way we need to get better at producing goods and services, we need to be innovative and produce more that is the way forward.

Focus on growth not austerity

The focus at the moment is too much on austerity and not enough on long-term growth. We need to rebalance our economy and rebalance the economic agenda, we need to focus more on how we are going to get long term growth rather than focus on austerity because austerity can destroy the long term foundations of economic growth.

The long term economic outlook for the UK depends on what happens in the rest of the world. We are not isolated from the problems in the Eurozone as this is one of our main markets. Growth in the newly industrialising countries, Brazil, Russia, India, and China, will help the world economy, and as they grow they will buy more of our goods and services helping us to grow too.

The current political focus on immigration will harm economic growth and will harm innovation. We need to be attracting talent from around the world to help drive innovation and growth. It is not surprising that we see the focus on immigration at the moment, we saw it in the 1930s, when we suffered the great slump, and we saw it in the 1970s with the rise of the National Front. Economic problems often result in a focus of "blaming" somebody else, blaming immigrants, and blaming other countries. We need to remain an open society and that means open to people coming in from abroad.

Investment is essential for long-term economic growth. We need investment in economic capacity - which could be driven by a National Investment Bank, charged with the role of developing long-term growth in key sectors. We also need investment in people - reversing the policy on immigration and being open to talented people coming in from abroad. The solutions are available: drop the dogma and grasp them!

The Proof of the Pudding - why the £200 million a year Small Business Research Initiative needs transparent implementation

By David Connell, Senior Research Fellow at CBR, Chairman, Archipelago Technology Group Ltd.

Listen to the podcast of this blog »

If you run a small business and need that all important first customer to help you develop and trial your innovative new product, then the Chancellor George Osborne's Budget has some good news for you.

The Small Business Research Initiative which uses government procurement practices to drive through innovation, is to be increased by nearly ten times to around £200 million per annum during this Parliamentary session.

This is excellent news and one that I and others have been campaigning for over the last ten years. But the SBRI will only be successful if it is implemented in a totally transparent and accountable way.

The SBRI is based on a successful and long running US programme called The Small Business Innovation Research Programme. This Programme uses Federal Government procurement expenditure, to give contracts to small businesses so that they can develop technology and products that the US government believes it needs in order to increase the effectiveness of its own departments like Defence and NASA . It also covers projects relating to broader policyobjectives, for instance in the case of the National Institutes for Health. In the US the programme is worth 2.5 billion dollars a year, and it is more important than venture capital in funding the early stages of new science and technology businesses.

In the UK the SBRI is important because it represents a sea-change in the kind of innovation support that the government is giving small businesses. This is because it doesn't focus on "technology push" to exploit our science base, but instead SBRI is much more about stimulating "demand pull". In particular it allows the public sector to play the role of "Lead Customer".

A Lead Customer in the science and technology sector is an organisation that is prepared to fund the development and trialling of new products and technology that then lead onto the purchase of prototypes and their subsequent first use within that organisation. Any organisation that goes first as a customer is taking a risk. For example, if a new UK business sets out to sell a product to a potential customer in the US or Germany virtually the first question they are going to be asked is – "Can you show me one operating in your home market?"

Lead Customers provide product endorsement for further customers and indeed for additional investment if needed. It is commonly thought that the most important source of innovation for science based companies is academic science , withventure capital the primary source of start up funds. But the reality is that for the most successful companies it is nearly always Lead Customers that play both of these roles.

If we look to the US, we know that Microsoft had no venture capital to start with and that Bill Gates was probably unbackable when he started his business! Gates began with a series of paid development contracts for his software and after a time he hit lucky and IBM allowed him, probably by accident, to sell the operating system that he developed for the first IBM PC to other companies. The rest, as they say, is history.

Intel is another example. It was venture capital based at the start, but development of the single chip processor, which has been the key to its success, was actually financed under a contract for a Japanese calculator company. We see this process repeated virtually everywhere. In Cambridge the most successful companies in terms of jobs are based very largely on technology developed for individual Lead Customers and financed by them. So Lead Customers are hugely important if we want to grow our science and technology based sectors.

In 2004 I launched a campaign with the then MP for Cambridge, Anne Campbell, precisely because I became aware as a CEO of a Cambridge Venture Capital Fund of how appalling irrelevant government support for small businesses was in the UK. We achieved success in 2009 when the current UK Small Business Research Initiative was introduced. This operates in a very similar way to the US programme and although it has been up until now quite small scale, about £20 million pounds a year, it has funded some very interesting technology developments in small businesses.

One of the best known SBRI programmes is operated by the NHS. It has, for instance, funded new technology in the area of wound care for individuals suffering from burns or diabetic ulcers. It has also funded a possible cure for macular degeneration which is a major cause of loss of eyesight in older people. A number of these developments look very promising, and some companies have already launched their products onto the market.

Osborne's ten-fold increase in his March 2013 Budget is most welcome but it will however, be quite challenging to achieve that level of growth and there will be some important dangers.

The first danger is that because of the pressure to increase spending government departments will deviate from the model that we know works best. This is precisely what happened in 2005 when Gordon Brown announced a £100 million programme. That programme was implemented through a series of departmental targets with departments reporting expenditure against those targets. The result was that they all reported that they had already achieved their targets without indicating what the figures covered! It will therefore be very important for Osborne's increased programme to be run in a very transparent way. As in the long established US programme, we will need to know what the exact competitions that are being run are and what funding has been provided through those competitions to each company.

But that said, the new £200 million per annum SBRI really is fantastic news for small businesses. It combines both customer demand, allowing businesses to see how potential customers might want to use their new product – and therefore how it should be designed, with funding in a form which is appropriate for them. The traditional mechanism by which government helps small businesses fund R & D is through grants and tax credits and in truth the amounts involved are very small. Unlike these, SBRI contracts provide 100% of project costs and do not require artificial collaborations just to get the money.

It is a myth to think of most new science and technology businesses starting out with bucket loads of venture capital and they are unlikely to achieve the kind of profitability that will enable them to spend significantly on R & D for many years. So what SBRI does for the first time in this Country is give start ups and small companies sufficient funding to make a real difference, increasing their chances of success and accelerating their sales growth. This has to be fantastic news for the UK economy, and for our growth prospects.

Of course, like Oliver Twist, we could always ask for more!

European Court’s Pringle judgment: good law, bad economics

By Professor Simon Deakin

Listen to the podcast of this blog »

Courts don't often try to decide the direction of economic policy. However, in effect, this is what the European Court has recently done. In its Pringle judgment the court made a number of important decisions on the legality of bail-out policies being pursued by the European Union.

It ruled that the establishment of the European Stability Mechanism - the fund through which financial assistance will in future be channelled to eurozone states facing the possibility of bankruptcy - was not contrary to EU law. By implication, the ruling also supports the recent attempts by the European Central Bank to shore up the euro by buying the government bonds of debtor states on secondary markets (that is, buying them from commercial banks that have first purchased them from governments).

But the court went further, insisting that the legality of the ESM will in future be dependent on the application of strict conditionality in the terms on which financial assistance is made. In other words, financial assistance under the ESM will only be lawful if it comes with strict conditions, which in practice will amount to instructions to privatise state assets, cut welfare expenditure and abolish labour laws, which currently protect workers against poverty pay and job insecurity. The ECB's bond-buying programmes will be similarly constrained.

In ruling that the ESM is legal, the court gave some much needed flexibility to the EU's emerging economic constitution. The ESM was established in a treaty agreed by the eurozone's members outside the main structure of EU law. Opponents of the stability mechanism argued that only the EU itself had the competence to act in the area of monetary policy. The court sidestepped this argument by drawing a distinction between monetary policy (maintaining price stability) and economic policy (ensuring the wider economic stability of the eurozone). In this way it could conclude that the establishment of the ESM was within the power of the eurozone states. Behind this rather formal legal distinction lay a debate about the steps that could, and should, be taken to save the euro.

The Pringle judgment, in validating the steps taken to preserve the single currency, is a landmark in EU law because it recognises the need for institutional adaptation to deal with an existential crisis that is putting at risk not just the euro, but the wider EU.

But the court's flexibility only went so far. Rather than limiting itself to a judgment on the narrow point of EU law before it, the court ventured into new territory, staking out a claim to channel the future direction of economic policy in the eurozone. This is where conditionality comes in. The court's ruling is intended to give no leeway to the European Commission and ECB in their future dealings with debtor states; financial assistance will not be permitted if it is not linked to structural adjustment packages aimed at cutting welfare expenditure and driving down wages.

At least for the time being, the commission and ECB need no encouragement to go down this path. Yet the results of pursuing this policy with the debtor states since 2010 have been little short of catastrophic. Cuts to social security benefits and wages, and the removal of basic labour protections, have taken demand out of their economies, while doing nothing to address the underlying causes of the crisis.

Under these circumstances, the last thing the EU should be doing is taking additional steps to depress wages and growth. To make this policy the cornerstone of the EU's emerging economic constitution would be a catastrophic error. The policy was misconceived even for the “good times” of the eurozone's early years. But to pursue it to the bitter end in the face of the existential crisis currently facing the union risks undermining all the steps taken to this point to save the single currency. Simply put, without economic growth there is no prospect of confidence returning to financial markets, and the crisis facing the eurozone will continue until the pressures on governments become too much to bear.

To save the euro, and the EU, will require more flexibility in future from its organs and institutions. The court, if it is to play any role at all in this process other than getting out of the way, should recognise the need for a growth-orientated economic policy. If the court were to resist this policy shift in future, it would run the risk of irrelevance at best or, at worst, a loss of legitimacy of the kind that will do the cause of EU law no favours, even if the EU itself survives.

The writer is director of the Corporate Governance Research Programme, the Centre for Business Research, Cambridge university.

Also posted on FT's Economists' Forum

Rejoining the north European mainstream

By Professor Simon Deakin

Listen to the podcast of this blog »

The campaign to increase the £6.19 an hour national minimum wage to a living wage of £8.55 in London and £7.45 in the UK should be supported on the grounds of both equity and efficiency. The living wage is good for families and workers, but also for firms and for the UK economy.

Joint research by the Resolution Foundation and the Institute for Public Policy Research has found that gross earnings would rise by £6.5bn if employees were paid a living wage. It also showed that paying UK workers a living wage would save the Treasury more than £2bn a year by boosting income tax receipts and reducing welfare spending.

This comes as no surprise to those who conduct research on public policy. If employers do not pay a living wage the state has to make up the difference through tax credits. These arrangements benefit no one except, possibly, firms which use tax credits as a pretext for paying low wages. These firms are more profitable as a result and their shareholders may also be better off. But their gains are being made at the direct expense of low-paid workers and the taxpayer.

The Council of Europe sets a decency threshold which implies that the minimum wage should be around two-thirds of the median wage (that is, the wage paid at the midpoint in the earnings distribution). The UK's national minimum wage has generally been around 45 per cent of the median wage since the late 1990s. The gap between the legal minimum and the decency threshold set by the Council of Europe has been met, in practice, by tax credits. This system has been allowed to develop because of fears that a high minimum wage would cause unemployment.

When the minimum wage was introduced in 1998, the Low Pay Commission was set up to advise ministers on its level. The commission was given the remit of determining what the likely economic effects of the minimum wage would be. Its membership consisted of a number of academic economists, in addition to representatives of management and labour. The outcome was a statutory minimum wage set at a level which did not meet families' living costs. To meet the gap, the then Labour government, which was committed to reducing household poverty, expanded the system of tax credits which it had inherited from the preceding Conservative administrations. This worked for a while. The rise in child poverty levels was reversed, but only up to the mid-2000s. The burden on public expenditure of increasing tax credits to make up for persistently low wages was becoming excessive.

The living wage campaign began as a response to adverse effects of low pay on many working households. These included very long working hours which were often spread over two or three separate jobs as earners attempted to meet living costs. Supporters of the living wage do not argue that it should become legally binding in the same way as the national minimum wage. Rather, they call on employers to recognise the principle of the living wage on a voluntary basis, and to make their position known to their contractors and suppliers, and to the public at large. The campaign is based on persuasion and an appeal to employers' enlightened self-interest.

Why would employers want to sign up to the living wage? The direct benefits include a more loyal and highly motivated workforce. Indirectly, employers with a stake in their local community may view the living wage as contributing to social cohesion. This is undoubtedly a factor in the support given to the living wage by many local authorities, hospitals and universities. But private sector employers in the retail and service sectors are also interested. There is a growing realisation that employers cannot insulate themselves from the social consequences of the decisions they make on wages and terms of employment.

What would be the effect of employers more generally accepting the principle of the living wage? Would it increase unemployment? This seems unlikely. One of the arguments for taking a cautious view on the level of the minimum wage in 1998 was that firms had come to rely on low pay as a means of cutting costs. The introduction of a high minimum wage would have been a shock to the economy, leading to increased unemployment. This argument has less resonance today. Employers have had over 15 years to get used to the minimum wage. As a result, the idea that wages should more reflect real living costs is becoming more generally accepted. Because the living wage is not mandatory, progress towards achieving it can be tailored to the circumstances of particular firms.

From the point of view of government expenditure, the living wage would be largely self-financing, thanks to the offsetting effects on tax credits. It would also bring wider benefits to the economy. The most productive economies in the world, those of the Nordic countries and the northern European systems influenced by the German model, either have high legal minimum wages or multi-employer collective agreements which set basic minimum rates of pay which are high by UK standards. These pay norms provide an incentive structure for investment by workers and employers in firm-specific skills. High minimum wages do not work on their own; they must be combined with other policies. These include active labour market policy to support the welfare-to-work transition such as in the Nordic countries, or the national vocational training system in Germany. Such measures might seem expensive, particularly during an economic recession. In fact, they largely pay for themselves once their impact on productivity is taken into account.

The living wage can be the basis for Britain to become a high-wage, high-productivity economy. We should aim to rejoin the north European mainstream on this issue. Looking further overseas, the very last thing we should be doing, if we wish to compete with the BRIC countries, is further deregulating our labour market. Brazil is addressing the issue of informal employment by putting a floor under household incomes through a basic income guarantee, while China has adopted a labour code which acknowledges the need for protection of individual and collective labour rights. These developing economies are gradually building systems of collective wage determination and social insurance of the kind we used to have. They understand that a competitive economy requires labour laws and a welfare state to provide insurance against labour market risks. We have not completely abandoned the same idea, which served us well for most of the 20th century. It is not too late to reconstruct our labour market institutions around the twin themes of equity and efficiency, as exemplified by the idea of the living wage.

Also posted on Progressonline

Shares for Workers' Rights - why entrepreneurial firms need employment law too

By Professor Simon Deakin

Listen to the podcast of this blog »

Under the government's current proposals for employment law reform, employees will be able to give up rights concerning unfair dismissal, redundancy pay, flexible working and time off for training in return for receiving shares in the company that employs them, gains on which will be exempt from capital gains tax.

It is right for the government to be encouraging worker ownership in companies; there is abundant evidence suggesting this improves labour productivity. What is completely unnecessary and counterproductive is to link this to the loss of employment protection rights.

Since the early 1970s, under laws initially introduced by a Conservative government, an employee with a minimum period of continuous service (currently two years) is protected against unfair dismissal. This means that if their employer wishes to terminate their employment, they must come up with a good reason, in principle, for doing so, such as misconduct, lack of capability or redundancy. The employer must also show that it has complied with certain procedures, including allowing the employee to put their case in a formal hearing. These laws do not confer a job for life and in no way permit "featherbedding". On the contrary, they give employers ample scope to incentivise and motivate employees. Nor do they prevent firms making workers redundant when there is a downturn in business. Their aim is to ensure that the workplace operates according to certain basic principles of fairness, which most of us could subscribe to: decisions on a matter as important as employment should not be made in an arbitrary fashion.

Although fairness is the main goal of these laws, they also have economic effects. They encourage workers to make a more serious commitment to the firm and to invest their time, effort and loyalty in it. Second, they provide firms with a strong incentive to treat the skills of their workers as a resource to be developed, rather than an asset to be disposed of at will. Employment protection laws encourage a virtuous cycle of investment in the knowledge and processes that are increasingly recognised as essential to economic success, particularly in high-technology sectors.

One of the government's aims in bringing forward this proposal is to encourage the kind of high-tech start ups associated with Silicon Valley in California. Silicon Valley is often said to have a "high velocity" labour market, in which employees move around from one firm to another, thereby promoting the circulation of knowledge. Employers, on the other hand, benefit from the flexibility that goes with having a skilled and mobile workforce. It is often assumed that the right of firms to hire and fire "at will" is critical to this type of flexibility. There is a major problem with this assumption, which is that it is simply not borne out by the facts.

The Californian law on dismissal is actually at the stricter end of the spectrum of US laws on employment. The principle that an employer can dismiss at will – that is, without good cause and on minimal, if any notice – has been qualified by the Californian courts, which require employers to demonstrate that they have acted in good faith when terminating a worker's employment. This principle is not so far removed from the notions of fairness that underpin British unfair dismissal law. The scope of the exceptions to employment at will have waxed and waned over the years, and it is possible to analyse the consequences of this for productivity and innovation. We know from econometric research that there is a correlation between tighter dismissal laws and innovation in California, as measured by increased number of patents and citations to patents. Not just that; as the law imposed constraints on the employer's power to dismiss, the number of small-firm start ups went up, as did the numbers employed in high-tech firms.

British dismissal law, like Californian, has varied over time, creating a similar "natural experiment" for research. The identical effect is also observed: stronger employment laws are correlated with innovation as measured by patents and citations to patents.

The intuition here is clear, and it is backed up by empirical research: when the law limits the right to dismiss, it enhances the confidence of workers that their efforts and knowledge will not be expropriated by the employer. The law can help to create an environment in which firms and workers make mutual investments in new technologies and processes, to the benefit of both sides.

Employment law plays another critical role in supporting technology-based innovation in US firms. In California, so-called "restrictive covenants" that prevent an employee resigning to set up his or her own firm or to work for a competitor are void. Californian courts refuse to enforce such clauses, on the grounds that they are a fetter on competition. This, rather than flexible dismissal laws, is the source of the much-vaunted "high-velocity labour market" of Silicon Valley. How does the UK compare? Under English contract law, contrary to the Californian practice, restrictive covenants are enforced by the courts almost as a matter of routine. We know this matters. When the state of Michigan changed its employment laws to make restrictive covenants enforceable, it saw a decrease in employee mobility.

So if the British government wants to do something to encourage innovation through employment law reform, there are two things it could do. The first would be to strengthen laws that promote fairness in the workplace. The second would be to take a closer look at judicial enforcement of restrictive covenants. There is clear evidence that these contract clauses restrict employee mobility and depress innovation.

Compared with these changes, which empirical evidence suggest would have a tangible effect, the proposed reforms are at best an irrelevance. At worst, they will set back innovation in British high-tech firms.

The writer is director of the Corporate Governance Research Programme, the Centre for Business Research, Cambridge university

Also posted on FT's Economists' Forum