by Ricardo Caballero, Kevin N. Cowan, Eduardo M. R. A. Engel, and Alejandro Micco
No. 2, September 2004 - December 2004

Motivation for the Research
Microeconomic flexibility, by facilitating the ongoing process of creative destruction, is at the heart of economic growth in modern market economies.

The main obstacle to microeconomic flexibility is adjustment costs. Some of these costs are purely technological, while others are institutional. Chief among the latter is labor market regulation, in particular, job security provisions. Although the literature on the impact of labor market regulation on labor markets is extensive and contentious, there is agreement that job security provisions reduce restructuring.

Despite this consensus, the empirical evidence supporting the negative impact of labor market regulation on microeconomic flexibility is scant at best. This is not surprising, as the obstacles to empirical success are legion. In this paper, the authors make a new attempt to develop empirical september 2004 – december 2004 21 evidence supporting the proposition that job security provisions reduce restructuring and thus limit microeconomic flexibility.

Research Approach
The authors develop a methodology that enables them to bring together an extensive new data set on labor market regulation constructed by Djankov et al., with comparable cross-country, crosssectoral data on employment and output from the UNIDO data set. They emphasize the key distinction between effective and official labor market regulation.

The methodology builds on the simple partial-adjustment idea that larger adjustment costs are reflected in slower employment adjustment to shocks. The accumulation of limited adjustment to these shocks builds a wedge between frictionless and actual employment, the main right-handside variable in this approach.

The authors propose a new way of estimating this wedge, enabling them to pool data on labor market legislation with comparable employment and output data for a broad range of countries. As a result, they are able to enlarge the effective sample to 60 economies, more than double the country coverage of previous studies in this literature. Their approach to measuring effective labor regulation combines existing measures of job security provision with measures of rule of law and government efficiency.

Key Findings

• Countries where effective job security legislation is in place adjust more slowly to imbalances between frictionless and actual employment.
  
  
• In countries with strong rule of law,moving from the 20th to the 80th percentile of job security lowers the speed of adjustment to shocks by 35 percent and cuts annual productivity growth by 0.86 percent.
  
  
• The same movement – from the 20th to the 80th percentile of job security – in countries with low rule of law reduces the speed of adjustment by only approximately 1 percent and productivity growth by only 0.02 percent.

Implications
Many papers have shown that, in theory, job security regulation depresses firm-level hiring and firing decisions. However, conclusive empirical evidence on the effects of job security regulation has been elusive. In this paper, the authors fill some of the empirical gap by developing a methodology that exploits (1) the recent publication of two cross-country surveys on employment regulations and (2) the homogeneous data on employment and production available in the UNIDO dataset. By combining the measures of employment regulation with various proxies for law enforcement, they also solve the problem posed by differences in the degree of regulation enforcement across countries. 22 research review

Full text of Working Paper 04-6