An image of the planned new headquarters of the European Central Bank in Frankfurt. The construction is expected to be completed by 2011.

In the Great Recession so far, the Eurozone labour market has held up much better than its US counterpart.  While the US unemployment rate has risen by more than 5 percentage points (pp) in the course of the recession to 9.8% of the labour force, according to the latest data point, its Eurozone counterpart has only increased by about 2pp, albeit reaching roughly the same level at 9.7% in Q3.  This discrepancy is even more striking as Eurozone output contracted much more sharply than in the US, where the output reduction from the peak was about one-third bigger. 

Data published in October 2009:

US lost 263,00 jobs in September; Official unemployment rate rose to 26-year high of 9.8% - - broad rate climbed to 17%

Eurozone unemployment rate rose to 9.6% in August 2009; Lowest in Netherlands 3.5%; Highest in Spain 18.9%; Ireland at 12.5%

US investment bank Morgan Stanley's Eurozone watcher Elga Bartsch comments on the reasons behind the greater resilience of the job market in the Eurozone and discusses its implications.  She concludes that:

• First, there are likely more layoffs to come and MS expects Eurozone unemployment rising for most of next year. The labour market deterioration should take a toll on the consumer this coming winter
• Second, the lack of payroll reductions in the Eurozone put unit labour costs on a steep rise of 5.5% annualised rise during H1 2009.  Contrary to the US, where unit labour costs are falling, profit margins are under pressure in the Eurozone due to a lack of (labour) cost cutting.  Hence, a revival in corporate profits, measured on the gross operating surplus (the macroeconomic equivalent of EBITDA - - Earnings before Interest, Taxes, Depreciation, and Amortization), might still be further away than in the US, especially if expectations for aggressive cost-cutting are disappointed.
• Third, with unemployment benefits being more generous (with a net replacement rate of around 66% compared to 57% in the US initially and of 46% compared to 30% later on), the lengthening in the dole queues yet to come will likely cause a further marked deterioration in public sector budgets. Unemployment benefits are also the main reason for greater sensitivity of Eurozone government budgets to swings in GDP growth.
• Finally, country differences are highlighted and as well as their implications for intra-Eurozone divergences. While Spain, which already saw its unemployment rate more than double to almost 20% of the workforce, has likely seen most of the labour market reaction to the downturn, Germany, where unemployment was falling for the last three months, still has a large part of the adjustment ahead of it.

Elga Bartsch says there are several reasons for the different labour market performance on both sides of the Atlantic.

First, despite some marked improvements over the last decade, tighter labour market regulations in continental Europe make hiring and firing still more expensive than in the Anglo-Saxon countries. Second, the use of short shift subsidies, which a number of countries, notably Germany and Italy, beefed up in response to the turmoil, seems much more widespread in Europe than in the US. Third, the greater internal flexibility regarding working hours (through flexible work-time arrangements, part-time work, overtime accounts, temporary plant closures - - notably in the car industry) gained over the last decade allow companies to adjust hours rather than payrolls.  In addition, the rise in fixed-term contracts and temp-agency workers over the last few years allowed companies, mostly in the construction but also in the car industry, to cut payrolls. As a result, temp workers have borne the brunt of the layoffs thus far in many countries, but most notably in Spain. Fourth, Europe has started to see a contraction in the labour force as migration flows seem to reverse and secondary income earners withdraw from an increasingly difficult labour market to pursue other interests. 

The greater cyclicality of labour force movements across national borders constitutes a new channel of labour market adjustment in the enlarged European Union, according to MS. With restrictions to the movement of workers within the EU being progressively lifted for the new member states in Eastern Europe, economic booms tend to attract foreign workers, allowing the boom to last longer without creating meaningful inflationary pressures.  Vice versa, economic busts can cause them to withdraw from the national labour force again, thereby reinforcing the downturn through a further shortfall in demand.

Elga Bartsch says the implications for the Eurozone labour market outlook are gloomy. 

For starters, she notes that the labour market tends to be more of a lagging indicator in the euro business cycle, whereas in the Anglo-Saxon countries it tends to be more of a coincident indicator.  This means that the labour market typically turns after the overall economy.  Together with a lacklustre, sub-par recovery, this implies that there are likely more layoffs to come across the Continent.  In addition, new entrants into the labour market find it increasingly difficult to find a job - - a message that comes through loud and clear from a sharp rise in youth unemployment.  As a result, MS forecasts a noticeable rise in the unemployment rate in the quarters ahead and expect it to peak out at around 10.7% of the labour force in the second half of next year. 

The MS new employment indicator is a simple statistical model that projects near-term employment dynamics based on companies' hiring intentions surveyed on a monthly basis across several sectors by the European Commission.  It suggests that there are indeed more layoffs on the way in the remainder of the year - - even though the pace of job losses should slow from that seen in the first half of this year. 

Tweaking the hours worked rather than the payrolls

Bartsch says if her conjecture that the hours worked are a major factor in adjusting the labour input in this recession turns out to be correct, then a return of job growth could be even further away than the MS current forecast shows.  This is because, initially, companies will raise the hours worked up to and including working overtime before hiring new staff.  

After the end of the recession of the early 1990s, it took until early 1994 for employment to rise again.  On the whole, she expects a sluggish recovery in the labour market.  That said, she says that the increased flexibility at the fringes of the labour market - - notably new flexible work arrangements - - will prevent a hysteresis effect, which was typical of past recessions in Europe and where unemployment ratchets higher in the recession and fails to fall thereafter.  On the updated MS forecasts, Bartsch expects employment to fall a further 1% in H2 2009 and another 0.7% next year. Even assuming that the labour force shrinks slightly going forward, this would likely push the unemployment rate close to 11% of the labour force in late 2010.  It is only in 2011 that MS expects to see the number of jobseekers coming down again.

Lack of labour cost cutting should dent profits: While wage pressures in the Eurozone are subdued and might moderate further in the quarters ahead, the unit labour cost dynamics show that even without major wage pressures, cost pressures for companies can arise due to a sharp fall in labour productivity caused by output shrinking a lot faster than employment.  This, to some extent, reflects the fact that in Europe labour costs - - at least in the near term - - have the characteristics of fixed costs and, hence, are hit by sharp drops in operating leverage as capacity utilization rates reach fresh record lows of less than 70%, way below the trough seen in the early 1990s recession.  These labour cost pressures, which MS in the past have identified as the major factor driving the macroeconomic profit cycle could also be reinforced by many European governments struggling to plug holes in national social security funds.  Faced with ever bigger funding shortfalls in their social security funds, governments might be tempted to raise non-wage labour costs, notably the contribution rates to social security schemes, which then will boost non-wage labour costs. In addition, for many multinationals headquartered in the Eurozone, the stronger EUR will likely introduce an adverse translation effect for overseas earnings, even if they are perfectly hedged in their currency exposure by producing where they sell their products.

The MS FX team expects further EUR strengthening in the coming quarters to $1.60 for EUR/USD by the end of 2010.

Potential risks around the base case: Like many other forward-looking components of the monthly business surveys, hiring intentions have started to rebound in recent months, suggesting that companies have started to scale back their layoff plans.  That said, even at these improved readings for hiring intentions, the MS employment indicator is still pointing to considerable lay-offs in the remainder of this year.  Moreover, the latest batch of business surveys brought no further upgrade to companies' output plans, no meaningful rise in order demand and only a muted improvement in current output.  Against this backdrop, Elga Bartsch says she cannot rule out that companies will adjust their staffing plans too. This would point to further downside risks to consumer spending.  Potential setbacks to the Eurozone recovery in the quarters ahead are on the downside, as the main source of upside surprises so far seems to stem almost entirely from the inventory cycle, rather than a sustainable revival in consumer and investment spending.