Employment protection and the labor market

What is the effect of employment protection legislation (EPL) on labor market outcomes? Conventional wisdom suggests that differences in labor market conditions can be explained by differences in EPL, so that different performances of U.S. and European labor markets depend on different degree of strictness of EPL. In this book we introduce the alternative view that the strictness of EPL depends on the labor market conditions, and investigate the consequences of this "reverse" causality nexus on labor market performance. The intuition is straightforward: when the level of economic activity is low, the costs of employment protection are higher, and EPL appears stricter than in economically healthier conditions. A relevant implication of this result is that labor market performance is the variable that moves the economic system towards a higher or lower level of rigidity in terms of job protection. Therefore, there is a reverse causality between EPL and labor market outcomes: it is not labor market rigidities that cause poor labor market performance, but rather, it is labor market conditions that cause the degree of rigidities of the labor market.