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A simple-minded view of a business trying to innovate might go like this: You spend some money, hire some workers, give it a try–and if it fails to produce revenue, you take your losses, close the books, and shut it down. But what if the act of shutting something down imposes additional future costs? In that situation, a business may become reluctant to innovate, because of the higher costs for failure.

Yann Coatanlem and Oliver Coste argue that this dynamic can help to explain the lack of innovation among European technology firms in “Cost of Failure and Competitiveness in Disruptive Innovation” (Institute for Economic Policymaking at Bocconi University, Policy Brief, September 2024.

They write: “It is now widely understood that the R&D intensity gap of the European Union against the United States is driven by tech sectors: the United States private R&D in tech is now 6 time higher than in the EU”. They argue that Europe’s employment protection laws are a major factor driving this difference.

The details of employment protection laws vary across European countries, but in general, they make it harder to fire workers and often require that fired workers be paid for several months after firing. (OECD data comparing employment protection across countries is available here). When a firm is faced with such laws, it reacts over time by finding ways to hire outside contract workers not covered by these laws, engaging in additional outsourcing and offshoring, and also investing in physical capital to reduce the need for future hiring.

If a firm is in a mature industry, where it is making money and its employment levels are not going to vary substantially over time, then employment protection laws may have only a moderate effect. But a new high-tech firm is a riskier proposition. It may involve hiring a substantial number of workers now, but given the uncertainty it faces, there is a realistic change that it will also need to fire those people. The authors note: “In a seminal paper, Gilles Saint-Paul has shown that high firing costs tend to direct R&D investment towards mature products rather than new ones. In an open economy, countries with high levels of employment protection tend to specialize in well established industries and leave innovation of new products to countries with less employment protection.”

How much higher are these firing costs in a country with substantial employment protection legislation? “Leveraging a combination of financial analysis, empirical observations, and limited existing literature, we estimate that restructuring costs (that include much more than severance packages) are approximately 10 times higher in countries with high labor protection, such as in Western Europe, than in countries with low labor protection such as in the United States.” It’s not just monetary costs, either: “In many European countries, such as Germany, France, Italy, the Netherlands, Sweden, and the UK, large companies must engage in extensive negotiations with trade unions and works councils. These discussions cover the scope, motivations, timing, team selection for redundancies, severance pay, and in some cases, employee retraining or support for finding new jobs.”

The resulting cost gaps show up in firm behavior.

The recent wave of tech layoffs illustrates key structural differences between the European and American models. For instance, in the U.S., Microsoft laid off 10,000 employees in January 2023, with severance costs totaling $800 million, or $80,000 per employee, equivalent to 5.9 months of median compensation. Similar figures were observed for Meta (4.2 months), 38 Google (7.5 months), and Twitter (3 months). What stands out in the American model is the agility of corporate decision-making. The rapid success of ChatGPT triggered immediate responses: Microsoft streamlined its workforce, invested $10 billion in OpenAI, and more in its own AI infrastructure. Meta paused its metaverse efforts, laid off 20,000 employees within months, and boosted its AI investments, spending a whopping $37 billion on
computing infrastructure in 2024. Similarly, Google, facing challenges in search, halted major projects, laid off 12,000 employees, and accelerated on AI by ramping up its R&D investments to $43bn in 2023, including hiring tens of thousands of engineers with AI background. In Europe, the three tech leaders – Nokia, SAP, and Ericsson – also announced restructuring plans. Nokia, the largest European tech investor, presented a headcount reduction of up to 14,000 employees. Despite a sharp 21% sales decline last year necessitating immediate action, regulatory constraints in Germany, France, and Finland mean it won’t complete the restructuring until 2026. Similarly, SAP, Europe’s software leader, announced 8,000 layoffs, provisioning over 18 months of compensation globally, with more than three years required in Europe. …

Might there be some ways for supporters of employment protection laws to support the general goals of such legislation, while reducing the costs? One simple possibility suggested by the authors is that the employment protection rules could only apply to the bottom 95% or 90% of worker by pay: that is, protect the average and above-average worker, but not the top of the wage distribution. Another possibility is that employees would put money into an account that could be drawn upon when fired. Yet another possibility, modelled after Denmark’s “flexicurity” approach, is that government take on the costs of supporting income and providing assistance with job search and retraining, while firms keep the flexibility to fire as they wish. The rules for European firms negotiating with unions and works councils could be clarified and simplified, as well.

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