The European Central Bankrelieved world financial markets not too long ago when it madeclear its willingness to provide needed liquidity. Even in the faceof new concerns about Spain, that commitment has helped calmmarkets. Less in the headlines, but perhaps even more welcome, arethe fundamental economic reforms, particularly in labor markets,that have begun to emerge in the beleaguered nations on Europe'speriphery. These efforts ultimately promise a more durable responseto Europe's problems than any financial aid from the ECB orelsewhere.

For years, labor laws in Spain, Italy, Greece, France andelsewhere in Europe have come under criticism. The InternationalMonetary Fund, analysts at the European Union itself, and Germanreform advocates have identified a bewildering complex ofemployment laws, regulations and practices that have imposedrigidities on labor markets in these economies; needlessly raisedproduction costs; and increased their rates of unemployment,particularly among the young. According to the IMF, the situationhas cut almost one percentage point a year off potential realgrowth rates in these countries, worsening their fiscal imbalancesand blocking needed adjustments to the current debt crisis.

It would take volumes to describe all these dysfunctional laborarrangements. Illustrative, however, are the restrictions thatFrance, Italy, and Spain have long imposed on hiring and,especially, firing. It has been incredibly difficult and costly inthese countries to let a full-time employee go. Often companieshave to make the case for layoffs in arbitration, even in extremeeconomic situations. Legally required severance can rise to severalyears' salary. Such strictures have discouraged hiring altogetheror impelled firms to hire only with limited, fixed-lengthcontracts. In such circumstances, the young have a hard timefinding rewarding work, while the economies lose the benefits oftheir talents and labor. What is more, older workers have clung totheir secure, protected positions rather than follow jobs tofaster-growing areas, in the process hamstringing firms' abilitiesto take advantage of new lines of business.

If these practices, long enshrined in law, have not been enoughto block flexibility and productive efficiency, additional rules inthese countries limited the latitude of companies to adjust workinghours to meet cyclical ups and downs or to accommodate seasonalproduction runs. Companies even have had trouble drawing on theunemployed to meet varying staffing needs. High unemploymentbenefits verging, according to the IMF, on 75% to 80% of theaverage worker's earnings, make even those out of work reluctant tofollow jobs where they appear.

Tax laws, by discouraging two-incomehouseholds, further block flexibility. Called the “tax wedge,”these burdens have sometimes climbed to over 40% of the additionalincome beyond normal income tax rates. Still more, high minimumwage laws have made it almost entirely uneconomic to employlow-skilled workers, leaving many unemployable and a burden on eachnation's social welfare system. The IMF estimates that minimumwages in Greece, Spain, and Portugal are close to 50% of the mediumnational wage. In France, they verge on 65%.

Unwinding such market impediments will not be easy and certainlycannot happen overnight. Still, it is encouraging that several ofthese nations have used the pressure of the crisis to begin theprocess. In just the last few months, for instance, Italy amendedits 1970 labor law to allow layoffs for economic reasons, not justmisconduct. Recent reforms also capped severance packages,admittedly to a still high maximum of 15 months of salary, andcreated a much less generous universal unemployment insurancescheme. Spain has reduced required severance; moved away fromnationwide, one-size-fits-all collective bargaining arrangements;and allowed more flexible hiring and firing rules, both to relieveyouth unemployment and to increase productive efficiency. Francehas moved more slowly, no doubt because it feels less immediatepressure than Spain and Italy, but even its new Socialistgovernment has proposed a relaxation of hiring and firing rules,provisions to allow decentralized collective bargaining, and meansto give firms more flexibility in setting workers' hours.

The Italian experience speaks loudly to how the crisis hasserved these reform needs. For years, the country tried to amendits labor law and, until this year, it has always failed. Pastefforts faced intense resistance from organized labor and hugeprotests. The last two major reform efforts, in 1999 and 2002, sawthe Red Brigades assassinate the major reform leaders of the time.This year, there were no killings, the protests were modest,certainly by past standards, and some unions even declined tocondemn the reform proposals.

These nations have a long way to go. There will be backsliding,no doubt. Just recently the Portuguese government had to cancelplans to make some workers contribute to their own pensions. Butthe efforts are more of a start than would have seemed possiblejust a year ago. The changes will also take a long time to haveeffect. But it is just such longer-term fundamental reform thatwill redress underlying differences within Europe and get to thetap root of today's problems. Such reform is also critical if theECB's monetary help is to do more than just paper overdifficulties. To that extent, such remarkable change is even moreencouraging than the ECB's welcome, more immediate efforts.