Fiscal consolidation in reformed vs. unreformed labour markets

Alessandro Turrini, 25 April 2012



Most EU countries have embarked on a path of fiscal austerity to ensure orderly debt developments at a juncture where unemployment is high and private-sector demand still weak. To what extent such consolidation programmes could compromise the recovery is object of current debate (see, notably, the debate launched by Giancarlo Corsetti 2012 on this website), although there is a certain consensus that for some countries the room of manoeuvre on the fiscal side is quite limited, in light of possible tensions on bond markets.

Quite interestingly, a number of countries with a serious debt issue (Greece, Portugal, Spain, Italy) are also facing major challenges with labour-market reforms with a view to stimulate job creation, foster sectoral relocation, and address the problem of segmentation often linked to a two-tier approach with previous reforms (eg Boeri 2011). These policy programmes raise a fundamental question. Would the employment impact of fiscal consolidation be more harmful if reforms liberalising the labour market were taken at the same time?

To address the above question I have estimated the impact of fiscal consolidations across European countries on unemployment and job-market flows using a recent database of consolidation episodes built on the basis of a ‘narrative’ compilation of measures taken during periods where governments aimed at improving the budget (IMF 2011, Devries et al 2011). These ‘action-based’ measures have a double advantage. They are not affected by the economic cycle and they are unlikely to imply risks of reverse causation (because mostly driven by the objective to adjust the budget rather than other factors, notably the level of economic activity and unemployment).

In order to shed light on whether labour-market regulation matters for the impact of fiscal consolidation on unemployment, I carry out the same analysis repeatedly for countries with more and less strict employment protection, as measured by the OECD indicator for overall employment protection.

Fiscal consolidations increase unemployment more in regulated labour markets…

Results show that fiscal consolidations do produce a significant impact on cyclical unemployment, although lower than 0.1 percentage points for each GDP percentage point of consolidation measures taken. By separating the effect of government revenues and expenditures, it turns out that the impact is significant for expenditures but not for revenues.1 Interestingly, when running the analysis separately for high-employment-protection and low-employment-protection countries, it is found that fiscal consolidations produce a somehow larger effect in regulated labour markets, even though, in light of the reduction in sample size, the estimated fiscal-policy effect is non-significant when the sample is split according to employment protection.

… because employment protection is associated with a stronger reduction in job creation

The result that fiscal consolidation is not less harmful in more regulated labour markets runs against the intuition. The explanation could lie in the different behaviour of job creation and job destruction. It is well-known from existing theory and evidence that strict employment protection is associated with lower exit rates from unemployment but also with a lower probability for the unemployed to find a new job (Mortensen and Pissarides 1994, Gomez-Salvador et al 2004). It could be the case that in high-employment-protection countries fiscal-policy shocks destroy fewer jobs but also lead to a stronger reduction in the rate at which new jobs are created, with a possibly overall strong effect on cyclical unemployment.

With a view to test this hypothesis, I have estimated the impact of fiscal policy on job separation and job finding rates (hazard rates) using data constructed as in Arpaia and Curci (2010), following the methodology proposed by Shimer (2007). Figure 1 reports the results. As expected, the impact of fiscal-policy shocks on job separation rates is much stronger in low-employment-protection countries, while the high- employment-protection countries suffer from a stronger reduction in the rate at which new jobs are created. Since a reduced job-finding rate corresponds to a longer average duration of unemployment spells, fiscal-policy shocks also tend to raise the share of long-term unemployment in high-employment-protection countries.

Overall, the evidence suggests that while in regulated labour markets fiscal consolidation is unlikely to be less harmful in terms of its impact on the unemployment rate, there are well-grounded reasons to expect it to be more harmful in terms of unemployment composition, as high employment protection is associated with a stronger reduction in job creation and a higher incidence of long-term unemployment. In these respects, the findings bode well for the strategy recently followed by some EU countries and support the view that, at the current juncture, tackling the challenges facing the Eurozone requires a multi-pillar approach comprising both fiscal consolidation and courageous structural reforms (Buti and Padoan 2012).

Figure 1. Impact of fiscal consolidation on job-finding rates, job-separation rates, long-term unemployment

Notes: The coefficients represents the impact response in the variables reported following a 1% of GDP discretionary improvement in the primary budget balance. Job separation and finding rates are estimated hazard rates, namely instant probabilities for an employed worker to be separated from his job or an unemployed to find a job. The share of long-term unemployment is computed on total unemployment. The grouping of countries with respect to the OECD overall employment-protection legislation (EPL) indicator is built on the basis of the median country-specific average value of the indicator over the sample period. T tests are reported and *, **, *** denotes statistical significance at, respectively, the 10, 5, and 1% degree of statistical significance.

Policy implications

This finding has implications for the feasibility of structural reforms during austerity periods. Although it is well-known that certain labour-market reforms may be hard to square with fiscal consolidation because of their electoral (eg Buti et al 2010) or budgetary costs (eg Deroose and Turrini 2005), governments with a strong mandate to bring public finances on a sustainable footing while taking courageous measures to improve to capacity of the economy to create jobs may be able to carry out austerity measures and reform employment protection at the same time.



Arpaia, A, and N Curci (2010), “EU labour market behaviours during the Great Recession”, European Economy Economic Papers 405.
Boeri, T (2011), "Institutional Reforms and Dualism in European Labour Markets", Handbook of Labour Economics, Elsevier, Amsterdam, pp. 1173–1236.
Buti, M, A Turrini, P Van den Noord, and P Biroli (2010), “Reforms and re-elections in OECD countries”, Economic Policy, 25, 61–116.
Buti, M, and P C Padoan (2012), “From vicious to virtuous: A five-point plan for euro-zone restoration”, CEPR Policy Insight 61.
Corsetti, G (2012), “Has austerity gone too far?”,, 2 April.
Deroose, S, and A Turrini (2005), “The short-term budgetary implications of structural reforms: Evidence from a panel of EU countries”, CEPR Discussion Paper 5217.
Devries, P, J Guajardo, D Leigh, and A Pescatori (2011), “A new action-based dataset of fiscal consolidation”, IMF Working Paper WP/11/128.
Gomez-Salvador R, J Messina and G Vallanti (2004), "Gross job flows and institutions in Europe", Labour Economics, vol. 11, pp. 469–85.
IMF (2010) World Economic Outlook, October, IMF Washington D.C.
Monacelli, T, R Perotti, and A Trigari (2010), “Unemployment fiscal multipliers”, Journal of Monetary Economics, 97(5), 531-553.
Mortensen, D, and C Pissarides (1994), “Job Creation and Job Destruction in the Theory of Unemployment”, The Review of Economic Studies, vol. 61(3), pp. 397–415.
Shimer, D (2007), “Reassessing the ins and outs of unemployment”, NBER Working Paper 13421.

1 This finding appears broadly consistent with existing evidence on the US based on structural VAR estimations which yield significant unemployment multipliers for government spending (Monacelli et al 2010).

Topics: Labour markets, Macroeconomic policy
Tags: employment protection, fiscal policy, unemployment

Alessandro Turrini

Economist and a Head of Unit, DG Economic and Financial Affairs, European Commission; and Research Affiliate, CEPR