Unemployment, labour-market flexibility and IMF advice: Moving beyond mantras

Olivier Blanchard, Florence Jaumotte, Prakash Loungani, 18 October 2013

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Growth in advanced economies is gaining some speed. The IMF projects these economies will grow 2% next year, up from an expected 1.2% this year. The average unemployment rate in advanced economies is expected to inch down from its peak of 8.3% in 2010 to 8% next year. This is progress, but it is clearly not enough. The state of labour markets remains dismal for a number of reasons.

First, even before the crisis, average unemployment rates were high in many countries, and potential output growth too low. For instance, between 1995 and 2004, the average unemployment rate in the Eurozone was 9.5%. Unemployment today is over 11%, but a return to the pre-crisis average would be far from nirvana.

Second, the labour market is plagued by a duality of outcomes, which the Great Recession has exacerbated. Workers on temporary contracts have limited employment protection, and have borne the brunt of labour-market adjustment. Low-skilled workers and young people have fared worse than high-skilled and older workers (see Figure 1). The long-term unemployed risk being cast away beyond reach of the tides of recovery.

Figure 1. Recovery differs across groups

Note: Ratio of each group's employment relative to overall employment.
aOECD average
b2008 Q1-2011 Q4, index = 100 at the start of the crisis

Third, some countries in the Eurozone need to boost competitiveness. With devaluation ruled out as an option, the channel to bring this about is through wrenching labour-market adjustments.

Micro and macro flexibility

The mantra of “labour-market flexibility” is invoked as a remedy for many of these problems. A Google search of the term yields a million hits, of which nearly a thousand emanate from IMF documents. In a presentation at a recent IZA conference, we tried to go beyond ritual invocation to describing why flexibility is needed and what labour-market institutions are critical to providing it. Against this backdrop, we then assessed IMF advice on labour markets during the Great Recession. We do not pretend to have uncovered new insights; rather, we tried to summarise the consensus among labour-market researchers and to show how the IMF has applied it in practice.

What is labour-market flexibility and why it is needed? We suggest that it’s useful to distinguish between micro and macro flexibility. Micro flexibility is the economy’s ability to carry out the reallocation of workers to jobs needed for productivity growth. High-productivity firms must be able to enter and grow, and low-productivity firms to contract and eventually exit. Such reallocation promotes productivity growth (Martin and Scarpetta 2012).
Economies need macro flexibility too. This is the ability to bring about adjustment in labour markets in response to economic shocks, such as the oil-price shocks of the 1970s and the more recent loss of competitiveness in some Eurozone countries.

Ensuring micro flexibility

“Protect workers, not jobs” is the right mantra when thinking about micro flexibility. But how, concretely, can it be put into practice? All labour-market institutions likely play some role, but two are critical – employment protection legislation and unemployment insurance.

Reallocation is important for productivity growth, but much productivity growth also comes from stable employment relationships. Employment protection is thus desirable, and some of it will be offered by firms that want their workers to invest in firm-specific skills. Some additional employment protection – in the form of a layoff tax for example – is justified by the fact that firms should take into account the costs they impose on society, namely the unemployment benefits paid to the workers who are laid off. But excessive protection or complex restrictions on the separation process hamper needed reallocation and productivity growth (Driffill 2013). Such overkill also leads to lower hiring and thus higher unemployment duration, so it does not end up protecting the cause of workers overall.

Some countries have tried a dual system with high employment protection for permanent contracts and lighter protection for temporary contracts. But this has had undesirable consequences. Temporary workers have suffered a high level of employment insecurity, alternating between dead-end jobs and unemployment, and received little training from firms.

Unemployment benefits are also essential to protect workers. For many workers, job changes involve an intervening spell of unemployment, and benefits play a critical insurance role. Their provision has an efficiency cost. It raises the reservation wage and thus unemployment duration, but longer search is not necessarily bad when it leads to better matching. Experience has shown that, more than the level of benefits, what matters is to have them decrease with duration and to have active labour-market policies to help workers return to work.

These two institutions – employment protection legislation and the unemployment insurance system – have been combined in quite different ways to protect workers. The ‘Anglo-Saxon model’ has low unemployment benefits and low employment protection, but it affords workers protection through high labour flows and a low duration of unemployment. The Nordic countries have moderate employment protection, and high unemployment benefits but with strong activation policies. The ability of many Nordic countries to keep unemployment duration low (see Figure 2), while also having low inequality of incomes, has made their ‘flexicurity’ model a beacon for many others.

Figure 2. Inflow into unemployment versus duration of unemployment (%, 1995-2007 average)

Source: International Labor Organization (ILO) based on Perez and Yao (2012).

Micro flexibility: IMF advice during the crisis

Has recent IMF advice on labour markets conformed to these principles? The first thing to note is that at the onset of the crisis, the focus of IMF advice on unemployment was more on monetary and fiscal policies than on labour-market policies. Getting macro policies right was regarded as critical to countering the sharp decrease in aggregate demand. Thus, the IMF supported the rapid reduction in policy interest rates by several central banks. Moreover, it played a key role in making the case for – and helping coordinate through the auspices of the G20 – a coordinated global fiscal stimulus (Spilimbergo et al. 2008). In tandem, we supported other policies to lower the incidence of unemployment, such as the use of short-time work programmes in Germany.

Other IMF advice can be tied more directly to our discussion of micro flexibility. The extension of unemployment benefits was generally supported, e.g. in the US and Iceland, to ease the pain of unemployment. The efficiency argument that longer unemployment benefits would decrease search intensity was thought to be weak in a severe recession. When vacancies are scarce relative to the pool of unemployed workers, any job not taken up by one worker (due to the provision of unemployment benefits) is quickly filled by another. Nevertheless, there were cases – such as Portugal, where existing benefits were the most generous in the EU – where the adverse impact on incentives for re-employment led the IMF to advocate a reduction in benefits.

The unequal distribution of unemployment and its concentration among young people was partly a fault of the dual employment protection systems. For instance, in Spain the vast majority of job losses were of those on temporary contracts (see Figure 3). In a number of countries – particularly Italy, Portugal, and Spain – the IMF’s recommendation has therefore been to reduce duality. This will not change things overnight; the large-scale destruction of jobs has already happened in some of these countries. A smooth transition, as well as grandfathering existing contracts, may well make sense. Lowering employment protection on existing contracts at this point would likely add to unemployment, though it may also facilitate the necessary process of economic restructuring. Reducing employment protection on new permanent contracts, where it is excessive, can help stimulate the hiring of the unemployed on more stable contracts as the recovery takes hold.

Figure 3. Cumulative job destruction in Spain since 2007 Q3

Macro flexibility

Macro flexibility is the ability of the economy to maintain a low unemployment rate in the face of macroeconomic shocks. Flexibility in this context has two dimensions – maintaining a low unemployment rate, and a stable unemployment rate. Here the critical institution is the structure of collective bargaining, and in particular the degree of coordination of social partners. What is the right amount of bargaining power for firms versus workers? Does centralised bargaining give too much to workers, decentralised bargaining too little?

In theory, the effect of coordination on the level of unemployment is not clear. On the one hand, more coordination should lead worker representatives to put more weight on the welfare of the unemployed. On the other hand, it increases their bargaining power and could lead to higher wage demands and thus unemployment. One often-advanced hypothesis is that the worst outcome is achieved with intermediate levels of bargaining, such as sectoral bargaining. Relative to centralised bargaining, it is likely to put less weight on the welfare of the unemployed; relative to firm-level bargaining, it increases the bargaining power of unions, with potentially adverse effects on employment.

There are two problems with this view. First, cross-country evidence on the impact of the structure of bargaining on unemployment is mixed. Second, extension agreements – which characterise sectoral bargaining – can be useful when there are large numbers of small firms (provided social partners are representative of a large share of the sector, and the agreements provide enough flexibility when there is a wide dispersion of productivity between firms).

The structure of collective bargaining also influences how much unemployment increases in the aftermath of an adverse shock. When an economy-wide adjustment of wages is needed, theory suggests that centralised bargaining is likely to dominate firm-level bargaining for two reasons – it gives more weight to the welfare of the unemployed, and it can solve a coordination problem. When wages are negotiated at the firm level, a decrease in the wage at a given firm is a decrease in the relative wage – something that workers will be reluctant to accept. When wages are negotiated at the centralised level, wages can be adjusted at once and across the board without changes in relative wages.

In short, what is needed for efficiency is a system that allows some decentralisation of wage setting – to aid adaptation across space, i.e. sectors, regions, firms – while keeping coordination to help with macroeconomic adjustment. This can be organised in various ways. To us, a combination of national and firm-level bargaining seems attractive. But we recognise that efficient forms of coordination of sectoral bargaining can also be found – e.g. the wage leadership of the tradable sector in Germany – and that trust may be more important than any particular bargaining structure.

Macro flexibility: IMF advice during the crisis

The toughest decisions were in those Eurozone countries where macro flexibility was needed to correct a large competitiveness problem at a fixed nominal exchange rate. To ease the adjustment, the IMF recommended accepting higher inflation in the ‘north’ of the currency union (Barkbu et al. 2012); and achieving wage reductions in the ‘south’ through national agreements among social partners. However, such agreements were difficult to achieve or did not take place, in some instances reflecting a lack of trust between social partners.

  • In Ireland, despite a tradition of tripartite agreements from the 1980s on, discussions turned contentious when conditions turned sour. The government undertook unilateral actions on pay and pension cuts before an agreement with unions was reached in 2010.
  • In Greece, with poor labour relations, no deal could be struck. In fact, real wages in 2009 – which incorporated inflation expectations that turned out to be too high – increased. This increased household incomes, but with wage growth outstripping the euro average, competitiveness further suffered.

In the absence of national agreements, the choices left to ensure macro flexibility were far less attractive. In periphery countries where intermediate levels of bargaining were not delivering sufficient adjustment (Greece, Portugal, and Spain), the IMF’s advice was to facilitate opt-out clauses from collective agreements. Decreasing public-sector wages has been another channel of adjustment. This helps with the fiscal situation, but the impact on private-sector wages has been mixed. For instance, in Latvia the sharp decrease in public wages had limited effects on private wages; instead, much of the improvement in unit labour costs came from productivity gains (Blanchard et al. 2013).

Conclusions

It is a difficult task to design labour-market institutions so they enhance micro and macro flexibility while protecting workers. Our view is that to have micro flexibility, workers should be protected more through unemployment insurance rather than high employment protection. Dual employment protection should be avoided. Macro flexibility depends critically on the collective bargaining structure. A combination of national and firm-level bargaining seems like an attractive solution to the needs for both flexibility and coordination. But the implications of alternative structures of collective bargaining are not well understood, suggesting that the IMF should tread carefully in its policy advice in this area. Moreover, trust among social partners appears to be just as important in bringing about macro flexibility as the structure of collective bargaining (see Figure 4). This suggests that trusting partners can make widely differing combinations of institutions work well.

Figure 4. Unemployment rate versus trust (%, 1995-2007 average)

Source: OECD and World Competitiveness Report.

IMF advice during the Great Recession has been to maintain aggregate demand to the extent possible, and to share the pain of lower demand through extension of unemployment insurance benefits. In countries that need to improve competitiveness, but also want to belong to a currency union or maintain a currency peg, the choices have been more difficult. Some of the IMF recommendations have in these circumstances been controversial, but we have done our best to explain their logic.

References

Barkbu, Bergljot, Jesmin Rahman, Rodrigo Valdés, and a staff team (2012), “Fostering Growth in Europe Now”, IMF Staff Discussion Note 12/07.

Blanchard, Olivier, Mark Griffiths and Bernard Gruss (2013), “Boom, Bust, Recovery: Forensics of the Latvia Crisis”, Draft, Fall 2013 Brookings Panel on Economic Activity.

Driffill, John (2013), “European labour-market reform”, VoxEU.org, 8 March.

Martin, J P and S Scarpetta (2012), “Setting It Right: Employment Protection, Labour Reallocation and Productivity”, De Economist 160(2): 89–116.

Spilimbergo, Antonio, Steve Symansky, Olivier Blanchard, and Carlo Cottarelli (2008), “Fiscal Policy for the Crisis”, IMF Staff Position Note 08/01.

Topics: Labour markets, Welfare state and social Europe
Tags: collective bargaining, EZ crisis, IMF, institutions, labour-market flexibility, trust, unemployment, Unemployment insurance

Chief economist, IMF, on leave from MIT

Senior Economist in the Research Department, IMF

Senior resource manager and advisor in the IMF's Research Department