economics

January 22, 2010

Labour markets: At the sharp end

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Something weird is happening to labour markets in the rich world. The link between depth of recession and rise in unemployment is broken. And for the first time in a generation, Europeans can bask in the knowledge that their unemployment would have to rise in order to approach US levels.

In some countries – the US stands out – the decline in output has not been so terrible but the employment shake-out has been brutal. Many more American jobs have been lost than in other countries – and many more than in the past.

In large northern European economies – Germany, the UK and France – the loss of output has been exceptionally nasty and far surpassed expectations, but the loss of jobs has been relatively modest. In countries around Europe’s geographic and economic periphery, meanwhile – Spain and Ireland in particular – the economic crisis has taken its toll on both employment and output.

Around the world, the accepted relationship in economics between employment and output – known as Okun’s Law – does not even appear to be a dependable rule of thumb. Instead, it seems to be an arbitrary relationship. As for the effect of the financial and economic crisis on households and society, collateralised debt obligations are an irrelevance; jobs are everything, as President Barack Obama saw to his cost in Massachusetts this week.

The loss of a breadwinner’s job shocks and angers families; if unemployment persists it can rob individuals of hopes and dreams, add to already growing burdens on taxpayers, limit rises in living standards and transmit its malign influences across regions and generations.

The failings of flexibility

Macroeconomics has learnt the art of eating humble pie. Since the onset of the financial crisis, long-cherished predictions, theories and rules of thumb about the way whole economies work have fallen by the wayside. Is it now the turn of microeconomists to taste some of the same medicine when it comes to the labour market?

For years, it has been the settled view in economics that, in most cases, flexible labour markets are best. More jobs might be lost in a downturn, but this cost was far outweighed by the benefits of flexible pay and the ease of reallocating jobs from dying industries to dynamic ones. No body was more closely aligned with such recommendations than the Organisation for Economic Co-operation and Development, the Paris-based club of developed nations.

But now the OECD is modifying its view. “We have been promoting flexibility, not for the sake of it, but for economic performance and for workers to get into new jobs,” says Stefano Scarpetta, the OECD’s head of employment analysis.

This motivation is allowing a change of view. “Judging from the outcomes so far, short-time working schemes seem to have been rather successful in containing the job haemorrhage,” he says, adding that even his organisation is “a little bit more positive on public works programmes: we argue that as part of a labour market approach, they might be worthwhile”.

While this is not a wholesale repudiation of the OECD’s former views, it reflects the fact that, according to the organisation’s own analysis, the gains in employment flexibility of recent years have failed to protect employees from the economic crisis. “There do not appear to be any clear grounds for concluding that workers, generally, are any better or worse prepared to weather a period of weak labour markets than was the case for the past several recessions,” the OECD concluded in its latest Employment Outlook.

Some top economists argue that the theory of superiority of flexible labour markets applies only at full employment. It will not work well when there has been a large shock to demand, output is well below potential and jobs are effectively rationed. In these circumstances, German-style institutions that cushion and spread the pain are probably superior.

For professor Richard Freeman of Harvard University, the problem is simpler. Microeconomists and policymakers spent much too much time fiddling with the work incentives of poor people. “If the unemployed person or the welfare mother . . . doesn’t do quite as much work as we would like them to do, or as they should, that’s a very small cost to society; when a big banker takes excessive risks, it can bring the whole system to a disaster . . . so we took the eyes off the ball of the really risky part of capitalism.”

So what is going on in global labour markets? The standard and dependable theory is that the US, with its hiring and firing culture, has suffered sharp rises in unemployment but also achieved gains in relative and absolute productivity. That will see it in good stead in the years to come. By contrast, employers in big European countries and Japan have been slow to recognise the seriousness of the recession and have often been more hidebound, both by law and cultural obligations, in addressing it – and so have held on to staff at the expense of plunging labour productivity.

The prediction flowing from this line of thinking is that in the recovery, the US will have much more rapid jobs growth than Europe and will be better positioned globally because it has already endured the pain and, having taken the medicine, can enjoy the recuperation.

There has to be truth in the explanatory part of the theory, since it is a description of the data. The Conference Board, a global business organisation, calculates that output per hour worked rose 2.5 per cent in the US in 2009, while it dropped 1 per cent in the eurozone and 1.9 per cent in the UK. “These are unusually large differences in productivity growth between the US and Europe,” says Bart van Ark, the board’s chief economist. “US employers have reacted much more strongly to the recession than their European counterparts in terms of cutting jobs and hours.”

Europeans are already nervous about what the theory predicts. Lorenzo Bini Smaghi, European Central Bank executive board member, warned last week that “if capacity utilisation remains at low levels, job losses may increase further”.

But there are some big problems with the productivity story, both in explaining the trends in unemployment and in predicting what will happen next. The theory does not really explain why the UK, also with a hiring and firing culture, looks more like Germany and France than the US – in fact, even worse. It does not explain why US employers have shed staff much more readily in this recession than in the past; nor why British and German employers have clung to their labour this time round; nor why employers in Spain and Ireland are rather like those in the US and unlike those in northern Europe.

One issue that cannot be discounted is that the figures on output might simply be wrong. Statisticians around the world have a habit of miscounting gross domestic product, the output of an economy. Intriguingly, the mistakes made in recent years, as painstakingly documented by Kevin Daly at Goldman Sachs, have reflected certain national stereotypes. Between 1999 and 2006, gung-ho American statisticians overestimated the first stab at US annual economic growth by 0.3 percentage points. Their more sober European counterparts underestimated growth by about 0.5 points.

So while the news has persistently implied that the US is a far more dynamic economy than Europe, the later reality is that at least two-thirds of that superior performance was a statistical mirage. If the traditional patterns of revisions are repeated for 2009, the fall in US output will grow, bringing it more in line with the loss of jobs, while the opposite will occur for Europe.

Stefano Scarpetta, head of employment analysis at the Paris-based Organisation for Economic Co-operation and Development, provides a second reason to doubt the simple productivity story. Advanced economies, he argues, have suffered from two quite distinct types of recession. One, characterised by an initial bust in housing construction before a drop in aggregate demand, is true of Ireland, Spain and the US; the other, hitting Germany, Japan, France and the UK, came predominantly via a collapse in consumer and business confidence and trade.

The argument that differing routes to collapse resulted in different impacts on jobs has much going for it. While a Californian housebuilding company knows it will be able to rehire a plasterer when a recovery comes, a Rhineland machine toolmaker cannot have the same confidence it will be able to find someone with the precise skills it needs when demand picks up.

Using this logic, Willem Buiter, chief economist of Citigroup, even dares to envisage a relatively optimistic outlook for the global jobs scene, saying: “The really good news might be that both [the US and Europe] have done the right thing given their institutions and demand.” But he adds that it is far too early to be sure this positive conclusion will survive the coming year.

T  he detail of individual labour market stories gives good reason to doubt the strength with which the US labour market will bounce back. It also casts a shadow over some European prospects, particularly in peripheral economies.

The US has experienced the worst recession in terms of jobs for at least a quarter of a century, with the early 1980s as the only recent parallel. Data (for job openings and labour turnover and supply) initially showed unemployment surging, because hiring evaporated at the same time as fewer people left their jobs voluntarily and firing stepped up a little from its naturally high level. More recently, the less rapid rise in unemployment has come as the rate of firing has declined but hiring rates have remained stubbornly low.

The fear has to be that hiring might not return to its former levels and might be weaker than in the 1980s. A perception is emerging that America’s wheels of economic adjustment are not turning as rapidly as normal.

Like Europe in the 1980s, the US unemployed are finding themselves out of work for increasingly long periods. Four in 10 have been unemployed for more than six months and many more have quit the labour market entirely, with the participation rate at its lowest level since 1985. The long-term unemployed, becoming less and less likely to land a job, are thus also less likely to act as a restraint on the working population in seeking inflationary wage increases. That raises the possibility that the sustainable growth rate of the entire US economy could fall.

US unemployment graphic

Part of the reason for the persistence of joblessness and the high numbers of dropouts from the labour market in the US this recession appears to be a decline in the mobility of Americans. The latest census data show a sharp drop in the proportion of Americans moving from one part of the country to another between 2004 and 2008 – perhaps a result of the housing boom-turned-bust that has left so many in negative equity.

“This is a serious long-term issue,” says David Autor, an economist at the Massachusetts Institute of Technology. “People who are discouraged may have trouble getting back into the labour market and, when they do, they generally have lower wages and less stable employment.”

Worst placed are the peripheral European economies, particularly Spain. There, companies have been firing the young, ethnic minorities and the low-skilled while hoarding older, more costly labour. The OECD’s Mr Scarpetta calculates that 85 per cent of jobs lost in Spain have been temporary contracts, a figure that rises towards 100 per cent in Italy.

So with a vicious unemployment problem touching 20 per cent of the labour force, Spain also lacks flexibility within companies. The danger is that these countries will lose both employment and productivity in the years ahead.

Big European economies, by contrast, are happy that growth in long-term unemployment is low, that the rise in joblessness has been so limited and that their temporary jobs programmes have received unexpected praise.

Alistair Darling, UK chancellor, told the Financial Times this week that the active role of government has helped, saying: “In the olden days, when you went along to the benefits agency, the discussion was about how much benefit, whereas the discussion now is, ‘how can we get you a job?’ ”

There are, nevertheless, country-specific fears for the future. In Germany, concerns centre on joblessness rising once the government’s Kurz­arbeit (short-time working) scheme comes to an end. In the UK, the worry is that unemployment will rise again once the government begins to cut public spending next year. Moreover, the tendency for European companies to hang on to labour at the expense of lower profits may not be sustainable. Nor does it suggest the recovery will be rich in new jobs.

Although northern Europe is feeling pleased with its labour markets right now, the details suggest a need to be cautious about expecting either a US hiring boom or rapid European adjustments to new patterns of demand and employment. Around the world, weirdness in labour markets may turn out to be far from wonderful.

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