C A Pissarides - London School of Economics 2014
Monetary and Fiscal Policies and the Labour Market in the Eurozone
Christopher A Pissarides
London School of Economics
and University of Cyprus
VIII IBM Rotating Chair in Studi del Lavoro
Università degli Studi di Milano
5 December 2014
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C A Pissarides - London School of Economics 2014
The Eurozone crisis
• Many countries in the Eurozone are still suffering from loss of income, slow recovery and growth and high and persistent unemployment
• Does the fault lie with the structure of labour markets or with monetary and fiscal policies that were followed after the recession?
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C A Pissarides - London School of Economics 2014
Labour markets and single currencies
• The post-Great Recession European crisis started as a debt crisis
• Policies to reduce public debts have exposed weaknesses in European labour markets
• For this reason, the crisis is often presented as a crisis of competitiveness and flexibility
• But it is not: it is a crisis of managing a common currency area when the criteria for optimality fail
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C A Pissarides - London School of Economics 2014
Labour markets in crisis?
• European labour markets have become inflexible
• Many reformed: UK in the 1980s, Netherlands in early 1990s, Germany in 2002-05, Spain in 2010-11 and Italy now
• Reforms are essential in Europe for reasons other than debt management (e.g., for competitiveness and adaptability)
• Debt management and inflexible labour markets got confused with bad outcomes for each
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C A Pissarides - London School of Economics 2014
Optimal Currency Area?
• Once the monetary policy tool is removed economic policy becomes more constrained
• OCA requires similar economic structures and business cycles to reduce the risk of different policy requirements
• But the crisis exposed dissimilarities between the members of the Eurozone
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C A Pissarides - London School of Economics 2014
Automatic stabilizers
• In theory free mobility of labour and capital and/or fiscal transfers could correct the imbalances
• But Europeans are well-off and prefer living in their country of birth – and receiving countries don’t like it either
• When it takes place it affects “wrong” professional groups
• Highly qualified people, unemployed who depend on social transfers remain. Social support is national
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C A Pissarides - London School of Economics 2014
Fiscal transfers
• Policy-induced fiscal transfers could balance the Eurozone
• But Eurozone does not allow them. Maastricht criteria are supposed to make sure they are not needed
• There has been some relaxation recently, with ESM and various rescue packages, but they are more in the form of loans than transfers
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C A Pissarides - London School of Economics 2014 8
Fiscal transfers have been critical in countries where monetary union worked
• United States when West opened up: infrastructure was provided with East Coast money
• German unification: East Germany was kick-started with West German money
• In both cases we had political union!
C A Pissarides - London School of Economics 2014
Dissimilarities in the Eurozone
• Recent crisis exposed some unanticipated dissimilarities between members with bad consequences
• Ireland, Spain, Portugal and Cyprus grew very large construction sectors, supported by bank loans
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C A Pissarides - London School of Economics 2014
Construction employment shares, 2007 (in red: program countries)
NETSLV
GER
BELDEN
MAL
NOR
AUT
EURO ITA
GRE
CZECYP
LAT
SPA0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
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C A Pissarides - London School of Economics 2014
Implications
• Crisis started in the housing sector – so countries with bigger construction sectors received a bigger shock
• Governments guaranteed banks to avoid bank failures
• Negative impact of the housing shock was reinforced by public debt explosion that forced contractionary fiscal policy
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C A Pissarides - London School of Economics 2014
Correlation between construction sector size and growth rates
0 1 2 3 4 5 6 7 8 9 1000
02
04
06
08
10
12
14
R² = 0.197477295735625
Average growth rate 2001-07
Co
nst
ruct
ion
sh
are
2007
CYP
EST
12
POR
SPA IRL
LAT
C A Pissarides - London School of Economics 2014
Correlation between construction sector size and growth rates
0 1 2 3 4 5 6 7 8 9 1000
02
04
06
08
10
12
14
R² = 0.3787432511015
Average growth rate 2001-07
Co
nst
ruct
ion
sh
are
2007
CYP
EST
13
LAT
C A Pissarides - London School of Economics 2014
Labour market responses
• With flexible exchange rates, when big negative shock hits exchange rate depreciates
• With fixed exchange rates the only mechanism left is “internal depreciation”, namely, wage reductions
• Unemployment needs to rise substantially to trigger this mechanism – and it did, making the recession worse
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C A Pissarides - London School of Economics 2014
Unemployment change 2007-2012
GE
MA AU
RO NO LU FR UK SK DE EU EZ LA IT LI CYG
R-5
0
5
10
15
20
25
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C A Pissarides - London School of Economics 2014
Did recession trigger the right labour market response?
• Nominal and real wages fell everywhere in the periphery
• But only in Greece to a non-trivial degree: 17% fall in real average earnings
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C A Pissarides - London School of Economics 2014
Real average earnings 2012(2009=100)
country Real average earnings Relative to Germany
Ireland 97.0 94.2
Italy 97.9 94.0
Spain 96.8 95.1
Portugal 90.6 87.9
Greece 82.5 80.1
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C A Pissarides - London School of Economics 2014
Did wage adjustments bring the right results?
• Biggest failure of the combined programmes of debt reduction and economic restructuring
• Massive fiscal austerity was reinforced by real wage reductions that spilled out to the whole economy
• Classic Keynesian response of labour markets: negative fiscal multipliers reinforced instead of being offset by wage reductions
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C A Pissarides - London School of Economics 2014
Why didn’t wage reductions work?
• For standard Keynesian reasons: deflation does not get a country out of a recession, especially one with large debts
• Wage and pension reductions accompanied by a fall in government spending, tax rises and dysfunctional (home-biased) banks reduce aggregate demand catastrophically
• The real value of debt rises; further spending cuts are introduced to reduce the debt to GDP ratio; deflation gets worse
• A vicious circle that leads to more debt and unemployment
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C A Pissarides - London School of Economics 2014
Labour markets at fault?
• Inflexible labour markets are not the reason for the Keynesian response
• Ireland has flexible labour markets: its aggregates are similar to other countries hit by the construction shock
• The key reason for Europe’s labour markets not working is the deflationary shock following the debt crisis
• Compare Ireland (flexible labour markets) with Spain (inflexible labour markets)
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C A Pissarides - London School of Economics 2014
GDP per head2007=100
2007 2008 2009 2010 2011 2012 201375
80
85
90
95
100
105
Ireland Spain
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C A Pissarides - London School of Economics 2014
Employment rates2007=100
2007 2008 2009 2010 2011 2012 201375
80
85
90
95
100
105
110
Ireland Spain
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C A Pissarides - London School of Economics 2014
Keynesian lessons
• Debt explosion triggered deflationary fiscal policies
• But debt explosion took place because of recession, so deflationary fiscal policies reinforce economic shock
• Optimal policy response is to find expansionary policies elsewhere to offset the two deflationary shocks
• Structural reforms still needed to raise potential GDP growth but actual GDP growth well below potential
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C A Pissarides - London School of Economics 2014
Optimal policy responses
• Expansionary monetary policy – move to 2% inflation target
• Fiscal transfers – low-debt countries push budget deficits to Maastricht thresholds
• Debt restructuring and some forgiveness
• Structural reforms
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C A Pissarides - London School of Economics 2014
The Renzi reforms
• Italy has been the “sick man of Europe” for two decades
• Politics and unstable governments are contributory factors
• With Hollande so ineffective Italy had the chance to take lead role in defending European South against German imposed policies
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C A Pissarides - London School of Economics 2014
Political and economic reforms
• For this reason the political reforms aimed at delivering more stable governments are welcome
• Twin economic problems
– low potential output growth because of poor institutions
– below potential growth because of debt and austerity
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C A Pissarides - London School of Economics 2014
Austerity versus reforms
• Italy needs to reduce debt and reform its economy to increase potential growth rate
• Austerity brings immediate unemployment rise; reforms need 3-4 years to have an impact
• UK in 1980s and 90s, Germany in 2000s and more recently Spain had to wait 4 or more years to see impact on potential output
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C A Pissarides - London School of Economics 2014
Timings
• Looser fiscal policy helps pass the reforms – more money for investments and low unemployment makes it easier to accept reforms that will bring temporary rise in job destruction
• In view of this repayment of debts in arrears should help. Morgan Stanley estimate that it could add 0.5 to 1% to cyclical GDP
• Benefit could be more if it facilitates structural reform
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C A Pissarides - London School of Economics 2014
Labour markets
• Something is clearly not right in Italian labour market
• Clear evidence of dual structure with adult males main beneficiaries
• Worst in Europe!
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C A Pissarides - London School of Economics 2014
Youth male unemployment relative to adult men, June 2014 (latest)
NETLA
TG
REAUS
SLKCYP
MAL
DENUSA
FINPO
RNO
RCZR
ROM
SWE
0.00.51.01.52.02.53.03.54.04.55.0
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C A Pissarides - London School of Economics 2014
Youth female unemployment relative to adult men, 2014
GER
NETIR
EAUS
MAL
FINCYP
SLV LUX
GRE
SLKPO
RPO
LCRO
CZR0.00.51.01.52.02.53.03.54.04.55.0
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C A Pissarides - London School of Economics 2014
Female employment relative to male, 2011
GRE
CZRPO
LSW
IHUN
POR
AUSUSA
GER
FRADEN
EST0
20
40
60
80
100
120
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C A Pissarides - London School of Economics 2014
North-South divergence
Per capita GDP, constant prices and PPP, relative to EU average
Germany Italy Spain Portugal Greece
1999 122 111 100 85 81
2012 125 95 95 75 75
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Italy worst performer since introduction of euro
C A Pissarides - London School of Economics 2014
Labour market reform: ideal
• Ideal scenario is “flexicurity”
• Flexibility in the labour market (limited employment protection, no red tape for hires, well organised apprenticeship system getting same attention as formal education)
• Government takes care of support during income loss due to unemployment
• Renzi reforms move the economy in that direction
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C A Pissarides - London School of Economics 2014
Government transfers
• Unemployment benefit is extended – positive, government takes on the support role
• But needs to do more – active policies not effective in Italy
• Youth guarantee (Hollande-Merkel initiative) was a good idea but ineffective
• Apprenticeships need to be encouraged more.
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C A Pissarides - London School of Economics 2014
Minimum wage
• Minimum wage can contribute positively to labour market by removing uncertainty for young people in particular but also all unskilled workers
• But it has to be a reasonable level, say 45-50% of median, and comprehensive
• Italian one is not – applies only for occupations not subject to collective agreements(?)
• Minimum wage should have positive supply effects but not negative demand effects
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C A Pissarides - London School of Economics 2014
Flexible market?
• Reform of employment protection desperately needed
• Dual structure not good – creates second-class citizens and encourages job rotation with high and more “jumpy” unemployment
• As alternative to current system one where worker accumulates financial benefits with tenure is much better
• Right of appeal to courts unduly delay dismissals
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C A Pissarides - London School of Economics 2014
Current reforms
• Contain positive elements in the gradual accumulation of financial benefits
• Incentives to eliminating dual structure: introducing some termination costs for fixed-term, reducing ones for open-ended, eliminating social contributions for three years for new open-ended contracts signed in 2015
• Have exemptions that enable the reinstatement of the worker in “disciplinary” dismissals
• The jury is out on the importance of the exceptions; once the courts get involved results are unpredictable
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C A Pissarides - London School of Economics 2014
Conclusions on labour market reform
• Monetary union needs a flexible labour market: ostensibly, the reasons UK and Sweden did not join in 1999 are the inflexible labour markets of continental Europe (including Germany at that time)
• Many countries, especially in the south, still lack flexibility
• Recent structural reforms are in the right direction but they need time to have a positive impact and they need the cooperation of all social partners.
• The German reforms of 2002-05 tool place in favourable conditions and still had their impact 4 years later
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C A Pissarides - London School of Economics 2014
Conclusions cont.
• But recent problems in European labour markets not due to inflexibility
• Better macro management needs to go in parallel with structural reforms
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