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Reforming labor markets

Summary:
The economy was doing poorly in the mid-2000s, with unemployment rates reaching up to 11%. Then, between 2003 and 2005, a series of bold reforms pushed workers into the job market and this led to strong growth in employment. The unemployment rate fell rapidly, and even during the Great Recession there was only a temporary blip upwards. By 2018, the unemployment rate had fallen to the 3% to 4% range. What country am I describing?  If you said Germany, you’d be correct: In response to the dismal labour market performance, in 2003-2005 the German government implemented a number of wide-ranging labour market reforms, the so-called Hartz reforms. The first three parts of the reform package, Hartz I-III, were mainly concerned with creating new types of employment

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The economy was doing poorly in the mid-2000s, with unemployment rates reaching up to 11%. Then, between 2003 and 2005, a series of bold reforms pushed workers into the job market and this led to strong growth in employment. The unemployment rate fell rapidly, and even during the Great Recession there was only a temporary blip upwards. By 2018, the unemployment rate had fallen to the 3% to 4% range. What country am I describing?  If you said Germany, you’d be correct:

In response to the dismal labour market performance, in 2003-2005 the German government implemented a number of wide-ranging labour market reforms, the so-called Hartz reforms. The first three parts of the reform package, Hartz I-III, were mainly concerned with creating new types of employment opportunities (Hartz I), introducing additional wage subsidies (Hartz II), and restructuring the Federal Employment Agency (Hartz III). The final part, Hartz IV, was implemented in 2005 and resulted in a significant cut in the unemployment benefits for the long-term unemployed. Overall, the Hartz reforms constitute one of the most ambitious attempts in recent history of restructuring the labour market of an advanced economy.

Figure 1 suggests that the Hartz reforms were quite successful. Between 2005 and 2008 the unemployment rate fell from almost 11% to 7.5%, barely increased during the Great Recession, and then continued its downward trend reaching 5.5% at the end of 2012. This view is shared by many economists in Germany and confirmed in our recent macroeconomic study of the Hartz reforms based on a calibrated search model (Krebs and Scheffel 2013). Specifically, we find that the Hartz IV reform reduced the non-cyclical unemployment rate in Germany by 1.4 percentage points. We further find that the Hartz I-III reforms decreased the non-cyclical unemployment rate in Germany by 1.5 percentage points. Thus, our analysis suggests that the entire reform package let to a permanent reduction in the German unemployment rate by almost three percentage points!

On the other hand, if you said Israel you’d also be correct:

When Mr Netanyahu was finance minister between 2003 and 2005, he was largely credited with rescuing the Israeli economy from the impact of the second intifada, which saw investment, tourism and business appetite shrivel under a spate of suicide bombings. Government expenditure soared because of security costs.

He nearly halved subsidies for the unemployed and cut child assistance payments, pushing people into the job market. He continued a privatisation drive that he had kick-started in his first run as prime minister in the mid-1990s.

Intellectuals will tell you that these are cruel neoliberal policies, despite their success in reducing unemployment:

Reforming labor markets

In contrast, Italy has not reformed its labor market and has double digit unemployment.  A study by Andrea Ichino and Johanna Posch of the European University Institute, Tito Boeri of Bocconi University and Enrico Moretti of the University of California, Berkeley compared Italy to Germany:

Nearly 350 national industrial agreements cover the vast majority of firms and formal employees in Italy. They take little account of regional differences in the cost of living and productivity. . . .

Wage bargaining in Germany, by contrast, was decentralised soon after unification. The authors find that earnings there are nearly four times as responsive to changes in regional productivity as those in Italy. Wages in the east are much lower than in the west, reflecting lower productivity and lower living costs.

The authors reckon a similar system in Italy could bring 2.5m more people into work, amounting to an increase of 13 percentage points in the employment rate in the south. Average earnings would be up to €114 ($129) higher a month. But southerners already in jobs would need to take a pay cut of 6%. That is no vote-winner. Greece, Portugal and Spain introduced similar reforms—but only after sovereign-debt crises. Instead Italy is launching a “citizen’s income” in the hope of reducing poverty and unemployment in the south.

PS.  Don’t take this post as an overall endorsement of Netanyahu, despite the fact that I agree with his economic views.

Scott Sumner
Scott B. Sumner is Research Fellow at the Independent Institute, the Director of the Program on Monetary Policy at the Mercatus Center at George Mason University and an economist who teaches at Bentley University in Waltham, Massachusetts. His economics blog, The Money Illusion, popularized the idea of nominal GDP targeting, which says that the Fed should target nominal GDP—i.e., real GDP growth plus the rate of inflation—to better "induce the correct level of business investment". In May 2012, Chicago Fed President Charles L. Evans became the first sitting member of the Federal Open Market Committee (FOMC) to endorse the idea.

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