Labour markets and monetary policy

Continuing with the discussions on monetary policy, I ran across an article at VoxEU by Ester Faia, Wolfgang Lechthaler and Christian Merkl on the ineffectiveness of monetary policy in heterogeneous European labour markets (here's the paper - it's a DSGE model). In particular they look at the link between large hiring costs in-between Eurozone economies (which are a proxy for unreformed labour markets) and policy trade-offs for central banks. The argument is that within a monetary union with heterogeneous labour markets (as evident on the graph below), monetary policy can be completely ineffective unless some sort of harmonization of firing costs across countries is achieved. This means that unless European labour markets all don't undergo a reform similar to the German Agenda 2003, it isn't likely that ECB's monetary easing will be very effective in decreasing unemployment. 

I'm not entirely sure whether their argument is supposed to be a sort of an explanation of the European liquidity trap (on how monetary policy is ineffective in a crisis) or is it supposed to be another justification of the idea that we can't have a monetary union without a fiscal union? What I'm certain however is that according to their main finding...
"A central bank facing higher firing costs should, thus, allow for larger deviations from its long-run inflation target to reduce this externality. Thus, the mandate of the ECB to solely maintain price stability is associated with welfare costs. To be more precise, a pure price-stability policy (i.e. stabilising inflation at its target) is suboptimal."
...they would assume that the ECB should opt for more monetary easing and a switch towards a higher inflation target (something close to NGDP targeting), however, they are unfortunately unable to do so due to the between-country differences in the rigidities of their labour markets (if I got this right).

The externality of which they speak is the following: 
"By hiring a worker today, firms reduce the future pool of applicants. This implies that firms hiring tomorrow will on average have to employ workers with lower productivity. We show that this negative composition effect cannot be offset by standard wage-setting mechanisms (neither collective nor individual). Thus, optimal monetary policy should be designed to reduce the macroeconomic effects of this externality."
I have a big problem with this assumption, as it fails to account for the new emergence of productive individuals on a yearly basis (new graduants, people switching jobs, etc.). I fail to see how this assumption is justified as an externality which is supposedly best fixed by monetary policy. If this is their main assumption for linking labour market inefficiency with ineffective monetary policy, then the conclusion fails the robustness test. A more plausible explanation would be that rigid markets with higher firing costs and stronger protection (like Portugal, Spain, Greece or France in the graph below) react more slowly to signals sent from the monetary authorities (or any other signals for that matter). This could perhaps explain why it takes a lot of time for both reforms to kick in and price signals to work in these countries, since businesses fail to adapt more successfully due to existing legal burdens. 

Source: Ester Faia, Wolfgang Lechthaler, Christian Merkl (2013)
 "Monetary policy and firing costs" VoxEU. 
The graphs shows a strong negative relationship between output volatility and the employment protection index (based on employment legislation), suggesting that economies in which labour markets are too rigid are less likely to experience output fluctuations both upwards and downwards. This is logical since an inability of companies to adapt faster to exogenous shocks (both positive and negative) means that the fluctuation of total output will be slower. 

Finally they conclude with the following point: 
"This implies severe complications for the Eurozone. With its large differences in firing costs, the monetary policy for the average Eurozone is not appropriate for every single country. Thus, there is a need for the harmonisation of firing costs. The divergence in the monetary transmission mechanisms due to the differences in labour-market institutions impairs the efficacy of the ECB’s policy. Without harmonisation, firing costs increase the tensions that are already present within the Eurozone."
Going back to my previous arguments, if we want to see an effective monetary policy (or stabilization policy in general), we first need to think of structural reforms of a rigid labour market and the regulatory environment. The authors of the paper in my opinion are on a good track in reaching such a conclusion, but operate under dubious assumptions of defining the labour market institutions. 

Comments

  1. One of the most interesting concepts and measures in economy, that jumps to my minds, is labor productivity.

    How can we measure precisely and define what productivity means, and what it means across borders and different cultures?

    For example, to account for productivity we must have a "value" (a numerical one) for the product being produced - so we can add the value added per unit or add the infinitesimal amount of GDP created.

    But what about the labor being done or product being produced that cannot be valued or (in this sense) measured through its price?

    On the issue of market rigidness, market that is firm is resilient also, but when having a downward slope, that is not a virtue.

    I have a simple analogy that I use, think of an economy as a simple cylinder. This cylinder has usual pressure and temperature. It also has a moving cap on the top of the cylinder. We can imagine that releasing all the extra liquidity in the system(ECB being an outside influence)it puts pressure on the economy increasing the temperature(activity) of its numerous particles(workers). If workers are inert or if the pressure is being released than the policy wont work. Pressure is being released in the cylinder by a small valve or being "taken" by an outside source of lower temperature(less active economy).

    So, liquidity can be applied in this system, but without the needed structure, it will not have the wanted effect, except to exhaust the outside influence - the ECB.

    On a different note, I believe that the world economy is the new "superstructure" that is always in continuous and dynamic balance and order. The EU has enjoyed very low interest on debt since the inception of the common currency. Once the construction of the currency was put under stress, it was natural too expect higher costs of interest on debt taken.

    Higher costs in one place do mean lower costs somewhere else. Not in a natural way, they came in the USA, taking a big proportion of the world saving to finance exuberant spending. I predict that the rise in debt interest rates will begin in China(need for debt also) to offset the surge of the oncoming private consumption(range - 5-10 years).

    EU will feel this as a surge in its exports and lowering in its own debt cost, until the next cycle is entered.

    What I am saying is that the EU's problems are structural as they are cyclical, and this cyclicality will be a chance for the EU to work on the structural issues.

    Tnx a bunch,

    D.

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    1. I am trying to understand your post. In what way are the EU problem's cyclical? Why would interest rates rise first in China when it is the USA which has a spending problem?

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    2. you do raise a few good points, and even though the analogy used is simplified, it draws a decent conclusion on applying excess liquidity in a structurally deprived system.
      On the interest rates in China, China is the most probable next bubble, but I'm not really sure how this will affect their interest rates. What if they experience the same problem as Japan?

      As for the cyclicality, that's an interesting perspective but I would think of the current shock as much larger then a pure cyclical movement, particularly when we think of how long has the current unsustainabe welfare state model been supported. There has to be an end to it sometimes, and a range of factors made it happen today. In a previous text on the Nordic model the conclusion was that they have reached this point in the 90s and have reformed ever since.

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  2. I remember reading some studies (but I cannot put my finger on them at the moment.) Which showed that the difference in labor costs between emerging economies like China, and advanced economies like Europe and the USA was not the wage rate. Wages were offset by the higher productivity in the advanced nations. But it was the regulatory costs and tax costs which really made the difference.

    When we make it difficult to fire, then it becomes difficult to hire.

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    Replies
    1. If you remember which studies these were let me know.

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  3. I havent had time to read this since I saw it on voxeu (still in my bookmarks), but here's a quick thought. There is a need for structural reforms to relax labour rigidities in some countries, but i fail to see why hiring costs should create problems for monetary transmission mechanism (unless they imply full employment is one of ECBs goals - which is not really true), after all there are differences between states in the US, and it doesnt seem to imply that a harmonization is needed. Mobility is maybe more important (OCA?). In EU labour mobility is much lower. Now, some of the questions related to mobility in EU are culture, differences in pension, welfare, health systems and transferral of the rights between countries. EU did some job on that but, obviously its not enough. In that sense, how Vuk explained (and KyleN), more comprehensive structural reforms are needed across EA - not "discretionary" but as a part of institutional overhaul. I doubt it will be very important for the monetary policy, i dont have a fancy DSGE model to confirm my view, though. There are reasons why ECBs monetary policy may not have same effects on all countries in the bloc, but hiring costs arent the primary ones. I think they are more like a symptom of underlying causes.

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    Replies
    1. I agree, I haven't found their assumption on wage-setting mechanism and hiring convincing either. Between-country institutional differences and as you mentioned labour mobility, are a much more important factor in explaining the mentioned ineffectiveness.

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  4. I believe most companies have it all wrong when they look upon their workers as just another expense. This is a 19th century model. In a age when knowledge is king cutting jobs does not produce results. Its amazing when you think about all the stuff talked about on the financial news shows about great leadership or how to manage your people your most valuable asset better to produce better produts and services and so forth. In the end many companies are really very shallow underneath the facade and in the end the best that many companies can come up with after all is said and done is job cuts in a attempt to improve results. I have owned stock in companies that have had serious problems and they always resort to cutting jobs in a feeble attempt to save the company money. In most cases it just makes matters worse. I have never seen a single case where just haphazardly cutting jobs produces and benefit to the company. My guess is that haphazardly cutting jobs produces worse results for a company.

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    1. I would argue that it really depends on the company, their industry, the environment surrounding the industry and most importantly their business practice.

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  5. I just wanted to ask you a general question about labor markets do you think that Germany by not having a minimum wage but other regulations has a more free labor market than the US, which has a minimum wage but fewer other regulations?

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    1. There is much more to it than observing just the minimum wage. In Germany it's a bit more complicated, since although they don't have an official minimum wage, they do have a law that forbids anyone from paying an immoral wage (which is most often allowed for the court to decide, and there is no consensus on what is this immoral wage). The labour market regulations do play an important role and this is where Germany has done more than the US in the past 10 years, particularly after the Agenda2010, implemented in 2005. You can read about it here.

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