Full employment or a 'natural' rate of unemployment (NAIRU)?

by

Dr Alfred KleinknechtEmeritus Professor of EconomicsFellow of WSI, Wirtschafts- und Sozialwissenschaftliches Institut, Hans Bӧckler Stiftung, Düsseldorfalfred-kleinknecht@boeckler.de

Historical Background:After the Great Crisis (1929-1941) …

A 'Golden Age of Capitalism' (1946- ca. 1973):•Unprecedented economic growth•Low unemployment•Low inflation•Fairly stable financial markets

Broad consensus:•Manchester capitalism is passé•Economic stability through fiscal and monetary policy•Solid regulation of financial markets•A decent security net

The Age of Keynes!

After the 'Golden Age' (1946-73) there is a turning point around 1975-1985:

• Slowdown of economic growth …• … which cannot be reversed by fiscal stimulation• Oil price shock and 'Stagflation' (stagnation +

inflation)• 'Dutch Disease' → plant closures and mass

unemployment• Growing government debt burden• Keynesian macro-models make tough forecasting

errors

All this was a fruitful breeding ground for an anti-Keynesian counter-revolution from the right: Supply-side

economics!

Supply-side economics (1):

• Passive economic policy: no more fiscal stimulation; only monetary policy for fighting inflation

• Striving for greater income inequality: 'Performance must pay!'

• Deregulation of labor markets: easier firing!

• Cutting back on social security ('it makes people passive!')

• Retreat of government: deregulation, liberalization, privatization; Hayek (Nobel Prize 1974): 'Minimal State'!

• Deregulation of financial markets: more room for financial innovation!

• Markets are never wrong … and government is at the roots of every problem!

Supply-side economics (2):

.

Estimated rates of NAIRU ('natural' unemployment rates):Netherlands 4.5%; most other countries: 5-7%

If unemployment is below the NAIRU level, there is a risk of wage-price inflation! → the ECB will intervene by raising interest rates → restore ‘sufficient’ unemployment → strong competition for scarce jobs assures modest wage claims …

NAIRU = Non-Accelerating Inflation

Rate of Unemployment

Theory of 'Natural Unemployment' → You need a sufficiently large rate of unemployment in order to discipline labour and prevent inflation through high wage claims

Frame: The Euro has to be a hard and reliable currency!

Supply-side economics works (at least in one point):Greater inequality …

Share in National Income in the US:

Of the richest 10%: 33% in 1976 50% in 2007

… and of the richest 1%: 8.9% in 1976 23.5% in 2007

Source: Atkinson, Piketty and Saez (2011)

US: Average income of the bottom 90% and of the top 1%, 1933-2006

Keynesiaanse periode

Supply-side politics

Kre

die

t

US: Domestic debt as a percentage of GDP (1950-2007)"Household" = Consumer and mortgage debt"Business" = Total non-financial business sector debt"Financial" = Total financial sector debt"Public" = total public sector debt (local and federal)

Sou

rce:

US

Fed

era

l R

eserv

e

Hefboom financieringen

!

Zeepbel met huizenprijzen

→ hogere hypotheken

voor consumptie

The labour market for professors in full employment equilibrium

S = Supply of professors

D= Demand for professors

As wages rise, more people offer

themselves as professors

As professors become cheaper, universities buy more of them (as

with apples!)

Equilibrium wage W e

Market clearing equilibrium quantity

How could we get long-lasting

(mass) unemployment

among professors?

Professors get unemployed as their wages are too high!

Q

Aggressive trade unions raise

wages

Universities demand fewer

professorsSupply of professors

is too high Unemployed professors

Market clearing

wage

One way to full employment: Follow the green arrows!

S = Supply of professors

D = Demand for professors

The dominant neo-classical view: High European unemployment is due to labour market rigidities: the price of labour is downwardly rigid and cannot adapt to economic shocks

Key policy targets: Lower minimum wages Lower social benefits More tailor-made wage contracts (de-centralization

of wage bargaining → allow for a more unequal income distribution!)

Easier firing: change power relations on the shop floor

Reduce the power of trade unions (= cartels that act against the real interest of labour!)

'Liberal Market Economies' (LME) versus 'Coordinated Market Economies' (CME) according to Hall & Soskice (2001)

LME countries:

USA Canada Australia Ireland Great Britain New Zealand

CME ('Old Europe'):

Most continental European countries

Japan

Labor market institutions in LME versus CME

LME (Anglo-Saxon): Easy hiring and firing Shorter stay in same firm Modest unemployment

benefits Weak trade unions Wage bargaining more de-

centralized: income distribution more unequal

CME ('Old Europe'): Protection against firing Longer stay in same firm Generous unemployment

benefits Strong trade unions Wage bargaining more

centralized: more income equality

Strong protection of investors

Strong protection of

labor

Labor market institutions in LME versus CME:

Is there a difference in economic performance? (incomes? job creation? Productivity growth? GDP growth?)

Looking at some key variables …

Development of real wages, 1960 = 100

Anglo-Saxon labour market institutions lead to modest wage growth…

Differences in real wage growth make no difference for GDP growth

… but it does make a difference for labour productivity growth

Development of labor hours 1960-2004 (1960 = 100)

0

20

40

60

80

100

120

140

160

180

200

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

2011

EU-12 excl. Luxemburg

Anglo-Saxon countries: US, UK, Canada,

New Zealand, Australia

… and for labour input

Anglo-Saxons create more jobs …

!

… or they have to work longer for the same GDP …

Is there a causal link from wage growth to labour productivity growth?

Traditional argument: Labour productivity growth → wage growth (end of story)

Alternative view: There is also a link: wage growth → labour productivity

growth (estimated coefficients: 0.39 ~ 0.49)

Source: R. Vergeer & A. Kleinknecht (2011): 'The impact of labor market deregulation on productivity: A panel data analysis of 19 OECD countries (1960-2004)', Journal of Post-Keynesian Economics, Vol. 33 (2): 371-407.

N.B. Evidence at macro-level is meanwhile confirmed by a series of firm-level studies

Reasons for feedback from wages to labour productivity growth:

Neoclassical theory:

Factor substitution Vintage effect 'Induced' technical change

Evolutionary theory:

'Creative destruction' (Rehn-Meidner theorem)

Theoretical arguments about the impact of flexible labour on labour productivity (1):

Difficult and expensive firing of redundant personnel frustrates labour-saving process innovations (Bassanini & Ernst, 2002; Scarpetta & Tressel, 2004)

With easier firing, shifting labour from old and declining industries to innovative activities is easier (Nickell & Layard, 1999)

Counter arguments: Difficult firing gives incentives for training thus increasing

functional flexibility; People on the shop floor possess much of the (tacit)

knowledge required for process innovations. People threatened by easy firing have incentives to hide knowledge relevant to labour-saving process innovations (Lorenz, 1992, 1999)

Theoretical arguments about the impact of flexible labour on labour productivity (2):

Easier firing enhances the inflow of 'fresh blood' (i.e. of people with novel ideas and networks)

Powerful labour may appropriate rents from innovation, thus reducing the incentive to take innovative risks (Malcom son, 1997; Menezhes-Filho & Van Reenen, 2003; Metcalf 2002)

↕ Counter argument: This holds primarily for (Anglo-

Saxon) de-centralized wage bargaining and much less for (European) centralized bargaining

Theoretical arguments about the impact of flexible labour on labour productivity (3):

The (latent) threat of easy firing reduces shirking (→ Counter argument: this is poor HRM policy!)

Firms can more easily replace weak people by better personnel (→ Counter argument: a fallacy of composition!)

Theoretical arguments about the impact of flexible labour on labour productivity (4):

Flexible 'hire & fire' reduces loyalty and commitment: Greater chances that trade secrets and

technological knowledge will leak to competitors, larger positive externalities leading to stronger under-investment in knowledge.

There is more need for monitoring and control. Anglo-Saxon countries have substantially larger management bureaucracies which is frustrating for creative people (Kleinknecht et al. 2006).

Share of managers in working population (19 OECD countries, 1984-1997)

0 5 10 15Managers as a percentage of the non-agrarian working population

CanadaUSA

AustraliaU.K.

NetherlandsAustriaFinland

DenmarkJapan

PortugalGermanyIreland

BelgiumSwitzerland

ItalySwedenGreeceSpain

Norway

According to De Beer (2001), the Dutch

figure increased from 2% to 6% during 1978-

98

Theoretical arguments about the impact of flexible labour on labour productivity (5):

Given easier firing and higher labour turnover: Firms will reduce investments in manpower

training as pay-back periods become shorter. Personnel have fewer incentives to invest in firm-

specific knowledge (e.g. safety instructions) A larger personnel turnover weakens the

'historical memory' of organizations and the 'learning organization'.

Easy firing of personnel will change power relations in firms. People will less easily criticize management decisions. Lack of critical feedback from the shop floor can favour problematic management practices.

Theoretical arguments about the impact of flexible labour on labour productivity (6):Schumpeter I model (1912): 'Entrepreneurial model': new firm foundation (e.g. in

ICT, biotechnology); inventor-entrepreneur ('Garage business').

Schumpeter II model (1942): 'Routinized innovation model': Professionalized R&D

labs in large firms. Incremental innovations based on continuous accumulation of (tacit) knowledge with strong path dependencies

Impression from trade statistics: Anglo-Saxon countries perform better in Schumpeter I

regimes 'Old Europe' performs better in Schumpeter II regimes

Schumpeter I Model(‘garage business'):

Schumpeter II Model('routinized innovation'):

Low tech firms; starters in high tech (e.g. IT)

Larger medium-tech and high tech firms with professional R&D labs

Many SME/young firms Stable oligopolies

Turbulence (many new entrants; high failure rates)

Stable hierarchy of (dominant) innovators

Properties of knowledge base…

Spontaneously available, general knowledge → low entry barriers

Dependence on historically accumulated and often firm-specific (tacit) knowledge from experience → high entry barriers!

… and appropriate labour market institutions:

Recruitment through external labour market

Internal labour markets → well-protected “insiders”This table is inspired by: S. Breschi, F.Malerba & L. Orsenigo (2000):

'Technological regimes and Schumpeterian patterns of innovation', in: Economic Journal, Vol. 110: 288-410.

Rounding up (1): Are flexible labour markets good for labour productivity growth?

Evidence at macro and micro level:

Flexible labour relations and wage restraint lead a to lower growth of labour productivity and a more labour-intensive (less capital-intensive) growth path

Ironically, this resembles the factor-intensive growth pattern in Eastern Europe before 1989!

A low-productive and labour-intensive growth path is problematic with an ageing population in Europe!

Rounding up (2): Can we create more jobs under an LME regime (with deregulated labour markets)?

Probably 'Yes': if you succeed to bring down labor productivity growth

But note: According to the logic of a declining demand curve for labor, you have to create mainly lower-paid jobs i.e. create a larger group of 'working poor'

A likely scenario if the NAIRU doctrine remains dominant!

Anglo-Saxon countries with deregulated labor markets have higher shares of working poor ('outsiders')

Rounding up (3): Can we bring down unemployment under an 'Old Europe' regime?Probably 'No' (or at least doubtful) under protective 'Old Europe' labor market institutions …

Why? High productivity growth!

Law of Verdoorn → higher growth of GDP will trigger higher growth of GDP/working hour (= labor productivity)!

N.B: In the past, Europe had long periods of high GDP growth in which input of working hours stagnated (or even slightly declined) → But full employment has been achieved through shorter working times …

A desirable Green-Left scenario (?) … but undesirable from a NAIRU viewpoint!

Development of labor hours 1960-2004 (1960 = 100)

0

20

40

60

80

100

120

140

160

180

200

1960

1963

1966

1969

1972

1975

1978

1981

1984

1987

1990

1993

1996

1999

2002

2005

2008

2011

Years

EU-12 excl. Luxemburg

Anglo-Saxon countries: US, UK, Canada, New Zealand,

Australia

Long-run growth of GDP, of GDP/labor hour and of labor hours (per 1% GDP growth)

Average Annual GDP growth

Average annual GDP growth per

hour worked

Growth of labor hours per 1% GDP growth

Old Europe

Anglo-Saxon

countries

Old Europe

Anglo-Saxon

countries

Old Europe

Anglo-Saxon

countries

1950-60

5.5 3.3 4.2 3.6 0.23 -0.09

1960-73

5.1 4.1 5.2 2.7 -0.03 0.34

1973-80

2.7 2.4 3.0 1.1 -0.14 0.55

1981-90

2.6 3.2 2.4 1.4 0.07 0.55

1990-00

2.4 3.1 1.9 1.9 0.21 0.40

2000-04

1.3 2.5 1.1 1.6 0.15 0.35

Old Europe: EU-12 (excl. Luxemburg) Anglo-Saxon: Australia, Canada, New Zealand, US and UK

Rounding up (4): Do Anglo-Saxon countries have lower unemployment rates?

Yes: Nickell, Nunziata & Ochel: 'Unemployment in the OECD: What do we know?', in: Economic Journal, Vol. 115 (2005): 1-27.

Doubts: According to our re-estimates*, their results are not robust! → It is doubtful whether the 'flexible' countries indeed have lower unemployment rates (in spite of their labour-intensive growth!)

Why no lower unemployment rates? Anglo-Saxon countries have generous immigration policies In the aftermath of Reaganomics: Longer working hours The role of the Central Bank (NAIRU!)

*Source:Vergeer, R. & A. Kleinknecht (2012): 'Do flexible labor markets indeed reduce

unemployment?' in Review of Social Eco nomy, Vol. LXX (December): 451-467.

Summarizing: What are the main differences between CME and LME?

The two regimes do not differ with respect to:•Long run economic growth•Unemployment rates (although LMEs create more jobs)

Where do they differ?•LME have lower rates of labour productivity growth (value added per labour hour); so they have to work more hours for the same GDP - in exchange they create more jobs•Income distribution in LME is more unequal (more working poor)•Innovation:

– Old Europe does better in Schumpeter II industries– LME do better on Schumpeter I industries

Summarizing: The most important barrier to full employment: NAIRU theory

The European Central Bank has the task of assuring a sufficiently high level of unemployment (in the name of fighting inflation) → prevent 'too much' solidarity by assuring strong competition for scarce jobs

NAIRU = Non-Accelerating Inflation

Rate of Unemployment

Handsome frame: The Euro should be a 'hard' and 'solid' (say: investor-friendly) currency!