What I Read: “SCIENCE!”-Articles mk. V

Labor Market Policies and IMF Advice in Advanced Economies During the Great Recession by O. Blanchard, F. Jaumotte, and P. Loungani (2013)

Summary: Blanchard et al. summarize the vast literature on labor market policies and use their knowledge to categorize the recent IMF recommendations into two broad categories: (1) micro flexibility and (2) macro flexibility. Micro flexibility presents the supply-side of the coin (reduce inefficiencies and frictions of the labor market), while macro flexibility the demand-side, or to be more precise “the ability of the economy to adjust to macroeconomic shocks” (5).

The four important variables for (1) are: (i) unemployment inflows, (ii) unemployment duration, (iii) unemployment insurance, and (iv) employment protection. The different manifestations then can be used to place the countries into three crude labor market models: Anglo-Saxon, Nordic and continental.

The Nordic model is considered to be the best. However, this might simply be because of the high trust level between workers and firms, as “the introduction of a trust variable often reduces much of the estimated impact of the specific institutions (both in magnitude and significance)” (8). trustemployment

There are two important factors for macro flexibility: (i) the minimum wage/the tax wedge and (ii) the collective bargaining system. The best solution here seems to be a combination of a low minimum wage, a negative income tax and a general reduction in tax wedges (Belgium, Austria, Germany, Hungary and France had the highest tax wedge in 2014). The theoretical implications of collective bargaining is ambiguous. Blanchard et al.’s advice would be to have “a system that allows decentralized wage setting […] while keeping coordination to help the macroeconomic adjustment” (13). Again, trust is necessary for a more complex and better-suited bargaining system to work.

In their last section the authors look at the IMF recommendations during the great recession concerning unemployment, competitiveness, and medium-term growth prospects. To fight unemployment the IMF supported demand-side policies, because the natural rate of unemployment did not increase (see Beveridge curve) at first. Then they promoted fiscal consolidation as the debt surged. To offset the negative side-effects of consolidation, unconventional monetary policy and an improvement in the trade balance was advised. Countries with a strong labor market duality will have a tougher time adapting the new situations and should be focused on.

To improve competitiveness the only short-term solution is to reduce relative wages. This is a problem for many countries because they cannot do this via currency depreciation. Therefore (a combination of) several options are available: shifting relative inflation rates, national wage-cut agreements, great flexibility in wage-setting, decrease public sector wages, decrease minimum wage or fiscal devaluations through a shift in taxation. Some of these were implemented in some countries, but many have not.

In Europe, the future of growth looks weak. Some structural reforms (lower the barriers for market entry of new firms) and labor market reform (support certain groups to join or remain in the labor market) should be implemented after productivity has gone up and the crisis has somewhat passed.

Comment: I especially liked their segment on trust and how important it is for labor market policies to work properly. It’s one of the most valuable resources in many advanced economy and certainly undervalued. At the same time it’s hard to operationalize and therefore difficult to grasp and promote. Many institutionalists think that trust is created by institutions but most research I’ve read point to the opposite – Blanchard also seems to thinks so.

The paper also strongly suggests (it is not keeping score) that many countries have not implemented the advised policies. At most, they implemented one or two policies were passed, but often without considering the negative side-effects associated with them. At the same time, the authors are aware of the political and historical constraints faced by the respective governments and show an understanding of their difficulties, especially involving the lack of trust.

Wider and Deeper? Enlargement and Integration in the European Union by R. D. Kelemen, A. Menon, and J. Slapin (2011)

Summary: The article explores whether or not the dichotomy wildly employed by media and politicians between widening and deepening does in fact exist for EU institutions.

They present two main formal approaches: (i) spatial models, which “highlight how enlargement multiplies the diversity of member state preferences, leading to more gridlock” (3) and (ii) Olson’s collective-action theory, where an increase in members decreases the amount of public goods produced. Not surprisingly (BIAS!), and in contrast to the media and politicians, they summarize the observed literature with: “For all the public and political debate about enlargement and its implications for deepening, the theoretical literature on European integration has, to date, failed to offer a systematic, convincing account of the relationship between widening and deepening” (5).

Their own approach is based on a spatial model and they go through various scenarios and their outcomes. Depending on the situation the results differ – SHOCK! They use several variables (preferences of new member states, voting structure, number of veto players, reaction of EU institutions, transaction costs) to show how institutions may react to a widening and how the actors themselves matter in a institutional context. It is, however, very hard to judge the influence of each variable in a purely theoretical setting, which is why they turn to empirical examples next.

These examples include: (a) comparative federalism, (b) international organizations, and (c) the EU’s own history.

As the case numbers are rather small, it’s hard to draw conclusions, but for (i) no relation between widening and deepening can be found. For (ii) the effects point to the opposite direction, meaning deepening causes widening. Furthermore, the addition of new member states also doesn’t seem to have any effect. Institutional adaptation, the lack of old-new member state cleavages and the formalization of procedures has kept the EU functioning at the same level as before.

Comment: The article provides some evidence that the picture perpetuated by the media and politicians is at least overly simplistic. Of course, the exact effects of widening/deepening are hard to gauge as the data is often lackluster and rudimentary at best.

In this field qualitative studies still seem to reign supreme and offer much more insight than the crude index-based quantitative studies – even if they often show some real operationalization ingenuity.

Advancing Macroprudential Policy Obejctives by D. K. Tarullo (2015)

Summary: The paper is actually a speech, but as I personally find macroprudential policies quite interesting I decided to review it nonetheless.

Tarullo speaks about a more practical approach to macroprudential policies, where progress has been made and where more or different regulation might be important in the future.

These macroprudential regulations “are designed specifically from a systemic, as opposed to a firm- or asset-specific, perspective” (3). Furthermore, instead of focusing on the standard policies of time-varying and countercyclical measures, Tarullo wants to concentrate on structural macroprudential measures. These can be – in contrast to time-varying or countercyclical measures – employed in the near future, as they allow for a slow and careful implementation via the administrative body of the central banks.

The new tools would be applicable to: (i) large financial institutions, (ii) normal market participants and (iii) central counterparties.

For large financial institutions even tougher capital standards (different from Basel III requirements), a new set of quantitative liquidity requirements to prevent another systemic liquidity squeeze and proper liquidation authority at the FDIC should be implemented.

For normal market participants he thinks “shadow banking” should be looked at in greater detail. During the financial crisis fire sales and short-term wholesale funding proved to be a systemic risk. And although some regulation has already been passed, there is room for increased prudential market regulation, where the goal is to implement “a policy framework that builds on the traditional investor protection and market functioning aims of securities regulation by incorporating a system-wide perspective” (12).

His last policy objective is to strengthen central counterparties. They play a central role in the system-wide financial stability and to limit a financial fallout they have to be capitalized accordingly. Especially their remaining procyclical-ness remains a problem. The introduced “Cover 2”-rule might simply not be enough, because it doesn’t take a system-wide perspective, which is necessary in a bigger financial tumult.

Comment: The speech obviously does not contain any detailed policies, but presents a good summary of some enacted and some proposed macroprudential policies. It somewhat baffles me how regulation with such a perspective had not been more prominent before the financial crisis.

At the same time, many microregulations may impede development and growth, so one has to be careful. Still, the danger does not seem apparent (yet), especially when you have enough time to implement the regulation properly (although that might mean they can be attacked easier, too).
Further Reading Gefährliche Schattenbanken: Auslöser der nächsten Finanzkrise?, Shadow Banking Shrinks to Least Since 2000 as Liquidity Declines, my review of “Making Macroprudential Policy Operational” (post looks rather ugly though), Macro-Prudential Tools (IMF video)


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