IMF – labour market regulations do not undermine potential growth

On the eve of the Annual Spring Meetings of the IMF and the World Bank in Washington last week, German Finance Minister Wolfgang Schäuble wrote an article in the New York Times (April 15, 2015) – Wolfgang Schäuble on German Priorities and Eurozone Myths – justifying the German stance with respect to the Eurozone crisis. He argued that the Eurozone was pursuing the correct response by placing a focus on “structural reforms”. He said that the IMF boss was in accord with this assessment and further structural reforms were necessary, including “more flexible labor markets”. He included labour market reform as part of a push for “modernization and regulatory improvements”. In denial of the basic rule of macroeconomics that ‘spending equals income’, Schäuble said that fiscal stimulus “is not part of the plan”. He might have read the complete text of the latest IMF World Economic Outlook (April 2015) – Uneven Growth: Short- and Long-Term Factors – before he sought comfort in the imprimatur of the IMF. That organisation seems to say one thing here and another there! It has become schizoid as it confronts the fact that its Groupthink sees itself as a major part of the neo-liberal free market (help the rich) putsch whereas its research economists find out that the facts don’t match the political (ideological) stance. The IMF should be defunded and recreated to serve positive purposes.

The German Finance Minister’s bias is reflected, generally throughout the world of policy. If there is any economic dysfunction, the neo-liberals claim the course is the mysterious ‘structural’ – which usually translates into claims that workers are being paid too much, or enjoying excessively luxurious working conditions.

Op Ed pieces penned by their bosses as they strut the world, flying first-class between Davos and some golf course, a full of claims that countries have to introduce more flexibility in the labour market hiring and firing – which just means that bosses can sack workers summarily with minimal security and hire people on zero hour contracts and various other ‘free’ arrangements, none of which enhance the freedom of the workers.

Structural reform is the neo-liberal de rigeur. It is the all-pervasive answer to every malaise that society encounters.

If unemployment is too high it is structural. How? Workers must be receiving too high minimum wages or job protections must be too high.

Or the workers don’t have the skills that bosses need even though if the bosses had to fight to get workers in a fully employed labour market they would restructure job offers to include job-specific training opportunities, just like they did when there was true full employment in the period after the end of World War 2.

Persistently high unemployment provides no incentive for capital to offer any training at all. They can pick and choose among the unemployed workers at will.

Legislation that undermines the security and protections enjoyed by workers further increases the pool of desperate people that bosses can choose from.

Real wage suppression, German-style structural reform, involved the creation of tens of thousands of so-called mini-jobs, which have reduced the capacity of German workers to enjoy a complete life and restricted domestic demand in that nation, despite what the German Finance Minister claimed in his New York Times Op Ed.

But it remains a religious mantra that creating more flexible labour markets is a key structural reform that will modernise the world economy and provide a buffer against further crisis.

Somehow, making workers cheaper to hire and sack and undermining their job security and income earning potential – will insulate an economy from a major spending collapse.

Apparently, paying workers lower overall wages (and I include all components here including the psychic income derived from job security), will motivate them to work harder and smarter and thus increase productivity.

Apparently, Greece is not competitive because they pay too higher wages and have too many public servants.

The German Finance Minister presented this view to the Brookings Institute while he was in Washington last week in the form of two rhetorical questions (Source):

Why, he asked, does the country still have a minimum wage that is higher than some members of the eurozone? And why is the ratio of those in public administration higher than in every euro state.

In the latest World Economic Outlook, there is some technical econometric analysis that bears on the question about the impacts of labour market regulations and economic growth.

As part of a study of “Perspectives on Potential Output”, the IMF conducted a formal econometric study of the “The Effects of Structural Reforms on Total Factor Productivity” see Box 3.5 of the WEO publication.

Table 3.5.1. Impact of Product and Labor Market Frictions on Total Factor Productivity Growth provides the results of the statistical study.

The context for the empirical work is the claim that:

…. potential growth has declined in both advanced and emerging market economies in the aftermath of the global financial crisis.

The IMF say that three factors contribute to this decline – “a reduction in capital growth and demographic trends in advanced economies and lower total factor productivity growth in emerging market economies”.

The lower capital growth is no surprise. Investment ratios have plunged as firms find they are able to satisfy spending demand by households etc with existing capital stock and expect no major improvement in sales given the austerity in force. Households, fearing further unemployment and, in some nations, burdened with record levels of debt, are also in no mood to spend in the same way that they were spending prior to the GFC.

The demographic trends relate to an alleged decline in “human capital growth” (skills etc) as populations age. One might also have noted that with austerity in place, the entrenched youth unemployment that it has created is a major reason why future skills and work experience will be deficient.

Certainly, if a population gets old and a higher proportion of people exit the working age group then the skill base will decline, other things equal.

But the trends in the dependency ratio can be offset if the new entrants to the workforce are better skilled with new technologies and robust investment in capital.

The austerity bias is undermining the capacity of nations to offset the ageing trends because it has created high and entrenched rates of youth unemployment and is cutting funds to public education and public health.

What about total factor productivity growth (TFP)? What is it?

First, I should note that the IMF conducts all this research within a highly flawed analytical framework. They define potential output as:

… the level of output consistent with stable inflation (no inflationary or deflationary pressure). In the short term, actual output will deviate temporarily from potential as shocks hit the economy. These deviations reflect the slow adjustment in wages and prices to shocks, which means that the reversion of output to its potential level is gradual. This slow adjustment due to “sticky” wages and prices is a key tenet of the New Keynesian macroeconomic framework used in this chapter.

For my critique of the New Keynesian macroeconomic framework please read these blogs:

1. Mainstream macroeconomic fads – just a waste of time.

2. A continuum of infinitely lived agents normalized to one – GIGO Part 3.

3. OECD – GIGO Part 2.

4. Those bad Keynesians are to blame.

The essence of my criticism is that New Keynesian models are plagued with unrealistic abstract starting assumptions which then are augmented with ad hoc additions to provide some accord with reality.

The resort to arbitrariness is fatal.

The mathematical solution of the dynamic stochastic models as required by the inherent rational expectations approach forces a highly simplified specification in terms of the underlying behavioural assumptions.

But the ability of these models to say anything about the actual operations of central banks is severely compromised by the highly simplistic behavioural assumptions employed.

Clearly, the claimed theoretical robustness of the New Keynesian models has to give way to empirical fixes, which leave the econometric equations indistinguishable from other competing theoretical approaches where inertia is considered important. And then the initial authority of the rigour is gone anyway.

This general ad hoc approach to empirical anomaly cripples the New Keynesian models and strains their credibility.

When confronted with increasing empirical failures, proponents of New Keynesian models have implemented these ad hoc amendments to the specifications to make them more realistic. I could provide countless examples which include studies of habit formation in consumption behaviour; contrived variations to investment behaviour such as time-to-build , capital adjustment costs or credit rationing.

But the worst examples are those that attempt to explain unemployment. Various authors introduce labour market dynamics and pay specific attention to the wage setting process. One should not be seduced by New Keynesian models that include real world concessions such as labour market frictions and wage rigidities in their analysis. Their focus is predominantly on the determinants of inflation with unemployment hardly being discussed (for example, Blanchard and Gali, 2005).

Of-course, the point that the New Keynesian authors appear unable to grasp is that these ad hoc additions, which aim to fill the gaping empirical cracks in their models, also compromise the underlying rigour provided by the assumptions of intertemporal optimisation and rational expectations.

So the IMF discussion is within this framework. In reporting their results, I am not suggesting the framework is valid. The point is that within their own logic, the results do not support their political position as part of the Troika.

The IMF estimate potential output and therefore output gaps (“divergence of actual from potential output”) using “multivariate filtering techniques” which we do not need to consider in brief. They are problematic because they rely on estimates of the unobserved “nonaccelerating infla- tion rate of unemployment (NAIRU)”. See the link to the blog on the NAIRU above for a critique.

With their estimates of potential growth, the IMF then use a standard – Growth accounting framework – which aims:

… to measure the contribution of different factors to economic growth and to indirectly compute the rate of technological progress, measured as a residual, in an economy …

Growth accounting decomposes the growth rate of economy’s total output into that which is due to increases in the amount of factors used – usually the increase in the amount of capital and labor-and that which cannot be accounted for by observable changes in factor utilization. The unexplained part of growth in GDP is then taken to represent increases in productivity (getting more output with the same amounts of inputs) or a measure of broadly defined technological progress.

The statistical application uses highly problematic ‘production function’ specifications (relationships between inputs and output) which has been used in the neo-classical framework to justify claims that all productive inputs are rewarded in proportion to their marginal contribution to production – and therefore Capitalism is a fair distribution system.

I won’t go into that literature (several blogs would be required) but if you are interested (and want to get involved in the technical debates required – search for critiques of Cobb-Douglas production functions and marginal productivity theory).

For example, the outcomes of the – Cambridge capital controversy – destroyed the legitimacy of this approach in economics. But in typical fashion, the mainstream economists just ignored these devastating critiques and continued to teach and used the flawed approach. The Cambridge controversies are barely known by economists so successful has been the denial.

Groupthink does that – it expunges any dangerous ideas which undermine the current ideological consensus.

Apart from providing a framework for justifying the ideological claims for distributional fairness, the other reason mainstream economists use this approach is that it is easy. Trying to estimate more realistic production functions is very difficult and do not necessarily yield results that the mainstream find ideologically palatable.

The IMF estimate a “standard Cobb-Douglas production function” which relates potential output to “the stock of productive capital”, “potential employment” and “potential total factor productivity – which includes human capital”.

Total factor productivity (TFP)

… is a variable which accounts for effects in total output not caused by traditionally measured inputs of labor and capital. If all inputs are accounted for, then total factor productivity (TFP) can be taken as a measure of an economy’s long-term technological change or technological dynamism.

So, essentially, the statistical models seek to explain variations in output in relation to the measured inputs used. The amount of the variation that are not ‘explained’ by the contribution of the measured inputs is considered to be TFP. It is an unexplained residual variation in output that must be due to unmeasurable inputs – technology etc.

This 2001 article – It’s Not Factor Accumulation: Stylized Facts and Growth Models – written by William Easterly (when he was a senior official at the World Bank) and Ross Levine, “documents the five stylized facts of economic growth”.

The authors say that:

The ‘residual’ (total factor productivity, tfp) rather than factor accumulation accounts for most of the income and growth differences across countries.

This statement is made in the context of their contention that evidence tells us that “‘something else’ besides capital accumulation is critical for understanding differences in economic growth and income across countries.”

Empirical observation and analysis confirms that “even after physical and human capital accumulation are accounted for, something else accounts for the bulk of cross- country differences in the level and growth rate of gross domestic product (gdp) per capita.”

The authors conclude that the “something else” is TFP. The problem is that we know very little about TFP, given that it is the ‘unexplained’ part of statistical models seeking to explain economic growth. That is, once we have accounted for things we can measure such as labour and capital input, there is still variations in growth that are unexplained.

[Reference: Easterly, W. and Levine, R. (2001) ‘It’s Not Factor Accumulation: Stylized Facts and Growth Models’, The World Bank Economic Review, 15(2), 177-219].

The IMF conclude that total factor productivity growth has been in decline over the last decade or so.

They say that:

… in the United States, whose technological development is commonly regarded as representing the world frontier, the growth in total factor productivity started to decline in 2003. This decline seems to reflect the waning of the exceptional growth effects of information and communications technology as a general purpose technology observed in the late 1990s to early 2000s

This decline “may have spilled over to other advanced economies”.

They also think that TFP has declined because “of a shift of resources away from sectors with high productivity (such as manufacturing and information and communications technology) toward those with low productivity (such as personal services, construction, and nonmarket services)”.

Further “human capital growth … declined during 2001-07”.

Then the GFC hit and the IMF sought to understand how the financial crisis caused the increased decline in TFP.

There is an motive to that quest. They want to deny that the slow growth associated with the aftermath of the GFC is not due to cyclical factors (deficient spend and fiscal austerity) but is rather a slowing of potential output.

So it would then follow that the solution is not to use fiscal stimulus to increase spending but to understand why potential output has fallen.

The IMF always is trying to justify its Troika-style ideology.

They correctly note that the major fall in investment undermined capital growth and hence potential output growth.

They also claim that the crisis has caused structural unemployment to rise as a result of “rigid labor market institutions” which undermines potential employment.

You know the story. The IMF continually claims that there would be much higher employment if only the workers were more skilled, more eager to work and the government regulations (job protection etc) didn’t undermine the employers’ desire to create more work.

This is the ultimate denial of the macroeconomic rule – spending equals income. If a firm was selling something at a profit yesterday before a major spending collapse occurred but cannot sell it today (after the collapse) then the problem is the spending collapse not ‘structural’ impediments.

The solution is not to cheapen labour which only undermines the spending capacity of the workers.

This is all background to their empirical work, which sought, among other things, to analyse “The Effects of Structural Reforms on Total Factor Productivity” (see Box 3.5 in the WEO report).

I won’t go into the econometric models used. You can read about them if you are interested.

The motivation is that the IMF consider that structural impediment constrain TFP through their effects on technological innovation which prevents an economy from reaching the so-called “technological frontier”.

They allow for structural reforms to take time.

The models they deploy examine:

… how institutional and product and labor market regulations affect efficiency and convergence to the frontier … which is important because more stringent regulations could curb total factor productivity growth by hindering efficient reallocation of resources across plants, firms, and industries.

So what do they find?

The IMF conclude that:

… labor market regulation is not found to have statistically significant effects on total factor productivity …

What does that mean?

Economic growth is restrained by factors that influence the evolution of potential growth – that is, the capacity of the economy to produce goods and services.

The IMF economists have now reported that their econometric research has determined that labour market regulations do not impact on the evolution of potential output.

They found that the significant influences on potential growth include “lower product market regulation and more intense use of high-skilled labor and ICT capital inputs, as well as higher spending on R&D activities, contribute positively and with statistical significance to total factor productivity”.

The product market reforms include things like reducing the control of some professions such as lawyers (in simple conveyancing etc).

The conclusion means that the policy agenda that focuses on reducing employment security, wage bargaining arrangement, and other entitlements do not improve technological innovation and potential growth paths.

The IMF still hangs onto the notion that such regulation reduces the absolute level of productive labour inputs, which reduces economic growth.

As noted above, the WEO Report argues that growth is hampered by structural unemployment. But that is another story.

I remind readers that in the last 10 years the OECD also been forced to back away from some of its more extreme positions with respect to labour market regulation.

In the last 10 years, partly in response to the reality that active labour market policies have not solved unemployment and have instead created problems of poverty and urban inequality, some notable shifts in perspectives are evident among those who had wholly supported (and motivated) the orthodox approach which was exemplified in the 1994 OECD Jobs Study.

In the face of the mounting criticism and empirical argument, the OECD began to back away from its hardline Jobs Study position.

In the 2004 Employment Outlook, OECD (2004: 81, 165) admitted that “the evidence of the role played by employment protection legislation on aggregate employment and unemployment remains mixed” and that the evidence supporting their Jobs Study view that high real wages cause unemployment “is somewhat fragile.”

The winds of change strengthened in the recent OECD Employment Outlook entitled Boosting Jobs and Incomes, which is based on a comprehensive econometric analysis of employment outcomes across 20 OECD countries between 1983 and 2003. The sample includes those who have adopted the Jobs Study as a policy template and those who have resisted labour market deregulation. The report provides an assessment of the Jobs Study strategy to date and reveals significant shifts in the OECD position. OECD (2006) finds that:

• There is no significant correlation between unemployment and employment protection legislation;
• The level of the minimum wage has no significant direct impact on unemployment; and
• Highly centralised wage bargaining significantly reduces unemployment.

This statement from the OECD confounds those who have relied on its previous work including the Jobs Study, to push through harsh labour market reforms, retrenched welfare entitlements and attacked the power bases on trade unions. It makes a mockery of the arguments that minimum wage increases will undermine the employment prospects of the least skilled workers.

Conclusion

The question that needs to be asked but which we already know the answer is: Why does the IMF continue to advocate harsh labour market policy changes which would undermine job security and wages as part of a structural component of their so-called “growth friendly austerity” when their own economists have found that “labor market regulation is not found to have statistically significant effects on total factor productivity” and hence potential economic growth?

Answer: because they are ideologically motivated and advocate policies that they think advance the interests of capital.

But then they are also incompetent and do not realise that entrenched unemployment is hardly an ideal environment to advance the interests of capital. Short-term gains from an existing output level might be possible but in the longer term these policies are just undermining the capacity of nations to produce.

That is enough for today!

(c) Copyright 2015 Bill Mitchell. All Rights Reserved.