Discussion Paper

No. 2015-55 | August 12, 2015
On the Efficiency of Labor Market Reforms: How to Solve the Spanish Puzzle?

Abstract

In this paper we shed light on the relationship between labor market policy, entrepreneurship and youth unemployment prior to and in the aftermath of the global financial crisis in Spain. We discuss the situation, where labor market and macroeconomic policies were largely inefficient in reducing high levels of (youth) unemployment after 2007. We rise the question why in a situation of low inflation rates, an increase in (youth) unemployment had been observed although the labor market becomes more flexible due to the associated structural reform in 2010. We call this the Spanish Puzzle. The main reason for this observation can be found in the phenomena of downward nominal rigidity and the existence of a liquidity trap. Given the recovery of the Spanish economy in 2015, this development is grounded on (besides the increase in private consumption and a trade surplus) several policy measurements in order to strengthen entrepreneurial activity in 2013. The corresponding boost in private investment expenditure can be identified as the sustainable main driver for job creation in the long run.

JEL Classification:

E24, E61, J13, L26

Assessment

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Cite As

Stephen Sacht (2015). On the Efficiency of Labor Market Reforms: How to Solve the Spanish Puzzle? Economics Discussion Papers, No 2015-55, Kiel Institute for the World Economy. http://www.economics-ejournal.org/economics/discussionpapers/2015-55


Comments and Questions


Tae-Seok Jang - Discussion on “On the Efficiency of Labor Market Reforms: How to Solve the Spanish Puzzle?” by Stephen Sacht
September 01, 2015 - 03:13

The paper discusses current economic issues in Spain that suffers from low inflation (or even deflation) and high youth unemployment rate, although the government has implemented the labor market reforms known as ‘Royal Decree Act 10/2010’. The complexities and subtleties of the economic situation – which is defined as the ...[more]

... ‘Spanish puzzle’ by the author reflect some kind of inconsistency observed in Spanish macroeconomic situation. Accordingly, the paper shows that serious economic difficulties stem from the problem of downward nominal wage rigidity and temporary jobs for young employed people during the Great Recession.

Indeed, the paper provides interesting glimpses on the Spanish economy which was strongly hit by the global financial crisis of 2008. Then, the author formalizes the analysis of the economic stagnation by using a simple diagram of AS-AD model. One of the interesting points made in the paper is that the lack of aggregate demand and the possibility of liquidity trap can be remedied through improving the investment climate via entrepreneurial activities. For that purpose, the government should put efforts on creating the incentive for a start-up enterprise, while supporting small and medium-sized firms in promising industries such as telecommunication and internet services, as well as biotechnology industry.

My comments and questions are as follows:

First, the author highlights the negative inflation (-0.15%) in 2014 as a major source behind the puzzle for the Spanish economy. The economic stagnation is closely connected to a large decrease in employment where the labor market reforms have not been effective enough to enhance job creation. But it is also well known that the world economy experiences low oil price in 2014 due to an increase of the oil supply. Hence, the author should need to reconsider the change in inflation in 2014 from economic stagnation and discuss to what extent the decrease in the oil price affects the deflation in Spain. Indeed, the paper ignores or even dismisses the other factors behind low inflation without details. For example, no data on financial market (or liquidity trap) are given in the paper. To avoid this type of criticism, the discussion in the paper needs to include the details of asset market volatility and financial disturbance in Spain (or the Euro area) during the macroeconomic stagnation.

Second, it is argued in this paper that the downward nominal rigidity is an important factor behind high youth unemployment rate in Spain. Admitting that low-skilled workers have low productivity, the author criticizes that they enjoy higher wages than they had previously. Because of the overcompensation and little evidence of wage cuts, Schmitt-Grohe and Uribe (2013) suggest that there should be an increase in inflation (more than 2%) to remedy current problems. However, the paper says that high inflation is not recommendable. Note here that the reason is based on the author’s belief on the importance of price stabilization in the Euro area. Then, the author should clarify some details behind his belief, e.g. either by discussing the details of distortions from high inflation in the Spanish economy or by examining the reason of low productivity with empirical data. Otherwise, the author’s claim on the reduction in wages might be criticized by researchers who suggest that there is a design flaw in the EU structure where Germany’s current account surplus is to blame for the eurozone crisis and its subsequent stagnation (Mankopf, 2012).

Third, the paper needs to be clear on the similarities and differences from the author’s previous policy paper by Jang and Sacht (2015). Jang and Sacht’s paper is published in a local Korean journal, and the author provides only simple comment such that the focus of his previous paper is on the comparison of labor markets between Korea and Spain only. But, I found that some contents in this paper overlap with his previous paper with Jang. If the main aim of this paper is to provide a rigorous analysis on the Spanish stagnation and high youth unemployment, it would be recommended to include quantitative assessments based on econometric tests, for example. Note that high youth unemployment and the importance of entrepreneurship in job creation are already discussed in Jang and Sacht’s paper.

Fourth, Greece, Portugal and Spain also suffer from high youth unemployment and economic stagnation during the Eurozone crisis. Is there any reason why the puzzle is relevant for the Spanish economy only? Is there any trend in the eurozone for the macroeconomic situation?

Finally, the paper can be improved by correcting some typos, such as ‘Royal Degree Act -> Royal Decree Act’. In addition, the paper includes sources that are not cited in the paper.

Nevertheless, I believe that the author’s analysis to the Spanish labor market situation is an important contribution which helps us to improve our understanding of economic problems during the Great Recession.


Reference:

Mahnkopf, B. (2012), 'The euro crisis: German politics of blame and austerity – A neoliberal nightmare', International Critical Thought, Vol. 2(4), pp. 472-485.

Schmitt-Grohé, S. and Uribe, M. (2013), 'Downward nominal wage rigidity and the case for temporary inflation in the eurozone', Journal of Economic Perspectives, 27(3): 193-212.


Stephen Sacht - Reply to the Comments by Tae-Seok Jang
September 08, 2015 - 00:53

Thank you very much for the comments. I appreciate the expositor's effort and his deep analysis of the paper. It has to be emphasized that the expositor is a co-author of mine with respect to various publications. Several points made by him will be considered for the revision of the ...[more]

... paper. Nevertheless, I have to contradict the statement that there are any sources included in the paper which have not been cited.

With respect to the first comment, it has to be emphasized that it is not the main objective of the paper to analyse the Spanish inflation dynamics. In fact, it can be seen from Table 1 that we observe rather a dis-inflationary than a de-flationary environment in Spain over the whole after-crises period. My point is to discuss the effect on the real wage as the inflation rate declines while the nominal wage is downward rigid. I agree with the expositor that it is well known that the sharp decline in the oil price since the mid of 2014 mainly explain deflation in this year. For future research this observation is crucial, especially in an open-economy framework used for an analysis (as I state in footnote 7 on page 12). It goes without saying that in this case the exchange rate dynamics have to be also taken into account, where with respect to the decline of the Euro, this stands for a opposite trend in the development of the Spanish inflation rate under consideration of the oil price shock.

From my point of view there is no need for an intensive discussion on financial data like asset market volatility. From a macroeconomic perspective it is the natural way to think of the liquidity trap as a zero-lower bound of the short-term nominal interest rate, i.e. ECB’s instrument for main refinancing operations. The situation of a liquidity trap has important implications for the transmission channel of monetary policy interventions. Hence, in the current economic situation a monetary stimulus is hindered as I explain in the paper.

With respect to the second comment, the importance of price stability in the belief of the ECB (not mine) is hard to negotiate on due to the central bank's sovereignty. Schmitt-Grohé and Uribe (2013) argue that a high inflation rate (for example of 4 %) will reduce the real wage under consideration of downward nominal wage rigidity. However, such a high rate will create also a distortion in the debtor/debtee relationship. This rises two important questions. First, what will be the effect on private consumption as real income declines? Note that private consumption can be identified as one of the main driver of the current short-run recovery in Spain as argued in the paper. Second, is a (massive) reallocation in wealth due to a high inflation rates preferred politically? Besides the heterogeneous effects of monetary policy on the Euro Zone member states, I state that these two questions (among others) show that the evaluation of this potential solution of high inflation rates is not straightforward.

As far as I known labor productivity is hard to measure. Instead providing empirical data on this issue, several studies (e.g. Balaram (2014) for Spain among others) show that low skilled workers, which are sorted into this class based on schooling and educational training, are hindered for market entry compared to high skilled ones. Under the neoclassical assumption that low skilled workers exhibit a low productivity, this must be mimicked by a lower real wage for this class in order to allow for hiring. Since the Spanish nominal wage is downward rigid the labor market entry of low skilled workers is fostered by an increase in the inflation rate. Under consideration of the liquidity trap, education and the investment in human capital might lead to a transformation of low to high skilled workers and, hence, resemble a potential solution to this problem.

With respect to the third comment, on page 4 I make clear that my paper is closely related to Jang and Sacht (2015), where, in fact, the former is a direct follow-up paper of the latter. While some thoughts based on my own contributions to Jang and Sacht (2015) had been adopted from this paper, there is no one-to-one overlap. Instead, the written text had been adjusted for the discussion of the “Spanish Puzzle” without any discussion on the Korean case. My own paper together with Tae-Seok Jang is totally silent on the economic theory used in order to investigate the efficiency of labor market reforms. In particular, the discussion in my stand-alone paper is on the interdependencies of labor market reforms, the liquidity trap and downward nominal wage rigidity in Spain and therefore stands for a novel contribution from my point of view. Spain represents a good candidate for this kind of study in order to answer the question why – from a macroeconomic perspective - labor market reforms alone seem to be not successful under certain economic circumstances. This analysis is not limited to the specific view on Spain and might be extended to other (European) countries. However, with respect to Greece I judge an intensive investigation in this case to be biased by economic as well as political turnovers and adjustments.

Balaram, B. (2014). The case of Spain. In Tolphin, T. (Ed.). States of transition. Youth unemployment, education and labor market policy in Europe and the US. Working Paper. Institute for Public Policy Research, London.

Jang, T.-S. and Sacht, S. (2015). Entrepreneurship, youth unemployment and macroeconomic policy: lessons from Korea and Spain. Koreanische Zeitschrift fuer Wirtschaftswissenschaften, 33(2): 1-22.

Schmitt-Grohé, S. and Uribe, M. (2013). Downward nominal wage rigidity and the case for temporary inflation in the eurozone. Journal of Economic Perspectives 27(3): 193–212.


Anonymous - Referee Report 1
September 15, 2015 - 09:40

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Stephen Sacht - Reply to the Referee No. 1
September 21, 2015 - 22:16

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Anonymous - Referee Report 2
September 21, 2015 - 11:28

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Stephen Sacht - Reply to the Referee No. 2
September 23, 2015 - 14:52

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Anonymous - comment
September 21, 2015 - 15:04

1. I think that the discussion on why analyse Spain rather than Greece is not really necessary. Each country has its own specificities and structural issues that should be taken into consideration in the analysis. Greece having more or different structural problems is not an argument to analyse another country instead. ...[more]

...

2. The author talks about a recent increase in the global level of youth unemployment. It would be good to provide some evidence, perhaps show a figure with numbers for some regions/countries: Europe, U.S., Latin America etc.

3. On page 10 the author talks about a slump in private investment. It would be good to provide evidence on this, perhaps in Table 1? This of course if under private investment one is to understand more than venture capital. Data on venture capital is given.

4. Perhaps emphasize the need to assume that new firms implement new technologies and the subsequent shift in the AS curve: done in order to replicate the fall in the price level observed after 2013, table 1.

5. On page 12: „… the government should provide support for start-ups, as well as small and medium-sized firms, in order to increase their life span.“ I think that this is a speculative suggestion. Firm turnover might be necessary in order to lead to the natural selection of the best firms. Supporting firms that would otherwise fail could reduce the average growth rate of surviving firms.

6. It will be helpful if the author puts into perspective the data on venture capital and start-ups. How many start-ups were there in Spain in total? Figure 2 provides evidence only on start-ups that received venture capital funding. How big is the share of venture capital for start-up funding? What about other sources: bank loans, EU or other forms of government funding, private funds of the entrepreneurs? Is there data on this?

7. The policy section suggests labor market policies in addition to those relevant for entrepreneurship. What is the motivation given that the paper has been arguing that labor market policies have been unsuccessful in the context of a liquidity trap? Or is the economy out of the liquidity trap after the Entrepreneur’s Act, in which case labor market policies would lead to higher GDP?

8. The paper emphasizes youth unemployment and the reader is somehow left to believe that the macroeconomic policies will have the same effect on youth unemployment as on aggregate unemployment. There are years however (2007 and 2013) in which aggregate unemployment decreases, while youth unemployment increases. It would be useful to include a discussion on the relation between adult and youth unemployment. Who gets hired first in a recovery, who is laid off first in a downturn? Are there any important differences and needs of the different groups that policy makers should take into consideration?


Stephen Sacht - Reply to the Anonymous Comments
September 28, 2015 - 00:55

Thank you very much for the comments. I appreciate the expositor's effort. The suggestions made will lead to an improvement of the paper. Among other things additional empirical observations will be added. In the following I will respond to the last three comments, while the remaining ones had been considered ...[more]

... for the revision of the paper as well.

6. According to the World Bank 'Doing Business' project, which provides annual data on registrars on newly registered companies with limited liability, the corresponding number decreases by 39,2 % between 2007 and 2012. While data on funding sources as government (e.g. financial support by the European Union) and private funds like bank loans are not available for this period to the best of my knowledge, I focus only on the total amount of venture capital and number of companies. I suppose that the share of venture capital for start-up funding is low based on the number of companies shown in Figure 2. On page 13/14 I made the point that the number of companies is positively correlated with the amount of venture capital. Therefore, the focus on venture capital only is sufficient in this respect. However, I agree that further investigations on start-up funding will be a promising step to be undertaken in future research conditional on the data available. Corresponding statements will be made in the Section 4.

7. In Section 5 I already mention that several policy interventions of the Spanish government took place after 2010 but „these measurements turned out to be less successful due to more severe structural issues on the Spanish labor market (as we discussed in Section 3).“ Therefore, I call for a stronger emphasis on apprenticeship as a cornerstone for a new designed labor law, which helps to amplify the positive stimulus generated by the Entrepreneur's Act. In other words a synthesis of labor market reforms and supply-side oriented policy would be fruitful from my perspective. With respect to the 'Spanish Puzzle', a labor law alone turns out to be less successful in the Spanish scenario as described in the paper. Corresponding statements will be made in the Section 5.

8. On page 6 I discuss in greater detail that young employees work primarily in temporary jobs. There are three reasons for this. First, employers face a high minimum wage for young people. Second, the the maximum length of a temporary contract is about 36 months. Third, the costs of dismissal for permanent jobs are high relative to temporary ones. Hence, temporary jobs are the first to be terminated or not renewed during the crisis (Balaram (2014)).

The expositor made an interesting observation regarding the reduction in GDP growth from 2006 to 2007 and the period of negative growth rates from 2012 to 2013. With respect to the pre-crises period (2006 and 2007) young employed workers had been dismissed first according to the reasons stated above, while I suppose that more experienced ones from the age group of 24 years or higher had been employed. Note here that GDP growth decreases but remains on a high level of 3.48 % in 2007. During the recession in the after-crises period (2012 and 2013), young employees are the first ones which lost their jobs. The surprising decrease in the total number of unemployed people can be most likely explained by the impact of the Royal Decree Law 3/2012 in 2012. Based on this law employees are now allowed to argue on the ground of projected losses and a permanent decline in income in order to displace employees with a lower compensation for 20's wages per year worked only (Corujo (2013)). The Royal Decree Law 3/2012 therefore also helps to amplify the impact of the Entrepreneur's Act in 2013 and can partly explain the significant reduction on both unemployment rates in 2014. Corresponding statements will be also made in the Section 5.

Balaram, B. (2014). The case of Spain. In Tolphin,T. (Ed.). States of transition. Youth unemployment, education and labor market policy in Europe and the US. Working Paper. Institute for Public Policy Research, London.

Corujo, B. (2013). Crisis and labour market in Spain. Labour Law Research Network Inaugural Conference Paper. University of Pompeu Fabra Barcelona.


Dr. Klaus Schrader - Invited Reader Comment
September 28, 2015 - 10:16

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Stephen Sacht - Reply to the Comments by Klaus Schrader
October 11, 2015 - 23:08

I am very grateful to Klaus Schrader for his comments and suggestions. Although the Royal Decree Law 3/2012 is mentioned already in Section 5, I have to admit that further investigations with respect to some of the suggestions made by the expositor are promising to be undertaken. Therefore, new insights ...[more]

... and observations had been added to the recent extended and fully revised version of the paper. Note, however, that the focus of the paper is primarily on the economic adjustments in Spain and their origins from a macroeconomic point of view.

First, the minimum wage remained nearly unchanged: it increases from 2007 to 2010 and decreases afterwards until 2014. In this year the hourly minimum wage was 5.5 US Dollar, which is equal to the same value in 2007. It seems that the Royal Decree Laws induced a reduction, with, however, the highest value of 5.8 US Dollar in 2010. Nevertheless, both unemployment rates increased until 2013, which questions the efficiency of the reforms regarding this issue.

Second, the hourly nominal wage increased over the whole time period considered, while the hourly real wage decreased only by a small amount. It had been shown in the literature [Horwitz and Myant (2015) plus IMF (2015)] that on the one hand the flexibility in the collective wage bargaining process lead to an increase in wage agreements on the firm level. On the other hand the average number of hours worked per full-time employees increased rather than decreased as being expected. Furthermore, the share of temporary contracts decreased but it increased with respect to newly issued ones. Hence, given that young unemployed people get access to the labor market conditional on a temporary contract, it seems that the corresponding age group did not benefit from these reforms. These statements rely on observations made in March 2013, i.e. already one month after the Royal Decree Law 3/2012 took place, until the end of 2014. Hence, speaking about a time lag, there is evidence that the labor market reforms unfold their impact on a short-time period after their entry into force. Further empirical investigations will be indeed helpful in this respect as new data on this topic will be available.

Third, additional literature [Bouis et al. (2013) and Bloom (2009)] with respect to policy interventions in the liquidity trap had been added. These studies discuss the situation where banks become less wiling to supply credit and firms react less to policy interventions. With respect to the former this holds due to considerable balance sheet adjustments and a high-level of uncertainty in the latter case. These theoretical considerations are mimicked by the empirical observations on the strong reduction in total venture capital start-ups received (which can be found already in Section 4). Furthermore, I present results based on business and consumer surveys provided by the European Commission [DG ECFIN (2007]. It can be seen that the corresponding sentiments in the construction and industry sector and with respect to consumption decreases dramatically from 2007 until 2014. These observations help also to motivate my explanations in Section 3 regrading agents' expectations, where their pessimistic view on future developments overcompensate the positive effects by the labor market reforms.

In conclusion, policy authorities should reinforce their efforts regarding the level of the minimum wage, the absolute number of temporary contracts and, most important, on apprenticeship (as I already had noted). However, as mentioned before, (more) empirical investigations are needed. This includes evidence on the presumed time lag and on the number of (young) unemployed people hired by start-ups.

The suggestions made will lead to an improvement of the paper. A revised version of the latter had been already resubmitted. This version included also more detailed information on the Royal Decree Law 3/2012.

Bloom, N. (2009). The impact of uncertainty shocks. Econometrica 77(3): 623-685.

Bouis, R., Rawdanowicz, L., Renne, J.-P., Watanabe, S. and Christensen, A.K. (2013). The effectiveness of monetary policy since the outset of the financial crises. OECD Working Paper 1081.

DG ECFIN (2007). The joint harmonised EU program of business and consumer surveys – user guide. European Commission.

Horwitz, L. and Myant, M. (2015). Spain's labour market reforms: the road to employment – or to unemployment? Working Paper 2015-03. European Trade Union Institute.

IMF (2015). Spain: selected issues. IMF Country Report 15 (233). International Monetary Fund.


Stephen Sacht - Revised Version
October 29, 2015 - 09:04

See attached file


Piero Ferri - Comment
October 29, 2015 - 10:47

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Stephen Sacht - Reply to the Comments by Piero Ferri
October 29, 2015 - 17:04

I thank Piero Ferri very much for his comments. I appreciate that he highlights some new aspects regarding labor market dynamics which had not been mentioned before. This holds especially for the computations based on Okun’s Law, where the results confirm my statement about the improvement of labor market’s flexibility. ...[more]

... Unfortunately, I believe that the expositor did not consider the revised version of the paper, which had been uploaded just right before his comments had been published. My analysis in the recent version had been considerably extended also with respect to new data being added. Therefore, most of the points in the critical assessment mentioned by the expositor had been well tackled already throughout the revision process.

For example with respect to demand, supply and credit aspects, in the literature we find evidence for the unwillingness to supply credit and a high-level of uncertainty in the after-crises period (p. 10/11). There is also evidence for a short delay in the (in)effectiveness of both labor market reforms (10/2010 and 3/2012) based on the change in the number of permanent and temporary contracts (p. 16/17). In particular, in the revised version I take a closer look on the relationship between permanent and temporary contracts, the development in the construction sector and, especially, agents’ expectations. With respect to the latter and to the aspect of storytelling, the complexity of the Spanish Puzzle emerged due to the phenomena of downward nominal wage rigidity, the existence of the liquidity trap and pessimistic expectations regarding future economic developments (where the corresponding dynamics based on a sentiments indicator are reported, p.3). I try to give some understanding of this complex puzzle also by undertaking a comparative-static analysis in the AD-AS model, which, of course, considers the movement in real wages and labor supply implicitly.

I agree with this (and all other) expositor(s) that in future research the emphasis should on a deeper econometric analysis of labor market dynamics among other things. For the time being my paper offers an overview on the interaction between macroeconomic and labor market policy under consideration of expectation formation in Spain in the aftermath of the crisis. It could be seen as a valuable point of departure for future investigations on this topic.