Rigid Labour Markets and Levels of Unemployment

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Yesterday evening, Karl Whelan of Irish Economy entered the wages and competitiveness discussion which stemmed from Philip Lane’s post written as a reaction to David Begg’s op-ed column in the Irish Times yesterday. Whelan provided his usual thorough, nuanced analysis which reads like a mainstream economic cheat-sheet on every aspect of the issue for the non-economist. However, although not versed in the current literature on labour market rigidities and what it says their effects are on the levels of unemployment there was one point that ran counter to something I had come across recently myself.

In the section of his post on what the government can do, he says:

“Beyond public sector pay, the Irish government could perhaps encourage lower wages by deregulating the labour market. It is well known that average levels of unemployment across countries tend to correlate positively with labour market rigidities, so reducing these rigidities may help to limit the increase in unemployment.

Three points can be made on this. First, even highly deregulated labour markets such as the US are suffering from high levels of unemployment during the current recession, so deregulation is not a panacea for recession. Second, Ireland does not have a highly regulated labour market: The World Bank’s Doing Business survey ranks Ireland 38th in the world in terms of the freedom of its labour markets, compared with 142nd for Germany and 148th for France.”

His point about Ireland not having a highly regulated labour market is good one. It is said far too many times now that Irish unions are part of the ‘establishment’ and that this unelected special interest group, through social partnership, is only interested in protecting their own interests over that of the general health of the Irish economy. This scenario is only wishful thinking on the part of those who believe that there should be no union representation for Irish workers whatsoever and that the terms and conditions of employment should be determined by the ‘market’.

However, it is point about reducing rigidities in the labour market to help limit the increase in unemployment that I was wondering about. In his paper, Maastricht 2042 and the Fate of Europe James K. Galbraith argues that the opposite is the case, that contrary to all the established literature on labour market rigidities, a more rigid labour market reduces the levels of unemployment. He also argues against the received notion that the US labour market is highly deregulated and that this lack of deregulation or greater labour market rigidity accounts for the long period of full employment that it has enjoyed up until very recently.

From the introduction, Galbraith talks about something that has a familiar ring to those listening and read the debates in Ireland:

“Labor market reform follows a logic familiar to every undergraduate who has ever taken an introduction to economics. Labor markets are supposed to operate under the guidance of supply and demand, with supply curves sloping upwards (mostly) and demand curves sloping downwards (always). If there is unemployment, the cause must lie in a failure of the real wage to adjust to its equilibrium value. Perhaps technological change and other factors have cut demand for workers equipped with relatively limited skills. To restore full employment, wages paid to such workers must decline. This can be accomplished by weakening unions, cutting job protections and unemployment benefits, and otherwise dismantling the market power that democratic governments have rashly allowed to accumulate in the hands of the unskilled.”

And then adds a note to that, should the suggestion that power lies in the hands of the unskilled seems a bit jarring:

“To the untutored, a claim that serious monopoly power is held by the mass of low-paid, unskilled workers may seem strange. One might think that market power would be more likely to accumulate in the hands of, well, monopolies–that the benefits of monopoly are more likely to be found in the stock options of executives than in the pay packets of the assembly line. But to think this way is to misunderstand the logic of supply and demand. Given that there is unemployment, it must be the case that real wages are too high. And this proves, without further recourse to evidence, that the problem of monopoly is a problem of worker power. Conversely, as no chief executive is ever fired for demanding too much money, that is proof that the market for CEOs clears at the competitive price. In some matters, it may be better to remain untutored.”

I realize that I am quoting at length here but this is good stuff.

The argument goes that to cure unemployment in Europe more flexibility in the labour market is required. And where does a model for this flexibility exist? In the United States, of course:

“In the medium term, the flexibility project envisages reaching levels of inequality characteristic of a “dynamic” capitalist economy. And for this, Europeans see a model–when they gaze across the Atlantic at the United States. The American Model stands as the template for the degree of inequality that must be achieved, in order to enjoy American full employment.”

Contrary to this, he argues:

“… in the late 1990s the United States achieved full employment while reducing inequalities in its pay structure, not by increasing them. The task remains to adapt this principle and experience effectively to European institutions, overcoming the true rigidities of Europe. These are not in labor markets but mainly in the credit and financial systems, in the public sector, and in the failure so far to recycle purchasing power effectively across the full extent of the EU.”

His paper goes into extraordinary depth on the issues, but here is a summary of its main thrust:

“To begin, we review the standard theoretical categories of unemployment, both neoclassical and Keynesian. We then take up an alternative perspective, emanating from development economics, with a contribution from the Swedish School. According to this model, unemployment, intersectoral inequalities and migration flows are linked. In this alternative framework, unemployment arises when increasing inequalities induce increased search for better jobs– including migration. With minor modification these models are applicable to modern Europe, and will become even more so as European integration progresses. The implications are consistent with what Baker et al. have already found: that egalitarian policies can reduce unemployment. If it turns out that further evidence supports the hypothesis, then conclusions must be drawn, and the fetish of rigidities should be abandoned.”

James K. Galbraith also provides a snappy overview of the argument in my interview with him in June of this year when we discussed this paper – the topic starts about 20 mins in.


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Donagh is the editor of Irish Left Review. Contact Donagh through email: dublinopinionAtgmail.com

One Response

  1. Marise

    August 3, 2009 3:17 pm

    I have a great respect for Jamie Galbraith, as I had for his father John. I was actually hoping he would be asked to join Obama’s economic council but obviously that was too much to hope for.

    I would note that the old models about supply and demand in the labour market are simplistic in this age, given that many discussions about them in the media don’t mention immigration and the mobility of capital. The models may still hold, but now the labour pool is the whole world and not just the nation-state. So most people hearing of this model aren’t told that the supply is world wide and the “clearing” price for unskilled labour resides somewhere in the third world.

    I’ve suspected this for a while, but it really comes home to me whenever I hear that skeletal fella from IBEC averring that Irish wages must fall to ensure “competitiveness”. What that means is he wants Irish labour to compete with the wage levels of — who? Eastern Europe? China? Vietnam? Can you imagine this, if the cost of living in Ireland doesn’t crash as well?

    An economist from the Center for Economic Policy Research in the USA, Dr. Dean Baker, notes that in the US (and perhaps worldwide, but I don’t know), the low-skilled labourer competes in a world market, but doctors, lawyers, economists, etc., are still very much protected, keeping their wages artificially high. This is not a discussion I hear in the mainstream, even when supposed “Free” Trade is being discussed. What’s up with that?

    Keeping professional services expensive through protectionist measures, along with intellectual property rights keeping many items like music, technology, and medicine high, will guarantee that prices won’t come down along with wages. So do they want the bulk of workers living in shanty towns, or have they simply not thought it through?

    Aargh on Ayn already!