Coping with crises: Policies to protect employment and earnings

Pierella Paci, Ana Revenga, Bob Rijkers

19 April 2011

a

A

“There cannot be a crisis next week. My schedule is already full.” – Henry A Kissinger

Crises are difficult to predict, yet their recurrence is an empirical regularity in both developing and developed countries. Nevertheless, as painfully highlighted by the ad hoc and reactive nature of the policy responses to the financial crisis of 2009 and 2010, many countries are ill-prepared to manage these recurrent shocks.

This is a cause for concern. When markets are not perfect, the lack of appropriate responses can exacerbate poverty and stunt post-crisis growth. Even short-lived shocks may have lasting detrimental effects on human and physical capital and asset accumulation by forcing households to cut back investments in education (Fereirra and Schady 2009, Paxson and Schady 2005) and to reduce spending on nutrition (Cutler et al. 2002). In addition to making future generations more prone to poverty, these coping strategies also worsen the prospects for future growth by reducing the productivity of the next generation.

Households may also be forced to sell productive assets, which further reduces their future income-earning potential and exacerbates their vulnerability to shocks. In addition, productive firms may not be able to expand or invest, and may even be driven out of business altogether as a result of exacerbated credit constraints (Borenstein and Lee 2002, Peek and Rosengren 2005, Barlevy 2002 and 2003, Nishimura et al. 2005). The concern is especially relevant for developing countries, where labour is the most important source of income for the vast majority of the population, and where both firms and households lack the ability to cope with even minor shocks to income (Lustig 2000). For policymakers confronted with a crisis, the question is thus not whether to intervene, but how.

In recent work (Paci et al. forthcoming), we review policy responses to past crises and identify a number of commonly used interventions that can coarsely be categorised as either mitigating short-term impacts or accelerating the recovery. The key difference between these two groups is in their respective time horizon. The first category includes policies with a near immediate impact on employment and earnings, such as wage subsidies, tax holidays and public-works programmes. The other group includes training programmes, more flexible entry and exit regulations, and other policies with a longer gestation period due to sluggish firms’ responses and to the time required to accumulate human capital. Policies can also be divided into those that aim to preserve jobs and productivity, and those designed to protect workers’ income and promote employability, i.e. those that operate on the demand or the supply side of the labour market.

This coarse taxonomy – presented in Figure 1 – highlights the trade-offs that might arise between these objectives as policies that focus on mitigating immediate impacts may aggravate market imperfections and thus backfire in the longer term. In Indonesia, for example, the 1997-1998 crisis sparked pro-labour pressures that led to better enforcement of minimum wages and to the introduction of severance pay and dismissal regulations. While these protected workers’ earnings and limited initial job losses, they also led to severe rigidities in hiring and firing (Manning 2000) which then hampered job creation and the recovery (Narjoko and Hill 2007; Hill and Shiraishi 2007). Conversely, policies that are conducive to long-run growth, when incautiously implemented, may do unnecessary damage in the short run. Thailand’s recovery from the Asian crisis is a case in point. While the Thai government introduced reforms conducive to long-run growth, the adjustment programme proved to be too harsh, leading to an unnecessarily sharp decline in output (Dollar and Halward-Driemeijer 2000).

Figure 1. Policy taxonomy

Win-win policies, highlighted in the middle boxes, avert these trade-offs by simultaneously minimising short-term impacts and accelerating recovery. Examples of such win-win policies include:

  • Credit-market policies that reallocate liquidity from inefficient to efficient firms, thus minimising credit misallocation,
  • well-targeted, self-reversing public-works programmes that yield productivity-enhancing infrastructure,
  • conditional cash transfers that nurture human-capital investments, and
  • targeted self-employment assistance.

However, depending on available fiscal resources, institutional capacity and prevailing political economy conditions, certain policy options that are theoretically superior may not be practically feasible. Building on programmes that are already in place and can be expanded quickly is highly desirable – particularly in the context of declining fiscal resources. When government budgets decline, as often happens during crises, the more relevant question is what policies to preserve, rather than what additional policies to undertake.

More generally, crucial elements of effective interventions are feasibility, flexibility (e.g. capacity for scaling up and down), and incentive compatibility. These characteristics ensure that leakages are minimised and market imperfections are not aggravated. For example, setting low wages in public-works projects ensures that only those willing to work for very low wages, which are likely those most in need, will benefit; smart targeting enhances effectiveness.

Be prepared

Nonetheless, perhaps the most important conclusion of the review is that there is no substitute for being prepared. Countries with prudent fiscal management and sound stabilisers in place before crises hit tend to suffer less than countries that lack these. Moreover, the depth and duration of shocks is lower if credit and labour market policies are sound (Bergoeing et al. 2004). Setting up safety nets during times of crisis is difficult and time-consuming and the speed with which programmes need to be implemented often requires compromises between design and effectiveness.

On the bright side, crises may provide opportunities to build the necessary consensus to implement unpopular measures and may serve as a stepping stone for the formation of more permanent safety nets. For example, the social programmes introduced in Mexico in response to the Tequila Crisis constituted the basis for the income support systems currently in place.

Our review also highlights the need to go beyond myopic and isolated policy responses which may be costly and counterproductive. It points to the benefits of a more comprehensive approach that delivers a coordinated and coherent policy package. Such a package needs to reduce market imperfections and build institutions to mitigate the impact of downturns on both the supply of and demand for labour while averting inter-temporal trade-offs.

References

Barlevy, Gady (2002), “The sullying effect of recessions”, Review of Economic Studies, 69(1):65-96.

Barlevy, Gady (2003), “Credit market frictions and the allocation of resources over the business cycle”, Journal of Monetary Economics, 50:1795-1818.

Bergoeing, Raphael, Norman Loayza, and Andrea Repetto (2004), “Slow Recoveries”, Journal of Development Economics, 75(2):473-506.

Borensztein, Eduardo and Jong-Wha Lee (2002), “Financial Crisis and Credit Crunch in Korea: Evidence from Firm-Level Data”, Journal of Monetary Economics, 49(4):853-875.

Dollar, David and Mary Hallward-Driemeier (2000), “Crisis, Adjustment, and Reform in Thailand's Industrial Firms”, World Bank Research Observer, 15(1):1-22.

Fallon, Peter and Robert Lucas (2002), “The Impact of Financial Crises on Labour Markets, Household Incomes, and Poverty: A Review of Evidence”, The World Bank Research Observer,17(1):21-43.

Fereirra, Francisco and Norbert Schady (2009), “Aggregate economic shocks, child schooling and child health”, World Bank Research Observer, 24(2):147-181.

Lustig, Nora (2000), “Crises and the poor: socially responsible macroeconomics”, Economia, 1(1):1-19.

Manning, Christopher (2000), “Labour market adjustment to Indonesia’s Economic Crisis: Context, Trends and Implications”, Bulletin of Indonesian Economic Studies 36(1):105-136.

Narjoko, Dionisius and Hal Hill (2007), “Winners and Losers during a Deep Economic Crisis: Firm- level Evidence from Indonesian Manufacturing”, Asian Economic Journal, 21(4):343-368.

Nishimura, Kiyohiko, Takanobu Nakajima and Kozo Kiyota (2005), “Does the natural selection mechanism still work in severe recessions? Examination of the Japanese Economy in the 1990s”, Journal of Economic Behaviour & Organization, 58:53-78.

Paci, Pierella, Revenga, Ana, and Bob Rijkers (forthcoming), “Coping with Crises: Policies to Protect Employment and Earnings”, World Bank Research Observer.

Paxson, Christina and Norbert Schady (2005), “Child Health and Economic Crisis in Peru”, World Bank Economic Review, 19(2):203-223.

Peek, Joe and Eric S Rosengren (2005), “Unnatural Selection: Perverse Incentives and the Misallocation of Credit in Japan”, American Economic Review, 95(4):1144-1166.

a

A

Topics:  Global crisis Labour markets Macroeconomic policy

Tags:  unemployment, financial crises

Lead Economist, World Bank

Director, Poverty Reduction and Equity Group, World Bank

Economist in the Trade and International Integration Unit of the Development Economics Research Group, World Bank

Events