The role of openness and labour market institutions for employment dynamics during economic crises

Elisa Gamberoni, Erik von Uexkull, Sebastian Weber 29 September 2010

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As a result of the global crisis and the related domestic and debt crises, global employment growth, according to the ILO’s Global Employment Trend (Jan 2010), slowed down to 0.7% in 2009 from 1.9% in 2007 and 1.4% in 2008. According to the ILO study, the slowdown occurred across all regions of the world except for the Middle East.

In a recent paper (Gamberoni et al. 2010), we analyse employment growth during and after past global economic downturns and domestic debt and banking crises, focusing on the role of trade openness and labour market institutions. Over the past 20 years, slowdowns of world GDP growth have occurred in 1991 to 1993, 1998 and 2001, even though none of these reached the magnitude of the global crisis of 2008 and 2009. In order to account for the numerous country specific economic crises during this period, we revert to a dataset compiled by Laeven and Valencia (2008) that identifies past domestic banking crises that reached a systemic level as well as sovereign debt crises that led to a government default.

Evidence from past crises

Not surprisingly, our results show that the reduction in employment growth is more pronounced under a domestic banking or debt crisis than during a global downturn, amounting to more than twice the magnitude. The effect of global downturns persisted longer on average, with the second lag being the lowest point, while employment growth reverted faster after domestic crises.

Applying instrumental variable techniques following Arrelano and Bover (1995), we analyse the role of openness and labour market institutions for the dynamics of employment growth. We evaluate the average response to a crisis for countries with low levels of trade, i.e. with a trade (imports + exports) to GDP ratio of 25% and compare the response to countries with a high openness level, i.e. of 130%. With respect to labour market institutions, we use a measure of the severance pay associated with laying-off workers. We compare the responses to a crisis when severance pay is one standard deviation below and above the mean. Finally, we also investigate how unemployment benefits alter the responses. Our results suggest that:

  • Higher openness led to a stronger reduction in employment growth in the initial phase of the crisis, but also allowed for a faster recovery (Figure 1). The initial negative impact of openness in the case of a debt and banking crisis is consistent with findings on the importance of access to finance for exporters (see Iacovone and Zavacka 2009 or Berman 2009). Unlike a global economic downturn, banking and debt crises have a direct impact on the availability of credit for firms. Since exporters are more sensitive to changes in external finance conditions given their high up-front costs, the higher the openness-to-GDP ratio the stronger is the importance of the financial constraint and the more pronounced the impact on employment.

Figure 1. Estimated impact of openness on the deviation of employment growth from its trend in response to a crisis (in percentage points)

  • Countries with low levels of severance pay suffer on average twice the size of the drop in employment growth than countries with very high severance payments (Figure 2). It would seem that firms find it more profitable to adjust to a negative shock through lay-offs when severance pay is low. If severance pay is high, firms revert to other means of adjustment. These could include reductions in wages or working time.

Figure 2. Estimated impact of higher severance pay on the deviation of employment growth from its trend in response to a crisis (in percentage points)

  • Countries with higher unemployment benefits suffered on average a more severe reduction in employment growth. One potential reason for this finding is that unemployment benefits can cause downward real wage rigidity (Campolmi and Faia 2005, Zanetti 2007) – if unemployment benefits are high, workers are more likely to resist a downward adjustment of wages. Another possible explanation is the role of informal employment. In poor countries with no or very low unemployment benefits and small welfare systems, workers who lose a formal job are often forced to take up informal activities instead. Thus, they do not appear as unemployed in our data, but typically suffer a substantial deterioration in their incomes and working conditions. Robustness checks revealed that the results for unemployment benefits are strongly driven by countries which have unemployment benefits in the upper 20th percentile. Thus, moderate unemployment benefits that provide a safety net for workers do not appear to be detrimental to employment growth during times of crisis.

Simulating the employment effects of the global crisis

With the estimation coefficients for both global downturns and domestic crises at hand, we can simulate the path of employment growth during the global crisis for any country with sufficient data availability, including openness and severance pay as explanatory variables. We identify whether countries experienced “only” the global downturn or the combined effects of a global and domestic crisis. In a number of countries the financial shock of 2008 and 2009 was associated with domestic banking or debt crises that came in various shapes, including debt-related balance of payment crises with strong correction in the housing market (Lithuania and Estonia), bank failures or major stress in the banking sector with the need for bailouts coupled with stress in the housing market (Belgium, Germany, Ireland, UK, US, Germany) or severe increases in the financing of government debt (Ireland, Portugal, Spain) or a quasi-default (Greece).

Our predictions perform reasonably well in nearly all cases where we assume no domestic crisis. This implies that despite the enormous trade collapse and the rather strong world GDP drop, the effect on employment is on average comparable with what we would expect from historical data. For countries in this category the simulation implies that employment growth will remain depressed in 2010 and then start to revert relatively quickly. Simulation results for countries which also experienced a domestic crisis vary in accurateness. For the US, Ireland, and Lithuania the results are close to the actual data. While Ireland is predicted to recover faster, the simulations for the US suggest continuously low employment growth in 2010. The difference in our prediction is caused by the fact that the US is a rather closed economy while Ireland is highly open and should receive a boost from net exports.

Conclusions

Our study shows that domestic banking and debt crises have had a much larger impact on employment growth than global economic downturns. This pattern is also mirrored in the effects of the global economic crisis of 2008 and 2009, where countries that experienced turmoil in the banking sector or public debt crisis suffered much more serious employment losses than those who were “only” exposed to the global demand shock. This finding emphasises the importance of the first line of defence for countries to protect themselves against contagion of financial crises. Sound macroeconomic policies should be at its core.

Second, deeper integration into the world economy leads to a deeper and faster initial slowdown of employment growth, particularly during domestic crises, but also to faster and sharper recovery. Adopting protectionist policies as a crisis unfolds thus seems like very bad advice.

Third, in terms of labour market policies, high severance pay seems to have been effective in encouraging companies to adjust to crises through means other than lay-offs. While not explicitly tested in our research, this also suggests that temporary subsidies for maintaining employees on payroll, as used by many governments during the global crisis, can be quite effective to cope with temporary shocks.

Fourth, with respect to unemployment benefits, the results are more mixed. While our research does not call into question the importance of unemployment benefits as a means to protect workers against the social impact of a crisis, it points to a potential trade-off between maintaining very high unemployment benefits and the goal to minimise employment losses during a crisis. Additional research on this topic, in particular taking into account the role of informal employment in countries with low unemployment benefits, is needed.

The views in this column are those of the authors and do not necessarily represent those of the International Labor Organization or The World Bank, or those of the Executive Directors of The World Bank or the governments they represent.

References

Berman (2009), “Financial Crises and International Trade: The Long Way to Recovery”, Economics Working Papers, ECO2009/23, European University Institute

Campolmi and Faia (2005), “Labor Market Institutions and Inflation Volatility in the Euro Area”, fourthcoming: Journal of Economic Dynamics and Control

Gamberoni, E, E von Uexkull, and S Weber (2010), “The role of openness and labor market institutions for employment dynamics during economic crises”, unpublished ILO/World Bank manuscript.

Iacovone and Zavacka (2009), “Banking Crises and Exports: Lessons from the Past”, Policy Research Working Paper Series 5016, World Bank.

Laeven and Valencia (2008), “Systemic Banking Crises: A New Database”, IMF Working Paper 08/224

Zanetti (2007), “Labor Market Institutions and Aggregate Fluctuations in a Search and Matching Model”, Bank of England working papers.

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Topics:  Global crisis International trade Labour markets

Tags:  unemployment, global crisis, labour market flexibility

Elisa Gamberoni

Policy Officer at the World Bank

Erik von Uexkull

Economist with the ILO’s Trade and Employment Program

Economist, International Monetary Fund