The Great Recession of 2008-2009 and Labour Market Flexibility – Which way Now?

Posted by Anis Chowdhury on 17 December 2009

The Great Recession of 2008-2009 and Labour Market Flexibility – Which way Now?

Iyanatul Islam, Griffith University, Australia[1]

Anis Chowdhury, University of Western Sydney, Australia

Now that the global economy seems to be on the mend, with quarterly GDP growth rates moving into positive territory in an increasing number of countries, and global trade and industrial production indices registering continued upward trends, the focus has to shift to the labour market. Experience from the past recessions shows that jobs recovery lags output recovery by 4 to 5 years. According to the ILO, 11 million people joined the ranked of unemployed in 2008, the largest increase since 1998. The OECD expects the jobless rate in its 30 members to approach 10 per cent in the second half of next year, meaning 57 million people out of work. In developing countries, more and more people will continue to cope with the situation by working in the low wage informal and agricultural sector, and hence will remain trapped in poverty.

The recent financial crisis has made it painfully clear that there is a need for better regulation of the capital market. The assumption that the market can correct itself and maximise societal wealth is now being seriously challenged. However, surprisingly, in the arena of labour market, the assumption of unbridled flexibility as an optimal arrangement still seems to enjoy wide-spread support, especially among international development agencies. In fact, it is not difficult to find calls to enhance labour market flexibility, meaning cuts in wages and employment conditions, in order to address gloomy job situation and rising unemployment levels. For example, a recent OECD working paper argued, “More flexible labour markets will be a key adjustment mechanism during the recession as well as in the medium term…”.[2] In a lead article, The Economist has pinned its hopes on a renewed commitment to a global agenda of labour market flexibility in order to cope with world-wide job losses and enact an employment-led recovery.[3]

This also seems to be the policy advice of the World Bank. While the Bank suggested short-term policies to stabilise employment and income, it maintains that “overly stringent employment protection laws constrain firm hiring and lead to suboptimal level of employment, a feature particularly important during economic downturns.”[4] In fact, many believe that financial crisis-induced recession is an opportunity to dismantle labour market regulations. For example, Alejandro Foxley, the former foreign and finance minister of Chile, argues that the economic crisis provides opportunities to remove labour market protections, stating that “Labor reform is always politically contentious, but the current crisis, by illustrating the dangers of ignoring necessary long-term reforms, has made it easier to reach consensus on the need for action.”[5]

How valid is this policy prescription? Should countries – regardless of their level of development – pursue the cause of labour market flexibility based on the logic that it is a sine qua non of designing effective policy responses to the Great Recession of 2008-2009?

The issue of labour market flexibility gained prominence after the 1994 OECD Jobs study that attributed higher unemployment (compared to the US) in Europe to labour regulations.[6] Powerful international organisations (most notably the Bretton Woods institutions) that matter in setting the global development agenda became wary of endorsing regulations that seek to protect labour rights and impose higher labour standards in developing countries.[7] Only the ILO, given its mandate, appeared to put up a battle in favour of regulations that sought to protect and enhance labour standards, both in rich and poor nations.

Interestingly, the international development agencies subscribe to a rather remarkable – and largely unremarked – thesis of asymmetry, making a distinction between ‘good regulations that seek to protect the rights of owners of capital (seen as essential to growth) and ‘bad’ regulations that seek to protect the rights of owners of labour services (seen as an impediment to growth). This is best exemplified in the World Bank’s Doing Business Report, which gives a low rank to countries with employment protection legislation (EPL), but a high rank to countries with legislations protecting investors’ interests, such as the right to repatriate profit by multinational corporations.

The apparent professional consensus linking labour market flexibility and economic performance began waning as a result of several empirical studies. For example, the OECD position (2006) no longer reflects the confident proclamations of the mid-1990s.[8] It concedes that it is not easy to identify a unique and optimal set of labour market institutions that engender and sustain economic prosperity. A variety of regulatory regimes that govern the labour market are compatible with good economic performance. Other studies, such as Berg and Kucera (2008), conclude that one cannot, on the basis of the available evidence, uphold the view that deregulating labour markets will lead to faster job creation and more growth.[9]

The uncritical embrace of labour market flexibility overlooks three key considerations. First – a consistent finding – countries with ‘labour-friendly’ regulations seem to be associated with lower wage inequality. This prompts Richard Freeman (2007) to suggest that regulations that seek to protect labour rights provide a tangible social benefit – lower inequality – without imposing any significant loss in terms of output and employment.[10]

Second, the current discourse on flexibility refers to a regime of employment at will, where governments impose no restrictions on hiring and firing or employment conditions. Hence, ideally, both employers and workers should be free to choose terms of employment to their mutual convenience. But in reality, flexibility is argued only for the employers. In good times, this asymmetrical feature of flexibility may go unnoticed. But in bad times, when firms are allowed to cut wages or fire en masse to reduce costs, this flexibility for employers translates into insecurity for workers, and hence cannot be advocated in the absence of a decent universal social protection scheme.

Third, an exclusive focus on speeding up the adjustment process in the labour market to cope with the global economic crisis runs the risk of impairing long-term growth potential. This could happen if regulatory changes create an incentive structure in which workers change their collective behaviour to induce a ‘low pay-low productivity trap’.

There is an implicit normative message in the basic model of a competitive labour market that ‘any job is better than no job’. Such a view discounts the value of fortifying job security. In the absence of formal risk-mitigation schemes, workers could be induced to readily accept low productivity jobs at low wages. This could propel an economy into a ‘low wage-low productivity trap. In this equilibrium, ‘bad jobs’ drive out ‘good jobs’.

High turnover of workers induced by flexibility might also reduce incentives for workers to acquire training that facilitates human capital formation. Insecure workers behave rationally in this framework. In the absence of any job security and legal protection, workers pay a premium (in the form of low wages and the ready acceptance of any job) to employers in order to reduce the risk of being unemployed. Under such circumstances, the imposition of higher labour standards and various risk-mitigation schemes could be both efficient (leading an economy towards ‘high productivity, high wage equilibrium’) and equitable (enabling vulnerable workers to deal with labour market risks).

It should be mentioned here that the World Bank’s Doing Business and its Employing Workers Index (EWI) have come under severe criticisms in recent years. Besides methodological flaws, the report created perverse incentives for policy-makers to play a ‘ranking game’ to the extent that they ended up undermining the core labour standards.[11] Furthermore, superficial changes in regulations can change country-rankings even though nothing of substance changes. In April, 2009, the World Bank decided to drop the EWI from its survey.

In sum, contrary to the so-called consensus view, there are strong reasons and sound evidence to support the view that the global economic downturn should be taken as an opportunity to reinforce the value of protecting and respecting workers rights – as is enshrined in the ILO’s core labour standards. The epochal economic events of today should be used to enact “new laws and policies” that would address “new trends in the world of work, brought about by shifting social norms, technological advancements and economic integration”.[12]

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[1] Iyanatul Islam is currently working at ILO (Geneva) and Anis Chowdhury at UN-DESA (New York). Views expressed here do not necessarily reflect the views of the UN or any of its agencies.

[2] Brixiova, Zuzana (2009), “Labour Market Flexibility in Estonia: What More Can be Done?”

OECD, Economic Department Working Papers, No. 697

[3] The Economist, “When Jobs Disappear”, March 19, 2009

[4] World Bank (2009), “How Should Labor Market Policy Respond to the Financial Crisis?”, HD and PREM Labor Market Teams, April 2009

[5] Foxley, Alejandro (2009), Recovery: The Global Financial Crisis and Middle-Income Countries, http://www.carnegieendowment.org/files/middle_income.pdf

[6] OECD (1994), The OECD Jobs Study: Facts, Analysis, Strategies, Paris: OECD

[7] One study finds that in 55 low-income countries that have are part of both ‘first generation’ and ‘second generation’ poverty reduction strategies (PRS) under the auspices of the IMF and the World Bank, 72 per cent of these strategies have labour market reforms as a key element. See ILO (2008),”Decent Work Issues in Poverty Reduction Strategies and National Development Frameworks”, A seminar report 15-17, December 2008, International Training Centre Turin.

[8] OECD (2006), OECD Employment Outlook 2006, Paris: OECD

[9] Berg, Janine and David Kucera (2008), eds. In Defence of Labour Market Institutions Cultivating Justice in the Developing World, Palgrave Macmillan.

[10] Richard B. Freeman (2007), “Labor Market Institutions Around the World” NBER Working Paper No. W13242

[11] See, Santos, Alvaro (2009), “Labor Flexibility, Legal Reform, and Economic Development”, Virginia Journal of International Law, vol.50(1), pp. 43-106.

[12] Berg and Kucera (2008:1).