Inequalities and crisis recovery

Creator: Raymond Torres, Stefan Kühn and Matthieu Charpe, ILO
Published in: Genevey, R., Pachauri, R., Tubiana, L., 2013, Reducing Inequalities: A Sustainable Development Challenge, TERI Press, New Delhi

Introduction

The global crisis which erupted after the collapse of Lehman Brothers in 2008 has led to significant debate regarding the importance of adequate financial regulation. The G20 Summit which was held in 2009 in Pittsburgh, for example, highlighted the critical role that improved financial regulation should play in securing sustainable economic growth. Important as it is, however, financial reform will not be enough to tackle the crisis. Indeed, some authors have called for the emphasis to be shifted onto the “real” factors behind the crisis, particularly inadequate employment growth and excessive income inequalities (KUMHOF and RANCIÈRE, 2010; TORRES, 2010).

This paper draws on this literature and shows how addressing employment and income gaps could contribute to the rebalancing of the real economy and promote recovery. We examine the appropriate policy mix needed to tackle the crisis. In this regard, the pros and cons of fiscal austerity measures and labour market deregulation are assessed 1.

In order to achieve this, a model which takes into account the connections between macroeconomic policies and labour markets has been developed by the International Labour Organization (ILO)2 . Importantly, the ILO model takes into account the impact that changes in income distribution may have on aggregate demand. Based on this model, the paper i) assesses the impacts of fiscal austerity and certain structural reforms on jobs; ii) examines how the labour market situation, in turn, affects macroeconomic performance; and iii) discusses what strategy would help meet both employment and fiscal goals.

Fiscal austerity is detrimental to output growth and employment:

The analysis is performed by way of three economic and social scenarios for the period 2012-15, based on the ILO model. The first encompasses further fiscal austerity through a cut in public spending starting from the first half of 2012, hereafter referred to as the “fiscal consolidation scenario”. The second analyses the effect of reforms that end up reducing wages and weakening workers’ bargaining power, hereafter referred to as the “lower labour standards scenario”. This second scenario also discusses the ability of minimum wage to limit income losses. In the third scenario, the “ILO scenario”, the effects of a policy mix combining sound fiscal policies to stimulate investment with policies that achieve balanced income developments are assessed over the selected period.

Figure 1 shows the main outcomes of the three above-mentioned scenarios. Employment trends over the next two and a half years are compared with a “baseline scenario”, which includes the economic and labour market projections as developed in Global Employment Trends 2012 3.

In the first scenario, further fiscal austerity would reduce employment vis-à-vis the baseline. Fiscal austerity is modelled here as a cut in public spending as a share of GDP by 1.4 percentage points in high income countries. Output declines by 1.6 percentage points at peak and by 0.6 percentage points by 2015. Similarly, employment decreases by 1.3 percentage points at peak and 0.5 percentage points by end 2015 (dash-dotted line in Figure 1). This corresponds to 2.84 million fewer jobs in high income countries by end 2015 as compared to the baseline scenario (see Table 1). In low and medium income countries, fiscal austerity is milder with the ratio of public spending to GDP declining by 1.1 percentage points only. This is translated into 11.5 million fewer jobs by end 2015 4.

Figure 1: Employment dynamics resulting from three policy options



Note: This Figure presents the simulated dynamic development of employment in the different policy scenarios. Fiscal consolidation is a scenario in which public consumption to GDP ratio is cut by 1.4 percentage points. The lower labour standards scenario is characterised by a fall in the share of labour income in total income by 1.8 percentage points. The ILO scenario combines infrastructure spending (1 percentage point increase in public investment) and efforts to ensure that labour incomes grow in line with productivity in all countries (an increase in the share of labour income in total income by 1.8 percentage points). The policies are assumed to take effect in mid-2012 and the effects are measured until end 2015.
Source: ILO, Global Economic Linkages model, IILS.

The result arises because fiscal consolidation reduces aggregate demand, in turn, affecting labour demand. Importantly, this simulation takes into account the fact that lower public spending creates room for higher private spending. However this positive “crowding-in” effect is outweighed by the direct negative impact associated with lower public spending. The deflationary pressures exacerbated by spending cuts tend to push up the real interest rate, which discourages private investment. Fiscal austerity does not succeed in stimulating private investment, which declines by 1.3 percentage points at peak. Additionally, budget cuts are costly to the public purse since they depress economic activity and raise unemployment, thus eroding tax revenues and adding upward pressure on social spending. The result is that short-term budget savings from fiscal austerity do not materialize. Indeed, public debt increases by 1.1 percentage points by end 2015.

…the same goes with policies that reduce the bargaining power of workers...

The second scenario illustrates the employment effects caused by a further deterioration in the bargaining power of workers. In the ILO model, the distribution of income between workers and firms depends on a parameter which captures the workers’ bargaining power over wages 5. The experiment conducted in the second scenario is to decrease this parameter such that the corresponding decline in the labour share of income is 1.8 percentage points. This drop corresponds to the decline in the labour share of income, which took place in the United States over the period 2008-2010.

In the second scenario, output declines by 1.2 percentage points at peak and 0.5 percentage points by end 2015, while employment declines by 1 percentage point at peak and by 0.36 percentage points by end 2015 (Figure 1, dashed line). This corresponds to a decline in the global number of jobs by 10.53 million, compared with the baseline scenario (Table 1).

The logic behind this result is that, even if lower wages may boost labour demand for any individual firm, a generalised fall in wages would affect household demand at the aggregate level, thereby depressing total output and employment. This means that, in the model, the negative demand effect dominates the positive impact that higher profits (associated with lower wages) may have on business investment. The positive effects of lower wages on profits are not materialized since the sharp decline in consumption pushes the economy into a liquidity trap. Private investment drops by 1.2 percentage points at peak. As with the first scenario, the second scenario is associated with a widening in budget deficits owing to lower tax revenues and larger spending related to increased unemployment benefits. Importantly, however, the model does not consider the possible effect that lower wages in the public sector would have on budget deficits.

Table 1: Employment effects of three policy options

(Cumulative employment levels (in million jobs) vis-à-vis GET projections for high-, medium- and low-income countries)


 

Note: The table presents the estimated additional job creation (in millions) in high, medium and low income countries, for different policy scenarios, compared to the Global Employment Trend (GET) 2012 baseline scenario. Fiscal consolidation is a scenario in which public consumption to GDP ratio is cut by 1.4 percentage points in high income countries and 1 percentage point in low and medium income countries. The lower labour standards scenario is characterized by a fall in the share of labour income in total income by 1.8 percentage points. The ILO scenario combines infrastructure spending (1 percentage point increase in public investment) and efforts to ensure that labour incomes grow in line with productivity in all countries (an increase in the share of labour income in total income by 1.8 percentage points). The policies are assumed to take effect in mid 2012 and the effects are measured until end 2015.

High income countries correspond to the category “Developed Economies and European Union” in the GET report, while low and medium income countries correspond to all remaining countries not included in the previous group.

Source: ILO, Global Economic Linkages model, IILS.
The negative effects of lower labour standards may be attenuated by labour market regulations in the form of minimum wage. Minimum wage sets a floor on wages and therefore limits the fall in labour incomes. It follows that consumption drops less and employment losses are limited. Figure 4 shows the employment dynamic following a decline in labour standards with and without minimum wage. In the presence of minimum wage, employment “only” drops by 0.3 percentage points against 1 percentage point in its absence. Additionally, the recovery is faster and employment is restored to its pre-crisis level by end 2015.

...whereas a global job pact would help on both the employment and macroeconomic fronts.


The third scenario looks at the effects of a crisis response inspired by the Global Jobs Pact, i.e. the implementation of the decent work agenda at times of crisis. Although such an agenda encompasses a large variety of tools and policy actions, numerical simulations can only be performed on a restricted set of instruments. For simplicity, the ILO scenario is here defined as a combination of i) infrastructure investment equivalent to 1 percentage point increase in the public investment to GDP ratio6 and ii) a rebalancing of the share of labour incomes in total income, corresponding to an increase in the share of labour income in total income by 1.8 percentage points7 .

The component of infrastructure spending intends to capture the aggregate demand effect of public spending as well as the productivity-enhancing effect for the private sector of well designed public investment. Infrastructure investment plays the role of a positive externality on firms, since public capital is an input in the production function of firms. This measure captures the set of instruments advocated by the ILO to support enterprises. The stabilization of labour share in total income captures the measures promoting rights at work and social dialogue as well as those measures aimed at achieving a more balanced income distribution.

These policies are especially relevant given the relative inefficiency of monetary policy in the current deflationary environment that prevails in most advanced economies: monetary authorities are faced with a liquidity trap as they are left with little room to further reduce interest rates to stimulate investment.

In the ILO scenario, output increases by 1.8 percentage points at peak and by 0.8 percentage points by end 2015, while employment increases by 1.1 percentage points at peak and by 0.35 percentage points over the same period (solid line in Figure 1). This translates in an additional 12.74 million jobs created worldwide (Table 1). Well-designed public investments are enterprise friendly to the extent that they generate a crowding-in of private investment, amounting to 1.1% of GDP by 2015.

Public debt declines in the short run due to additional tax revenues. This increase is however moderate and does not exceed 1.6 percentage points of GDP at peak value. This scenario shows that the debt level is mainly driven by revenue associated with economic activity.

Figure 4: Employment following a drop in labour standards with and without minimum wage



Note: This Figure presents the dynamic of employment under the lower labour standards scenario with and without minimum wage. The lower labour standards scenario is characterized by a fall in the share of labour income in total income by 1.8 percentage points. The policies are assumed to take effect in mid 2012 and the effects are measured until end 2015.

Source: ILO, Global Economic Linkages model, IILS.

Comparison with other model results

Compared to other modelling studies, the ILO model yields similar results concerning the effects of fiscal austerity. For instance, the IMF global model (GIMF) shows that in a situation of underemployment of productive resources, fiscal austerity will worsen the employment situation. Similarly, public investment has beneficial demand effects while also boosting enterprise investment and labour demand. Neither model, however, take into account the risk premium which financial markets might impose on government refinancing costs.

As to the effects of labour standards, the findings of the ILO model are more favourable than is the case with GIMF. This is because the ILO model takes into account the impact that changes in income distribution may have on aggregate demand. Indeed, in contrast to the GIMF model, the ILO model features bargaining over wages between workers and firms. Due to the low substitutability between capital and labour in the short run, a reduction in wages (due to lower labour standards) entails limited labour/capital substitution. By contrast, with many households relying exclusively on labour income, the fall in wages lowers aggregate demand, depressing employment prospects. Recent IMF research, such as for instance Kumhof and Ranciere (2010), has taken into account income distribution effects and finds results in line with the ILO model.

Importantly, the ILO model assumes that policies are coordinated across countries. In the absence of policy coordination, ILO friendly policies carried out by one country in isolation may yield much less gains than projected in the third scenario.

Finally, and crucially, none of the alternative models consider the implications of a prolonged labour market recession from the point of view of labour market participation (“hysteresis” effects). This means that employment effects of fiscal austerity and certain structural reforms are probably under-estimated. It is expected that later developments of the model will remedy this important knowledge gap.


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1 The IMF and OECD propose three scenarios based on the Global Integrated Monetary and Fiscal Model (GIMF). In a first scenario, further fiscal consolidation leads to lower output and employment due to its negative impact on aggregate demand. In a second scenario, lower taxes on labour income and profits as well as more flexible labour markets have strong supply side effects leading firms to increase labour demand and production. In a third scenario, rebalancing in Asia reduces global imbalances between high income and emerging economies.
2 For further details, see Charpe and Kühn (2012). More information on the Global Economic Linkages (GEL) model can be found at: /public/english/bureau/inst/research/global/index.htm. See also Charpe and Kühn (2011).
3 ILO. Global Employment Trends (2012)
4 OECD Quarterly data on government accounts shows that spending to GDP ratio has declined by 1.4 percentage points between the third quarter of 2010 and 2011 in 25 advanced economies. Similarly, the World Economic Outlook forecasted a decline in spending to GDP ratio of 1 percentage point in developing economies between 2009 and 2011.
5 In detail, wage setting is subject to Nash bargaining over the surplus from an additional match. Wages therefore depend on a variety of elements such as the marginal productivity of labour, the replacement wage of workers, the interest rate as well as a parameter capturing the bargaining power of workers.
6 The 1 percentage point increase takes place on impact. Spending then gradually declines at a rate of 10 per cent per quarter during the simulation period until they return to their starting value.
7 This experiment relies on the assumption that this policy mix is undertaken jointly by all countries and that no country engages in strategic games leading to free riding behaviour.