Can labour markets be too flexible?
Krugman has an interesting article in the New York Times. In it he suggests that when interest rates are at the zero lower bound and therefore (in an economy where physical cash is still important) unable to fall further, there is effectively no floor to aggregate demand. Here are his charts showing the difference between an economy where interest rates can fall and one where they can't.
Classical AS/AD model.
LRAS = long-run aggregate supply
SRAS = short-run aggregate supply
AD = Aggregate demand
Krugman explains this chart as follows:
"Suppose aggregate demand falls for some reason, say a global financial crisis. Then what the textbook says happens is illustrated by the red arrows. First the economy contracts, then, over time, it expands again as prices fall. And this leads to the notion that demand-side stories are all bound up with the assumption of price stickiness......... you should think though the mechanism by which flexible prices supposedly restore full employment. In the picture I just drew, the answer is that you slide down the AD curve. But why is the AD curve downward-sloping? Any plausible story runs through interest rates: either you have a fixed nominal money supply, so a rise in the real money supply drives rates down; or you have in mind some kind of stabilizing policy by the central bank."
So either you have an automatically-stabilizing currency system*, or you have an activist central bank.
Classical AS-AD model with interest rates at the zero lower bound.
"Falling prices can’t reduce interest rates, so it’s hard to see why the AD curve should slope down....and in fact, because falling prices worsen the real burden of debt, it’s a good bet that the AD curve slopes the “wrong” way. "
For non-wonks, that means if real interest rates are too high and are unable to fall, falling prices and wages drive the economy into depression. Let me explain what that means in relation to the Eurozone periphery.
In most advanced economies, central banks have been using unconventional monetary tools such as QE to depress real interest rates. The jury is out on how effective these tools are at achieving that, but it is fair to say that countries such as the US and UK have not experienced the disastrous economic collapse that the Eurozone periphery countries are currently going through.
In contrast, the ECB has not eased monetary conditions for the distressed periphery countries. In fact it is currently tightening them as LTROs are repaid. The difference in real interest rates between core and periphery is substantial, and this has a direct bearing on the cost of finance for businesses, individuals and governments alike in periphery countries. Put bluntly, the periphery countries are experiencing a credit crunch - the cost of debt is very high relative to real incomes. The ECB claims that it can do nothing more to ease this situation.
Krugman's model assumes that real interest rates can't fall because of the zero lower bound. But in the Eurozone periphery, real interest rates are nowhere near the zero lower bound. They have considerable room to fall, but don't do so because of market perception of risk, a dysfunctional banking system, and ECB ineffectiveness. If the Eurozone periphery countries had their own currencies, we would expect their central banks to put downwards pressure on real interest rates by a variety of means including cutting reference rates, asset purchases and outright currency devaluation. But they can't do so because they are using the Euro. The ECB's refinance and deposit rates are already very low - the deposit rate is zero - so to ease further would require ECB asset purchases. There has been some discussion about whether the ECB should cut refi and depo rates further and/or do QE: but indiscriminate QE would also cut real interest rates in core countries, where they are already very low. What is really needed is bond purchases targeted at economies where real interest rates are too high - and that means OMT. OMT has extremely tight fiscal conditions attached to it, which is why it has never been used. But a central bank has no business dictating fiscal terms to sovereign governments. The job of a central bank is to support aggregate demand in the countries that use the currency that it issues. The ECB is using failure to comply with fiscal conditions as a reason not to support aggregate demand. Frankly that is disgraceful. The ECB is not acting as a central bank should.
So to adjust Krugman's model, there is effectively no floor to aggregate demand if real interest rates cannot fall, regardless of whether or not they are at the zero lower bound. If the central bank is ineffective, markets pessimistic and banks dysfunctional then interest rates will remain too high, aggregate demand will continue to fall and the economy will fail to recover - a self-reinforcing depression loop.
That's bad enough. Now add to the mix the structural reforms being imposed on Eurozone periphery countries to improve the flexibility of their labour markets.
The effect of structural rigidities in labour markets is to prevent wages and employment adjusting to economic conditions. On the face of it, therefore, structural reforms aimed at removing these rigidities should be a good thing. After all, in the classical model (the first of Krugman's charts), if wages and employment can adjust downwards, that enables prices to adjust downwards too as business costs fall, and once prices fall to levels that people are prepared to pay, then demand will rise and the economy will start to recover. But in the second of Krugman's charts, there is no price level at which demand starts to rise. And if real interest rates can't fall - as appears to be the case in the Eurozone periphery - then the second chart applies. In which case structural reforms to improve labour market flexibility will make matters worse, not better, because by encouraging wages to fall and unemployment to rise, they increase the pace at which aggregate demand falls. As Krugman puts it (my emphasis):
"In this context price flexibility doesn’t lead to full employment. In fact, the more flexible prices are, the worse the economic contraction."
Structural rigidities, although they distort labour markets, at least put a floor under wages and employment, and therefore support aggregate demand. In the absence of other forms of support for real incomes, removing them means that the economy cannot recover. Prices and wages will continue to fall. The slump is never-ending.
There is, of course, a "get-out" clause - and it is this that the Eurozone paymasters have been relying on. That is the role of exports. The theory is that if a country can cut its production costs enough, it will compete effectively against other, more expensive economies for exports, and its economy will recover as exports rise - an "export-led" recovery. And when the world is reasonably balanced between imports and exports, it is indeed possible for individual countries to bootstrap their recovery off others in this way, as Germany did after reunification. But that's not the case at the moment. Most countries are trying to reduce imports and increase exports. And that makes export-led recovery virtually impossible. It's the fallacy of composition: when everyone is trying to increase exports and cut imports, no-one can. Sure, the Eurozone periphery economies have shown considerable improvement in trade balance, and some are even running surpluses. But if the entire world moves to tighten imports, this improvement cannot continue. And even in the present climate it is highly unlikely to compensate for continuing collapse in domestic demand due to tight money and fiscal contraction.
Recently, perhaps recognising that export-led recovery is looking less likely, Eurozone leaders have adopted a different strategy. They are encouraging migration from periphery countries. Now, if you have a product that is in demand internationally, but of which you have an excess supply, then exporting it should be a good way of rescuing your economy, especially if warehousing that excess supply is expensive. Eurozone periphery economies currently have an excess of labour, particularly young people. When there is little international or domestic demand for domestically produced goods & services (so unemployment is high), but there is international demand for cheap labour, people will move. Indeed they are already doing so. So the theory is that migration should eventually enable Eurozone periphery economies to recover, as labour supply falls to the point where it meets demand and wages stabilise. But it's not that simple. Aggregate demand depends on people. When the population falls, unless real incomes rise, domestic aggregate demand also falls. Unless people who migrate send substantial amounts of money back to support those left behind, exporting labour will only make the economic problems of the Eurozone periphery worse.
And so, to answer the question I asked in the title to this post. Can labour markets be too flexible? The answer is yes, under some circumstances. When real interest rates are unable to fall and the fiscal stance is unsupportive, flexible labour markets make depression worse. However, this is not really an argument for maintaining structural labour market rigidities over the longer term. As I noted above, they distort labour markets - typically making employment prospects worse for young people, which amounts to mortgaging the future to support the present. Rather, it is an argument that reforming labour markets is the wrong thing to do when wages and prices are collapsing, unemployment is rising and real interest rates are too high. The priority is to support aggregate demand so the economy can recover: whether this is by monetary or fiscal means is frankly irrelevant, although personally I am in favour of both. Labour market reforms can, and should, wait for better times.
Models and mechanisms (wonkish) - Paul Krugman (NYT)
The movement of people (and its consequences) - Coppola Comment
The zero-sum trade in people - Coppola Comment
Unfortunately, monetary policy is now ineffective in the Eurozone - Flash Economics (Nataxis)
* Many people will immediately think of the classical gold standard as a self-balancing currency system. But it was never really self-balancing. In "Golden Fetters", Eichengreen showed that in fact it depended on the active cooperation of governments and banks (including central banks where they existed) to maintain it. The role of the banking system in balancing the economic cycle is much misunderstood.