Reform policy in need of a new focus

Over the last few years, the term “structural reform” has been used as a synonym for deregulating European labour markets. In this piece we are going to argue that this emphasis is intrinsically wrong at least as far as it is an illusion to hope for a boost to economic growth from this kind of approach.


The backbone of our thinking is the traditional double mark-up model that underpins the theory of the natural, i.e. non-inflationary, rate of unemployment in which wages are set as a mark-up on prices and prices are set as a mark-up on unit labour costs. Labour market reforms or an approach of moral suasion in order to achieve wage restraint either implicitly or explicitly aim to reduce the mark-up on the labour market side of the equilibrium. In turn unit labour costs are reduced and, under the assumption of a constant mark-up on the firm’s side, prices will be reduced. All told, labour market reforms can thus be argued to set a disinflationary impulse. Of course, this is not a bad thing in itself. However, prima facie there is no theoretical ground to expect such a policy to boost economic growth as some supply siders (and a lot of politicians) tend to argue. This is for two reasons.


First, the mark-up on the price-setting side is the macro equivalent of the micro pricing power in a monopolistic market or the slope of the price-demand curve. If this slope does not change, neither will the amounts of goods produced in the profit maximising equilibrium.


Second, a reduction of unit labour cost growth by reducing the wage setting mark-up and a corresponding disinflationary impulse could, of course, bring along more exports. However, this comes at the expense of domestic demand. Germany is probably a very striking example of this kind or reorientation of resources from the domestic to the export sector. On balance the impact on economic growth then depends on the gains or losses on either side of the demand aggregates. If we assume for sake of simplicity that there are equal elasticities of demand for goods from both wage income on consumption spending and relative domestic/foreign prices on export demand, then the impact of more exports relative to foregone consumer spending will only be larger if the share of exports in GDP is larger than the share of consumption in GDP. (In fact, we would assume it quite plausible that the elasticity of demand from lower relative prices would be somewhat less than that from lower wages so that a direct positive impact on GDP is even more unlikely). Bottom line: Reducing the wage mark-up alone will only encourage economic growth in the case of a small open economy but not in a large open economy. And while it might be reasonable to classify some European economies as small open ones, it is more difficult to do so for the big four (Germany, France, Italy and Spain) and neigh on impossible for EMU as a whole.


From our perspective, there are two ways to properly bring about the harked about positive growth effects.


First, the disinflationary void of domestic demand left by the reduction of the wage mark-up could be filled by stimulating fiscal or monetary policies. Indeed, the Irish tripartite agreement in the 1990s to exchange reductions in the income tax rates for wage restraint by the unions could serve as a good example in this context. Of course, the ECB could also respond to labour market reforms by lower interest rates. We would grant, though, that it will be very difficult to estimate the precise disinflationary impact of labour market reforms in individual member states on area-wide aggregates and there is also an incentive for free-rider behaviour in the case of using monetary policy.


Second, the emphasis could be shifted from the reduction of the wage mark-up to the reduction of the price mark-up. This would amount to a direct shift towards higher aggregate output at any given price and thus directly stimulate economic growth both on the internal and the external side of the economy. The reform dividend in terms of growth, jobs and inflation would be a lot higher in case of such a shift of focus in structural reform policies.


Yet, this second line – which we would favour – would quite naturally be a strong shift in focus.

2 Responses to "Reform policy in need of a new focus"

  1. Sebastian Dullien   January 15, 2008 at 8:02 am

    Nice post. There is, however, a political economy problem with the proposal: Reforms focusing on the mark-up of goods prices can be expected to be met with resistance of business and employers’ federations. And reforms cannot easily be enacted economy-wide, but have to be applied sector-by-sector. If, however, you try to reform the goods market in a single sector, you will not only meet resistance buy the business of that sector, but probably also by the unions of that sector as they are now sharing in in the profits from a sheltered sector. The workers from other sectors who might benefit, in cotrast, are very unlikely to support these reforms strongly, as their benefits are only marginal.

  2. Ulrich Fritsche   January 15, 2008 at 12:52 pm

    I agree, nicely put. This is by the way the position of Olivier Blanchard and others who call for product market deregulation as complementary to labour market deregulation.