Whether Mario Monti will be remembered as Italy’s savior (from default) or as just another well-meaning economics professor, will largely depend on the government’s “Phase2”. In “Phase 1”, the government’s objective was adopting “structural” reforms that would durably curb the budget deficit. The pension reform, the property tax and the anti-tax evasion measures were the prominent means to that end (see here for a discussion). The task for “Phase 2” will be much harder to achieve: to spur economic growth after 15 years of stagnation. A failure here will disintegrate the benefits from “Phase 1″and prompt the country into restructuring the debt: interest rates will not fall if the rate of growth will not be resuscitated.
The “mother of all reforms” in Italy is the reform of the labor market, a “dual” market where largely protected (in terms of pension rights, unemployment benefits, maternity and illness leave, employment protection) workers, mostly senior and blue collar in industrial large firms, coexist with totally unguaranteed ones, mostly young/females workers employed in services. There are at least two politically “hot” issues here: the first is the employment protection legislation, where reformers want to move from a system protecting (obsolete) jobs to one that would assist workers during unemployment spells, the so called “flexicurity” model; the second is the adoption of a more decentralized wage-bargaining system where wages reflect productivity more closely, possibly at the plant level.
This column makes the following points. The first is that reforming the employment protection legislation (i.e. less constraints on hiring and firing and protection to people not jobs) is about increasing labor productivity, incomes and output (which is exactly the reason why Monti should do it), and not about increasing employment. The second is that if employment protections are reduced during a recession, then the only way the government can avoid a potentially disruptive rise in unemployment is to reform the wage system at the same time (so that wages can adjust downward).
To clarify the discussion, let’s consider the simple standard framework of Figure 1, where firms belonging to two sectors (A and B) produce and sell an homogeneous output by employing labor (which is homogeneous and mobile across firms). The labor demand of firms A (B) is measured on the horizontal axis from OA (OB ) to the right (left), and depends negatively on the real wage, w, on the vertical axis. The size of the box OA-OB represents the (fixed) labor supply. Every period there are idiosyncratic productivity shocks (high, H or low, L) in each sector, so that when labor demand is high in sector A (schedule LAH , the dotted blue line ), it is low in firms B (LBL , the dotted red line) and vice versa. With perfectly flexible wages and no hiring/firing costs, there is always full employment, as workers move from the low to the high productivity sector. When productivity is high in sector A and low in B, OA – L1 workers are employed in sector A, and the remaining L1 – OB are employed in B, so the economy is at point 1. When the sectors’ productivity realizations are reversed, workers move from sector B to sector A, to point 2. Now compare this situation (flexible or competitive market) with one where firing/ hiring cost are so high that employment cannot adjust (and the real wage, negotiated by centralized bargaining, does not reflect productivity and is fixed at w). Initially we are at point 1, and a negative shock hits sector A and a positive one hits B. If OA – L1 workers are frozen in A, sector B cannot expand above L1 – OB. Therefore, workers in sector A will be paid more than their marginal product (and firms in A may go bust) while workers in sector B will be paid less. More crucially, less output would be produced in the economy, since too few (many) workers are employed in the high (low) productivity sector. Employment is unaffected, but the labor market rigidity implies a loss of output, income and productivity equal the area of the triangle B2H
Reform in a Recession
Now suppose that the reform of the employment protection is enacted during a recession, when labor demand is low in both sectors. If wages could adjust, the economy would move from the initial point 1 to point H, where demand is low in both sectors and the real wage falls so that the labor force is fully employed. However, if firms can freely fire/hire but the real wage does not adjust, firms in sector A shed L1-L2 workers and employ only OA – L2 workers, while firms in B still employ L1 – OB: the L2-L1 workers fired in sector A become unemployed.
This exercise suggests that if Monti wants to reap the productivity gains of a labor market reform during the present recession, he must simultaneously enact a comprehensive change in both the employment protection legislation and of wage bargaining system A half-baked labor market reform will backfire and result in a rise in unemployment, so that it will likely be rolled back.