Monti and the ‘Mother of All Reforms’

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).

Employment Protection
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.

5 Responses to "Monti and the ‘Mother of All Reforms’"

  1. Stray__Cat   January 5, 2012 at 6:08 pm

    I'm petrified.
    Who could really think that lowering wages and freedom to fire have something to do with the Italian crisis? There's all the freedom to fire and hire required, and the battle around this topic is political. Center and right wingers are just trying to trash the unions as it was done in the UK by conservatives. This, they believe, will bring a better world, with few riches and a mass of docile poors, with short and miserable lives.

    Italian salaries are among the lowest in the EU, the imported inflation is soaring, lowering wages would just reduce the internal demand and deepen the crisis (not all the companies export). Now we need something that would rise the working class actual income, like a decisive cut on personal taxes.

    Gaining productivity by lowering wages is a Banana Republic solution. Productivity must rise by technology improvement. A good measure would be detaxing high tech companies (aerospace, defense, electronics, biotech, nanotech, IT) which establish in Italy and create local employment (as long as they do) as Ireland did in the past.
    The other productivity leg is reforming the Italian state organization to cut away wasteful branches. The state must be lighter not to do less things, it actually should do much more IMHO, but it should do more with less.

    Sorry for being so long and descriptive, but this post is just an academic math exercise depicting a nightmare scenario.

  2. Ira Leifer   January 6, 2012 at 10:29 am

    Looking at how FIAT has become a shell of its former self, and manufacturing continues to move to east europe and asia, I think this a red herring. On the other hand, the numerous bottlenecks in Italy, such as the monopoly of tabacchi, or pharmacy, etc., bureaucratic limits to enterprise formation, and other assorted economic forms of patronage are never mentioned for reform. Agree with Stray_Cat, dont see much benefit to imitating a Latin American type of economy.

  3. lucad10   January 6, 2012 at 1:38 pm

    It's really sad to read from an italian professor such an analysis: do you really believe that an internal devaluation could enable italian economy to restart growing ?

    As I am a business practitioner and not a researcher, I kindly suggest you to check
    your thoughts with a Paul Krugman latest post on a similar issue, whose summary is: "The bottom line is that internal devaluation still looks like a very bad strategy".
    (see: http://krugman.blogs.nytimes.com/2011/12/30/pain-

    Let's hope that phase2 in Italy, will be focused on wishes you wrote in your previous wiser article (Mario Xmas).

    • @mmeijeri   January 8, 2012 at 5:35 am

      Krugman, like so many prominent economists, is a politician, not a scientist. He tells people what they want to hear, not what they need to hear.

  4. Manoj   January 10, 2012 at 2:57 am

    Would it not be better to first look at the "business model" for an economy as a whole. For example what should be the needs of infrastructure, social protection, education.

    For example in every enterprise, when it plans it looks at what it needs to run its business be it facilities management, security, training, recruitment costs etc.

    Should governments not revisit The country's business model and plan what are a countries realistic needs both to provide essential gov/-admin services as well as social protection programmes covering the young, old, poor and disadvantaged.

    At present, I see governments showing a total lack of vision and hence it is surprising that you have so little support for gov programmes to reduce debt or costs