American Lessons From The German Employment Miracle

For empirical macroeconomists like us there is a wealth of data to pour over and see whether any interesting suggestions, lessons, or conclusions can be drawn.

For instance, we've noted that Japan experienced a bigger financial shock than the US (either in the 1930s or the 2008 shock), a shock in which the equivalent of three years of GDP in wealth was wiped out, yet Japan didn't experience anything like a Great Depression.

Japan didn't even experience anything like double digit unemployment. In fact, there was hardly a budge in the unemployment rate. The main reason, of course, is that Japan never really experienced a strong recession (they experienced mild ones in 1997 and 2001 when they prematurely retrenched on fiscal policy). But part of the answer lies in labor market institutions.

Something similar can be said for Germany after the 2008 financial crisis. As anyone familiar with the work of Michael Lewis will know, while there wasn't any lending or asset bubble domestically, many German banks gorged on sup-prime toxic financial products out of the US, in the subsequently proven erroneous belief that when rating agencies say these are triple A, they are triple A.

As a result, Germany suffered an even slightly bigger decline in GDP compared to the US. But while unemployment has surged in the latter, it has stayed relatively flat in either Japan and even declined(!) in Germany:

Before one argues that the Germans exploit the South of the euro zone running massive trade surpluses with them, we repeat that Germany suffered a (slightly) bigger shock to GDP than the US. That includes any trade benefits.

If you consider the relative demand shocks, the labor market performance of the US is particularly poor:

As shown in Figure 1, between 2007:Q4 and 2009:Q4, output in the US fell slightly less than in Germany. However, total hours worked fell nearly 8% in the US but only 1% in Germany, and US employment declined 6% over the same period but edged up in Germany (that is, German hours per worker declined more than total hours worked) [Ohanian and Raffo]

click to enlarge

On the other hand, the German labor market performance seems particularly odd. Despite the downturn, unemployment actually decreased. What's going on here?

Labor market adjustment and institutions

How did they pull it off? Well, in principle, there are several ways companies can react to a negative demand shock (say a (negative) demand shock of 20%):

• One can fire 20% of the workforce
• One can reduce wage costs by 20%
• One can reduce working hours by 20%.

Of course, one can use a combination of the three. How did the US react? Well, the larger part (70%) fell on a reduction in employment, 30% on reduction of work time. One reason US companies react this way is because employment protection legislation is particularly low in the US. Here is an international comparison:

The level of collective bargaining is also particularly low and benefits like healthcare make reducing working hours unattractive (as these are fixed costs).

Germany reacted in quite a different way, by reducing working hours (or 'labor hoarding,' as it is often called. This happened in The Netherlands as well). Why did they react the way they did? Well, here it's summed up:

There are institutional reasons why firms responded by reducing hours, rather than firing people:

• Firing is quite expensive, Germany has quite a strong level of legal employment protection (see figure above)
• Germany has relatively high levels of collective bargaining, combined with unions focused on job security and facilitating widespread introduction of working-time banks (where overtime in the past can be taken up as less work now) and allowing for negotiated reductions in overtime.

Important as well was a Government policy called short-time work (SWT), which provided part-time unemployment benefits to workers working less hours.

What's better?

One might also give some thought to what would actually be better. Keeping a workforce together has some considerable advantages:

• No firing cost (even where these are low)
• No need for selection and training when the economy picks up
• Instilling a sense of community in the workforce (this is an intangible, but potentially an important one)
• For society as a whole: firms don't externalize the cost of surplus labour (like unemployment benefits)
• There is also considerable evidence unemployment is particularly bad for one's physical and mental health, especially if it lasts (for which there are additional cost like losing of relevant skills and work habits)
• In a hire-fire economy, companies face considerably reduced incentives to train their workforce, especially in general (non-company specific) skills.

Against these advantages of labor hoarding, there is one disadvantage: it hinders efficient allocation of labor between firms. This isn't much of a problem during a general recession, when most firms are faced by reduced demand, but it could be a bit of a problem during good times, when unemployment is low and there is significant difference in speed of development of industries (and a need for reallocating labor from shrinking to expanding industries).

German lessons?

So what can the US learn from Germany? Probably quite little. One has to understand that labor market institutions are a complex set of practices, arrangements, habits and laws that are an intricate whole, not unlike a puzzle. Changing one element almost certainly has significant implications for others (the institutional economics literature speaks of 'employment systems' for a reason).

We can't see the US increasing the cost of firing employees, or moving to collective bargaining any time soon (if ever). A little more likely is the introduction of more STW. In fact, a number of states introduced similar policies but on a modest scale, and since the incentives for US firms to fire rather than keep workers on but with lesser hours are skewed to the former (compared with Germany), it's much less effective on its own.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.