Erkki Liikanen: The great recession and its long shadow - youth
unemployment
Speech by Mr Erkki Liikanen, Governor of the Bank of Finland, at the University of Tartu,
Tartu, 30 May 2012.
* * *
Unemployment to center of policy debate
The financial crisis has brought unemployment back to center of the policy debate in Europe
and elsewhere. Almost 4 million jobs were lost in the euro area since the start of the crisis in
2008, and employment still remains about 3 million workers below the pre-crisis level.
Differences in unemployment experiences and youth unemployment reflect shocks and
institutions
The impressive aggregate figures mask large differences across countries and across worker
groups. While some euro area countries have experienced dramatic increases in
unemployment, in others the labour market adjustment has been milder than expected. One
the one hand these differences reflect the different nature of shocks affecting individual
countries. On the other hand, they reflect labour market institutions and policies in place in
these countries.
The shocks and institutions are also behind the perhaps most worrisome manifestation of the
crisis on the labour market, the rise of youth unemployment to record levels. It has risen to a
half of the youth labour force (aged 15-24) in Spain and Greece and a third of the youth
labour force in Ireland. In Estonia the youth unemployment rate stands at the current 25%
(although peaking at 40% in 2010). However, at the same time some countries have
experienced only moderate increases in the youth unemployment rate, and in Germany it
has actually fallen to the current 8%.
Earlier debate on shocks and institutions relevant again
Looking at these recent developments, the debate on the interaction of shocks and
institutions behind the rise and persistence of European unemployment seems highly
relevant again.
The chief economist of the IMF, then a professor at MIT, Olivier Blanchard claimed in 2000 in
his Harry Johnson lecture and his article with Justin Wolfers (Blanchard & Wolfers 2000), that
to explain both the rise and cross country heterogeneity in European unemployment since
the 1960s, the interaction between shocks and institutions is crucial.
Lars Ljungqvist and Thomas Sargent (1998) blamed the high European unemployment since
the 1980s to welfare states' diminished ability to cope with more turbulent economic times,
such as the ongoing restructuring from manufacturing to the service industry, adoption of
new information technologies, and a rapidly changing international economy.
Assar Lindbeck and Dennis Snower (2001), in their insider-outsider theory, examine why
labor markets are segmented into "good jobs" (with relatively high wages and high job
security) and "bad jobs". They also examined how various types of labor turnover costs give
insiders their market power, how they use this power to their own advantage (e.g., in pushing
up their wages), how the insiders' activities affect the outsiders and vice versa. They also
assess, what this insider-outsider interaction implies for employment, unemployment, and
other macroeconomic activities.
Discuss shocks and institutions behind the European youth unemployment
High costs for both individuals and society
Relevant in European countries fighting with deteriorating public finances,
competitiveness and aging populations
Today, I will discuss the shocks and institutions behind the European youth unemployment
problem. The relocation of unemployed young workers to new jobs is a key policy issue
facing European policy makers, as prolonged unemployment at the start of the working
career has substantial short and long term costs for both individuals and society. In addition
to the immediate lost output, these costs may include loss of skills, lower productivity and
wages and a permanent decrease in potential output (or increase in the NAIRU) in the years
to come. These costs are especially relevant in Europe, where countries are fighting with
deteriorating public finances, competitiveness issues and aging.
A well-functioning labour market improves the efficiency of monetary policy
transmission
The functioning of the labour market also affects the economic environment in which
monetary policy is conducted. A flexible and well functioning labour market improves the
efficiency of monetary policy transmission, and provides an economic environment which
facilitates price-stability oriented monetary policy of the ECB.
Why is youth unemployment generally higher than that of other age groups?
Youth unemployment has more than doubled in some countries
The rise of youth unemployment since the start of the crisis is stupefying. The euro area
aggregate youth unemployment rate (i.e. 16-24 years old) exceeded 20% by the end of
2011.
In some countries, however, youth unemployment has more than doubled during the crisis.
In Spain it has risen from 19% to 51%, in Greece from 23% to 50% and in Ireland from 9% to
31% and in Estonia from 7% to the current 25% (although it peaked at 40% in 2010q1).
Although less dramatic, the rise in youth unemployment in Italy and Portugal has been
considerable.
However, at the same time some countries have experienced only moderate increases in the
youth unemployment rate, and in Germany it has actually fallen from 11% to 8%.
Youth unemployment is high over the cycle also a structural issue
Youth unemployment is higher than unemployment for other age groups also over the
business cycle. On average, it is more than double the overall unemployment rate for euro
area countries. In Italy and Sweden it is more than three times higher than the overall
unemployment rate. We have seen a strong rise in youth unemployment during the crisis, but
it is also a structural issue. Policy measures must be designed accordingly.
Young workers as labour buffers
Young people are more vulnerable on the labour market than other age groups and they are
also easily used as labour buffers when employers adjust their work force. Reasons for high
youth unemployment lie in the properties of young workers relative to older workers, in habits
and common practices in the labour market as well as in labour market institutions.
As to getting hired and being laid off, young workers have a disadvantage relative to their
older colleagues. They have limited or no work experience and in particular they have little
firm-specific skills. The unemployment rate of labour market entrants tends to be high due to
frictions in the transition from education to work (e.g. inexperienced in job search). Often
young workers have temporary contracts, and they are subject to last-in-first-out rules when
personnel reductions take place.
Labour market institutions that differentiate across worker groups often penalize youth. In
particular, dual employment protection legislation (firing costs) that depends on employment
duration (e.g. Italy, Spain) is commonly seen as an important factor behind the spectacular
rise in youth unemployment during the crisis in e.g. Spain. The ease of ending temporary
contracts relative to permanent ones has led to a situation where young workers on
temporary contracts can be laid off without costs, while older workers on permanent
contracts have largely kept their jobs.
The youth are also typically overrepresented in cyclically sensitive sectors such as
construction, which also reflects dual labour market institutions in European countries.
Sectoral shocks from the crisis have hit hard on the young
Collapse of construction sector in Spain, Ireland and Estonia massive job destruction
The rise in unemployment and youth unemployment has been strongest in the countries
where imbalances, a booming construction sector or accumulated loss in competitiveness,
have been prominent before the crisis.
In the run-up to the crisis, the construction sector absorbed a large share of the workforce,
and young people were overrepresented in this growing sector. For instance in Spain,
dropping out from studies to work on the construction sites was a large scale phenomenon.
The subsequent collapse of the overheated construction sector in Spain, Ireland and Estonia,
lead to a massive loss of jobs. In Ireland and Spain, the construction sector accounts for
around 50%, of the overall employment contraction. Relative to the peak of the cycle, the
Spanish construction sector has lost 1.1 million jobs, and the Irish equivalent 160,000 jobs.
These jobs focused particularly on the young because in these countries the construction
sector employed an especially large number of young people.
Industry accounted for the bulk of the employment decline in Slovakia, Slovenia and Italy
although the number of jobs in this sector also decreased markedly in Estonia and Spain.
Temporary export shock in Germany and Finland labour hoarding by adjusting working
time
In contrast, in Germany and Finland the crisis was felt mainly through the export sector while
domestic demand remained relatively robust. The downturn in international trade was rather
short, which made it possible for firms to focus also in the availability of labour in the future.
Labour hoarding, by adjusting hours of work rather than the number of workers, moderated
the rise in unemployment. Unlike in the construction sector, the loss of jobs in the export
sector was not particularly focused on the young, as the proportion of young people in the
manufacturing is approximately the same as their share in the work force as a whole.
Property bubble and a credit crunch lead to more domestic disturbances, more
permanent restructuring than temporary export shock
The source of the shock has been an important factor for the labour market consequences.
The export shock during the initial quarters of the crisis was temporary and hence firms could
retain workers in anticipation of the trade recovery. The bursting property bubble and a credit
crunch lead to more domestic disturbances, more permanent restructuring and uncertainty
so that firms are more reluctant and less able to retain staff.
Sectoral shocks and reallocation
After the crisis, the need for alternative sources of employment has grown. In particular this
is the case in countries such as Spain and Ireland, where the sectoral growth outlook for the
hardest hit sector (construction) remains poor.
Relocation is a slow process
The relocation of surplus labour from permanently downsized sectors to more resilient ones
with a better growth potential can be a slow process even in a growing economy. In the
absence of robust growth this is an even more daunting endeavor. In Spain, it is made more
difficult by the low educational level of a part of the young people, as during the upswing
many abandoned their education to work on the building sites.
In manufacturing, too, there is pressure for reallocation. Already before the crisis, the
employment trend in Europe has been downwards for an extended period. The EU27 area
has lost 5.8 million manufacturing jobs since the year 2000. This persistent weakness on the
labour market and the slow relocation of labour into potential growth sectors is harmful to
both labour productivity and labour supply. The loss of young people's labour input, in
particular, will have long-lasting consequences.
Restructuring is a factor behind the perhaps strikingly large and persistent employment
consequences of deep recessions
Implies mismatches evidenced by outward shifts of Beveridge curves
As Reinhart and Rogoff (2009) point out, restructuring during deep recessions is a factor
behind the large and persistent employment consequences of deep recessions. The need for
relocating unemployed workers to different sectors of the economy implies mismatches on
the labour market that will make unemployment more persistent in the years to come. These
mismatches are already manifested by an outward shift of the euro area Beveridge curve
and by outward shifts of the Beveridge curve in countries most severely hit by sectoral
shocks.1,2
Failure to reallocate young workers would lead to a lost generation
Given the magnitude of the youth unemployment problem, European economies cannot
afford to fail in relocating the unemployed young workers to new jobs. Failure in this task
would imply a lost generation and all the individual and macroeconomic costs that follow with
it.
Dual labour markets place young people in the frontline in a recession
In many countries specific worker groups are affected by labour market institutions in
different ways. This certainly applies to employment protection legislation. Since the
implementation of labour market reforms in the 1980's, efforts have been made to increase
labour market flexibility in European economies. The reforms were targeted at reducing the
high and persistent structural unemployment rates in European countries, and to ease the
relocation of labour from stagnant sectors of the economy to sectors with growth potential.
Partial reforms focused on more flexible use of temporary employment contracts
These partial reforms, however, focused primarily on more flexible use of fixed-term
employment contracts. Carrying through these reforms was easier politically than changing
the conditions applied to permanent employment contracts (eg diluting employment
protection). This created a dual labour market in many European countries, not only in Spain,
but also in France, Italy, Portugal (and Sweden).
Relative position of fixed-term (typically young) employees has weakened
As the labour market has split in two, the position of fixed-term, often young employees has
weakened relative to permanent (typically older) workers. The reforms have liberalised
regulations concerning the use of temporary contracts, while the conditions for permanent
contracts have been left literally unchanged. The use of temporary contracts had earlier been
restricted to e.g. seasonal work in agriculture, tourism, and construction, but after the reforms
they could be used more easily for regular activities.
Differences in severance payments between fixed-term and permanent employment
contracts have grown, and in some cases there are no severance payments related to the
termination of temporary contracts. Temporary contracts can typically not be contested in
labour courts.
Use of temporary contracts has become more widespread has particularly affected the
position of young people, as fixed-term employment contracts are common among the
young
Consequently the use of temporary contracts has become more general with these labour
market reforms, but there are large cross-country differences. In Spain the proportion of
temporary workers of all workers was about 30% before the crisis (in 2007), in Portugal it
was 22% and in France 15%. These differences are in part explained by differences in
severance payments. For example, severance payments for permanent workers in Spain are
much higher, and the regulations concerning the use of temporary contracts much laxer than
in France.
The trend towards dual labour markets has particularly affected the position of young people,
as fixed term employment contracts are common among the young. In France, Sweden and
Spain over 50% of employment contracts for young people are fixed-term.
Dualism has directed the employment shocks especially to fixed-term workers and, by
extension, young people
During the crisis the rise in unemployment has been strong particularly in southern European
countries. The dualism in labour markets has directed the employment shocks especially to
fixed-term workers and, by extension, young people. In Spain, 88% of layoffs has been
focused on temporary contracts, and thus strongly on young workers.
The key problems of duality
A key problem in dual labour markets is that temporary contracts do not work as a
"springboard" to more stable employment relationships. The transition from temporary
contracts to permanent ones is low, and workers find themselves in a vicious circle of
temporary jobs, including recurring spells of unemployment.
The problem lies in the large gap in firing costs between permanent and temporary
jobs, and in the discrete jump in the cost
The problem lies in the large gap in firing costs between permanent and temporary jobs, and
in the jump in the firing cost when a temporary contract is converted to permanent one. In
addition, lax regulations concerning the use of temporary contracts worsen the situation.
Threshold to regularize a worker is high
For the employer there is a large step in the potential firing cost when converting a temporary
contract to a permanent one, and therefore the threshold to regularize a worker is high. In
particular, this is the case when regulations concerning the use of temporary contracts are
lax. Temporary contracts will be renewed or the workers will be changed to avoid paying the
firing cost. This has often been the case in recent years in e.g. Spain.
The consequences of high and persistent youth unemployment
The relocation of the unemployed youth to new jobs is a pressing issue, as prolonged
unemployment at the start of the working career has substantial short and long term costs
both for individuals and for the society.
Unemployment at the start of the working life can cast a long in terms of wages,
productivity and employment
At the individual level, unemployment at the start of the working life can cast a long shadow
over the working career. Wages and productivity are deteriorated by the reduced early career
work experience that is caused by unemployment. In addition, a vicious circle of fixed-term
contracts influences productivity due to weaker incentives for both employers and employees
themselves to invest in the training. Weak labour force attachment also raises the risk of
exclusion and poverty.
At the macro level, the costs include foregone output, higher social security outlays and
lower level of potential output and overall welfare
At the macro level, the immediate cost of youth unemployment is lost output and social costs.
Still more important are the macro level long term costs. Weak labour productivity evolution
at the individual level accumulates to a lower level of potential output (or increase in the
NAIRU) and overall welfare in an economy.
The costs of prolonged unemployment, weak labour market attachment, exclusion, including
costs related to higher criminality and worse health outcomes, build a heavy long term
burden on public finances.
Highly relevant in the current European context, where countries are fighting with
deteriorating public finances, competitiveness issues and aging populations
These costs are especially relevant in the current European context, where countries are
fighting with deteriorating public finances, competitiveness issues and aging populations.
The functioning of the labour market also affects the economic environment in which
monetary policy is conducted
The functioning of the labour market also affects the economic environment in which
monetary policy is conducted. A flexible and well functioning labour market improves the
efficiency of monetary policy transmission, and provides an economic environment which
facilitates price-stability oriented monetary policy of the ECB.
What can be done about youth unemployment?
The structurally high youth unemployment and its spectacular rise during the crisis can be
explained by the properties of young workers relative to older workers, the institutions that
govern the educational system and the labor markets, as well as the nature of the shocks
during the crisis.
May not always be meaningful to focus policy measures on the youth in particular
If the consequences of youth unemployment are considered more serious than those of other
age groups, it may be justified to focus measures particularly on the youth. At the same time
many measures aimed at lowering unemployment in general, affect the young unemployed
more than other age groups. This is why often general measures to lower unemployment are
most important for the young unemployed. They can be complemented but not replaced by
specific measures which focus only on the young.
We can assess the youth unemployment also from the viewpoint of the supply and demand
of the labour input of young workers, as well as mismatch problems and issues of specificity.
We must also keep in mind structural as well as cyclical aspects of high youth
unemployment.
(i) Labour supply
The value of alternative activity relative to job search and employment...
For the labour supply a key determinant, in addition to wages, is the value of alternative
activity relative to job search and working. Labour market institutions and the educational
system have a central role in determining the value of alternative activities and thus the
supply of labour. In the long run labour supply determines the potential output of an
economy. This is especially relevant with ageing populations.
Unemployment insurance reforms should activate workers and avoid income traps
Generous and long lasting unemployment insurance policies are criticized for their
passivating effect on job search. For this reason many countries (e.g. Germany) have
recently adopted policies aiming at activating workers. The measures include reducing
overall the level and duration of unemployment benefits, tightening the rules of accepting job
offers, at the risk of reduced or losing benefits, responsibility of job search, and means tested
benefits.
Social security systems frequently have unintended effects, such as "income traps" where it
is not worth accepting a job low wage or short term job for a worker. This is because the rise
in earned income leads to a larger drop in social benefits. Effectively this implies a marginal
tax rate of over 100%, which reduces labour supply. Measures that allow for some earmings
before losing social benefits have been implemented for example in the German Hartz
reforms.
Return to education in bad times may be rational
In recessions young workers exit the labour force more than other age groups. In many
cases the young return to education, which may be a rational choice considering the lower
opportunity cost of studying (expected value of job search is lower). Also a higher
educational level improves labour market prospects for the worker. Promoting transitions to
education by increasing temporarily the number students may be optimal from the society's
perspective as well, as the opportunity cost in terms of lost output is lower in a recession.3
(ii) Labour demand
The demand for young workers may be associated with both cyclical and structural elements.
When unemployment and youth unemployment is due to a cyclical weakness in aggregate
demand, unemployment is involuntary (and supply policies may be relatively weak).
In recent years, efforts to sustain aggregate demand have been implemented through
expansive fiscal policies. In the longer term this is not sustainable due to public finance
constraints. Fiscal stimulus may also not address the underlying structural problems, such as
the reduced competitiveness or the structural change needed in the economy.
A part of the job losses are permanent
During the crisis the level of output has dropped to a lower level in many countries, and part
of the job losses are permanent. This means that a recovery will not necessarily bring back
the lost jobs. It is possible that labour costs must fall, to bring employment back to its
pre-crisis level.
The productivity of a worker and the cost of labour determine its demand
In the longer term the key factors for labour demand are the productivity of a worker and the
price of labour, namely, the costs that accrue to the employer from a worker. The wage is, of
course, an essential part of the costs, but the employer also bears other wage related costs,
possible training, search and firing costs.
Wage formation that leads to a wage distribution that is more compressed than the
productivity distribution, tends to weaken young workers employment.
The price of a labour is the wage. The productivity of young workers is often lower than that
of older ones, but wages do not always fully reflect this productivity difference. If personnel
reductions are focused on those for whom the productivity-wage difference (profitability) is
the lowest, the reductions will primarily be on the young workers.
Overall, wage formation that leads to a wage distribution that is more compressed than the
productivity distribution, tends to weaken young workers employment. A wage distribution
that is narrower than the productivity distribution may be caused by a number of factors.
These include aiming at wage inequality, wage bargaining institutions that represent the
median worker or insider workers or minimum wages. A rapid rise in unit labour costs (wages
that rise faster than productivity) may also endanger especially the jobs of the youth.
Many countries have reduced minimum wages for young workers
Minimum wages often concern the least educated and least productive workers, and often
young people often fall into this category. Thus, the level of minimum wages is potentially
important for the employment of young workers. In fact, many countries have reduced
minimum wages for young workers, for example, 80% of the minimum wage. A reduced
minimum wage is, however, meaningful only in countries where there is a significant share of
workers working at the minimum wage (for example in France).
One wage related measure is to reduce the employers' social contributions to targeted
groups, such as low-productivity workers (often young), to promote employment of young
persons. This is on the other hand has to take into account the losses to public finances
caused by the reduction and substitute them from other sources.
Apprenticeship places that pay a sub-minimum wage, and where the contracts include a
training commitment from the employer, have been successful (e.g. in France).
Dual employment protection legislation weaken the position of the youth
Firing cost should be gradually increasing with the duration of employment relationship
Employment protection legislation often treats different categories of workers in different
ways. Differences in redundancy costs of fixed-term and permanent employees are large in a
number of countries. Fixed-term contracts are common, particularly among young workers
and ideally they can act as a "bridge" to a permanent position. But the temporary contracts
are in a weaker position relative to ongoing contracts, and layoffs have been concentrated on
fixed-term contracts. So young people are in general in a weaker position due to their
over-representation in these contracts. For fixed-term contracts to be converted into
permanent ones more frequently, the threshold for converting should become lower. A
proposed solution has been that the firing cost would be gradually increasing with the
duration of employment relationship (e.g. Bentolila et al. 2011). Then a large jump in the
firing cost when continuing the employment relationship, would be avoided.
(iii) Mismatch and reallocation
The recovery in European economies and the success in reallocating the surplus labour from
permanently downsized sectors to more resilient ones are intertwined and will determine the
economic fortunes of European economies in the years to come.
If there is a problem of mismatch, a recovery or expasionary policies will not likely
lower such structural unemployment
Indeed, understanding the nature of euro area unemployment has important policy
implications. When unemployment is cyclical and due to a lack of job creation, a pick-up in
economic growth or expansionary policies will tend to reduce unemployment. However, when
there is a mismatch between job vacancies and available workers, a recovery in growth or
expansionary policies will not affect such structural unemployment much.
Mismatch calls for measures that improve matching efficiency, along with adjustment in
workers skills and adjustment in relative wages
This calls for measures that improve matching efficiency in European labour markets, along
with adjustment in workers skills and adjustment in relative wages.
The transition from education to work is an important point of friction. According to the OECD
job search programmes have proved to be successful and cost efficient in employing the
youth who are employable.
Youth unemployment tends to be the highest for the least educated. Sufficient education, or
lack of it, is crucial in determining labour market outcomes of young people. Completing
basic education and obtaining a secondary degree are a minimum requirement for a young
person to obtain and retain a job, as well as to being able to learn in a job. Especially for
marginalized youth, education outside of the class room has been successful, so that the
youth are continuously exposed to a work environment and accumulate experience. German
style apprenticeship programs have been found to pave the way from education to working
life.
Wages provide incentives
Wages provide incentives. The relative wages of different occupations should reflect demand
and supply conditions and direct young workers to those sectors and occupations where
work is available.
Is the "German labour market miracle" a textbook example of successful reforms?
In Germany both unemployment and youth unemployment have continued during the crisis,
now the unemployment rate being at its lowest rate in two decades, at 6% and youth
unemployment at 8.5%.
Although this impressive evolution of unemployment and youth unemployment is in part due
to better economic development than in other euro area countries, the German labor market
institutions play a role. The target of the German labor market institutions and reforms has
not been the youth only, but because the youth are at "the margin", meaning that changes in
unemployment affect them more than proportionately, the general labour market reforms
have successfully also reduced youth unemployment. The key institutions and reforms in
Germany are the Hartz reforms (2003-2005), wage moderation, the "Kurzarbeit" short time
working scheme, and the apprenticeship vocational training programme. All of these include
elements that promote the fall in youth unemployment.
Hartz reforms aimed at both labour supply and demand
The Hartz reforms included a number of measures aiming at both labour supply and
demand. By tightening the eligibility of and reducing the duration and level of unemployment
benefits, as well as with different types of low-wage jobs and wage subsidies the German
government aimed at activating unemployed workers. Labor market regulations were
reduced, by altering employment protection and the rules for temporary contracts. Opening
clauses to labour contracts were introduced, to bring flexibility in times of trouble. These
concern flexibility of working time and wages.
Wages have grown moderately
Wages have grown moderately in recent years in Germany, which has contributed to the fall
in unemployment. The increase in low-wage jobs has in part supported the employment of
low productivity workers, often the young.
"Kurzarbeit" has had a positive employment effect during the crisis beneficial especially
for the employment of workers on permanent contracts, typically older workers
Whereas labour input adjustment has been made through the reduction of (temporary)
workers in many countries, in Germany the adjustment has been made largely in hours per
worker with the so called "Kurzarbeit" short time working scheme. In this programme, firms
temporarily reduce the hours of their workers and the loss in wages is partly compensated by
the public funds. This short time working scheme has had a positive employment effect
during the crisis.
Short time working arrangements may amplify insider-outsider problems in the German
labour market
The Kurzarbeit programme has, however, been beneficial especially for the employment of
workers on permanent contracts, typically older workers. For temporary workers the effects
have been smaller (Hijzen & Venn 2010). Thus the short time working arrangements may
amplify insider-outsider problems in the German labour market. Until now the positive
economic development of the German economy has kept this hidden.
A short-term vs. long term tradeoff: current employment vs. restructuring
The short time working schemes may also involve a short-term vs. long term tradeoff.
Although these schemes have been successful in mitigating the rise in unemployment, they
may also hinder the reallocation of labour across sectors of the economy. If this is the case,
the short term benefits of higher employment may come at the cost a harderneed for
rest