Monti and the “Mother of All Reforms”

Whether Mario Monti will be remembered as Italy‚Äôs savior (from default) or as just another well-meaning economics professor,  will largely depend on the government’s “Phase2”. In “Phase 1”, the government aimed at adopting “structural” reforms that would durably curb the budget deficit. The pension reform, the property tax  and and the anti tax-evasion measures were the prominent means to this end  (see here). The task for “Phase 2” will be much harder: to spur economic growth after 15 years of stagnation. A failure here will disintegrate the benefits from “Phase 1″and prompt the country into default. The “mother of all reforms” in Italy is the reform of the labor market, where largely protected (in terms of pension rights, of unemployment benefits, maternity leave, employment protection) workers, mostly senior and blue collar in industry and public sector, coexist with totally unguaranteed  workers, mostly young/females 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”); the second is the adoption of a more decentralized wage-bargaining system where wages reflect productivity more closely, possibly at the plant level.
This colums makes the following  points. The first is that reforming the employment protection legislation (i.e less constraints on hirings and firings) is about increasing labor productivity 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 bargaining system at the same time (so that wages can adjust downward).

  1. Let’s consider the simple framework of Figure 1, where firms belong to two sectors (A, in blue, 
    and B in red);  they 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 from OA  (OB ) to the right (left) on the x-axis. The size of the box is the labor supply. Every period, in “normal times”,  there are idiosyncratic productivity shocks (high, H or low, L) in each sector, so that when labor demand is high in sector  A (schedule   ),  it is low in firms B and viceversa. With perfectly flexible wages (w) 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’ situation is reversed, workers move from A to B firms, to point 2. Now compare this situation with one where firing/ hiring cost are so high that employment cannot adiust (and the real wage is fixed at w). Initially we are at point 1, a negative shock hits sector A and a positive one hits B. If OA – L1 workers are forzen in A, sector B cannot expand employment above L1 -OB.   Hemce, workers in sector A will be paid more than their marginal product (and firms in A may go bust) while workers in 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 delivers a loss in output, productivity and real incomes that is  equal the area of the triangle B2H.
  2. Now suppose that the reform of the employment protection legislation is enacted during a “recession”, when the labor demand is low in  both sectors. If wages could adjust,  the economy would move from the initial point 1 to point H where  the real wage falls so to ensure that the labor force is fully employed. However, if firms can freely fire/hire but the real wage does not adjust (partial reform), firms in sector A will shed L1-L2 workers and employ only OA – L2 workers, and firms in B will still employ L1 – OB, so that the L2-L1 workers fired in sector A will become unemployed.

This exercise suggests that if  Monti wants to reap the producitvity gains of a reform in the employment protection legislation,  during the present recession, he must simultaneously enact a reform of the wage bargaining system: a partial reform will otherwise raise unemployment,  threatening social cohesion, and will likely result in a roll-back the reform drive. A half-baked labor market reform will likely back-fire.