Can Institutional Reform Reduce Job Destruction and Unemployment Duration?

Can Institutional Reform Reduce Job Destruction and Unemployment Duration? Yes It Can. By Esther Perez & Yao Yao
IMF Working Paper No. 12/54
February 2012
http://www.imf.org/external/pubs/cat/longres.aspx?sk=25738.0

Summary: We read search theory’s unemployment equilibrium condition as an Iso-Unemployment Curve(IUC).The IUC is the locus of job destruction rates and expected unemployment durations rendering the same unemployment level. A country’s position along the curve reveals its preferences over the destruction-duration mix, while its distance from the origin indicates the unemployment level at which such preferences are satisfied Using a panel of 20 OECD countries over 1985-2008, we find employment protection legislation to have opposing efects on destructions and durations, while the effects of the remaining key institutional factors on both variables tend to reinforce each other. Implementing the right reforms could reduce job destruction rates by about 0.05 to 0.25 percentage points and shorten unemployment spells by around 10 to 60 days. Consistent with this, unemployment rates would decline by between 0.75 and 5.5 percentage points, depending on a country’s starting position.


Introduction

This paper investigates how labor market policies affect the unemployment rate through its two defining factors, the duration of unemployment spells and job destruction rates.  To this aim, we look at search theory’s unemployment equilibrium condition as an Iso-Unemployment Curve (IUC). The IUC represents the locus of job destruction rates and expected unemployment durations rendering the same unemployment level. A country’s position along the curve reveals its preferences over the destruction-duration mix, while its distance from the origin indicates the unemployment level at which such preferences are satisfied. We next provide micro-foundations for the link between destructions, durations and policy variables. This allows us to explore the relevance of institutional features using a sample of 20 OECD countries over the period 1985-2008.

The empirical literature investigating the influence of labor market institutions on overall unemployment rate is sizable (see, for instance, Blanchard and Wolfers, 1999, and Nickell and others, 2002). Equally numerous are the studies splitting unemployment into job creation and job destruction flows (see, for example, Blanchard, 1998, Shimer, 2007, and Elsby and others, 2008). This work connects these two strands of the literature by investigating how labor market policies shape both job separations and unemployment spells, which together determine the overall unemployment rate in the economy. The IUC schedule used in our analysis is novel and is motivated by the need to understand the nature of unemployment, as essentially coming from destructions, durations or a combination of both these factors. This can help clarify whether policy makers should focus primarily on speeding up workers’ reallocation across job positions rather than protecting them in the workplace.

One fundamental question raised in this context is whether countries with dynamic labor markets significantly outperform countries with more stagnant markets. By dynamic (stagnant) we mean labor markets displaying high (low) levels of workers’ turnover in and out of unemployment. Is it the case that countries featuring high job destruction rates but brief unemployment spells tend to display lower unemployment rates than labor markets characterized by limited job destruction but longer unemployment durations?  And how do institutional features shape destructions and durations?


Conclusions

This paper reads the basic unemployment equilibrium condition postulated by search theory as an Iso-Unemployment Curve (IUC). The IUC is the locus of job destruction rates and expected unemployment durations that render the same unemployment level.  We use this schedule to classify countries according to their preferences over the job destruction-unemployment duration trade-off. The upshot of this analysis is that labor markets characterized by high levels of job destruction but brief unemployment spells do not necessarily outperform countries characterized by the opposite behavior. But, the IUC construct makes it clear that high unemployment rates result from extreme values in either durations or destructions, or intermediate-to-high levels in both.

Looking at unemployment through the lenses of the IUC schedule focuses the attention on each economy’s revealed social preferences over the destruction-duration mix. Policy packages fighting unemployment should take into consideration such preferences. Some countries seem to tolerate relatively high destruction rates as long as unemployment duration is short. Others are biased towards job security and do not mind financing longer job search spells. A few unfortunate countries are trapped in a high inflow-high duration combination, seemingly condemned for long periods of high unemployment.

An optimistic message arising from this study, especially for countries located on higher IUCs, is that an ambitious structural reform program tackling high labor tax wedges, activating unemployment benefits and removing barriers to competition in key services can effectively contain job losses, limit the duration of unemployment spells and yield substantial reduction in unemployment.