The Unassuming Economist

Fiscal tightening, whether based on cutting spending or raising taxes, has raised inequality and lowered the wage share of income. These are the main findings of my co-authored IMF working paper released today. The results are based on 173 episodes of fiscal consolidation during 1978-2009 for 17 OECD economies (Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, Portugal, Spain, Sweden, the United Kingdom, and the United States). Some of the key charts from the paper are given below.

Fiscal consolidation raises inequality (as measured by the Gini Coefficient)
(The horizontal axis shows the year of the consolidation—year 0—and the impact up to 8 years after the consolidation)

Consolidation based on spending cuts raises inequality …

… as does consolidation based on tax increases

Fiscal consolidation lowers the wage share of income

Unemployment in advanced economies averages 8% today, a sharp rise from 5 ½ % at the start of the Great Recession. European unemployment is particularly high—about 11% on average. What can be done?

In a celebrated mid-1980s paper, Olivier Blanchard, along with Rudi Dornbusch and others, argued that tackling the high unemployment and low growth in Europe at that time would require a ‘two-handed approach’: a combination of demand-side and supply-side policies. It is not coincidental that the IMF’s current advice to countries reflects the return of the two-handed approach.

In presentations delivered at the European Commission, ILO, World Bank and other venues, Prakash Loungani—advisor in the Research Department and co-chair of the IMF’s “Jobs & Growth” working group—has made the case for balancing demand and supply initiatives to tackle unemployment in advanced economies. He notes that, contrary to some assertions, unemployment and growth have remained linked during the Great Recession and the Not-So-Great Recovery. This preserves the hope that the jobs will return when the growth does.

Evidence suggests that the bulk of the rise in unemployment in most countries has been cyclical. Hence, as the Wall Street Journal noted recently, it’s time to “stop worrying about the ‘jobless recovery’ [and] start worrying about the recovery-less recovery.” Citing work on Okun’s Law by IMF authors and other recent evidence, the Journal concluded that “it isn’t unemployment benefits or other specific [structural] factors that are holding back hiring. It’s the economy, stupid.”

Several factors are behind the tepid recovery in output. In work done for the recent World Economic Outlook, Ayhan Kose, Prakash Loungani and Marco Terrones note that a key difference between the current global recovery and past global recoveries is that fiscal policy has not been able to provide the support this time that it did in the past—a point that has been picked by many observers including Paul Krugman (see the figure on fiscal spending below and Krugman’s essay here).

Real Primary Government Expenditures

From the Wall Street Journal:

Stop worrying about the “jobless recovery.” Start worrying about the recovery-less recovery.

Nearly four years after the recession officially ended, the unemployment rate remains elevated, at 7.5%. The share of the population that’s working or looking for work is at a 30-year low. More than 2.5 million fewer Americans are working today than when the recession began.

Such grim statistics have led many economists to ask whether there might be deep, “structural” factors holding back hiring. Various papers have attributed the slow pace of job growth to the weak housing market, the downturn in specific industries and the long-run decline in the share of the population that’s working.

Others, however, have argued that there is little evidence for structural problems, and have said weak hiring is due to something much simpler: the slow pace of overall economic growth. In one recent paper, economists Laurence Ball, Daniel Leighand Prakash Loungani said the improvement in the job market during the recovery has been consistent with a long-documented relationship between unemployment and economic growth known as Okun’s Law.

In a new paper published by the National Bureau of Economic Research,University of Wisconsin economist (and blogger) Menzie Chinn and French economists Laurent Ferrara and Valerie Mignon also look at the relationship between economic growth and the job market. But rather than focus on unemployment, they focus on employment — an approach that allows them to avoid the nettlesome question of who should count as unemployed.

Mr. Chinn and his colleagues find that slow growth accounts for the majority of the continued jobs gap — but not all of it. The U.S. has about 1.2 million fewer jobs than it should based on long-run trends. The authors are careful not to say the entire gap is due to structural factors — some of it may be due to short-term issues, or to flaws in their economic model — but their findings do suggest the weak recovery alone doesn’t explain the weak job market.

Continue to the read the article here.

A WSJ blog notes: Changing euro-zone labor-market institutions has been one of the main goals of the bailout programs managed by the International Monetary Fund and euro-zone authorities over the last three years.

The thinking is: Europe’s labor markets – particularly those in the euro-zone periphery – need overhauls to allow wages to keep pace with changes in productivity and economic circumstances. This sounds like dry stuff, but it’s been one of the fund’s more controversial bailout recommendations. Making labor markets more “flexible” has in practice meant reducing the role of labor unions in wage-setting across much of southern Europe, leaving unions none-too-pleased with their more limited powers.

In a paper published on Friday, IMF economists led by Olivier Blanchard took a somewhat soul-searching look at the fund’s labor-market advice over the last three years. One interesting finding: The fund should “tread carefully” in its recommendations on collective bargaining, the paper suggests, since evidence about what kinds of bargaining arrangements work best is mixed. Read the full article here.