Continuing with the discussions on monetary policy, I ran across an article at VoxEU by Ester Faia, Wolfgang Lechthaler and Christian Merkl on the ineffectiveness of monetary policy in heterogeneous European labour markets (here's the paper - it's a DSGE model). In particular they look at the link between large hiring costs in-between Eurozone economies (which are a proxy for unreformed labour markets) and policy trade-offs for central banks. The argument is that within a monetary union with heterogeneous labour markets (as evident on the graph below), monetary policy can be completely ineffective unless some sort of harmonization of firing costs across countries is achieved. This means that unless European labour markets all don't undergo a reform similar to the German Agenda 2003, it isn't likely that ECB's monetary easing will be very effective in decreasing unemployment.
I'm not entirely sure whether their argument is supposed to be a sort of an explanation of the European liquidity trap (on how monetary policy is ineffective in a crisis) or is it supposed to be another justification of the idea that we can't have a monetary union without a fiscal union? What I'm certain however is that according to their main finding...
"A central bank facing higher firing costs should, thus, allow for larger deviations from its long-run inflation target to reduce this externality. Thus, the mandate of the ECB to solely maintain price stability is associated with welfare costs. To be more precise, a pure price-stability policy (i.e. stabilising inflation at its target) is suboptimal."
...they would assume that the ECB should opt for more monetary easing and a switch towards a higher inflation target (something close to NGDP targeting), however, they are unfortunately unable to do so due to the between-country differences in the rigidities of their labour markets (if I got this right).
The externality of which they speak is the following:
"By hiring a worker today, firms reduce the future pool of applicants. This implies that firms hiring tomorrow will on average have to employ workers with lower productivity. We show that this negative composition effect cannot be offset by standard wage-setting mechanisms (neither collective nor individual). Thus, optimal monetary policy should be designed to reduce the macroeconomic effects of this externality."
I have a big problem with this assumption, as it fails to account for the new emergence of productive individuals on a yearly basis (new graduants, people switching jobs, etc.). I fail to see how this assumption is justified as an externality which is supposedly best fixed by monetary policy. If this is their main assumption for linking labour market inefficiency with ineffective monetary policy, then the conclusion fails the robustness test. A more plausible explanation would be that rigid markets with higher firing costs and stronger protection (like Portugal, Spain, Greece or France in the graph below) react more slowly to signals sent from the monetary authorities (or any other signals for that matter). This could perhaps explain why it takes a lot of time for both reforms to kick in and price signals to work in these countries, since businesses fail to adapt more successfully due to existing legal burdens.
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| Source: Ester Faia, Wolfgang Lechthaler, Christian Merkl (2013) "Monetary policy and firing costs" VoxEU. |
The graphs shows a strong negative relationship between output volatility and the employment protection index (based on employment legislation), suggesting that economies in which labour markets are too rigid are less likely to experience output fluctuations both upwards and downwards. This is logical since an inability of companies to adapt faster to exogenous shocks (both positive and negative) means that the fluctuation of total output will be slower.
Finally they conclude with the following point:
"This implies severe complications for the Eurozone. With its large differences in firing costs, the monetary policy for the average Eurozone is not appropriate for every single country. Thus, there is a need for the harmonisation of firing costs. The divergence in the monetary transmission mechanisms due to the differences in labour-market institutions impairs the efficacy of the ECB’s policy. Without harmonisation, firing costs increase the tensions that are already present within the Eurozone."
Going back to my previous arguments, if we want to see an effective monetary policy (or stabilization policy in general), we first need to think of structural reforms of a rigid labour market and the regulatory environment. The authors of the paper in my opinion are on a good track in reaching such a conclusion, but operate under dubious assumptions of defining the labour market institutions.