Structural Reforms and the Functioning of the Labor Market Klaus F. Zimmermann IZA and University of Bonn LAC-EU ECONOMIC FORUM 2013 Santiago, Chile January 22, 2013

Germany‘s Astonishing Development 2 The sick man of the euro The biggest economy in the euro area, Germany’s, is in a bad way. And its ills are a main cause of the euro’s own weakness. […] Thus the biggest economic problem for Europe today is how to revive the German economy. The Economist, June 1999 The Economist, March 2010 What are the factors that have put Germany back on track?

Unemployment in Germany ( ) 3 Sources: Federal Statistical Office, Federal Employment Agency Post-war economic boom Oil crises German reunification Hartz reforms

Late 1990s: The “Sick Man in Europe” ► Germany faced serious problems in the late 1990s, among which overcoming the high level of unemployment was crucial ► These problems have been linked to the high level of employment protection, high labor costs, and the strictly regulated labor market ► Although the availability of rather generous insurance-based social benefits depending on previous wages helped limiting income inequality and wage dispersion, these results came at the cost of a strong labor market segmentation and a large stock of long-term unemployed ► The welfare state was thus at risk of losing its sustainability; and the increasing burden of non-wage labor costs to cover deficits in social insurance seriously jeopardized Germany’s international competitiveness 4

5 Labor Market Institutions during the 1990s: The Need for Reforms (1/2) Passive Labor Market Policy: ► Unlimited UB/UA payment duration extraordinary feature of the German system ► Replacement rates for long-term unemployed were higher than in any other OECD country (OECD, 2004) ► Replacement rates for short-time unemployed comparable to many other OECD countries ► Incentives to take up a job were very low, especially for low-skilled:  Generous benefit levels and benefit durations  High benefit reduction rates if taking up employment

6 Labor Market Institutions during the 1990s: The Need for Reforms (2/2) Active Labor Market Policy: ► High expenditure levels and long durations of programs ► Most important programs:  Job creation schemes  Training programs ► Job search assistance and monitoring was given low priority ► Sanctions were rarely implemented ► Assignment to programs based on the caseworkers‘ discretion (no systematic individual profiling) ► No systematic evaluation

7 Major Labor Market Reforms ( ) “Hartz Reforms” Implementation in four waves („Hartz I-IV“) between 2003 and 2005: ► Hartz I-III  Stronger role of activation (e.g. sanctions)  Significant reduction of long-term benefits  Massive deregulation of fixed-term contracts, agency work and marginal part-time ► Hartz IV  Restructuring of the unemployment benefit and social assistance schemes  Means-tested flat-rate benefit replaced earnings-related long-term unemployment assistance ► Implementation of the reforms was tied to an evaluation mandate

8 Threefold Reform Approach (1/3) (1) Improving employment services and policy measures ► Re-designing of old measures and introduction of new measures ► Modernization of employment services along the lines of “New Public Management”  Results-based accountability of local employment offices  Outsourcing of many offices  Open competition between private service providers ► Customer-orientated one-stop centers, offering individual profiling, job search assistance, social services, and administration of benefits

9 Threefold Reform Approach (2/3) (2) Activating the unemployed according to „right and duties“ ► Implementation of an activation strategy  Priority to measures that support unemployed workers who are pro-actively seeking integration into regular employment ► Introduction of jobs exempt from any or with reduced social security contributions to take up employment in low-wage sector  “Minijobs”/ “Midijobs” ► Restructuring of the benefit-system  Reduction of unemployment benefit levels and durations  Eligibility for subsistence allowances according to a person's ability to work rather than according to previous contribution payments  Possibility of benefit sanctions and reductions

10 Threefold Reform Approach (3/3) (3) Stimulating labor demand by deregulating the labor market ► Deregulation of the temporary work sector ► Introduction of exemptions from restrictions on fixed-term contracts and dismissal protection

Successful Labor Market Reforms ► Reforms successfully addressed the German labor supply problem:  Work incentives for older workers (no early retirement options)  Ineffective policy instruments abolished (e.g., job-creation schemes)  Long-term unemployment benefits reorganized and reduced  Requirement for the unemployed to prove ongoing job search efforts ► As a result, the effectiveness and efficiency of labor market policy instruments has significantly increased, unemployed individuals have stronger incentives to take up jobs and overall labor force participation rates have increased ► Traditional setting of standard employment has been preserved, but accompanied by a growing segment of non-standard employment, e.g., marginal employment and temporary agency work 11

12 Evolution of the German Labor Force ( ) Source: SOEP Decrease in the share of permanent full-time employment Decrease in the share of inactive individuals Growth of flexible jobs

Labor Force Participation Rates ( ) 13 Hartz Reforms

Regaining International Competitiveness ► The labor market reforms contributed to Germany regaining its international competitiveness ► However, it is important to realize that the key factor – the decline in unit labor costs – did not stem primarily, as is widely believed, from wage restraint on the part of the trade unions ► More important was that the social partners used the collective bargaining process to arrive at more flexible labor arrangements ► These allowed the adjustment, restructuring and reorganizing of existing work processes not just at the industry or sector-wide level, but also at the firm and the plant level ► This newfound localized flexibility is the real source of the German economy’s new resilience – also in the great recession 14

Unit Labor Costs in International Comparison 15 Source: OECD Index OECD base year 2000=100 Seasonal adjusted values (national currency)

16 Germany in the Great Recession: Background ► Strong impact of the crisis on the German economy:  GDP declined by 4.7 percent in 2009  Output decline of 18.1 percent in manufacturing ► Mild impact of the crisis on the German labor market:  Employment remained at a record level of more than 40 million in both 2008 and 2009 (recently: more than 41.5 million)  Unemployment increased only marginally: already by the end of 2010, the unemployment rate was below its pre-crisis value  But average annual hours per worker decreased substantially and dropped by more than 3 percent between 2008 and 2009 ► Germany as a strong case of internal flexibility

GDP and Employment in the Great Recession ( ) 17

18 Contributing Factors: Overview ► Important factors that have contributed to the surprisingly mild response of the German labor market include: (1)Strong economic position due to recent labor market reforms (as previously discussed) (2)Nature of the crisis affecting mainly export-oriented companies (3)Discrete policy response: extension of short-time work (4)Behavior of social partners and automatic stabilizers ► Key role: Interaction between short-time work and increasing shortages of skilled workers in sectors and regions that were particularly affected by the crisis

19 Short-Time Work Cushioned the Labor Market Impact of the Great Recession ► Short-time work as the “German answer” to the economic crisis (Brenke, Rinne and Zimmermann, 2011):  Existing instrument which has been slightly modified during the crisis  Number of short-time workers strongly increased in the recession and peaked at more than 1.5 million in May 2009  Without the extensive use of short-time work, unemployment would have risen by about twice as much as it actually did ► Success was due to the fact that the crisis mainly affected export-oriented sectors with expected shortages of skilled labor  Firms had a great interest in retaining their qualified workforce  Short-time work was the instrument through which this could be managed at reasonable costs

Stock of Short-Time Workers ( ) 20

Germany: A Role Model for Other Countries? ► Aspects of the “German model” are transferable to other countries:  Structural labor market reforms!  Firms that were mainly affected by the crisis had the incentives and the necessary instruments to follow a strategy of labor hoarding (including flexibility at the firm level, e.g., working time accounts)  Other countries should carefully study the much more fine-tuned and open-minded level of cooperation between unions, employers and the government in Germany ► But other features of the German case are not transferable:  Firms’ past experience with short-time work, specific nature of the crisis in Germany (sector-specific transitory external demand shock), expected shortages of skilled labor ► Hence, while lessons can be learned from the German model, we must resist the temptation to believe in any one-size-fits-all solution 21

Concluding Remark: Austerity vs. Growth? ► The necessary efforts to reduce public budget deficits and to achieve fiscal stability do not rule out growth-oriented public investments ► Austerity is not a growth strategy: fiscal stability is only a necessary condition to achieve future economic growth ► Optimizing the use of public resources to foster growth makes sense if it is combined with structural labor market reforms ► Both are vital to the economy, which (like the human body) requires constant exercise and monitoring to get into and stay in shape ► Germany is today widely perceived as a role model for many countries in Europe – but spending cuts for their own sake were never the “German style,” as is now widely, but falsely speculated  Package: fiscal consilidation AND growth-oriented labor market reforms 22

References and Further Reading 23 ► Karl Brenke, Ulf Rinne and Klaus F. Zimmermann (2011): Short-Time Work: The German Answer to the Great Recession, IZA Discussion Paper No (available at ► Werner Eichhorst and Klaus F. Zimmermann (2007): And Then There Were Four… How Many (and Which) Measures of Active Labor Market Policy Do We Still Need? Applied Economics Quarterly 53 (3), ► Ulf Rinne and Klaus F. Zimmermann (2012): Another Economic Miracle? The German Labor Market and the Great Recession IZA Journal of Labor Policy 1, Article 3. (available at

Klaus F. Zimmermann IZA and University of Bonn IZA, P.O. Box 7240, Bonn, Germany Phone: +49 (0) Fax: +49 (0)