Are structural reforms of the (East) German labor market a template for Europe? 3 graphs

About a week ago I promised to write a little more about Cyprus, Dijsselbloem and all that. I first set out to state that the ECB does not only has an inflation mandate: it also has a legal mandate to foster prosperity. And belatedly but nevertheless the ECB has de facto said ‘goodbye’ to its long-standing conviction, inspired by ‘rational expectation economics’, that as long as inflation is low and stable, financial stability is guaranteed.

The ECB however still clings to another fallacy, i.e. the ‘rational expectations economics’ idea that unemployment has to be solved by ‘structural’ measures, i.e. changes in national labor market institutions and in the medium run by definition is caused by labor market rules, just like large slumps are caused by dysfunctional labour markets.

Read Ed Prescott, winner of the economics Nobel, who makes the mistake of thinking that, when average hours per member of the labor force went down because of increasing unemployment in the Great Depression, this was a rational choice of the entire sector households, which as a sector acted like the neo-classical hyper rational  individual atomicon and chose less hours per person, on average, because of changing labor market rules. A ridiculous idea which however is part and parcel of ‘Real Business Cycle theories’ – but we all know that you can drown in a river which is, on average, 40 centimeters deep.  Anyway – why did these labor market imperfections suddenly disappear when countries left the gold standard?

But the ECB still seems to stick to these ideas and promotes the idea that structural changes are the silver bullet which will solve unemployment. To test such ideas it is interesting to see what happened to East Germany after 1991. Did structural changes, like the famous Harz reforms, suddenly lead to a buoyant labor market. No, they did not. They are no silver bullet.

1. 22 years after unification and 10 years after ‘Harz 1’ unemployment is lower than it used to be – but is still way higher than the West-German level (graph 1).

2. The East German labor force never recovered from the 1991-1993 blows and is still shrinking (graph 2), which explains a substantial part (44%) of the decrease of unemployment (measured in persons) post 2006

3. Substantial job growth in the 2007-2012 period is absolutely dwarfed by the decrease of employment after 1991

 

(Graph meta: the grey background color of the graphs is inspired on the new color of the walls of the reopened Rijksmuseum: http://www.guardian.co.uk/culture/2013/apr/05/rijksmuseum-reopens-long-refurbishment-rethink)

If East German job growth stays on the 2007-2012 trajectory and even when we ascribe this growth to structural reforms, it will take about 40 years before ‘structural reforms’ enable East Germany to get back to the 1991 level. No magic bullet there. Maybe they don’t want to get back to the pre-bust level level – but Spain and Greece do.