• Home ::
• Fundamental ::
• Analysis Reports ::
• Friday Notes

• Send
• Print
• Add To
• Rss

Friday Notes

2cb12e7e-20f6-4f7f-9795-1377ff161427

14

0

Labor markets are the Achilles Heel

Fri, Oct 16 2009, 12:46 GMT
by UniCredit Research

UniCredit Group

• Recovery. The global economy is recovering, and there is mounting evidence that the third quarter was probably strong. Nevertheless, there are lingering doubts about the sustainability of the upswing. We are sticking to our picture of a W-shaped recovery – without expecting a relapse into recession.

• Doubts. The reason for our caution is the sluggish private sector. The spark of global trade will not make the jump to consumption and investment activity since households and businesses have to deleverage even further. As a result, the upswing will weaken once the stimulus programs and the inventory cycle come to an end.

• US. Strains on personal consumption are coming not least from the labor market. US businesses may be laying off fewer people than in the spring, but they are not hiring either. There will be no change in this situation over the next few months. For that reason, the unemployment rate will rise to roughly 10½% by the beginning of 2010. And the empirical evidence shows that the Fed will wait months before raising the Fed funds target rate (pages 3-5 & chart below).

• Germany. Labor market weakness is unfolding in Europe as well. The good numbers in Germany are a statistical anomaly. The development adjusted for special factors is, however, already worse than in previous cycles. And the usual deterioration in the second year following a recession should also materialize this time around. Excess capacity and the rapid rise in unit wage costs should see the jobless number spike to as high as 4¼ million by the middle of next year (pages 6-9).

• Further topics:

  – Weekly Comment: A jobless recovery? (page 2)

  – EMU: Residential investment still has some way to fall (page 10).

  – Eastern Europe: Relief, but no euphoria (page 12)

  – Data outlook: Ifo business climate to continue to improve (page 16).

  – Market outlook: EUR-USD to test 1.50 mark (page 23).

A jobless recovery?

In this issue of our Friday Notes, we focus on the most socially painful consequence of the crisis: unemployment. Alexander Koch and Harm Bandholz take an in-depth look at labor market developments in Germany and the US. The picture that emerges is worrisome, although perhaps not as dramatic as one might have feared given the intensity of the downturn in the first part of the year.

In the US, unemployment has more than doubled from the pre-crisis lows of about 4½%, and is now rapidly heading towards 10%. This is a significantly worse deterioration than what we have observed in the euro zone as a whole, where unemployment has risen to 9.6%, but starting from a relatively high 7.2% at the beginning of last year. In Germany, the increase appears negligible, to 8.2% from 7.6%, at face value a very benign impact for a contraction in real GDP which should be in the region of 5%. The increase has been somewhat sharper in Italy, to 7.4% from a 2007 low of 5.6%, but here as well the rise is not as brutal as one might have feared given the magnitude of the recession (again in the region of 5%) – and interestingly, Italy outperforms the euro zone average on this measure. I should also warn up front that across these countries, as well as in the rest of the euro zone, we expect unemployment to keep trending higher even as economic activity stabilizes.

It would therefore appear that Europe’s social model is serving its workers well, cushioning the impact of the most severe recession we have seen in a long time. In some cases, the picture might be skewed by changes in registration practices – as Alexander Koch highlights for Germany. But overall, what we are seeing at work is the impact of a number of measures taken to try and help firms to hold on to as large a share of their labor force as possible. In many cases, this is achieved by shortening working weeks, and in some cases governments have stepped in to top up the corresponding reduced wage payments. This was a rational strategy to adopt, and not just from a social perspective: this crisis is unprecedented, and as such it was impossible to predict both the speed and duration of the downturn, and the speed and duration of the recovery. It is therefore sensible for companies to hold on to their labor force to the extent possible, so as to minimize the turnover, especially if the government can mitigate the cost. In addition, limiting the increase in unemployment helps to support consumption, thereby reducing the intensity of the downturn.

Indeed, if this were to turn into a genuine V-shaped recovery, companies could quickly bring their employees back to fulltime, and would be able to ramp up production much more rapidly than if they had to restart the hiring process. If this becomes a V-shaped recovery therefore the labor market measures adopted will help it to take off quickly.

If, however, the recovery loses steam as we expect, there is a significant risk that firms will be forced to lay off more workers, pushing the unemployment rate higher. Moreover, firms might end up weathering most of the recession with a higher-thanoptimal number of employees – and as a consequence might be very reluctant to hire as the recovery gathers momentum. There is a significant risk therefore that the price some countries will pay for the relatively moderate rise in unemployment this year will be a jobless recovery in 2010-11.

Finally, it is important to consider the longer-term consequences of the current trends. A clear disadvantage of the European strategy of helping firms to hold on to their workers is that it slows down the painful but necessary process of reallocating resources from sectors which will be permanently damaged by the crisis to sectors that will provide stronger growth opportunities in the future. To the extent that surmounting the crisis requires a rebalancing within national economies, slowing the rise in unemployment hinders this process and might therefore slow down the recovery and hamper potential growth. Moreover, one should look with greater attention at the differential impact of the rise in unemployment on different cohorts of workers. We have not yet developed a full-fledged analysis, but anecdotal observation suggests this might be a serious problem in labor markets characterized by a sharp insider/outsider dichotomy. Outsiders are generally younger workers with fixed-term contracts, which accounted for the largest share of employment creation before the crisis. These are the workers who are now quickly being laid off, and will find it difficult to find another job in the near future. Especially if their previous working history has been "checkered", a succession of short-term assignments, these young individuals will find themselves with an extremely weak work background once the economy has recovered, having missed the chance for consistent professional development. If this affects a significant share of the young workforce in some countries, it would imply a tremendous loss in human capital with potentially damaging effects on growth potential.

Bottom line: the jury is still out on whether labor market policies implemented during the crisis were the right ones; but in any case, governments should already take a much closer look at the longer-term impact on the labor force and potential growth – especially as robust growth will be essential to facilitate a return to fiscal sustainability.

• Download Full Friday Notes

Published on  Fri, Oct 16 2009, 12:54 GMT