Employment and Macro Policy in the Aftermath of the Crisis

1. Employment and Macro Policyin the Aftermath of the Crisis Coen Teulings University of Cambridge Presentation OECD Paris 14 Februari 2014

2. Introduction • Employment at this stage of European history • Based on my previous CPB experience • Minimum wages? EPL? Wage subsidies? ?

3. Introduction • Employment at this stage of European history • Based on my previous CPB experience • Minimum wages? EPL? Wage subsidies?

4. Introduction • Employment at this stage of European history • Based on my previous CPB experience • Minimum wages? EPL? Wage subsidies? • Housing and macro policy • On-going research

5. Overview of the talk • Stylized facts • Theory framework • Outline of the model • Policy experiment • The 10 commandments

6. Overview of the talk • Stylized facts • Theory framework • Outline of the model • Policy experiment • The 10 commandments

7. The effect of Financial Crises 15 cases (Reinhart & Rogoff)

8. GDP effect largely permanent Sweden Finland Hong Kong, Indonesia

9. House price slumps Benetrix, Eichengreen, O’Rourke

10. Anecdotical Evidence on Europe • House price decline ↔ Unemployment • Small decline: Ger, Swe, Nl (till 2010) • Strong decline: Esp, Ire, UK, Denmark, Nl (since 2010) • Denmark and Nl high mortgage debt, unemployment • Spain • 25% males work in construction • fall in human capital • Current account since 2002 • Surpluses: Ger, Swe, Denmark, Nl, Austria, Finland • Deficits: UK, Gre, Esp, Por

11. House prices

12. Unemployment

13. Sovereign debt interest rate

14. House price overvalued?

15. House prices, wealth, employmentMian & Sufi

16. Decomposition of demand

17. Fiscal multiplier

18. Overview of the talk • Stylized facts • Theory framework • Outline of the model • Policy experiment • The 10 commandments

19. House price decline =Wealth transfer between generations • High house prices • Good for current generation: wealthier • Bad for future generation: must buy expensive houses • Hence: fall in house prices = wealth transfer • Large! 30% decline = 60% of GDP = 80% of sovereign debt • Balance budget reduction in tax deductibility = intergenerational wealth transfer • Value of housing captures NPV deductibility

20. Saving response • Take a real, not a financial view of saving • What is saving in a small open economy? • Export more! • Shift of employment from domestic to tradable

21. Keynes or Friedman? • Paradoxical situation • Only current income matters? House price decline would be irrelevant • Argument relies on Permanent Income Hypothesis • Can we do macro without rigid prices? • Would be much simpler! • It turns out we cannot

22. Overview of the talk • Stylized facts • Theory framework • Outline of the model • Policy experiment • The 10 commandments

23. Structure of Economy • Overlapping generations model Blanchard-Yaari • Workers die at fixed rate 2. 5%, new cohorts enter • Once and for all shock, perfect foresight after • 5 industries + share in consumption • Tradable 20% • Domestic 25% • Informal 25% • Construction/Land 5% • Government 25% • Cobb Douglas utility • Both inter-temporal and across commodities • Hence: constant gross consumption shares over lifetime

24. Unemployment • Workers enter unemployed • Industry specific human capital • Switching industries requires unemployment • 2-5 years period • No congestion effects • Runs counter to empirical evidence

25. Labour reallocation • If wages are flexible • Hiring industries pay full wage • Non-hiring industries pay lower, clearing wage downsizing by retirement • Firing industries pay lower bound wage firing = quitting unemployment = good limit to wage reductions, though at low levels: 50% fall • If wages are inflexible • Wage determined by competitiveness on global market • Drop in industry demand? Firing workers firing ≠ quitting unemployment = bad

26. Government • Pays interest on debt 1.5% • Pays its civil servants • (Pays mortgage subsidy) • Collects consumption tax • VAT • … but also income tax: pension contributions are tax exempt • Policy instrument: future taxes • We assume an exponential path back to LR equilibrium • Hence: • Model = system of linear differential equations • … if there is no construction (housing is only land)

27. What not? • Apart from housing, no capital • Constant interest rate • Hence: no sovereign debt crisis • No financial intermediation • No uncertainty / precautionary saving • No bequest motive • More general: no behavioural issues • Perfectly elastic demand for tradable

28. Overview of the talk • Stylized facts • Theory framework • Outline of the model • Policy experiment • The 10 commandments

29. Policy experiment • Start from a steady equilibrium • Applies to the Netherlands (?) • … but not to Spain (excess construction, bubble) • … and Denmark (overheating?) • … Germany (catching up due to labour market reform) • Shock to productivity ↓and debt↑ (e.g. 10%) • Hence: excess housing (e.g. 5%) • Policy response, fully credible • Perfect foresight of adjustment path

30. What policy response? • No response = No option: higher interest • Raise taxes to cover only higher interest? • Optimal from tax smoothing perspective • Sovereign debt becomes random walk • Increases vulnerability for future shocks • Hence: recovery of old public debt level • 60%? • Temporarily higher taxes, converging to steady state • Question however: at what speed? • Risk of (too much) overshooting

31. Phases in adjustment process Typical adjustment process • Initial non-hiring/firing in domestic (construction?) • Firing only under wage inflexibility • Accelerator mechanism • Substitution to informal industry due to high tax • Domestic starts rehiring • Construction starts rehiring

32. Effect on wealth and consumption • Human capital current generation falls • Lower wages in non-hiring industries • Unemployment • Financial capital falls due to house prices • Hence: permanently lower consumption • Retirement + interest rate = 4% • Fits wealth effect of 4 cents per euro • New generations gross consumption unaffected • Conditional on tax policy • Consumption effect lasts long • Unemployment effect not

33. Implications for debt and deficit • Higher taxes reduce wealth current generation • … and induce inter-temporal substitution • Hence: aggregate consumption postponed • Leads to employment shift to tradable • … which reduces value of human capital • … and hence current consumption • ... and house prices, hence consumption • Short run effect on deficit is negative • Might even be negative? Open research question • Fits multiplier studies Auerbach& Gorodnichenko

34. Welfare evaluation • Optimal fiscal policy = setting wealth distribution between generations • Market is efficient • Hence, postponing hurts future generations? • Might be false: taxation leads to distortions • Temporary overshooting • Inefficient unemployment instead of retirement • Substitution to informal sector • All depends crucially on degree of wage flexibility • Assuming wage flexibility contradicts empirical evidence

35. Other things • Tax treatment mortgage interest: balance budget reform makes things worse! • Same applies to NPV of market distortions • Italy • … and in the future Germany? • Bubbles? • Lead to excess consumption • Adjustment unavoidable • Critical role trade balance • Also bubble adjustment can be overshooting

36. Overview of the talk • Stylized facts • Theory framework • Outline of the model • Policy experiment • The 10 commandments

37. The 10 Commandments (I) • House price decline = intergenerational wealth transfer (large!) • House price variability, not level is main concern • Reduction sovereign debt = substitute, not complement • Adequate response fiscal policy: intergenerational insurance • Requires long run stance fiscal policy

38. The 10 Commandments (II) • House price decline = intergenerational wealth transfer • House price variability, not level is main concern • Reduction sovereign debt = substitute, not complement • Adequate response fiscal policy: intergenerational insurance • Requires long run stance fiscal policy • Shock therapy likely to be counterproductive • Maybe adverse short run response budget deficit • Hence: budget deficit=wrong control variable • Hence: EU regulatory framework inadequate role output gap • Applies also to product market reforms