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Gayle Allard

Gayle Allard: Rigid Labor Markets Reduce Productivity

Despite strong growth over the last years, a number of factors will inhibit growth over the next years, according to Professor Gayle Allard, Professor of Economics at IE Business School. Data show that economies with greater inequality grow slower than those with less inequality. This runs counter to theses which advocate using cheap labor as a growth driver.

Another growth inhibitor is the relationship between rigid labor markets and research & development (R&D). R&D is not a very successful growth driver in rigid labor markets. This is a result of a study on 73 countries.

You have explained in your research that R&D is not a very successful growth driver in rigid labor markets. However, the relationship between rigid labor markets and research & development (R&D) is in fact a growth inhibitor. What is the reason for this and what is the resolution of this problem?

Innovation is a really important part of development. It is one of the things that drives a country’s development. We talk about a triple helix: industry, government and business together drive the competitiveness of the country, as they work together on research, innovation and applying research to the real economy instead of having some sort of abstract theory.

So what we were trying to find out in our research was if a country had a rigid labor market, meaning that it is hard to hire and fire workers, or it is expensive to hire workers. It is a complicated question. Because on the one hand, if workers are protected by law, you can’t just fire a worker when you want to. I understand that in Georgia it is fairly easy to fire workers, but in Spain it is not. So on the other hand you might say: it is a good thing if you can’t get rid of workers, because they have accumulated experience, and they are identified with the company, if they stayed for a long time maybe that is good for research. If workers know that they are going stay in the future no matter what, they do not care about trying new things, so it could have a negative impact.

That was the issue we wanted to solve. And we have gotten mixed results there, as we did find that rigid labor markets were not helpful for innovation, but if you are thinking about universities, maybe more stable employment helped universities promote more research. So it is kind of a mixed result. If you talk to the government and tell them what they should do to promote research and innovation, there would be mixed recommendations.

What are the effects of a rigid labor market on a wide range of economic outcomes?

Lots of research has been done on this and some is contradictory, but we find in general that rigid labor markets actually reduce productivity. But if you look on a company level it is a little different compared to the country level.

So on the company level: if you look at different companies that operate in the same sector, the one with workers who stay longer, with fewer temporary workers, is more productive.

There is a one thing that happens on a company level and another thing that happens on a country level. Another thing is that we find rigid labor markets tend to reduce employment, because when it is hard to get rid of workers, sometimes companies do not want to hire workers. So we do see that countries with rigid labor markets tend to have less employment growth. Sometimes that means higher employment, sometimes it does not. There is another effect of rigid labor markets: if companies could choose whether to hire workers as permanent workers or temporary workers in rigid labor markets, they want temporary workers, because they want to keep all options open.

Whereas in Georgia for instance, where the market is quite flexible, companies do not care, because they can get rid of workers if needed. So there are some negative effects of rigid labor markets. We are looking for a very clear effect on innovation and it is not as clear as we would like it to be.

Data shows that economies with greater inequality grow more slowly than those with less inequality. What are the factors that affect the economic growth of a country, and what should countries with greater inequality do to prevent or reduce inequality?

We suspect that when inequality rises in a country, you tend to get slower growth over time. The reason is that when most of the income is going to the middle and lower class in a very equal country, they tend to spend it. If more income is going to the upper class they tend to keep it—maybe they invest it in financial assets, or take it out of country, or save it. Everything being equal, take a country that is unequal and where the rich have more money, there’s going to be less consumption, because the rich are not spending all of their income. Whereas if it’s a very equal country and the middle and lower classes have most of the money, then they will tend to spend it. So you will have virtuous cycle where you’ve got sustained long-term growth, and it tends to be pretty strong.

And when we look at the world after World War II, most developed countries had sustained long term growth, because they had big middle classes and they had equality. And that is getting worse, as inequality is rising. What we suspect, what we fear, is that looking forward, countries will experience less sustainable growth, because more money is in the hands of the rich. So this is a concern.

So how do you fix this? Inequality is produced by lot of things. One thing that causes inequality is immigration, because if you have a country where a lot of people are coming in who are poor, you are coming to the bottom and your income stretches out. And yet immigration is good for the world, because people who are poor can move to the countries that are richer, so within a country it becomes less equal, but globally it becomes more equal.

One does not always mean the other. Immigration is good for growth, inflation, and for the world. Another thing you could do to reduce inequality is of course tax the rich more heavily and transfer that money to the poor. Most countries do that to a certain extent: we have progressive tax system where we tax the rich more heavily, and then we have programs to help the poor. If we look at the countries in the world with the lowest inequality, for example Sweden and Denmark, they tax very heavily and transfer it to the poor. But Japan also has very low inequality, because it is very homogenous country: everybody is Japanese and they have very few emigrants. That helps to, but if your country is heterogeneous it tends to be less equal.

One of the things we have been noticing is that with the globalization, there is a tendency for a small group of corporations to be keeping more profits. This also causes inequality, because the owners of the corporations tend to be rich.

Today it is hard to make a country more equal than it used to be in the past. You have to tax more and transfer more to get the same inequality it used to have. For example, in Spain, which is the country where I live now, inequality rises, but if you look at inequality before taxes and transfers it is rising a lot more. So in other words: a country which is working really hard to reduce inequality, and is not getting the same results they used to. But then you have countries like the U.S., which have cut taxes on the rich. We have cut taxes on corporations, so we are increasing inequality with our tax policy.

How can we maintain a stronger global economy, and what are the roles of individual countries in this process?

In some ways, global growth is going to slow down no matter what we do. I really think we are looking forward to a slower growth world. Part of the reason is demography, because the world population will soon begin to shrink, and there are a number of countries which are shrinking already: Germany, Japan and China will soon shrink, Italy is shrinking. Birth rates are falling as well. At the same time, to grow the economy and develop business, you need people to join the workforce, to be able to work for companies, and you also need people to consume. So demography is having an effect on growth. Another very strange thing that we do not understand is that productivity growth has slowed down: we do not know why, because there are lots of technological changes, but for some reason, productivity growth has gone way down, and this slows down growth too.

There’s a debate among economists—some say productivity growth is going to rise really fast in the future, and it’s just a matter of waiting for it, because we have all these innovations and have not seen their effect yet. Others do not believe that is going to happen. They say productivity growth has slowed down because innovations such as social media are not raising our productivity, they might be reducing it. Maybe you are sitting at work and looking at Facebook.

Global growth has slowed down because of demography, productivity and inequality. Maybe it has slowed down because of the environment, because we can’t grow in the way we used to.

Automatization is also another restraining issue for global growth. You have a company that produces cars, for instance, and you have workers in your company that earn a good salary and have health benefits. If you replace those people with robots, then those people will find other jobs, which will probably be worse paid jobs. Maybe they go work in a fast food restaurant or become cleaners instead having good manufacturing job. This will be reflected in decreasing consumption demand levels.

So what should we do to have strong growth? All of these trends are hard to change. We can change inequality if we really work at it. If we allow more immigration there will be more growth, and that is a good thing. As countries are shrinking, they need more workers. There are limits on deregulating business—Europe is looking for ways to help countries which are falling behind, like Greece.

Another thing we need to do is keep trade free, and you know that Trump has started a trade war. That would not help global growth; trade is important and necessary. We have lots of strikes against global growth. If you could get rid of some of these negative things: inequality and restrictions on trade and immigration, then growth would continue.

By Nutsa Galumashvili
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