1. How supply-side labor market reforms harm innovation and labor productivity growth
Budapest, March 2018
Alfred Kleinknecht
Professor of Economics (Emeritus)

3. Possible explanations of the productivity slump
Is it a measurement problem? (No, see Byrne et al. 2016)

4. Possible explanations of the productivity slump
A low technological opportunities explanation: Exhaustion of the American IT Boom (Robert Gordon, 2016)

6. Possible explanations of the productivity slump
Short-termism in business (and among governments): A World-wide decline of basic research, OECD 2015 (+ lower absorptive capacities)

7. Possible explanations of the productivity slump
My explanation: supply-side labor market reforms

8. The Emergence of Supply-side Economics
The Age of Keynes
After the 'Golden Age of Capitalism' ( ) economic growth declined substantially: rise of unemployment, high inflation ('stagflation' etc.) …
… Keynesian economists seemed to have no good explanation … and Keynesian macro-econometric models made serious forecasting errors after about 1975

9. The Emergence of Supply-side Economics
The crisis of Keynesianism was a breeding ground for a revolution in the economics discipline:
from 'demand-side economics' (Keynes) …
… to 'supply-side economics' (Hayek, Friedman) and a sharp attack on the Keynesian welfare state.

10. What does supply-side economics mean?
Sobering of the welfare state
Privatization & deregulation an a broad scale
A ban on fiscal policy
More inequality of incomes ('performance must pay!')
No full employment but (sufficiently high) levels of 'NAIRU' unemployment
Deregulation of labor markets – Easy firing and (downwardly) flexible wages

11. But Supply-side Economics had a limited reach:
Albert (1991) and Hall & Soskice (2002) distinguish two types of capitalism:
Anglo-Saxon Liberal Market Economies (US, UK, Canada, New Zeeland, Australia) with 'flexible' labor markets (weak protection of labor)
Coordinated Market Economies ('Old-Europe' + Japan) with 'rigid' labor markets (strong protection of labor)
Complaint by supply-siders:
Old Europe is too slow in adopting 'structural reforms' of labor markets!

12. Liberal Market Economies (LME) versus Coordinated Market Economies (CME)
Comparing some core variables for
Liberal Market Economies (US, UK, Canada, New Zealand, Australia) versus:
Coordinated Market Economies (proxy: EU-15, excl. UK)

17. Key question: Does wage growth influence labor productivity growth?
Theoretical rationale:
Lower wage growth causes a slow diffusion of labor-saving process technology

18. Does wage growth influence labor productivity growth?
Key finding from panel data estimates: A one-per cent wage decline (increase) leads to ̶ 0.49% lower (higher) growth of value added per labour hour
Sources:
Vergeer & Kleinknecht 2011: The impact of labor market deregulation on productivity, Journal of Post-Keynesian Economics, Vol. 33(2):
Vergeer & Kleinknecht 2014: Does labor market deregulation reduce labor productivity growth? International Labour Review, Vol. 153(3):

19. Summarizing:
Deregulation of labour markets changes power relations between capital and labour → lower wage growth
… which has little influence on GDP growth, but …
… causes a slower diffusion of advanced process technology → lower growth of GDP per working hour
… leading to a labour-intensive growth path
... but with low productivity gains there is little to be (extra) distributed and this creates pressure towards:
'Precarization' of work (working poor)
Pressure on public sector budgets
Erosion of the middle class (Trump effect)

20. Additional arguments: Why should structural reforms of labor markets restrain innovation and labor productivity growth?
Easier firing reduces loyalty and commitment of workers:
→ Easier leaking of trade secrets and technological knowledge (i.e. stronger externalities)
→ more need for monitoring & control
→ thicker management bureaucracies
Kleinknecht, Kwee & Budyanto (2016): Rigidities through flexibi­lity: Flexible labour and the rise of management bureaucracies, Cambridge Journal of Economics, Vol. 40(4):

21. Share of managers in the working population (19 OECD countries, 1984-1997; Source: ILO statistics)5 10 15
Managers as a percentage of the non-agrarian working population
Canada
USA
Australia
U.K.
Netherlands
Austria
Finland
Denmark
Japan
Portugal
Germany
Ireland
Belgium
Switzerland
Italy
Sweden
Greece
Spain
Norway
According to De Beer (2001), the Dutch figure increased from 2% to 6% during (the period of ‘flexibilization’ of the Dutch labour market)

22. Why should structural reforms of labor markets restrain innovation and labor productivity growth?
Deregulation of labor markets and higher job turnover lead to:
Lower investment in firm-financed training
Lower benefits from 'learning by doing' and weaker 'organizational memories' (learning from past failures)
More power for top management and less critical feedback from the shop floor → more autocratic management

23. Why should structural reforms of labor markets restrain innovation and labor productivity growth?
Flexible firing increases risk-aversion on the shop floor: in the selection of innovative solutions, people that are easy to fire will choose less risky options → too little progression!
Empirical support using patent and patent citation data:
Acharya, Viral V., et al. (2010): Labor laws and innovation, NBER Working Paper Cambridge, MA: NBER

24. Why should structural reforms of labor markets restrain innovation and labor productivity growth?
People on the shop floor possess much of the (tacit) knowledge required for implementation of process innovations. People threatened by easy firing have incentives to hide knowledge relevant to labour-saving process innovations (Lorenz, 1992, 1999)
More generally, people that are easy to fire may hide information about how their work could be done more efficiently (exploiting information asymmetry between management and the shop floor)
→ in a hire & fire regime you make poor use of the (tacit) knowledge of your workers

25. Why should structural reforms of labor markets restrain innovation and labor productivity growth?
Liberal Market Economies have more decentralized wage negotiations ➙ technological laggards can stay competitive by enforcing lower wages (rather than modernizing equipment)
This contributes to explaining the OECD's (2015) finding of a growing discrepancy between high productivity growth in 'superstar firms' and weak productivity growth among the rest!

26. Finally, much depends on the type of innovation model:
Evidence from firm-level regressions: Flexible labor has little influence on innovation / productivity growth
Schumpeter I innovation model:
'Entrepreneurial model': start-ups, inventor-entrepreneur ('Garage business').
Knowledge base: General (and generally available) knowledge
Schumpeter II innovation model:
'Routinized Innovation': Professional R&D labs in larger firms. Continuous improvement of products, processes or systems requires continuous accumulation of knowledge.
Knowledge base: Historically accumulated, firm-specific and often 'tacit' knowledge (i.e. ill-documented knowledge from personal experience)
Evidence from firm-level regressions:
Flexible labor has a negative influence on innovation / productivity growth

27. Concluding: how to explain the productivity slowdown?
The slowdown is real (not due to deficient statistics)
Low investment ratios during the Great Recession after 2008 may have aggravated the slowdown
There is a long-run exhaustion of technological opportunities due to:
World-wide cuts in basic research weakening the pool of radically new knowledge and reducing the capability of businesses to use it (lack of absorptive capacities)
The exhaustion of the US – IT boom: e.g. Moore's Law is off the rails, etc. …

28. Concluding: how to explain the productivity slowdown?
Supply-side labor market reforms contributed to weaker innovation performance as:
Weak wage growth makes investments in labor-saving technology less rewarding
A power change between (top) management and the shop floor favors autocratic management practices: culture of fear; poor use of knowledge from workers' experience
Knowledge accumulation becomes more difficult: Much knowledge is 'embodied' in people and can only be mobilized under longer job tenures (mutual trust and commitment)
Flexible firing reduces trust and loyalty ➛ larger bureaucracies for monitoring & control curb creativity of intra-preneurs
Decentralization of wage bargaining allowed technological laggards remaining competitive due to workers sacrificing wages (rather than the firm modernizing its equipment) ➛ growing productivity gap between 'superstar' firms and the rest (OECD 2015)

29. Outlook:
Deregulation of labor markets (easier firing, downwardly flexible wages etc.) leads to more jobs …
… but this is at the cost of low labor productivity growth …
… and with low labor productivity growth, somebody needs to sacrifice income …
… in real life we get a growing class of working poor on precarious jobs …
… and an erosion of the middle class (e.g. Brexit; Trump effect!)
➜ Populism leads to bad governance … reinforcing the slowdown?