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GERMANY’S LABOUR MARKET: The key reform was not benefit cuts but improving the way unemployed workers are matched to job vacancies

  • Published Date: December 2014

Inefficiencies in the process by which unemployed workers were matched to open positions were the main causes of rigidities in Germany’s labour market in the period from the 1980s to the early 2000s. So the widely recognised success of the so-called Hartz reforms was not due to the reduction in unemployment benefits, but to measures designed explicitly to improve matching workers and jobs: fostering alternative forms of employment; making marginal employment more attractive; and changing the organisational structure of the country’s employment offices.

These are the central conclusions of research by Philip Jung and Moritz Kuhn, published in the December 2014 issue of the Economic Journal. Based on new empirical evidence combined with state-of-the-art theory, their study reveals the inaccuracy of widely held beliefs that stricter firing protection legislation, higher unemployment benefits and/or stronger unions have been the key obstacles to a more efficient labour market in Germany.

The researchers note that reforming European labour markets is high on the political agenda. Particular attention is paid to Germany’s labour market reforms as a potential role model for other European countries. But for decades, politicians and economists had pointed to Germany as the ‘sick man of Europe’, a country characterised by a rigid labour market, particularly when compared with the United States.

Previous research on the differences in labour market dynamics between Europe and the United States has mainly focused on differences in average unemployment rates. Zooming in on the microstructure of job flows, this research documents that the share of workers going in and out of unemployment each month is four and five times smaller in Germany than in the United States.

This fact is used to justify the characterisation of Germany as a highly rigid labour market, and the claim by many researchers and policy-makers that the culprits are stricter firing protection legislation, higher unemployment benefits or stronger unions. But focusing only on average transition rates does not make it possible to discriminate between the various proposed explanations of the cross-country differences.

The new study instead shows that differences in the labour market dynamics over the business cycle provide additional valuable information to identify the key cross-country differences. The researchers document that inflows to unemployment (job losses) react twice as much to business cycle shocks and contribute 60% to the change in unemployment rates over the business cycle in Germany but only 40% in the United States. Despite stricter employment protection legislation, Germany (as well as many other European countries) mainly uses the firing margin to adjust to shocks, while the United States adjusts by hiring fewer workers.

Based on this surprising fact, the researchers show that inefficiencies in the process of matching unemployed workers to open positions is a consistent explanation both for the differences in the average transition rates as well as for the cyclical adjustment process, while the traditional explanations all fail to account for the business cycle dynamics.

These findings have important consequences for policy reforms. The Hartz IV reform – that is, the reduction in unemployment benefits – has received much attention in the public debate. But this research provides a rationale why the reform steps associated with Hartz I-III – designed explicitly to improve the efficiency of the matching process by fostering alternative forms of employment (Hartz I), making marginal employment more attractive (Hartz II) and changing the organisational structure of the country’s employment offices (Hartz III) – might have been the real keys to success.

ENDS

Notes for editors: ‘Labour Market Institutions and Worker Flows: Comparing Germany and the US’ by Philip Jung and Moritz Kuhn is published in the December 2014 issue of the Economic Journal.

The empirical results are based on labour market data from the Current Population Survey for the United States and from the BA-employment panel of the Institute for Employment Research (IAB) for Germany.

Philip Jung and Moritz Kuhn are in the Department of Economics at the University of Bonn. Moritz Kuhn is currently visiting the University of Minnesota, Minneapolis.

For further information: contact Philip Jung on +49-228-73-62095 (email: phjung@uni-bonn.de); Moritz Kuhn on +1-612-625-3331 (email: mokuhn@uni-bonn.de; Skype: kuhnmo); or Romesh Vaitilingam on +44-7768-661095 (email: romesh@vaitilingam.com; Twitter: @econromesh).