Project B2:

Labor income risk and labor market reform: a macroeconomic analysis


Prof. Tom Krebs, Ph.D / Prof. Dr. Philip Jung



Starting Point and Goals
Project-related publications of the investigators

Starting Point and Goals
Labour-market reforms in Germany have been the centre of discussion among academic scholars and policy makers for many years. In particular, the so-called Hartz reforms, implemented in 2003-2005, have been the topic of many policy debates. Although there has been a large amount of empirical work by labour economists on the effects of the Hartz reforms, there has been surprisingly little macroeconomic work on the issue and, until recently, no quantitative work that takes into account the effect of the Hartz reforms on labourmarket
risk and the welfare of risk-averse workers. Specifically, if individual workers are risk-averse and labour-income risk is not fully insurable, then a possible increase in risk exposure may provide a very rational explanation for the frequently observed resistance to reform. Moreover, in such a case, the design of best policies should explicitly take into account the risk effect of economic reform.
The goal of this project was to provide a comprehensive macroeconomic analysis of the Hartz reforms, and in particular the Hartz IV reform, with special emphasis on the risk exposure and welfare of risk-averse workers. In other words, this project aims at providing a quantitative analysis of labour-market reform in Germany that allows for changes in aggregate output and employment as well as changes in individual income risk.

The analysis combines micro-level empirical work with macroeconomic analysis.

The investigators found that the Hartz IV reform resulted in a substantial reduction in the long-term unemployment rate in Germany – in the baseline model, about 1.4 percentage points. The main force behind the reduction is a significant increase in the job-finding rate for the long-term unemployed, though the job-finding rate of the short-term unemployed also increases. The reform has increased aggregate output, but reduced real wages.
However, the real-wage reduction is relatively modest (about 2-3 per cent). Finally, and most importantly for this research project, they find that the Hartz IV reform creates winners and losers. Employed workers win in the sense that they experience a welfare gain, but the long-term unemployed experience a substantial drop in welfare. Short-term unemployed workers also lose, but their welfare losses are smaller.
The welfare losses of the unemployed provide a simple and coherent explanation for the resistance of large segments of the German population to the Hartz reforms, an explanation that is fully grounded in the rational-choice paradigm of economics. Put differently, in order to understand why the Hartz reforms are still relatively unpopular in Germany, even though they achieved their main goal, namely to reduce the long-term unemployment rate, the researchers only need to introduce risk aversion and ex ante heterogeneity into the analysis!
In the empirical part of the project, they estimated labour-income risk in Germany using micro-level data with a panel dimension, the Soziooekonomischen Panel (SOEP). The main results can be summarized as follows.

Labour-income risk in Germany has a large transitory component and a large permanent component. Permanent labour-income risk in Germany is slightly higher than in the US. In a similar way to the US, permanent labour-income risk is the lowest for workers/households with a low level of education, and the highest for workers/households with a medium level of education. These results hold for both household-level income variables and worker-level income variables. Finally, permanent labour-income risk in Germany has been trending upwards for the last 20 years with no sign that this trend has been reversed.

They have studied the German labour market in a standard search-and-matching framework as well, which does not allow a proper treatment of the risk issue that is a main concern in this project. They also use the framework to provide a comparison of the German labour market and the US labour market. The main findings of the analysis can be summarized as follows: In Germany, average worker flow into and out of unemployment is much lower than in the US. However, the relative volatility of worker flow out of unemployment in Germany and the US is similar, and the volatility of worker flow into unemployment in Germany is higher than in the US. These differences between the German labour market and the US labour market can be explained by differences in matching efficiency. Further, differences in matching efficiency are directly linked to the fact that the human capital of German workers is, on average, more job- and/or occupation-specific than the human capital of the typical US worker. Finally, the authors find that differences in labour-market institutions, such as unemployment benefits, union bargaining power, and employment protection, cannot explain the observed differences in worker flow volatilities between Germany and the US.

Project-related publications of the investigators

a) Peer reviewed

Jung, P. and M. Kuhn (2013). Labor Market Institutions and Worker Flows: Comparing Germany
and the US. Working Paper. Economic Journal.

b) Other Publications
Krebs, T. and M. Scheffel (2013). Macroeconomic Evaluation of Labor Market Reform in Germany. Working Paper. IMF Economic Review (Special Issue on Labor Markets through the Lens of the Great Recession).

Krebs, T. and Y. Yao (2013). Labor Market Risk in Germany. Working Paper.

Manger, C. (2013). How Joe the Plumber Pays the Tuition of Future White Collar Workers. Working Paper.