Employment policy

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By Michael Knox

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Chief Economist and Director of Strategy

Date posted:

14 July 2014, 8:57 AM

In 2010, Christopher Pissarides was one of three economists who won the Nobel Prize in economics. The others were Peter Diamond and Dale Mortensen. They won the Nobel Prize for their ground-breaking work in the economics of employment. These three economists developed what is known as the DMP model (named after the initials of its creators). Olivier Blanchard, the Chief Economist of the IMF says that the DMP Model "has proven to be both a theoretical wonder and an incredibly useful one with which to look at data".

The DMP Model is also a very good way to think about the design of labour market policies. Many countries have policies to make it harder for employers to fire employees. Australia has policies like this in the area of unfair dismissal. The DMP Model argues that these policies cost employers time and money when they let a worker go. Essentially they are a tax on dismissal.

Such employment protection legislation has indeed been shown to reduce the flow of workers into unemployment by limiting job destruction. The problem is that the legislation also hinders job creation. In his Nobel Prize lecture, Pissarides notes "when the firm is creating a job, it expects to have to pay the high dismissal tax in some future date if it has to dismiss the worker. Job creation falls as a result." This means with lower job creation, people stay unemployed longer and move back to employment more slowly. This means that a policy designed to protect workers from unemployment in fact has the result of actually increasing the time that people stay unemployed and reduces the rate of job creation.

In Chart 1 we see policies designed to make dismissals more difficult on the bottom axis. Duration of unemployment is shown on the left axis. We see that as dismissal legislation becomes stronger and more effective, the length of time in unemployment increases.

The use of the DMP Model tells us that we should try and "protect workers, not jobs". Trying too hard to protect existing jobs through restricting dismissals can in fact restrict the creation of jobs.

It is better to protect workers from the consequences of joblessness through unemployment benefits. These should be accompanied by active policies to get the unemployed back to suitable jobs before their skills and confidence deteriorates. Pissarides also notes that employment protection helps older male workers but hurts other workers like women and young people who go in and out of the labour force more frequently.

These days Pissarides is particularly concerned with problems of European unemployment. He thinks that the lack of flexibility in European labour markets is damaging the prospects of European unemployed regaining work.

He thinks there are great opportunities in the service sector. He says that more flexibility and better employer incentives could create jobs in retailing, hotels and automobile services that could employ a lot of young people and women.

He says that it is essential for minimum wages to be kept low so that employers can take a chance on new workers. Of course, a lot of these comments might not go down well in some parts of the union movement. But then, Pissarides does have a Nobel Prize. He might just know something.

References: Finance & Development, Volume 51, Number 2, IMF - June 2014

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