Labor Market Reform and the Cost of Business Cycles

By Tom Krebs and Martin Scheffel

This paper studies the effect of labor market reform on the welfare cost of business cycles. Motivated by the German labor market reforms of 2003-2005, the so-called Hartz reforms, the paper focuses on two labor market institutions: the unemployment insurance system determining search incentives and the system of job placement services affecting matching efficiency. The paper develops a tractable search model with idiosyncratic labor market risk and risk-averse workers, and derives a closed-form solution for the welfare cost of business cycles as a function of the various parameters of interest. An improvement in job placement services leads to a reduction in the welfare cost of business cycles, but a change in unemployment benefit generosity has in general an ambiguous effect. A quantitative analysis based on a calibrated version of the model suggests that the German labor market reforms of 2003-2005 reduced the non-cyclical unemployment rate by 3 percentage points and reduced the welfare cost of business cycles by 30 percent.

Labor market reform exercise are rarely assessed on how they impact welfare. It is OK to see what they do to, say, the unemployment rate, but economic well-being is more than that, the average level of things. This paper is a step in the right direction. It takes as a starting point that business cycles are costly in terms of welfare. Then it shows that some policies from the Hartz reforms where efficient in reducing that cost, but for others it is not that clear at all.

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