Download Flotillas and the Wars of Public Opinion

Coping with crises: Policies to protect
employment and earnings
Pierella Paci Ana Revenga Bob Rijkers
19 April 2011, VOX.EU
When a crisis hits, how should policymakers move to save jobs? This column reviews the
evidence from policy responses to recent crises, highlighting the importance of being prepared. It
finds that countries with prudent fiscal management and sound policy infrastructure tend to suffer
relatively smaller and shorter negative shocks than others.
“There cannot be a crisis next week. My schedule is already full.” – Henry A Kissinger
Crises are difficult to predict, yet their recurrence is an empirical regularity in both developing and
developed countries. Nevertheless, as painfully highlighted by the ad hoc and reactive nature of
the policy responses to the financial crisis of 2009 and 2010, many countries are ill-prepared to
manage these recurrent shocks.
This is a cause for concern. When markets are not perfect, the lack of appropriate responses can
exacerbate poverty and stunt post-crisis growth. Even short-lived shocks may have lasting
detrimental effects on human and physical capital and asset accumulation by forcing households
to cut back investments in education (Fereirra and Schady 2009, Paxson and Schady 2005) and
to reduce spending on nutrition (Cutler et al. 2002). In addition to making future generations more
prone to poverty, these coping strategies also worsen the prospects for future growth by reducing
the productivity of the next generation.
Households may also be forced to sell productive assets, which further reduces their future
income-earning potential and exacerbates their vulnerability to shocks. In addition, productive
firms may not be able to expand or invest, and may even be driven out of business altogether as
a result of exacerbated credit constraints (Borenstein and Lee 2002, Peek and Rosengren 2005,
Barlevy 2002 and 2003, Nishimura et al. 2005). The concern is especially relevant for developing
countries, where labour is the most important source of income for the vast majority of the
population, and where both firms and households lack the ability to cope with even minor shocks
to income (Lustig 2000). For policymakers confronted with a crisis, the question is thus not
whether to intervene, but how.
In recent work (Paci et al. forthcoming), we review policy responses to past crises and identify a
number of commonly used interventions that can coarsely be categorised as either mitigating
short-term impacts or accelerating the recovery. The key difference between these two groups is
in their respective time horizon. The first category includes policies with a near immediate impact
on employment and earnings, such as wage subsidies, tax holidays and public-works
programmes. The other group includes training programmes, more flexible entry and exit
regulations, and other policies with a longer gestation period due to sluggish firms’ responses and
to the time required to accumulate human capital. Policies can also be divided into those that aim
to preserve jobs and productivity, and those designed to protect workers’ income and promote
employability, i.e. those that operate on the demand or the supply side of the labour market.
This coarse taxonomy – presented in Figure 1 – highlights the trade-offs that might arise between
these objectives as policies that focus on mitigating immediate impacts may aggravate market
imperfections and thus backfire in the longer term. In Indonesia, for example, the 1997-1998
crisis sparked pro-labour pressures that led to better enforcement of minimum wages and to the
introduction of severance pay and dismissal regulations. While these protected workers’ earnings
and limited initial job losses, they also led to severe rigidities in hiring and firing (Manning 2000)
which then hampered job creation and the recovery (Narjoko and Hill 2007; Hill and Shiraishi
2007). Conversely, policies that are conducive to long-run growth, when incautiously
implemented, may do unnecessary damage in the short run. Thailand’s recovery from the Asian
crisis is a case in point. While the Thai government introduced reforms conducive to long-run
growth, the adjustment programme proved to be too harsh, leading to an unnecessarily sharp
decline in output (Dollar and Halward-Driemeijer 2000).
Figure 1. Policy taxonomy
Win-win policies, highlighted in the middle boxes, avert these trade-offs by simultaneously
minimising short-term impacts and accelerating recovery. Examples of such win-win policies
include:

Credit-market policies that reallocate liquidity from inefficient to efficient firms, thus
minimising credit misallocation,

well-targeted, self-reversing public-works programmes that yield productivity-enhancing
infrastructure,

conditional cash transfers that nurture human-capital investments, and

targeted self-employment assistance.
However, depending on available fiscal resources, institutional capacity and prevailing political
economy conditions, certain policy options that are theoretically superior may not be practically
feasible. Building on programmes that are already in place and can be expanded quickly is highly
desirable – particularly in the context of declining fiscal resources. When government budgets
decline, as often happens during crises, the more relevant question is what policies to preserve,
rather than what additional policies to undertake.
More generally, crucial elements of effective interventions are feasibility, flexibility (e.g. capacity
for scaling up and down), and incentive compatibility. These characteristics ensure that leakages
are minimised and market imperfections are not aggravated. For example, setting low wages in
public-works projects ensures that only those willing to work for very low wages, which are likely
those most in need, will benefit; smart targeting enhances effectiveness.
Be prepared
Nonetheless, perhaps the most important conclusion of the review is that there is no substitute for
being prepared. Countries with prudent fiscal management and sound stabilisers in place before
crises hit tend to suffer less than countries that lack these. Moreover, the depth and duration of
shocks is lower if credit and labour market policies are sound (Bergoeing et al. 2004). Setting up
safety nets during times of crisis is difficult and time-consuming and the speed with which
programmes need to be implemented often requires compromises between design and
effectiveness.
On the bright side, crises may provide opportunities to build the necessary consensus to
implement unpopular measures and may serve as a stepping stone for the formation of more
permanent safety nets. For example, the social programmes introduced in Mexico in response to
the Tequila Crisis constituted the basis for the income support systems currently in place.
Our review also highlights the need to go beyond myopic and isolated policy responses which
may be costly and counterproductive. It points to the benefits of a more comprehensive approach
that delivers a coordinated and coherent policy package. Such a package needs to reduce
market imperfections and build institutions to mitigate the impact of downturns on both the supply
of and demand for labour while averting inter-temporal trade-offs.
References
Barlevy,Gady (2002) “The sullying effect of recessions”,Review of Economic Studies, 69(1):65-96
Barlevy, Gady (2003), “Credit market frictions and the allocation of resources over the business
cycle”, Journal of Monetary Economics, 50:1795-1818.
Bergoeing, Raphael, Norman Loayza, and Andrea Repetto (2004), “Slow Recoveries”, Journal of
Development Economics, 75(2):473-506.
Borensztein, Eduardo and Jong-Wha Lee (2002), “Financial Crisis and Credit Crunch in Korea:
Evidence from Firm-Level Data”, Journal of Monetary Economics, 49(4):853-875.
Dollar, David and Mary Hallward-Driemeier (2000), “Crisis, Adjustment, and Reform in Thailand's
Industrial Firms”, World Bank Research Observer, 15(1):1-22.
Fallon, Peter and Robert Lucas (2002), “The Impact of Financial Crises on Labour Markets,
Household Incomes, and Poverty: A Review of Evidence”, The World Bank Research
Observer,17(1):21-43.
Fereirra, Francisco and Norbert Schady (2009), “Aggregate economic shocks, child schooling
and child health”, World Bank Research Observer, 24(2):147-181.
Lustig, Nora (2000), “Crises and the poor: socially responsible macroeconomics”, Economia,
1(1):1-19.
Manning, Christopher (2000), “Labour market adjustment to Indonesia’s Economic Crisis:
Context, Trends and Implications”, Bulletin of Indonesian Economic Studies 36(1):105-136.
Narjoko, Dionisius and Hal Hill (2007), “Winners and Losers during a Deep Economic Crisis:
Firm- level Evidence from Indonesian Manufacturing”, Asian Economic Journal, 21(4):343-368.
Nishimura, Kiyohiko, Takanobu Nakajima and Kozo Kiyota (2005), “Does the natural selection
mechanism still work in severe recessions? Examination of the Japanese Economy in the 1990s”,
Journal of Economic Behaviour & Organization, 58:53-78.
Paci, Pierella, Revenga, Ana, and Bob Rijkers (forthcoming), “Coping with Crises: Policies to
Protect Employment and Earnings”, World Bank Research Observer.
Paxson, Christina and Norbert Schady (2005), “Child Health and Economic Crisis in Peru”, World
Bank Economic Review, 19(2):203-223.
Peek, Joe and Eric S Rosengren (2005), “Unnatural Selection: Perverse Incentives and the
Misallocation of Credit in Japan”, American Economic Review, 95(4):1144-1166.