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Do unions enhance macroeconomic performance?
Frode Meland
Revised version of obligatory lecture held for the degree Dr. Polit., December 2003.
INTRODUCTION
When discussing whether something is good or not, economists often tend to try to
evaluate whether this "something" is efficient. More precisely, we tend to look for
Pareto efficiency; that is a situation where you cannot make anyone better off without
hurting someone else. Thus you have exhausted all mutual gains.
Also, quite early on, we learn that the competitive equilibrium is Pareto efficient.
The competitive equilibrium, however, involves a set of assumptions that are almost
never fully satisfied in the real world. For instance, all agents must be price takers.
Thus market power of all sorts must be excluded.
There might then be a reason to strive for a very competitive environment as it may
produce Pareto efficient outcomes, and a quite popular perception is, for this reason,
that anything contributing against a competitive environment, is bad for the workings
of the economy. Unions have market power in the labor markets, and thus they do not
take prices as given. Quite on the contrary, they push wages beyond the market
clearing level, and consequently employment is lower than Pareto efficiency would
dictate (this is based on a right-to-manage kind of argument).
For later reference, I’ll term this view the ”textbook view”. According to this kind of
thinking, unions are basically a performance inhibiting rigidity (keeping wages high
and possibly inflexible), and we could simply answer the above question, ”Do unions
enhance macroeconomic performance?” with a ”no”.
The competitive assumptions are rarely fulfilled in any market, however, and nothing
tells us that removing one ”disturbance” – like unions – will necessarily improve the
situation when there are other ”disturbances” present in the economy. There is at least
the theoretical possibility that the distortion caused by unions may reduce other
distortions. A prominent example is market power in the hands of firms.
Firms may have power over individual workers, pushing wages and employment
down. A union may then prevent firms from using any monopsony power they may
have in absence of unions, and consequently induce increases in employment (and
wages) toward the competitive level.
Since the textbook view and the potential advantages of the competitive equilibrium is
presumably well known to economists, the focus here is mainly on theoretical reasons
why unions may improve the workings of an economy, and whether the empirical
literature supports this notion. Attention is restricted to growth, unemployment,
inflation and shocks as the main measures of macroeconomic performance. It is
reasonably assumed that higher growth, lower unemployment and/or inflation and less
disturbance from shocks, are positive for welfare.
With this focus, then; how can unions be good? We have already discussed
monopsony, and there is a battery of possibilities how unions may improve on other
deficiencies.
On the micro-related level, the above monopsony argument can be augmented by, for
instance, a public goods argument. Safety measures at the workplace may be thought
of as a public good – once they are in place, all workers benefit equally. A union may
then improve the situation by being able to push for safety-measures on behalf of all
workers, while no one worker would put in the time and effort to do so. There are also
a lot of other such micro-related potential benefits of unionism.
However, the focus here is on macroeconomic implications of unionism. We start by
addressing two such issues, both of which hinge on the fact that unionism tends to
cause wage compression.
Wage compression
To illustrate the effect of unions on the distribution of wages, note that in the U.S. where unions have limited power on average, the wage difference between the 10%
lowest paid workers and the 10% highest paid workers is 440%. It is similarly 98% in
Norway, a country generally considered to be highly unionized (see Wallerstein,
1999).
The reasons why unions seem to be associated with wage compression, can be many
other than economic in nature – for instance may the pure interest in equality be
important. However there are also potential economic gains from such a policy:
First, wage compression may serve as insurance against future volatility in wages. If
you do not know what your wages will be and you are risk averse, there is a case for
wage compression. This could increase welfare directly.1
Another interesting theory is due to two trade union economists in Sweden in the 40s
and early 50s, Gösta Rehn and Rudolf Meidner. They came up with the idea that wage
compression would be good for growth as it increases the speed of transition from old
declining industries to new and prospering ones. The competitive wage difference that
would have to emerge to facilitate such moves, would have to be large, and thus pose
a tax on new industries. Wage compression keeps wages up in the declining
industries, leading to higher mortality rates among old firms. At the same time, wages
are similarly kept down in the new industries.
The textbook view would be that the wage difference needed to transfer labor from
old to new industries reflects the correct prices of moving workers, and nothing could
be gained by forcing higher mobility.
Moreover, wage compression may yield lower incentives for schooling and effort,
which would of course be unwanted. A lower wage differential may decrease the
incentives for schooling as the payoff from education may drop, and if firms do not
1
See for instance Agell and Lommerud (1992).
have the option to use differentiated wages at the workplace, it might be difficult to
induce effort.
So how could such wage compression be good anyway? Again, if one of the
assumptions behind the competitive equilibrium is not satisfied, there might be room
for improvements. We will here make use of the argument made by Agell and
Lommerud (1993):2 Wage compression might be beneficial as it "internalizes" a
learning externality in a "modern" sector: Assume that there are two sectors or
industries, a "modern" one and an "old" one. Assume also that the modern sector has a
learning externality, which means that a worker in this sector contributes to the
productivity of workers in other firms. Thus if you move one worker from an "old"
sector to the modern sector, there is a gain in addition to the value which is produced
for the firm where the worker is employed. Competitive firms, however, are not
willing to pay for this extra value, and thus migration is too slow. If unions force
wage compression, workers may lose their job in the traditional sector, and be forced
to move. Higher transition may however be beneficial to the economy as a whole.
So what does the empirical literature say? Hibbs and Locking (2000)3, using evidence
from Sweden, find that wage compression at firm and industry levels may not be good
as it deprives the firms of incentive-producing wage differentials (that is; the textbook
view), but across sectors and industries it might be good for growth. Thus both
theoretical arguments seem to find support. This also has possible implication for
what kind of unionization that may be thought to be beneficial. If it is wage
equalization across industries that we want, one could think that bargaining at the
industry level is not the way to go. To get inter-industry wage compression, one
would possibly need national unions, or at least unions covering more than one
industry.
Also there is strong support that wage equalization is larger the more centralized
bargaining is (Flanagan, 1999; Wallerstein, 1999).
2
3
See also Moene and Wallerstein (1997).
Flanagan (1999) discusses important earlier studies.
Now, if we think wage equalization has been good, and centralized bargaining
produces more equalization – can we then conclude that unions may be good for
macroeconomic performance – at least when bargaining is centralized? There is some
evidence for this conclusion, but the discussion so far has focused on growth. Before
we make such a leap of faith, therefore, it may be worth taking a glance at the
literature on the level of bargaining centralization and unemployment. Presumably,
given the high unemployment rates that some countries experience, reducing
unemployment may be very important.
UNEMPLOYMENT
Before economists started to look into this problem, political scientists had already
attempted to answer the question of what level of bargaining would be best. The result
was the "corporist" view that bargaining between labor-unions, employers’
federations and the government would be easier with central bargaining. The
government had an active role here, making policy concessions in exchange for better
coordination. For this reason, the view was that higher degrees of centralization of
wage setting would decrease unemployment (Figure 1). Actually, as the argument
goes, inflation would also be lower for higher degrees of centralization, for the same
reasons.
Unemployment
Corporist
Degree of centralization
Figure 1
This argument is not founded on microeconomic principles. When economists tried to
answer the same kind of question, micro-foundations were introduced. However the
economists exorcised the government from the story, so interaction between
governments and labor unions was not studied.
Economists initially argued the same association between centralization and
unemployment as the "corporists", on the basis that bargaining at more centralized
levels could internalize important externalities. For instance could an increase in
wages for one group of workers mean that prices tended to rise. This has negative
effects on other workers. If they were all bargaining collectively, they would take this
into account and demand lower wages. Thus centralization is good.
This was challenged on the grounds that it did not include the competitive position of
firms. Enter the famous Calmfors-Driffill (Calmfors and Driffill, 1988) hump-shaped
curve:
Unemployment
Calmfors/ Driffill
Corporist
Degree of centralization
Figure 2
The idea here is that when bargaining is decentralized , a wage increase cannot yield
high increases in prices as the firms then loose considerable sales to their competitors
(with labor either non-unionized or unionized in different unions). Consequently,
unions are disciplined if they are "small", and unemployment is low (the left-most
part of Figure 2).
At the industry level, however, all close substitutes are internal to the wage bargain,
and a wage increase will to a larger degree be passed on to other groups through a
price increase. Thus wage discipline is low and unemployment high (the middle part
of Figure 2).
At the central level, this kind of "price effect exporting" of the wage increase, is again
internalized. Wage demands are thus relatively low, and unemployment is therefore
low (the right-most part of Figure 2).
However, this is not the end of the theoretical discussion – far from it. The above
argument for the Calmfors-Driffill "hump-shape" applies to a closed economy. In a
competitive sector that is only a small part of the world market, prices cannot be
passed on no matter bargaining structure (there is always some foreign firm producing
the same product who is willing to supply it at the going price), which means that
there is no less wage restraint for intermediate structures (than in the decentralized
case). For the centralized case, the negative price-spillover is lower since the increase
in wages that spills over into higher prices, may hurt foreigners. Consequently, the
effects are not completely internalized by a national union, and centralized bargaining
may not yield the same wage restraint as in the closed economy. This makes Danthine
and Hunt (1994) predict that bargaining structure does not matter as much in open
economies – that is any previous effect of centralization has dwindled. In reference to
the previous figure, the Calmfors-Driffil hump-shape is flattened:
Unemployment
Danthine/
Hunt
Calmfors/ Driffill
Corporist
Degree of centralization
Figure 3
The textbook view that unions are simply distortional cannot in a consistent manner
be placed in this figure, as it is not bargaining structure per se that is the "problem" in
this literature; rather it is coverage – less employees covered by such agreements
would give lower unemployment. Actually, on this basis (a "bit" rash), OECD has
issued recommendations to try to reduce the possibility that union wage agreements
spills over into non-union sectors...
So what does the evidence say?4 Well, evidence was provided for both the "corporist"
view and the Calmfors-Driffill hump-shape. However, the evidence provided by the
literature turned out to be highly fragile – depending heavily upon the countries
included and nuances in critical definitions. An important issue was the treatment of
countries like Japan. Bargaining in Japan physically happens at the decentralized
level, but wage bargaining is highly coordinated across bargaining units. The data that
allegedly supported the hump-shape curve, was made on the assumption that Japan
had decentralized bargaining, which it – in relation to the discussion in Calmfors and
Driffill (1988) - effectively does not. Studies reclassifying Japan and other "similar"
countries as having centralized bargaining, shows higher effective centralization
(coordination) to have positive effects on employment. Recent empirical research thus
seems to show that more coordinated or centralized wage bargaining produces
superior results in term of unemployment.
However, it seems to be important whether the centralized bargaining outcome is
weakened by subsequent bargaining at lower levels – it is important that the
coordinated outcome is not undermined by for instance wage drift. If this is the case,
matters may be very different – with much worse outcomes than with decentralized
bargaining.5
So, what to make of this?
High degrees of centralization seems to be able to increase both employment and
growth. But if you think there is a consensus view that coordination is generally good,
4
The subsequent discussion is based on Flanagan (1999), Booth et al. (2001), Traxler and Kittel (2000)
and Traxler (2003 a,b).
5
Wage drift in Scandinavian countries has been ranging between 30-60 percent of total earnings
increases.
you may think again.6 It is not easy – and probably not desirable either – to loose sight
of the fact that the U.S. – with low unionization rates and decentralized bargaining
structure, performs quite well. Average European unemployment, although there are
large differences, is much higher than in the U.S. – some 11% against half of that in
the US. Also, why – in that case – is the trend showing less centralized wage
bargaining?
Lindbeck and Snower (2001) argue that the more frequent use of multitasking
(workers have more than one task) makes it ever more important to arrange for a
situation of wage differentiation and flexibility – neither of which may be possible
with centralized bargaining. This can, in their view, explain the move towards more
decentralized bargaining.
Also, it has been commented that the Danthine and Hunt result that bargaining
structure is becoming less and less important for unemployment, has not been tested
in a sufficient manner. Thus there are concerns that the positive impact that
coordination may have had in the past, is not relevant as a prescription of future
behavior.
INTERACTION
So far we have discussed how centralization may directly affect unemployment. What
is not discussed are interactions between unions and other institutions, most notably
monetary and fiscal policy, and how the labor market performs when faced with
shocks. These issues may be very important when it comes to the effects of unionism,
and especially bargaining structure (Berger et. al, 2001; Booth et. al, 2001).
Fiscal policy
When we discussed the "corporist" view of how unemployment would fare in the
presence of different levels of unionization, there was some vague statements that
agreements involving policy concessions would be easier to implement if bargaining
6
See the discussion by Nickell (1997) and Siebert (1997).
happened at a centralized level. Thus unemployment and inflation would be lower for
centralized bargaining. The opposite effect is suggested by Calmfors (1982) and
Calmfors and Horn (1985): Left wing governments with roots in the labor unions may
increase public sector employment in response to unfavorable changes in
employment, which lowers the incentive of unions to prevent such situations. More
importantly, only centralized unions take such effects into consideration, and this
presents the theoretical possibility that more centralization yields higher
unemployment – but not as long as these policies of increased public sector spending
have not yet proven to be unsustainable. This may be argued to be/ have been the case
in Scandinavian countries.
Other fiscal arguments include endogenous tax effects: Unions at central levels
anticipate the change a wage increase will have on tax income and what that means
for redistribution. The end result including this kind of fiscal tax interaction seems to
be, however, that centralization is still beneficial (see Booth et. al., 2001).
Shocks
Blanchard and Wolfers (2000) note that:
Changes in unemployment over time and between countries can only be explained by
an interplay of shocks and differences in labor institutions.
That is, neither shocks or differences between the labor institutions across countries
may explain what has happened historically, but an interplay of these effects may.
There is also some evidence that
...macroeconomic shocks have less pervasive employment effects under coordination
(Booth et. al, 2001).
A suggested reason is that it may be easier to slow down real wage growth in response
to an adverse shock if it is done in a coordinated fashion. What you need in face of a
shock is an adjustment mechanism – wage flexibility may be just such a mechanism.
There is apparently little empirical evidence, but there are "...strong theoretical
reasons to expect coordinated wage bargaining to make nominal wages more flexible"
(Booth et. al, 2001). One possible reason is that workers are interested in relative
wages. In this case, it might be difficult to get some workers to decrease wages if
others do not do so simultaneously. Accordingly it might be easier to coordinate a
wage decrease at higher levels of bargaining centralization.
Monetary policy
According to the above argument, more centralized bargaining may contribute to a
lower short term impact of monetary policy on output. This can happen since
centralization (or coordination) increases wage flexibility, and thereby reduces the
possibility that firms keep prices constant in face of monetary shocks.
After the second world war, the view was that unions could be a source of sustained
inflationary pressure. However if unions were continuously to obtain increasing
wages under relatively stable market conditions, they would have to be gaining power
all the time. This was not the case, but it was argued that accommodating monetary
policy may contribute to a wage and price spiral – wages rose and the monetary
authorities contributed by increasing the money supply.
This may bee seen alongside the dynamic inconsistency argument: The basic
argument goes that in an economy with production lower than the potential level –
causing unemployment – a surprise increase in inflation might increase production
temporarily. However, rational agents will anticipate this move by the monetary
authorities, and thus there is no surprise. The argument then goes that we get no
increase in production, but only an increase in inflation. Rogoff (1985) suggested the
appointment of a conservative central banker to decrease this problem. Later there has
been a considerable spin-off of this literature, and inflation targeting can be seen as
the ultimate commitment not to inflate the economy.
Unions come into this picture through two channels. First unions, by raising wages,
might be the reason why unemployment is high and there exist such a temptation to
increase inflation. This is in line with the textbook view that unions are distortional.
Second, it is argued that monetary policy may have real effects – that is monetary
policy may change unemployment permanently when unions are present in the
economy. Thus monetary policy may have permanent effects. According to traditional
insights, monetary policy should not affect real variables like production and
employment, at least in the long run. However, it has been argued quite extensively
that this no longer holds with unions present.
There are again basically two strains of this literature. The ”oldest” literature – and by
"old" we mean published prior to 1999 – assumed unions to be inflation averse.7 Of
course with inflation averse unions, monetary policy that determines inflation, will
have real effects.
Later models focus instead on the imperfect competition issue and the fact that
monetary policy may have real effects if there are imperfectly competitive entities in
the economy.8 The argument goes that if unions raise their wage claims, prices tend to
increase. If the monetary authorities then increase interest rates to battle this increase
in prices, demand may drop. If this happens, unions face a larger reduction in
employment as a result of a given wage increase than with accommodating monetary
policies (meaning that the authorities increase the money stock or reduce interest rates
when wages increase). Hence, strict monetary policy (like inflation targeting) may
reduce wage claims, and unemployment may drop.
Seen in light of these results, "flexible" inflation targeting may be a mixed blessing:
While flexible inflation targeting is meant to make the Central Bank able to respond
flexibly to shocks and thereby reduce the fluctuations in employment and production,
this may also signal that the Central Bank will less fiercely fight a wage-induced price
increase. Thus employment might prove to become less responsive to wages,
contributing to higher wages and unemployment than under a more strict inflation
targeting regime.
7
See Skott (1997), Jensen (1997), Cukierman and Lippi (1999) and Guzzo and Velasco (1999).
See Iversen and Soskice (1999), Bratsiotis and Martin (1999), Coricelli et. al (2002, 2003), Soskice
and Iversen (2000) and Lippi (2003). Cukierman (2002) surveys both approaches.
8
If one believes in the Calmfors-Driffill hump-shape, the discipline imposed by strict
monetary policy will mostly affect unions at intermediate levels of bargaining, since
wage-pressures are highest there. Thus theoretically, also the inclusion of strict
monetary policy into the picture may flatten the Calmfors-Driffill curve (as the
argument by Danthine and Hunt did). However, there is much to be done in this line
of economic research. No strong consensus has yet been reached – see for instance
Holden (2003), where it is argued that precisely because discipline is highest at the
intermediate levels of bargaining, there are under strict monetary policy lower
incentives to coordinate wage bargaining – resulting possibly in higher
unemployment.
The empirical research along these lines neither seems to have reached a consensus.
Conclusion
So what to conclude? Besides the lack of results from the literature on unionmonetary-policy interaction and the possible reservation concerning the Scandinavian
countries and an unsustainable public sector expansion, it seems unions may be good
for the economy, at least if bargaining takes place at the central level.
We started out with the fact that the competitive equilibrium is Pareto efficient.
However, there are reasons to expect that perfect competition might not provide
efficiency at all times. Theoretically, a social planner aiming for efficiency, however,
could. It is possible to view coordinated wage bargaining as the closest thing you
come to a social planner – incorporating as much as possible from the entire economy
into bargaining. However, if the famous economist Assar Lindbeck were to read this,
he would probably frown at the experience – voicing as he has a hostile view towards
centralized wage setting. His comments to Flanagan et al. (1993) echoes at least as
strongly today as it did then: Making decisions centrally looses sight of information
that is only present at the firm or market levels. This is one of the important
arguments against any centralized form of market control, extending well beyond the
economic arena.
In addition, changing market conditions may prove that even though there may have
been a positive effect of unions, or at least increased levels of coordination, these
positive effects may not hold in the future. Also, the reason why coordinated
economies in Europe has so far fared so well with respect to unemployment may not
be due to coordination in itself, but rather the interaction with the authorities,
producing long run unsustainable policies.
On the question whether unions improve macroeconomic performance, the result
seems to be a hung jury.
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