In the last two and a half decades, the idea of economic freedom – low levels of government intervention in the economy and wide scope for individual freedom of choice -has been widely embraced by both conservative and social democratic governments. This is because of the wide belief among many economists that liberal reforms (increases in economic freedom) have a positive impact on output and employment and on the resilience of the economy.
However such reforms often raise community concerns about possible effects on income and wealth distribution, quality of life and social cohesiveness. Governments may choose to ignore these concerns and rely on the welfare safety net and trickle down effects. Or they may decide to defer or dilute the liberal reforms and forego some of the economic benefits. Or they may try to compensate the losers through the tax/transfer system, even though it might have some economic disincentive effects. Or they may look for alternative ways of achieving the same economic outcomes without the social cost.
Which of these four courses is taken will depend in part on the extent of the social costs (and whether they are transitional or prolonged). But they will also depend on the scale and durability of the prospective economic benefits – the focus of this posting.
My overall theme is that the prospective economic benefits of liberal reform vary considerably from one area of reform to another and tend to diminish after a certain threshold of economic freedom is reached. What follows is a brief summary of the salient points. For those who want the full argumentation and references they should read a paper (Economic Freedom: the good and the ugly) published in the Australian Quarterly July/August 2007 (available from the Australian Institute of Policy and Science web site).
- Reforms which remove competition barriers in product, service and financial markets have potentially large economic benefits because competitive markets give sellers strong incentives to minimise costs, innovate and channel goods and services to those consumers who value them most highly.
- On the other hand, the economic benefits of smaller government lower levels of government expenditure and taxes per se are much more uncertain. To an economist, there is no optimal size of government. Depending on the starting point and, most importantly, on the nature and composition of government spending, smaller government does not necessarily produce higher per capita incomes. Perhaps this is why even conservative governments like Howards ignore this dimension of freedom.
- The same uncertainty applies to labour market deregulation. Its benefits depend on how much labour market freedom there is at the start and what exactly is being deregulated. In particular, it is useful to distinguish between four dimensions of labour market freedom.
- The first dimension relates to levels of government intervention in wage determination. In Australia, minimum wages have been at high levels relative to average earnings but have been steadily declining relative to median earnings in the last decade and longer. Most economists accept that this relative decline has been good for employment.But, apart from social concerns (do we want a US-style population of working poor?), many economists caution against going much further down the road of downward flexibility because it would reduce the willingness of employers to train their low-paid workers, lighten the pressure on management to innovate and reduce waste; allow relatively uneconomic industries to survive and (if the market falls below the so-called efficiency wage) dampen the motivation and effort of workers.
- The extent of employment protection legislation (EPL) is a second important dimension of labour market freedom. It is designed to protect workers from such risks as unfair dismissals, loss of severance payments and bad hiring practices.Even before 2006, Australia was counted by the OECD as a low EPL country. With the employers right to fire greatly increased by Work Choices (which removes the legal redress against unfair dismissals in businesses with under 100 employees and allows larger companies to sack workers for operational reasons without any great accountability process), Australia may now rank almost as high on this freedom indicator as the USA. [It is worth adding that in other respects WorkChoices is extremely prescriptive rather deregulatory].
Studies suggest that countries with high and intrusive levels of EPL (such as France, Italy and Spain) could benefit employment-wise from deregulation. However, countries starting from low levels (like Australia) are likely to get only marginal gains in employment from a further deregulation and these need to be weighed against the loss of psychological wellbeing by workers who are risk-averse and attach importance to job stability and those who want to have a say in decisions affecting their wellbeing in the workplace, especially their working hours and conditions. This is an aspect of economic wellbeing most conventional models completely ignore.
As to the effects of EPL on productivity, there are conflicting forces at work. EPL constrains resource flexibility at the enterprise level but tends to foster workers effort, cooperation and willingness to be trained, which is positive for efficiency.
- A third dimension of labour freedom is the degree of restrictiveness of unemployment benefits. In Australia, we have seen a tightening of eligibility requirements, an increase in penalties for non-compliance, a decline in the relative real value of unemployment benefits and a relentless psychological war mounted by politicians against welfare recipients. Australia still has a more open-ended system than the majority of OECD countries (i.e. the duration of benefits is longer on average) but this advantage is diminishing steadily and Australia remains in the lower half of OECD countries on generosity of benefits relative to earnings levels.Most of the literature agrees that tough eligibility and job search requirements for people of working age help ensure a worker-friendly economic environment and put extra pressure on people to break out of welfare dependence. That said, the literature also finds that generous benefits need not hurt employment if there are strong incentives for the unemployed to find work and well targeted labour market programmes such as training and wage subsidies.
- A fourth dimension of labour freedom relates to rights of access to trade unions.
In Australia, trade union activities are much more legally restricted than in most other OECD countries and WorkChoices will make access even more difficult.The economic literature suggests that trade unions hinder employment. But much of that literature is out of date. Nowadays trade unions bargain on a decentralised basis and mostly operate in a tightly competitive product and service markets. In this situation, trade union leaders know that employers have a limited wage capacity and that if they push too hard, their members will be out of jobs. Indeed they have every incentive to do productivity enhancing deals with employers if that increases capacity to pay. Many trade unions have shown they can be both flexible and innovative.
Some trade unions do operate in industries where employers have a degree of monopoly pricing power and in such circumstances they are able to extract high wage settlements. This could lead to higher prices. But if a quasi-monopoly firm is earning excess profits, the effect of trade unionism is simply to redistribute rents from shareholders to workers or, as noted below, from one group of workers to another.
In any case, there is an economic rationale for trade unions that is often ignored or disputed. Even in a full employment situation, the bargaining power of low-skilled workers is very poor relative to skilled, professional and managerial staff: the latter are likely to get a higher share of a given employers available wage fund (which covers the wage bill and cost of other job attributes). If unions force individual employers to reallocate some of the wage fund to the more vulnerable workers, it could produce a superior welfare outcome within the firm without hurting third parties.