Financial regulation and employment growth

Financial market regulation and job creationInsights from the recent ILO Global Employment Trends Report

Ekkehard Ernst1

1Employment Trends UnitInternational Labour Organization

[email protected]

http://ekkehard.ernst.free.fr

ECBFeb 10th, 2012

E. Ernst (ILO) GET presentation Frankfurt, 2012 1 / 26

Overview of the GET report What is the GET?

The ILO Global Employment Trends Report

I ILO’s annual flagship study.I Discusses global and regional employment

trends.I Medium-term projections on the basis of

consensus GDP forecasts (up to 2016).I Analyses of particular key macro and

policy developments.I This year: Financial market crisis and its

consequences.I Available at: http://www.ilo.org/get


Overview of the GET report Key messages

Key messages from the GET report

Global unemploymentI has increased by 27 million since the start of the crisisI could reach up to 210 million next yearI will only gradually decline by 2016

Working povertyI 1 in 3 workers is either poor or unemployedI Declining trend in working poverty has been stopped by the crisis

Global investmentI An increase by 2 pp could absorb global unemploymentI Corresponds to $1200 billion.


Overview of the GET report Motivation of today’s talk

Investment is key for employment recovery

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Total unemployment Total unemployment −downside scenario

Unemployment rate Unemployment rate −downside scenario

Unemployment rate −upside scenario

Unemployment rate −boosting investment


Overview of the GET report Motivation of today’s talk

Financial market returns and investment

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Financial markets and unemployment flows Research strategy

How do financial markets affect jobs?


Financial markets and unemployment flows What drives unemployment dynamics?

An overview of the model flows I

I Decomposing unemployment dynamics

4Ut =4Lt −4ETt = INt −OUTt

I Labour force growth

4Lt = α3 + β314Lt−1 + β324ut−1 + β33Taxt

I Employment growth

4ETt = JobCreationt −JobDestructiont



An overview of the model flows II

I Job creation

JobCreationt = β11ETt−1 + β12wt + β13ADt + β14Ut + β15Vt + β16Financet−1

I Job destruction

JobDestructiont = β21TFPt +β22Financet +β23εt +β24IMPt +β25wt +β26ADt

I Wage determination:

wt = α4 + β41Kt + β42CBt + β434ut−1 + β44Taxt



Putting the pieces together

Substituting the flow equations:

OUTt = JobCreationt

INt = JobDestructiont + ∆Lt−1

Hence:

OUTt = β̃11OUTt−1 + β̃12INt + β̃13X JobCreationt + β̃144ut−1 + β̃15Financet−1

INt = β̃21INt−1 + β̃22OUTt + β̃23X JobDestructiont + β̃244Lt−1 + β̃25Financet

where:

Finance =

{Share prices Interest rates

Financial development Market volatility

}


Financial markets and unemployment flows Financial market development and unemployment flows

Finance and unemployment flows: Hypotheses

Mount-Pelerin-HypothesisI Financial development positive for labour dynamicsI Reduces unemployment inflowsI Increases unemployment outflows

Schumpeter-HypothesisI Financial development leads to more turnoverI Increases both U inflows and outflows

Attac-HypothesisI Financial development comes at the expense of the real

economyI Destroys jobs without creating new somewhere else


Financial markets and unemployment flows Financial market regulation and unemployment flows

Financial market regulation

Regulation of international capital flowsI e.g.: FTTs, capital controlsI reduce availability of foreign capitalI lower financial market competition but also reduce volatility

Banking sector regulationI e.g. macro-prudential regulationI reduces credit growthI ambiguous effect on interest rates, expected to reduce volatility

Regulation of (securitized) financial productsI e.g. CCPsI reduce diversity and availability of (securitized) productsI ambiguous effects on volatility


Finance and jobs Data and methodology

A word on the data

I Unemployment flows come from Elsby et al. (2008)I Constructed on the basis of information regarding unemployment duration atdifferent duration lengths

I Information on financial market development is based on updated data byTorsten Beck

I Size of financial sector assets and liabilities (banking, bond markets, stockmarkes)

I Financial sector reforms has been provided by Abiad et al. (2008)I Information on interest rate ceilings, credit growth restrictions, entry barriersfor banks, (financial sector) privatisations and security market reforms

I Information on international capital flows has been used from Lane andMilesi-Ferretti (2006)

I Importance of internationally traded assets and liabilities, such as foreign directinvestment, portfolio equity and debt flows, and financial derivatives

I Macro indicators come from the OECD Economic Outlook database and theOECD Main Economic Indicators (vacancies, share prices)



Estimation methodology I

Step-by-step estimation

Step 1: Identify base-line equationsI Macro variables to affect unemployment flowsI Reduced-form panel estimatesI GMM used to control for endogeneityI Results published in Ernst (2011)

Step 2: Identify relevant financial variablesI Use baseline specifications and add financial market variablesI Separately for financial development and regulationI Identify preferred specification



Estimation methodology II

Step 3: Estimate macro modelI Introduce macro-economic closure: Okun’s lawI Introduce endogenous policy rulesI Estimate using GMM

Step 4: Design reform scenariosI Develop reform scenariosI Take into account feedback loops from financial communityI Analyse impact on employment growth


Finance and jobs Financial development and unemployment flows: Evidence

Financial determinants of outflowsDependent variable: Unemployment outflows(1) (2) (3) (4) (5)

Unemployment outflows 0.750*** 0.847*** 0.646*** 0.638*** 0.810***(lagged) (3.6e-2) (3.0e-2) (4.3e-2) (4.0e-2) (3.3e-2)Employment rate 0.517 0.065 0.700 0.969**(lagged) (1.2e-1) (1.1e-1) (9.1e-2) (1.1e-1)Output gap 1.8e-2*** 1.9e-2*** 2.6e-2*** 2.2e-2** 1.6e-2**

(7.0e-3) (7.0e-3) (7.0e-3) (6.0e-3) (7.0e-3)User cost of capital -1.4e-2** -1.6e-2*** -1.7e-2*** -1.5e-2** -1.6e-2**

(7.0e-3) (7.0e-3) (6.0e-3) (6.0e-3) (7.0e-3)Wage-interest rate -9.1e-2*** -8.6e-2*** -8.7e-2*** -8.3e-2*** -1.1e-1***ratio (3.1e-2) (3.2e-2) (3.3e-2) (2.8e-2) (3.7e-2)Real share price growth 1.3e-1*** 1.2e-1** 1.3e-1*** 1.4e-1*** 1.4e-1***

(4.8e-2) (5.2e-2) (4.7e-2) (4.5e-2) (5.5e-2)Gross fixed capital 2.473*** 1.516* 1.992** 2.872*** 1.540investment (8.8e-1) (9.1e-1) (8.8e-1) (8.2e-1) (9.8e-1)Real household disposable 2.206*** 2.435*** 2.132*** 2.012*** 2.510***income growth (6.2e-1) (6.6e-1) (6.1e-1) (5.8e-1) (6.9e-1)Financial market 0.131*** 0.127***development (3.9e-2) (3.4e-2)Banking sector -0.127*** -0.094**leverage (3.6e-2) (3.7e-2)International financial -0.001*** -2.9e-4***openness (lagged) (0.000) (1.1e-4)Real growth in liquid 0.459*** 0.398**liabilities (1.4e-1) (1.6e-1)Observations 191 192 179 190 176Number of countries 8 8 8 8 8

Note: All estimates performed using Arellano-Bond System GMM estimator. Standarderrors in parentheses. The number of asterisks indicate the statistical significance level*** p<0.01, ** p<0.05, * p<0.1


Finance and jobs Financial development and unemployment flows: Evidence

Financial determinants of inflowsDependent variable: Unemployment inflows

(1) (2) (3) (4) (5)Unemployment inflows 0.965*** 0.966*** 0.958*** 0.962*** 0.956***(lagged) (1.0e-2) (1.0e-2) (1.1e-2) (1.0e-2) (1.1e-2)Output gap -2.9e-2*** -2.8e-2*** -2.7e-2*** -2.1e-2*** -2.4e-2***

(5.0e-3) (5.0e-3) (5.0e-3) (5.0e-3) (5.0e-3)TFP growth 2.8e-1*** 2.8e-1*** 3.1e-1*** 3.2e-1*** 2.7e-1***

(5.2e-2) (5.3e-2) (5.5e-2) (5.3e-2) (5.6e-2)Labour force growth 1.179** 1.146** 1.238** 1.626*** 2.170***(lagged) (5.0e-1) (5.0e-1) (5.6e-1) (5.2e-1) (5.8e-1)User cost of capital 6.0e-3** 6.0e-3** 5.0e-3* 5.0e-3* 7.0e-3**(lagged) (3.0e-3) (3.0e-3) (3.0e-3) (3.0e-3) (3.0e-3)Financial market 3.3e-2** 4.8e-2**development (1.5e-3) (2.0e-3)Banking sector 3.2e-2* 8.4e-2***leverage (1.8e-2) (2.2e-2)International -1.4e-4** -2.6e-4***financial openness (6.9e-5) (8.0e-5)Real credit -2.3e-1*** -2.6e-1***growth (5.5e-2) (6.0e-3)Observations 304 305 273 303 270Number of countries 12 12 12 12 12

Note: All estimates performed using Arellano-Bond System GMM estimator. Standarderrors in parentheses. The number of asterisks indicate the statistical significance level*** p<0.01, ** p<0.05, * p<0.1


Finance and jobs Financial reguation and unemployment flows: Evidence

Financial regulation and unemployment flows I

Dependent variable: Unemployment outflows(1) (2) (3) (4)

Unemployment outflows 0.857*** 0.860*** 0.823*** 0.886***(lagged) (0.0273) (0.0248) (0.0291) (0.0288)Financial derivatives liabilities -2.851*** -2.532*** -3.238*** -2.736***(in % of GDP, lagged) (0.711) (0.634) (0.659) (0.751)Removing directed credit 0.0536**provisions (lagged) (0.0219)Loosening of interest rate controls -0.0431*(lagged) (0.0251)Lifting of entry barriers -0.0417***(lagged) (0.0159)Bank privatization 0.0228(lagged) (0.0165)Deregulation of international capital flows 0.0685 0.174***(lagged) (0.0455) (0.0530)Capital account openness 0.0350** 0.0220(lagged) (0.0156) (0.0170)Securities markets deregulation 0.123*** 0.116*** 0.135*** 0.135***(lagged) (0.0345) (0.0398) (0.0358) (0.0383)Prudential regulation of banks 0.0376*** 0.0348*** 0.0298*** 0.0265**(lagged) (0.00911) (0.0119) (0.0108) (0.0127)Banking sector distance to default 0.00626*

(0.00323)Financial stress index -0.0131**(lagged) (0.00654)Observations 145 152 149 139Number of countries 8 8 8 7

Note: All estimates performed using Arellano-Bond System GMM estimator contain a(significant) constant. Standard errors in parentheses. The number of asterisks indicatethe statistical significance level *** p<0.01, ** p<0.05, * p<0.1



Financial regulation and unemployment flows II

Dependent variable: Unemployment inflows(1) (2) (3) (4)

Unemployment inflows 0.939*** 0.936*** 0.933*** 0.943***(lagged) (0.0184) (0.0196) (0.0199) (0.0203)Removing directed credit 0.0308**provisions (lagged) (0.0121)Financial derivatives liabilities 0.194 -0.0601 0.197 0.236(in % of GDP, lagged) (0.406) (0.439) (0.394) (0.423)Loosening of interest rate controls -0.0199(lagged) (0.0138)Lifting of entry barriers -0.00659(lagged) (0.0108)Bank privatization 0.0244***(lagged) (0.00850)Deregulation of international 0.0169capital flows (lagged) (0.0283)Capital account openness -0.0530*** -0.0629*** -0.0579*** -0.0567***(lagged) (0.00939) (0.0115) (0.00926) (0.0107)Securities markets deregulation 0.0546*** 0.0467** 0.0659*** 0.0768***(lagged) (0.0152) (0.0222) (0.0155) (0.0258)Prudential regulation of banks -0.0123** -0.0218*** -0.0116** -0.0119*(lagged) (0.00547) (0.00730) (0.00589) (0.00646)Change in financial stress index 0.00656**(lagged) (0.00258)Change in banks’ distance -0.00378*to default (lagged) (0.00228)Observations 211 211 192 192Number of countries 12 12 10 12Note: All estimates performed using Arellano-Bond System GMM estimator. Standarderrors in parentheses. The number of asterisks indicate the statistical significance level*** p<0.01, ** p<0.05, * p<0.1



A first summary

Financial market developments and unemployment flowsI Financial market development raises labour market turbulence by increasing

both unemployment out- and inflows.I Credit growth promotes employment growth unambiguously by decreasing

inflows and raising outflows.I Banking sector leverage depresses labour market dynamics.I International openness lowers labour market turnover.

Financial market regulationI Prudential regulation of banks strengthen labour market dynamics.I Deregulation of securities market increase labour market turnover.I Ambiguous effects of credit controls.


Reform scenarios and employment dynamics A macro-model to assess employment effects of financial reforms

Setting up the macro-model

I Labour market flows and matching:

OUTt = αOUT + β̃11OUTt−1 + β̃12INt + β̃13X JobCreationt

INt = αIN + β̃21INt−1 + β̃22OUTt + β̃23X JobDestructiont + β̃24X LabourForce

t

ETt = αET + β̃31OUTt − β̃32INt

I Okun’s law:

Gapt =−δ1INt−1 +δ2OUTt−1 +δ3INVt−1 +δ4GovConst−1−δ5Taxt−1 +δ6∆NetExportst−1

I Philipps curve:

πt = γbπt−1 + γ

f Eπt+1 +Gapt−1 +TOTt−1

I Taylor rule:

imt = (1−ϕ) imt−1 + ϕ [b1Eπt+1 +b2Gapt +b3 (GovConst−1−Taxest−1)]

I Investment dynamics:

INVt = ∆RSharet−1 +R lt−1 + ∆ETt−1 +GovInvt−1−GovConst−1 + ∆Prodt−1


Reform scenarios and employment dynamics Financial reform scenarios

Reforms are not being implemented in isolation

I Reform debates in different countries and at different levelsI Banking sector reforms (e.g. Basel III)I Reforms of derivative markets (e.g. central clearing houses)I International reforms (e.g. tax on international transactions, capital controls)

I Financial market problems are multi-facetedI Credit growth and leverage has been too highI Systemic interconnections have been too frequentI Lack of transparency has prevented better appreciation of risks by investors

I Different actors pursue different political agendasI Policy makers care about access to funds and economic stabilityI Workers care about job stability and wage increasesI Financial investors care about diversification and investment opportunitiesI Managers care about empire-building and earnings growthI Political compromises involve multi-dimensional agendas to satisfy all fouractors



What shapes financial market regulation?



Four broad reform scenarios emerge...

1 Business-As-Usual (BAU): No or ineffective reformsI No (major) changes in financial market regulation and continuous high marketvolatility

I Profit sharing between CEOs and financial investors; pressure on wages andfurther increase in inequality

2 Brakes on (financial) globalizationI Managed international flows but no domestic reformsI Less international volatility but few(er) possibilities for diversificationI Moderate improvements in wage developments and inequalities

3 A new compromise: Domestic reforms with open international capitalmarkets

I Substitution of domestic by international financial liquidityI Stonger pressure by international financiers for favourable regulation

4 Full-scale regulation: Both international and domestic (re-)regulationI Reduced international and domestic volatility at the expense of higher usercost of capital

I Profit sharing at the firm level between workers and managers and improvedwage-productivity linkage

I Less reliance on public debt but larger role of the state (at least in the form ofhigher taxes)



...and their expected macro consequences

XXXXXXXXXXXXXXXDomesticfinancial markets

Internationalcapital flows Unreformed Tightened Regulation

Unreformed

Scenario I :Permanent increase in

financial stressReturn to highly value sharesContinued export and import

growthHigh international capital

flows

Scenario III :Moderate reduction in financial

stressModerate reduction or stable share

pricesFurther export and import growthModerate increase in international

capital flows

Tightenedregulation

Scenario II :Moderate increase in

financial stressStable share pricesSlower trade growth

Reduced international capitalflows

Scenario IV :Permanent reduction in financial

stressLower real share prices

Slower growth of world tradeReduction in international capital

flows



What happens to jobs?

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Baselinescenario

Internationalreforms only

Domesticreforms only

Fully coordinatedreforms

After 1 year After 3 years After 5 years

Note: The chart compares employment growh rates of different reform scenarioswith the baseline. The bars represent differences in annual employment growthrates in percentage points.


Concluding remarks

Lessons learned and outlook

What have we learned so far?I Financial markets have significant effects on labour dynamics.I This holds for both financial market development and regulation.I Reform scenarios yield substantially differences in employment growth.

Avenues for future researchI Derive financial market interactions from first principlesI Introduce different forms of financial frictionsI Specify the political economy interactions


Economy & Finance

Financial regulation and employment growth