Lessons for the IMF: Sometimes Efficiency is Not the Best Measure

John Schmitt
International Herald Tribune, September  30, 2004

Rodrigo de Rato, the managing director of the International Monetary Fund, can't seem to step off an airplane without urging the local government to introduce more flexibility into labor markets.

In a visit to Johannesburg in early September, for example, de Rato told the government of South Africa that its national economic priority should be "more flexibility in your labor market." A few days earlier, in Chile, which has one of the most liberal economies in the developing world, he expressed concerns that "the Chilean labor market is too rigid." The Chilean labor minister deflected the criticism by noting that "the IMF has reiterated this position to Chile and other Latin American countries for years." He could also have listed Africa and Asia, or even high-performing South Korea — another recent recipient of the IMF's one-size-fits-all labor-market advice. From its inception, the IMF has had a mandate to advise countries facing macro-economic imbalances. Even if the abysmal growth performance of most of the world's developing economies over the last 25 years or soin-house expertise, on labor-market policies. If the IMF insists on trying to shape labor markets in developing countries, it should at least consult recent research by the Organization for Economic Cooperation and Development, which has significant expertise analyzing national labor-markets regulations in rich economies. The IMF could learn at least four key lessons from the most recent issue of the OECD's annual Employment Outlook, which includes a review of the theoretical and empirical effects of national employment protection legislation (EPL). First, countries generally adopt institutions that reduce labor-market flexibility for good reasons — to shield workers from economic uncertainty and hardship. Therefore, the OECD notes, "any overall assessment of EPL has to weigh costs against benefits." So far, IMF pronouncements on labor-market institutions have been long on efficiency costs and short on social benefits. IMF advice for developing countries should spend as much time measuring the social benefits of EPL as measuring any efficiency costs. Second, in addition to social benefits, the labor-market institutions out of favor at the IMF may actually increase the efficiency of national labor markets. According to the OECD report, "the social value of a job may be higher than its private value. ... A job may thus become unproductive for an employer, while still generating some resources for society. Therefore, without government intervention, there would be too many layoffs compared to what would be socially and economically desirable." Third, much of the case against labor-market institutions rests on empirical evidence that is not sufficiently conclusive to inform policy. In the case of EPL, for example, the OECD cautions that "more tests for the robustness of the results should be carried out before drawing policy conclusions." Fourth, the IMF should resist old habits and not try to shoehorn every national economy into an identical set of policies. The OECD's analysis concluded, for example, that Denmark's "flexicurity" system — which includes generous unemployment benefits, moderate employment protection, and "active labor market policies" to help the unemployed get back to work — produced outcomes at least as good as those obtained in the less-protective United States.

The IMF might also benefit from one final piece of advice that does not flow directly from the OECD. To the extent that decisions about labor-market institutions involve tradeoffs between efficiency and equity, economists at the IMF should spell out the terms of the tradeoff as precisely as possible while noting the range of economic uncertainty. Their findings, together with national values and preferences, could then be used to decide where along the efficiency-equity tradeoff to locate national institutions.

A nuanced understanding of local labor markets and a truly democratic approach to economic policy would require some changes at the IMF, including a readiness to deplane long enough to understand that different countries require different kinds of economic policies.