Financial regulation and employment growth

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

Ekkehard Ernst1

1
Employment Trends Unit
International Labour Organization
Geneva
ernste@ilo.org

http://ekkehard.ernst.free.fr

ECB
Feb 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

ILO’s annual ﬂagship study.
Discusses global and regional employment
trends.
Medium-term projections on the basis of
consensus GDP forecasts (up to 2016).
Analyses of particular key macro and
policy developments.
This year: Financial market crisis and its
consequences.
Available at: http://www.ilo.org/get


Overview of the GET report Key messages

Key messages from the GET report

Global unemployment
has increased by 27 million since the start of the crisis
could reach up to 210 million next year
will only gradually decline by 2016

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

Global investment
An increase by 2 pp could absorb global unemployment
Corresponds to $1200 billion.


Overview of the GET report Motivation of today’s talk

Investment is key for employment recovery

220 7.0
Unemployment (in million)

210

Unemployment rate (in %)
6.5
200

6.0
190

180
5.5

170
5.0
160

150 4.5
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Total unemployment Total unemployment −
downside scenario
Unemployment rate Unemployment rate −
downside scenario
Unemployment rate − Unemployment rate −
upside scenario boosting investment


Overview of the GET report Motivation of today’s talk

Financial market returns and investment

4.0
2010
2006
2007
Annual average productivity growth

2000
2004
3.0

2005

2011
2.0

2003
(in percent)

2008

2002
1.0

2001
0.0 −1.0

2009

−2.0 −1.0 0.0 1.0
Changes in investment shares
(in percentage points)


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

Decomposing unemployment dynamics

Ut = Lt − ETt = INt − OUTt

Labour force growth

Lt = α3 + β31 Lt −1 + β32 ut −1 + β33 Taxt

Employment growth

ETt = JobCreationt − JobDestructiont



An overview of the model ﬂows II

Job creation

JobCreationt = β11 ETt −1 + β12 wt + β13 ADt + β14 Ut + β15 Vt + β16 Financet −1

Job destruction

JobDestructiont = β21 TFPt +β22 Financet +β23 εt +β24 IMPt +β25 wt +β26 ADt

Wage determination:

wt = α4 + β41 Kt + β42 CBt + β43 ut −1 + β44 Taxt



Putting the pieces together

Substituting the ﬂow equations:

OUTt = JobCreationt
INt = JobDestructiont + ∆Lt −1

Hence:

OUTt = β11 OUTt −1 + β12 INt + β13 XtJobCreation + β14 ut −1 + β15 Financet −1
INt = β21 INt −1 + β22 OUTt + β23 XtJobDestruction + β24 Lt −1 + β25 Financet

where:
Share prices Interest rates
Finance =
Financial development Market volatility


Financial markets and unemployment flows Financial market development and unemployment flows

Finance and unemployment flows: Hypotheses

Mount-Pelerin-Hypothesis
Financial development positive for labour dynamics
Reduces unemployment inflows
Increases unemployment outflows

Schumpeter-Hypothesis
Financial development leads to more turnover
Increases both U inflows and outflows

Attac-Hypothesis
Financial development comes at the expense of the real
economy
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 flows
e.g.: FTTs, capital controls
reduce availability of foreign capital
lower financial market competition but also reduce volatility

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

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

Finance and jobs Data and methodology

A word on the data
Unemployment flows come from Elsby et al. (2008)
Constructed on the basis of information regarding unemployment duration at
different duration lengths
Information on financial market development is based on updated data by
Torsten Beck
Size of financial sector assets and liabilities (banking, bond markets, stock
markes)
Financial sector reforms has been provided by Abiad et al. (2008)
Information on interest rate ceilings, credit growth restrictions, entry barriers
for banks, (financial sector) privatisations and security market reforms
Information on international capital flows has been used from Lane and
Milesi-Ferretti (2006)
Importance of internationally traded assets and liabilities, such as foreign direct
investment, portfolio equity and debt flows, and financial derivatives
Macro indicators come from the OECD Economic Outlook database and the
OECD Main Economic Indicators (vacancies, share prices)


Estimation methodology I

Step-by-step estimation

Step 1: Identify base-line equations
Macro variables to affect unemployment flows
Reduced-form panel estimates
GMM used to control for endogeneity
Results published in Ernst (2011)

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



Estimation methodology II

Step 3: Estimate macro model
Introduce macro-economic closure: Okun’s law
Introduce endogenous policy rules
Estimate using GMM

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


Finance and jobs Financial development and unemployment flows: Evidence

Financial determinants of outflows
Dependent 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*** 1.540
investment (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 191 192 179 190 176
Number of countries 8 8 8 8 8

Note: All estimates performed using Arellano-Bond System GMM estimator. Standard
errors 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 inflows
Dependent 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 304 305 273 303 270
Number of countries 12 12 12 12 12

*** 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 145 152 149 139
Number 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 indicate
the 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 0.0169
capital 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 211 211 192 192
Number of countries 12 12 10 12
*** p<0.01, ** p<0.05, * p<0.1



A first summary

Financial market developments and unemployment flows
Financial market development raises labour market turbulence by increasing
both unemployment out- and inflows.
Credit growth promotes employment growth unambiguously by decreasing
inflows and raising outflows.
Banking sector leverage depresses labour market dynamics.
International openness lowers labour market turnover.

Financial market regulation
Prudential regulation of banks strengthen labour market dynamics.
Deregulation of securities market increase labour market turnover.
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
Labour market flows and matching:

OUTt = αOUT + β11 OUTt −1 + β12 INt + β13 XtJobCreation
INt = αIN + β21 INt −1 + β22 OUTt + β23 XtJobDestruction + β24 XtLabourForce
ETt = αET + β31 OUTt − β32 INt

Okun’s law:

Gapt = −δ1 INt −1 +δ2 OUTt −1 +δ3 INVt −1 +δ4 GovConst −1 −δ5 Taxt −1 +δ6 ∆NetExportst −1

Philipps curve:

πt = γ b πt −1 + γ f E πt+1 + Gapt −1 + TOTt −1

Taylor rule:

itm = (1 − ϕ) itm 1 + ϕ [b1 E πt+1 + b2 Gapt + b3 (GovConst −1 − Taxest −1 )]
−

Investment dynamics:

INVt = ∆RSharet −1 + Rtl −1 + ∆ETt −1 + GovInvt −1 − GovConst −1 + ∆Prodt −1


Reform scenarios and employment dynamics Financial reform scenarios

Reforms are not being implemented in isolation

Reform debates in different countries and at different levels
Banking sector reforms (e.g. Basel III)
Reforms of derivative markets (e.g. central clearing houses)
International reforms (e.g. tax on international transactions, capital controls)
Financial market problems are multi-faceted
Credit growth and leverage has been too high
Systemic interconnections have been too frequent
Lack of transparency has prevented better appreciation of risks by investors
Different actors pursue different political agendas
Policy makers care about access to funds and economic stability
Workers care about job stability and wage increases
Financial investors care about diversification and investment opportunities
Managers care about empire-building and earnings growth
Political compromises involve multi-dimensional agendas to satisfy all four
actors



What shapes ﬁnancial market regulation?



Four broad reform scenarios emerge...
1 Business-As-Usual (BAU): No or ineffective reforms
No (major) changes in financial market regulation and continuous high market
volatility
Profit sharing between CEOs and financial investors; pressure on wages and
further increase in inequality
2 Brakes on (financial) globalization
Managed international flows but no domestic reforms
Less international volatility but few(er) possibilities for diversification
Moderate improvements in wage developments and inequalities
3 A new compromise: Domestic reforms with open international capital
markets
Substitution of domestic by international financial liquidity
Stonger pressure by international financiers for favourable regulation
4 Full-scale regulation: Both international and domestic (re-)regulation
Reduced international and domestic volatility at the expense of higher user
cost of capital
Profit sharing at the firm level between workers and managers and improved
wage-productivity linkage
Less reliance on public debt but larger role of the state (at least in the form of
higher taxes)


...and their expected macro consequences

XXX International
XXX
XXX capital flows Unreformed Tightened Regulation
Domestic XXX
financial markets XX X
Scenario I : Scenario III :
Permanent increase in Moderate reduction in financial
financial stress stress
Return to highly value shares Moderate reduction or stable share
Unreformed
Continued export and import prices
growth Further export and import growth
High international capital Moderate increase in international
flows capital flows
Scenario II : Scenario IV :
Moderate increase in Permanent reduction in financial
financial stress stress
Tightened
Stable share prices Lower real share prices
regulation
Slower trade growth Slower growth of world trade
Reduced international capital Reduction in international capital
flows flows



What happens to jobs?

2.5
Annual employment growth

2.0
(in percent)
1.0 1.5
0.5
0.0

Baseline International Domestic Fully coordinated
scenario reforms only reforms only reforms

After 1 year After 3 years After 5 years

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


Concluding remarks

Lessons learned and outlook

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

Avenues for future research
Derive financial market interactions from first principles
Introduce different forms of financial frictions
Specify the political economy interactions


Financial regulation and employment growth

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