Skip to main content

Macroeconomic Evaluation of Labor Market Reform in Germany

Abstract

In 2003–05 the German government implemented a number of far-reaching labor market reforms, the so-called Hartz reforms. At the heart of the reform package was the Hartz IV law, which resulted in a significant cut in the unemployment benefits for the long-term unemployed. The paper develops a macroeconomic model with search and incomplete markets, calibrates the model economy to German data and institutions, and uses the calibrated model economy to simulate the effects of the Hartz reforms, and in particular Hartz IV, on the German labor market. The paper finds that the Hartz IV reform reduced the noncyclical unemployment rate in Germany by 1.4 percentage points. Employed workers benefited from the Hartz IV reform in welfare terms, but unemployed workers lost. It further finds that the Hartz I–III reforms reduced the noncyclical unemployment rate in Germany by 1.5 percentage points. Finally, the authors’ analysis suggests that the Hartz reforms contributed to the good performance of the German labor market during the Great Recession.

This is a preview of subscription content, access via your institution.

Figure 1
Figure 2
Figure 3
Figure 4
Figure 5
Figure 6
Figure 7
Figure 8
Figure 9
Figure 10
Figure 11
Figure 12

Notes

  1. 1.

    The Hartz IV reform entailed a significant change in the official measurement of unemployment, which added more than half a million workers to the pool of unemployed between January 2005 and March 2005 (see Bundesagentur fuer Arbeit, 2005) and resulted in a spike in the unemployment rate in 2005. More than 80 percent of these added unemployed workers lacked the equivalent of a high-school degree.

  2. 2.

    We use a closed-economy model with an aggregate resource constraint (market clearing) that determines wages and the interest rate endogenously. We think that it is desirable to include an analysis of possible real wage effects of the Hartz reform, something that would be missing if we had used a standard small open economy framework. Clearly, the Germany’s export sector is large (about half of GDP), and an extension of the current analysis that allows for current account effects of the Hartz reform is an important topic for future research.

  3. 3.

    Data on the job finding rates for short-term and long-term unemployed before and after the reform support this prediction of the theory. See Section I for more details.

  4. 4.

    We use an endogenous growth model in which the labor market reform affects the long-run growth rate of the economy, including the long-run growth rate of real wages. The real wage decline we discuss here is a decline relative to the long-run trend. See Figure 8 for details.

  5. 5.

    Our results do not rule out the possibility that adopting other parts of the Hartz reforms (Hartz I–III) could prove more beneficial to France or Spain.

  6. 6.

    Franz and others (2012) analyze the Hartz IV reform using a microsimulation approach where households make a static labor supply decision.

  7. 7.

    A glance at Figure 4 shows that wage moderation has been taken place in Germany, but it also shows that this process of wage moderation started many years before the Hartz reforms. The wage evolution in Germany depicted in Figure 4 further suggests that in Germany, where union coverage is still relatively high, the bargaining power of unions in wage negotiations has been small for some time. Thus, our modeling assumption of a competitive labor market might be appropriate to a first approximation.

  8. 8.

    The fact that the German job finding rate has only a negligible cyclical component has also been documented in Jung and Kuhn (2012), a finding that stands in contrast to the findings for the United States (Shimer, 2005).

  9. 9.

    The OECD reports the fraction of long-term unemployed (the incidence of long-term unemployment). In accordance with the model prediction, in the data this variable decreased after the reform. However, the data on the incidence of long-term unemployed are not well suited to “test” the basic mechanism for two reasons. First, this variable is heavily influenced by movements into and out of the labor force, which can be very different for short-term and long-term unemployed workers. Second, the variable has a strong cyclical component.

  10. 10.

    To gather public support for the reforms, the government took advantage of a scandal involving the Federal Employment Agency, which had grossly mis-reported the success of job placement.

  11. 11.

    Of course, most European countries introduced some type of labor market reform in the last 20 years, but they were either much more limited in scope or the implementation was much more gradual.

  12. 12.

    In addition, the eligibility period for short-term unemployment benefits (Unemployment Benefit I) was reduced in February 2006, but this change was not officially a part of the Hartz-laws and had only a small effect on the average net replacement rate (see Figure 5).

  13. 13.

    In the model, the net replacement rate is not b, but b/((1−τ)r h ), and we choose b so that the implied value of b/((1−τ)r h ) matches the corresponding net replacement rate.

  14. 14.

    The results are similar, at least in terms of the effect of Hartz IV on net replacement rates, if we take couples instead of singles as long as we weigh the group without children and the group with two children the same way. The OECD does not report net replacement rates for households with one child. Hartz IV had a larger effect on the net replacement rate of households with one child than it had on the net replacement rate of households with two children, and our weighing scheme therefore understates the effect of Hartz IV on net replacement rates.

  15. 15.

    We also computed the benefits rate that maximizes social welfare and found that this rate is lower than the postreform benefit rate, but the welfare gains of this further benefit reduction are very small.

  16. 16.

    This effect is somewhat smaller than sum of the two individual effects because of nonlinearities.

  17. 17.

    Of course, this approach is somewhat crude, but seems appropriate given that the Hartz reforms mainly affected job finding rates and our interest is in analyzing how the Hartz reforms changed the dynamic response of the German labor market to macroeconomic shocks. Clearly, our approach is necessarily silent about the fundamental factors underlying the cyclical rise in job destruction.

  18. 18.

    Contrary to popular belief, this shows that the German job destruction rate increased during the Great Recession (relative to trend), though the increase was probably less pronounced than what one would expect given that GDP contracted by 5 percent in 2009. Jung and Kuhn (2012) and Gartner, Merkl, and Rothe (2012) compute the cyclical component of the job destruction rate (flow rate from employment to unemployment) using IAB data for the time period before the Hartz IV reform, and find that the job destruction rate in Germany is in general highly volatile.

  19. 19.

    Different assumptions about the implied search elasticities are another possible explanation for the different findings in the macro literature on Hartz IV. However, neither Krause and Uhlig (2012) nor Launov and Waelde (2013) report the respective micro-level search elasticity that their calibrated macro models imply, and it is therefore difficult to analyze the issue further.

  20. 20.

    Thus, B W is the set of all functions, V, with L(x)≤V(x)≤U(x) for all xX.

  21. 21.

    Alvarez and Stokey (1998) provide a different, but related argument to prove the existence and uniqueness of a solution to the Bellman equation for a class of unbounded problems similar to the one considered here, though without moral hazard.

References

  1. Acemoglu, D. and R. Shimer, 2000, “Productivity Gains from Unemployment Insurance,” European Economic Review, Vol. 44, No. 7, pp. 1145–1224.

    Article  Google Scholar 

  2. Addison, J., M. Centeno and P. Portugal, 2008, “Unemployment Benefits and Reservation Wages: Key Elasticities from a Stripped-Down Job-Search Model,” IZA Discussion Paper.

  3. Alvarez, F. and N. Stokey, 1998, “Dynamic Programming with Homogeneous Functions,” Journal of Economic Theory, Vol. 82, No. 1, pp. 167–189.

    Article  Google Scholar 

  4. Ball, L., D. Leigh and P. Loungani, 2013, “Okun’s Law: Fit at 50?,” NBER Working Paper No. 18668.

  5. Blanchard, O. and J. Wolfers, 2000, “The Role of Shocks and Institutions in the Rise of European Unemployment: The Aggregate Evidence,” Economic Journal, Vol. 100, No. 462, pp. 1–33.

    Article  Google Scholar 

  6. Bornhorst, F. and A. Mody, 2013, “Tests of German Resilience,” in Germany in an Interconnected World Economy, ed. by A. Mody Washington DC: (International Monetary Fund).

    Google Scholar 

  7. Boysen-Hogrefe, J., D. Groll and C. Merkl, 2010, “The German Labour Market Miracle,” National Institutional Economic Review, Vol. 214, No. 1, pp. R38–R50.

    Article  Google Scholar 

  8. Bois, R., O. Causa, C. Demmon, R. Duval and A. Zdziemicka, 2012, “The Short-term effects of Structural Reform: An Empirical Analysis,” OECD Economics Department Working Paper No. 949.

  9. Bundesagentur fuer Arbeit. 2005, “Der Uebergang von der Arbeitslosen- und Sozialhilfe zur Grundsicherung für Arbeitssuchende,” Sonderbericht.

  10. Bundesagentur fuer Arbeit. 2011, “Der Arbeitsmarkt in Deutschland: Sockel- und Langzeitarbeitslosigkeit,” Arbeitsmarktberichterstattung.

  11. Burda, M. and J. Hunt, 2011, “What Explains the German Labor Market Miracle in the Great Recession?” NBER Working Paper No. 17187.

  12. Chetty, R., 2008, “Moral Hazard vs Liquidity and Optimal Unemployment Insurance,” Journal of Political Economy, Vol. 116, No. 2, pp. 173–234.

    Article  Google Scholar 

  13. Elsby, M., B. Hobijn and A. Sahin, 2008, “Unemployment Dynamics in the OECD,” NBER Working Paper No. 15979.

  14. Fahr, R. and U. Sunde, 2009, “Did the Hartz Reforms Speed Up the Matching Process? A Macro-Evaluation Using Empirical Matching Functions,” German Economic Review, Vol. 10, pp. 284–316.

    Article  Google Scholar 

  15. Fuchs-Schuendeln, N., D. Krueger and M. Sommer, 2010, “Inequality Trends for Germany in the Last Two Decades: A Tale of Two Countries,” Review of Economic Dynamics, Vol. 13, No. 1, pp. 103–132.

    Article  Google Scholar 

  16. Franz, W., N. Guertzgen, S. Schubert and M. Claus, 2012, “Assessing the Employment Effects of the German Welfare Reform—An Integrated CGE-Microsimulation Approach,” Applied Economcis, Vol. 44, No. 19, pp. 2403–2421.

    Article  Google Scholar 

  17. Gartner, H., C. Merkl and T. Rothe, 2012, “Sclerosis and Large Volatilities: Two Sides of the Same Coin,” Economic Letters, Vol. 117, No. 1, pp. 106–109.

    Article  Google Scholar 

  18. Hansen, G. and A. Imrohoroglu, 1992, “The Role of Unemployment Insurance in an Economy with Liquidity Constraints and Moral Hazard,” Journal of Political Economy, Vol. 100, No. 1, pp. 118–142.

    Article  Google Scholar 

  19. Hofmann, B., 2012, “Short- and Long-Term Ex Post Effects of Unemployment Insurance Sanctions,” Journal of Economics and Statistics, Vol. 232, No. 1, pp. 31–60.

    Google Scholar 

  20. Hopenhayn, H. and J. Nicolini, 1997, “Optimal Unemployment Insurance,” Journal of Political Economy, Vol. 105, No. 2, pp. 412–438.

    Article  Google Scholar 

  21. Hunt, J., 1995, “The Effect of Unemployment Compensation on Unemployment Duration in Germany,” Journal of Labor Economics, Vol. 13, No. 1, pp. 88–120.

    Article  Google Scholar 

  22. Jacobi, L. and J. Kluve, 2006, “Before and After the Hartz Reforms: The Performance of Active Labor Market Policy in Germany,” IZA Working Paper No. 2100.

  23. Jung, P. and M. Kuhn, 2012, “Labor Market Institutions and Worker Flows: Comparing Germany and the US?” MRRA Working Paper No. 32322.

  24. Klinger, S. and T. Rothe, 2012, “The Impact of Labour Market Reforms and Economic Performance on the Matching of the Short-Term and the Long-Term Unemployed,” Scottish Journal of Political Economy, Vol. 59, No. 1, pp. 90–114.

    Article  Google Scholar 

  25. Krause, M. and H. Uhlig, 2012, “Transitions in the German Labor Market: Structure and Crisis,” Journal of Monetary Economics, Vol. 59, No. 1, pp. 64–79.

    Article  Google Scholar 

  26. Krebs, T., 2003, “Human Capital Risk and Economic Growth,” The Quarterly Journal of Economics, Vol. 118, No. 2, pp. 709–744.

    Article  Google Scholar 

  27. Krebs, T. and Y. Yao, 2013, “Labor Income Risk in Germany,” Working Paper, Unpublished.

  28. Landais, C., P. Michaillat and E. Saez, 2010, “Optimal Unemployment Insurance over the Business Cycle,” NBER Working Paper No. 16526.

  29. Launov, A. and K. Waelde, 2013, “Estimating Incentive and Welfare Effects of Non-Stationary Unemployment Benefits,” International Economic Review forthcoming.

  30. Layard, R., S. Nickell and R. Jackman, 2005, Unemployment: Macroeconomic Performance and the Labour Market (Oxford: Oxford University Press, 2nd ed.).

  31. Lentz, R., 2009, “Optimal Unemployment Insurance in an Estimated Job-Search Model with Savings,” Review of Economic Dynamics, Vol. 12, No. 1, pp. 37–57.

    Article  Google Scholar 

  32. Lucas, R., 2003, “Macroeconomic Priorities,” American Economic Review, Vol. 93, No. 1, pp. 1–14.

    Article  Google Scholar 

  33. Ljungqvist, L. and T. Sargent, 1998, “The European Unemployment Dilemma,” Journal of Political Economy, pp. 514–550.

  34. Meyer, B., 1990, “Unemployment Insurance and Unemployment Spells,” Econometrica, Vol. 58, No. 4, pp. 757–782.

    Article  Google Scholar 

  35. Meyer, B. and W. Mok, 2007, “Quasi-Experimental Evidence on the Effects of Unemployment Insurance from New York State,” NBER Working Paper No. 12865.

  36. Mortensen, D. and C. Pissarides, 1994, “Job Creation and Job Destruction in the Theory of Unemployment,” Review of Economic Studies, Vol. 61, No. 3, pp. 397–415.

    Article  Google Scholar 

  37. Mueller, K. and V. Steiner, 2008, “Imposed Benefit Sanctions and the Unemployment-to-Employment Transition: The German Experience,” DIW Discussion Paper 792.

  38. Rinne, U. and K. Zimmermann, 2013, “Is Germany the North Star of Labor Market Policy?” IZA Working Paper No. 7260.

  39. Schindler, M., 2013, “What Does the Crisis Tell us About the German Labor Market?,” in Germany in an Interconnected World Economy, ed. by A. Mody (Washington DC: International Monetary Fund).

    Google Scholar 

  40. Shimer, R. and I. Werning, 2008, “Liquidity and Insurance for Unemployed Workers,” American Economic Review, Vol. 98, No. 5, pp. 1922–1942.

    Article  Google Scholar 

  41. Shimer, R., 2005, “The Cyclical Behavior of Equilibrium Unemployment, Vacancies, and Wages: Evidence and Theory,” American Economic Review, Vol. 95, No. 1, pp. 25–49.

    Article  Google Scholar 

  42. Streufert, P., 1990, “Stationary Recursive Utility and Dynamic Programming under the Assumption of Biconvergence,” Review of Economic Studies, Vol. 57, No. 1, pp. 79–97.

    Article  Google Scholar 

  43. Stokey, N. and R. Lucas, 1989, Recursive Methods in Economic Dynamics. (Cambridge, MA: Harvard University Press).

    Google Scholar 

Download references

Authors

Additional information

*Tom Krebs is Professor of Economics at Mannheim University and Martin Scheffel is Assistant Professor of Economics at Cologne University. The authors thank seminar participants at various institutions and conferences for useful comments. They thank the editors of this journal, two referees, and their discussant, Roman Duval, for many suggestions and insightful comments. The authors also thank the Center for European Research (ZEW), Mannheim, for supporting their work on labor market reform. Tom Krebs also thanks the German Science Foundation (DFG) for support under SFB884.

Appendix I

Appendix I

Proof of Proposition 1

The household maximization problem we consider in this paper has the feature that probabilities depend on choices, in contrast to the class of problems analyzed in Stokey and Lucas (1989). However, the standard argument for the principle of optimality still applies. Similarly, another standard argument shows that the Bellman equation (9) has a unique solution in an appropriately defined function space (contraction mapping theorem). Guess-and-verify then shows that the value function (equation (11)) with coefficients determined by Equation (12) solves Equation (9) with optimal policy function defined in Equation (10).

There is a technical issue regarding the construction of the appropriate function space as the economic problem is naturally an unbounded problem. To deal with this issue, one can, for example, follow Streufert (1990) and consider the set of continuous functions B W that are bounded in the weighted sup-norm , where x=(w, θ, s) and the weighting function W is given by W(x)=|L(x)|+|U(x)| with U an upper bound and L a lower bound, and endow this function space with the corresponding metric.Footnote 20 A straightforward but tedious argument shows that confining attention to this function space is without loss of generality. More precisely, one can show that there exist functions L and H so that for all candidate solutions, V, we have L(x)≤V(x)≤H(x) for all xX. This completes the proof of Proposition 1.Footnote 21

Proof of Proposition 2

From Proposition 1 we know that individual households maximize utility subject to the budget constraint. Thus, it remains to be shown that the intensive-form market-clearing condition (equation (14)) is equivalent to the market-clearing conditions (equation (7)) and that Equations (15) and (16) are the equilibrium law of motions for Ω and U.

First, note that the solution to the household problem only depends on the first component s1, but not on the i.i.d. component s2. Recall that and let be total wealth in period t after production and depreciation has taken place. The aggregate stock of physical capital held by households in period t+1 is

The second line in Equation (A.1) uses the equilibrium law of motion for the individual state variable w, the third line is simply the law of iterated expectations, the fourth line follows from the fact that the portfolio choices only depend on s1, and the last line is a direct implication of the definition of Ω. A similar expression holds for the aggregate stock of human capital held by all households, E[h t ]=E[(1−θ t )w t ], and the aggregate stock of human capital held by employed households, E[h t |s1t=e]=E[(1−θ t )w t |s1t=e]. Dividing the expression for E[k t ] by the expression for E[(1−θ t )w t |s1t=e] proves the equivalence between Equations (7) and (14).

Define r(s1t, s1,t+1) as the investment return after the expectation over s2t and s2,t+1 has been taken. The law of motion for Ω can be found as

where the second line uses the equilibrium law of motion for the individual state variable w, the third line is simply the law of iterated expectations, the fourth line follows from the fact that portfolio choices only depend on s1 in conjunction with the definition of r, and the last line is a direct implication of the definition of Ω. This shows that the law of motion for Ω is Equation (15). The law of motion (equation (16)) for U is obvious. This completes the proof of Proposition 2.

Computation

To compute stationary equilibria, we use Proposition 2, that is, we solve the equations (12), (13), (14), (15), (16) with Ω′=Ω and U′=U. The max problem (equation (12)) is solved using the first-order conditions approach for portfolio choice and effort choice. Thus, we find a stationary equilibrium by solving a low-dimensional nonlinear equation system.

For the computation of the transitional dynamics, we iterate over the sequence of aggregate wealth shares and unemployment rates, that is, over sequences of the relevant aggregate state variable. Specifically, if we denote the aggregate state by X=(Ω e , Ω su , Ω lu , U su , U lu ), then the solution algorithm proceeds as follows:

Step 1:

  • Compute the prereform and postreform stationary equilibrium allocation and the respective lifetime utilities.

Step 2:

  • Set the number of periods T the economy needs to converge to the new stationary equilibrium. Guess a sequence of aggregate states, {X t }t=0T, where the initial aggregate state and the final aggregate state correspond to their pre- and postreform equilibrium values, respectively.

Step 3:

  • Given the sequence of aggregate states and the households’ life time utility function in intensive form, we start at period T and solve backwards for a time series of individual households portfolio and effort choices, households’ intensive-form lifetime utility, the aggregate capital-to-labor ratio, and the consumption tax rate.

Step 4:

  • Given the time series for households’ portfolio choices and effort choices and aggregate capital-to-labor ratio, we use the recursive formula (equation (15)) and (equation (16)) for the aggregate state variable to solve forward for a sequence of aggregate state variables {X t }t=0T.

Step 5:

  • If max||{X t B}t=0T−{X t F}t=0T||<tol, the backward and forward solutions converged and we have solved for the transitional dynamics of the endogenous variables; otherwise, update the guess for the evolution of the aggregate state variable {X t B}t=1T−1={X t F}t=1T−1 and go back to step 3.

Solving for the transitional dynamics, we find that setting T=100 is sufficient and that the algorithm converges within five iterations to a tolerance level tol=1e−8.

Rights and permissions

Reprints and Permissions

About this article

Cite this article

Krebs, T., Scheffel, M. Macroeconomic Evaluation of Labor Market Reform in Germany. IMF Econ Rev 61, 664–701 (2013). https://doi.org/10.1057/imfer.2013.19

Download citation

JEL Classifications

  • E21
  • E24
  • D52
  • J24