Sudip Bandyopadhyay’s Blog

The economic paradigm developed during the boom years was based on the idea of flexibility. The economically successful countries were those that allowed flexibility in goods and labour markets. Rapid growth lay ahead of them if they permitted companies to hire and fire without restrictions; if wage contracts made it possible for companies to adjust wages up and down quickly to changing economic conditions. New growth models were developed by academic economists stressing the need for flexibility. International organizations chastised those countries with rigid labour and goods markets and urged them to introduce “structural reforms”. The European Commission was mesmerized by the idea of flexibility and had the ambition of transforming the European Union into a flexible economy. The great role model was the US which was seen to have a superior economic model thanks to its flexibility. Today it is becoming increasingly clear that flexibility may not be a quality at all, but a serious handicap, When economies are hit by debt deflation they need circuit breakers. Rigidities in wages, prices and employment contracts are such circuit breakers. They slow down the debt deflation dynamics, allowing for a more orderly retreat. Workers do not immediately lose their jobs; their wages are not cut instantaneously, giving some respite in the orderly winding down of debt levels. Of course, these circuit breakers do not eliminate the debt deflation dynamics; they slow them down. There is one ultimate circuit breaker, however, that has the capacity to stop the dynamics. This is the social security system, “Rigid economies” have been chastised for having too generous social security systems. They pay their unemployed too much for too long. It now turns out that this ultimate source of rigidity is a great advantage. The workers that are made redundant in the rigid countries will have higher unemployment benefits that will sustain consumption and reduce the fall in prices. The debt deflation dynamics hit a floor.

One may argue that since the unemployed in the rigid countries get paid better, the budget deficits in these countries will increase more than in the flexible countries. This is far from certain though. For sure, the governments of flexible countries will spend less on unemployment benefits, but to the extent that the debt deflation leads to a stronger decline in economic activity in these countries, government revenues will decline more. As a result, budget deficits may actually increase more in the flexible countries.