In theory, labour market deregulation has two effects on an open economy’s current account balances. To the extent that it fosters future growth, it decreases current savings by consumption-smoothing households that anticipate an increase in their future income, and tends to make the current account more negative. But by making labour income flows more uncertain, labour market deregulation also induces stronger precautionary savings, and may have the opposite effect on external balances. As we discuss in the paper, the first effect should predominate when financial markets make it possible to prevent labour income risk from influencing consumption patterns. In reality, however, financial markets are far from being perfect and complete. Empirically, we find that labour market deregulation was on average positively related to current account surpluses between the 1980s and up to the mid-2000s in a panel of OECD country-level data, and that the relationship between reforms and external balances was shaped by households’ access to credit. Indeed, reforms were negatively associated with current account imbalances in the less regulated and more market-friendly Anglo-Saxon countries and, within Europe, in countries where financial markets were or became more developed.
Chosen excerpts by Job Market Monitor. Read the whole story at Labour market reforms and international imbalances | VOX, CEPR’s Policy Portal.