Abolish Rigid Labor Markets

This article appeared in the July 2007 issue of Globe Asia.
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Yugoslav strongman Josip Broz Tito died on May4, 1980, and his funeral was witnessed by more politiciansand state delegations than any other in history.Even though Marshall Tito might be dead, his ideas arealive and well.

In 1948, Tito made his mark by breaking ranks with Stalin. Moscowwas quick to label Tito's form of communism revisionism. After all,the hallmark of Tito's foreign policy was the Non-Aligned Movement,which counted Tito's Yugoslavia (along with Nasser's Egypt and Nehru'sIndia) as a founding member, and at home, Yugoslavia's unique form ofdecentralized "market socialism" featured worker-managed firms.

The worker-managed firm idea attracted much interest and manycamp followers around the world. In Yugoslavia, however, the systemfailed to produce enough jobs to fully employ Yugoslavs because thesocialist worker-managers viewed new additions to the labor force as"profit" poachers who would cut into their share of the "profit" pie. Inconsequence, Yugoslavia faced a chronic surplus labor problem.

To solve the problem and mask the flaws in the worker-managedsystem, Tito came up with a simple, but ingenious, economic strategy:he opened the Yugoslav borders — at least by communist standards — andexported surplus labor. At its peak in the early 1970s, there were overa million Yugoslavs, about 11% of the labor force, working in WesternEurope. The hard-money remittances (primarily German marks) thatthose Yugoslavs sent home amounted to as much as 30% of Yugoslavia'sexports. Tito's broom worked like a charm.

Like Yugoslavia, Indonesia exports surplus labor. In Indonesia,laws governing businesses' hiring and firing practices have created adysfunctional labor market. As indicated in the table, Indonesia's labormarket is ranked 140th out of 175 in the World Bank's Doing Business2007 report (just one notch above Iran).

Labor Market Scoring

It's difficult for Indonesian businesses to hire new workers andcostly to fire them. The labor market mess forces an estimated 70% ofthe labor force to work "off the record" in the relatively unproductiveinformal sector of the economy and 11% to remain unemployed. Anestimated 3 million are legally working overseas, with at least anothermillion doing so illegally, and they sent home at least $3.5 billion in remittanceslast year.

As Indonesia uses Tito's broom to export its surplus labor, it is usingcountries like Singapore, Australia and Malaysia as a dustpan, withmore than half of all Indonesian contract laborers abroad working inMalaysia and the permanent Indonesian migrant community in Australiagrowing at almost 10% per year since 2001.

The reason? Look at the accompanying table: Indonesia scoredvery poorly (61) on the Doing Business 2007 report's Difficulty of Hiringindex, the component of the labor market score that measures therestrictions employers face when hiring workers. Neighboring countries — Singapore, Australia and Malaysia — faced none of these restrictionsand consequently each registered a perfect score of 0 on the Difficultyof Hiring index.

Post-Crisis Real GDP/Capita Growth Rates

The Doing Business 2007 report tells a similar story for the followingmetrics: Rigidity of Hours, Difficulty of Firing and Firing Costs.Indonesian labor laws impose far more restrictions, expenses and procedureson companies than do its neighbors.

In fact, an Indonesian business requires third-party approval beforeit can even fire redundant workers, and each firing costs an average of108 weeks of the employee's salary (compared to a cost of 0 in the US.).Indonesia's labor market is inflexible and unable to respond to competitivepressure and to create an adequate number of jobs.

Labor market dysfunction explains, in part, Indonesia's anemicoverall economic performance since the collapse of the rupiah in 1997.Indonesia's GDP per capita has grown at a meager 1.18% rate. It tookseven years for it to return to pre-crisis levels!

It's not surprising that Indonesia is dumping labor into countrieswith better functioning labor markets and more rapidly growing economies.It's time to reform Indonesia's labor markets so that Tito's broomcan be put back into the closet.

Steve H. Hanke

Steve H. Hanke is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute in Washington, D.C. He was advisor to former President Suharto in 1998.