Economics 201

Case of the Day: Unemployment in Slovakia

I spent the fall semester of 2015 in Bratislava, the capital of Slovakia, teaching and doing research as a Fulbright Scholar. My econometric research on unemployment in Slovakia and neighboring countries is ongoing and far from reaching a conclusion. This case presents some of the puzzles that motivated my interest in the country and that might be useful examples of how (and perhaps why) unemployment rates differ. The focus here is on natural rates of unemployment—the long-run levels to which unemployment rates in a region return when the macroeconomy is in balance—not on short-run fluctuations associated with business cycles.

Brief history and geography of Slovakia

The Slovak Republic is a small, landlocked country in Central Europe, bordering on the Czech Republic, Austria, Hungary, Ukraine, and Poland.

Although it has been a self-governing country only since the 1993 breakup of the former Czechoslovakia, the Slovak people have lived in the region for over a thousand years and have a culture and a language that are distinct from those of surrounding peoples (though very similar to those of the Czechs next door). From the Middle Ages to the end of World War I, Slovakia was ruled by Hungary and later by the joint monarchy of Austria-Hungary. Nationalist Hungarians still refer to Slovakia as "North Hungary." The policies of "Magyarization" under which the Hungarian rulers attempted to mandate the use of Hungarian language and customs in Slovakia led to the rise of a Slovak nationalist movement and to periodic, if unsuccessful, revolts.

During World War I, as the defeat of the Central Powers (including Austria-Hungary) looked likely, Americans of Czech and Slovak descent began to agitate for a unified state of Czechoslovakia. To this end, they drafted the "Cleveland Agreement" in October 1915, which also received support from nationalist groups within present-day Czechia and Slovakia. Under the influence of U.S. President Woodrow Wilson, the Treaty of Trianon established the state of Czechoslovakia in 1920. But the independence of this state lasted less then 20 years before Nazi Germany occupied the region, setting up a protectorate in the Czech regions of Bohemia and Moravia and a vassal state of Slovakia: the first distinct state of Slovakia. The Nazi-dominated Slovak state lasted until the end of World War II in 1945. Shortly thereafter the again-unified Czechoslovakia fell under the domination of the Soviet Union.

After the fall of Communism in the "Velvet Revolution" of November 1990, Czechoslovakia began to establish an independent, post-Communist state. Two years into that process a Slovak nationalist movement succeeded in separating the Slovak third of the country from the Czech regions as a separate country—the first truly independent Slovakia. Since its establishment on January 1, 1993, the Slovak Republic has made considerable economic progress and its official position has been largely pro-Western, though some leaders have had strong nationalist and populist sentiments. It joined NATO and the European Union in 2004 and became the lowest-income member of the Eurozone in 2009.

Slovakia is about 1/5 the size of Oregon (smaller than West Virginia but larger than Maryland among U.S. states) and has between 5 and 6 million people (more than 1 million more than Oregon). It is a country of small cities and towns. The largest city is Bratislava, which has fewer than 500,000 residents—roughly the size of Fresno, California and about 1/5 the population of the Portland metro area (though not much smaller than the Portland city proper). Bratislava is located in the extreme southwest corner of the country, just 50 miles from Vienna, Austria. It is the only capital city in the world from which three countries are visible: Slovakia, Austria, and Hungary. The only other city with more than 100,000 residents is Košice (KO-sheet-say) in the east of the country.

Administratively, the country is divided into 8 kraj, or regions, each of which is named after its largest city.

The central and eastern parts of the country are mountainous and have a long history of mining. The southwest is flatter plains surrounding the Danube and Morava rivers and is mainly agricultural. Manufacturing industry has begun to develop in the west through an attractive combination of access to the EU and low labor costs. The auto industry is particularly prominent with Volkswagen, Kia, Peugeot, and now Jaguar-Land Rover having major factories in Bratislava, Trnava, Žilina, and Nitra. Slovakia claims to be the world's largest auto producer ... per capita.

Unemployment rates in Slovak regions

The table below shows the pattern of unemployment rates in Slovak regions since 1999.

Table 1

Table 1 reveals several patterns. First, there has been a lot of variation over time in unemployment rates across Slovakia. Apart from some cyclical wobbles, unemployment rates have been falling since 2002 in most regions. The worldwide recession in 2008–10 had a rather muted effect on unemployment in much of Slovakia, being felt fairly strongly in the western regions but not much at all in the central and eastern parts of the country.

The most important pattern for our analysis is the large, persistent differences in unemployment rates across regions. The three western-most regions (the first three in the table) have an (unweighted) average unemployment rate over the 15 years of 9.1% compared with 18.2%—exactly twice as high—for the central and eastern regions.

Within the west-lying regions, the unemployment rate in the Bratislava region is consistently much lower than any other region. There is not a single sample year in which the unemployment rate in Bratislava is less than 1.5 percentage points lower than the next-lowest region in that year.

Among the central and eastern regions, unemployment rates in Nitra and Žilina (the furthest west and north) have fallen considerably since the early years of the sample and are now closer to those of western Trnava and Trenčín than to the farther-east regions of Prešov and Košice.

Possible explanations for differences

Under Communism, the state controlled all large firms in the economy and employed the vast majority of workers. Employment in state firms was often a method of income distribution as well as a mechanism for labor input. Unemployment was very low because state industries simply absorbed all the labor that was available, often more than the efficient amount needed. Redundant labor meant that labor productivity was very low. While wages were also low, the cost of necessities was kept even lower through administered prices, with queues arising to allocate goods for which there was excess demand at the artificially low prices. An old workers' joke said "We pretend to work and they pretend to pay us."

When the Communist system was abolished after 1990, the entire economy needed to be restructured according to market principles. Large state-owned industrial giants had to be either transferred to private ownership (privatized) or shut down. In the majority of cases, state-owned firms would make large losses when inputs and outputs were valued at market prices. Private investors were unwilling to take on many of these businesses and many had to be closed (or kept under the government's protective wing at significant cost to the taxpayer). In the case of privatized firms, redundant labor needed to be eliminated and production facilities modernized. Prices moved to market equilibrium levels, often much higher than the subsidized prices of the Communist era, and wages had to find an equilibrium corresponding to the productivity of labor in market-based firms.

Eastern Slovakia had two disadvantages in adapting to the emerging market system. First, the Soviets had located defense industries in the East, close to the borders of the Soviet Union. These industries vanished with the end of the Cold War and the westernization of Slovakia. Second, mining and mineral processing were important industries in the central and eastern regions, and these industries suffered from the exhaustion of easily extractable deposits and the inefficiency of their production methods. As a result, much of the industry in the East was destined for closure and the workers were inevitably displaced.

As Slovakia joined the EU, it became a popular investment destination for Western manufacturing firms. Bratislava is only 50 miles from Vienna, but Slovak wage costs were a small fraction of those in Austria so labor-intensive production could occur there with low labor costs and moderate transportation costs. It was natural for this investment to occur in regions most directly connected to the large markets of Western Europe, which was initially Bratislava and the surrounding region. Road and rail connections developed quickly between Bratislava and Trnava, Trenčín, Žilina, and Nitra, allowing those regions to follow Bratislava as industrial destinations. In contrast, there is still no four-lane motorway connecting Bratislava with Banská Bystrica, Prešov, or Košice 25 years after the fall of Communism. The inflow of foreign direct investment allowed displaced workers from state enterprises in the western regions to be absorbed more quickly into private firms than in the east.

Education is also strongly correlated with unemployment in most countries. In the Bratislava region, 38% of the labor force had a college education in 2013, compared with 18% in the rest of the country. Part of this discrepancy is that educated workers tend to move to the city, but part is that educational opportunities are greater in Bratislava than in some other parts of the country. In terms of current enrollment rates, there is no significant difference in primary and secondary school enrollment rates across regions, but the college enrollment was (in 2012) over 13% of the population in Bratislava and 3% in the rest of the country.

Wages in Slovakia are very low by our standards, but they vary less than you might expect across regions within the country. Average monthly earnings in low-unemployment Bratislava in 2014 were 1,286€, but in the other regions they ranged from 767€ to 908€.(Much of this reflects the difference in education levels.) A key factor in labor-force participation and employment is the difference between the wage that one can earn in work and the social benefits that can be received by staying home.

While unemployment insurance benefits are not particularly generous in Slovakia, there are other benefits that often blunt the incentives to work. Parental and child benefits are paid regardless of income or employment and can amount to 250€ or more per month depending on the number of children. For families with low incomes, the "material-need benefit" provides a monthly benefit of 150€ to 200€. There are other benefits available, including an "activation allowance" for anyone doing job training or government make-work activities. And health care is provided with an absurdly minimal co-payment, for example, 1.99€ for an emergency-room visit and 0.07€ per kilometer for ambulance services.

Thus. a worker with several children can thus earn close to 500€ in benefits and have generous health-care coverage just by staying home. These benefits do not vary from region to region, so the difference between working and staying home is much larger in higher-wage Bratislava than in other regions. In areas where the average wage is around 800€, the incentive to work is not very strong, especially if one's wage is below the regional average and if can earn a few extra euros in the informal economy.

Why don't unemployment rates converge?

It is natural for an economist to expect that unemployment rates across regions would tend to converge. Workers without jobs in regions with high unemployment would tend to move to regions with better employment prospects. Firms seeking advantageous labor-market conditions would find it beneficial to locate in regions with high unemployment because wage costs might be lower and workers more available. (Though wages in the East still must be high enough to induce potential workers to give up the generous social benefit.)

However, even in the United States the degree of worker and employer mobility in response to unemployment differentials is very limited and very one-sided. Olivier Blanchard and Lawrence Katz looked into mobility in response to regional differentials in unemployment in the United States in a famous 1992 paper called "Regional Evolutions," published in the Brookings Papers on Economic Activity. They found that while workers eventually tended to move out of depressed, high-unemployment areas, firms rarely moved in. The mobility was all on the worker side and not on the employer side. And workers did not begin to move immediately but rather after several years of high unemployment.

In Slovakia, there are strong reasons for firms not to move to the east. The transportation difficulties discussed above mean that it would be much more costly for firms locating in Banská Bystrica, Prešov, or Košice to transport manufactured products to markets in Western Europe. (And the markets to which they have easier access in Poland, Eastern Hungary, and Ukraine are not highly profitable ones in which to sell.) These infrastructure impediments are not balanced by significantly lower labor costs because the difference in wages is relatively small. Hence, firms building factories in Slovakia are likely to locate in Bratislava, or, if they want a lower-wage locale, in Trnava, Trenčín, Žilina, or Nitra.

So why don't workers all move to Bratislava, where jobs seem to be plentiful and wages are higher? There are many reasons impeding worker mobility. For one, the home ownership rate in Slovakia is over 90%—nearly the highest in all of the European Union. This is a legacy of privatization after the end of Communism when those renting government housing were given the opportunity to buy their domiciles at concessionary prices. People who own their homes or apartments are less likely to sell them and attempt to buy a house in a new location. This often keeps them in their current residences even if better opportunities exist elsewhere. Moreover, home prices and rents in Bratislava are much higher than in the rest of the country (though very, very low by Western standards) and vacancy rates are extremely low, it may be infeasible to sell a house in the east and move to Bratislava.

In any country, and especially in a traditional one such as Slovakia, there are family and cultural reasons to stay in one's home city or region. Elder care often falls on the younger (working) generation, which means either moving elderly parents or grandparents to Bratislava (prohibitively expensive) or making do in the East despite the depressed labor market. And many rural Slovaks seem to value their rural lifestyles and local culture: Even if they could make more money (or have a steady job at all) by moving to "the city," they are more comfortable sacrificing some material well-being and remaining in their familiar environment with attachments to family and friends.

Questions

1. The data suggest that unemployment rates in Bratislava were more sensitive to the global downturn in 2008–10 than other regions, why do you think that happened?

2. The United States is a highly mobile society. Yet there are substantial differentials in unemployment rates across states. What are some barriers to mobility of workers and jobs in the U.S. that impede the convergence of unemployment rates? To what extent would you expect them to be larger or smaller than in a country like Slovakia?

3. If the Slovak government asked you for advice about how to reduce unemployment differentials, what would you recommend and why?

Answer the questions on the Moodle site