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November 14, 2005

The Latest Word on High European Unemployment

Olivier Blanchard's latest on European unemployment:

Olivier Blanchard (2005), European Unemployment: The Evolution of Facts and Ideas (Cambridge: NBER Working Paper No. 11750): Abstract: In the 1970s, European unemployment started increasing. It increased further in the 1980s, to reach a plateau in the 1990s. It is still high today, although the average unemployment rate hides a high degree of heterogeneity across countries. The focus of researchers and policy makers was initially on the role of shocks. As unemployment remained high, the focus has progressively shifted to institutions. This paper reviews the interaction of facts and theories, and gives a tentative assessment of what we know and what we still do not know.

6 Do We Know Enough to Give Advice?

At the end of this tour, one may ask whether we know enough to give advice to policy makers about how to reduce unemployment. I believe we do—-with the proper degree of humility. In this last section, I summarize what I think we know and we do not know.

6.1 A General Story Line

Going back over the last thirty years, there is little question that the initial increase in unemployment in Europe was primarily due to adverse and largely common shocks, from oil price increases to the slowdown in productivity growth. There is not much question that different institutions led to di®erent initial outcomes. Whether collective bargaining led to a decrease in the growth of bargained wages, whether inflation could be used to reduce real wage growth, all played a central role in determining the size of the increase in unemployment.... [T]he increase in unemployment led, in most countries, to changes in institutions as most governments tried to limit the increase in unemployment through employment protection, and to reduce the pain of unemployment through more generous unemployment insurance.... [S]ince the early 1980s, because of financial pressure and intellectual arguments, most governments have partly reversed the initial change in institutions. But this reversal has been partial, and sometimes perverse. The different paths chosen may well explain the differences in unemployment rates across European countries today.... The role of shocks and the interaction with collective bargaining emphasized by initial theories, the role of capital accumulation and insider effects emphasized by the theories focusing on persistence, the role of specific institutions clarified by flow-bargaining models, all explain important aspects of the evolution of European unemployment.

6.2 Which Institutions?

It is one thing to say that labor market institutions matter, and another to know exactly which ones and how. Humility is needed here, and there is no better reminder than the comparison between Portugal and Spain. Both experienced revolutions and wage explosions in the 1970s (the Portuguese labor share reached 100% in the mid 1970s...); both have, at least on the surface, rather similar institutions, including high employment protection. Yet, Spanish unemployment has been very high, exceeding 20% in the mid–1990s, whereas Portuguese unemployment has remained low, with a high of 8.6% in the mid–1980s, and a decrease thereafter.... [T]he history of the last thirty years is a series of love affairs with sometimes sad endings, first with Germany and German–like institutions—-until unemployment started increasing there in the 1990s... -—then with the United Kingdom and the Thatcher–Blair reforms, then with Ireland and the Netherlands and the role of national agreements, and now with the Scandinavian countries, especially Denmark, and its concept of “flexisecurity”....

We know much more about the incentive aspects of unemployment insurance on search intensity and unemployment duration, be it the length and time shape of unemployment benefits, or the form of conditionality or training programs.... We know more about the effects of decreasing social contributions on low wages.... We know more about the effects of employment protection, and the effects on the labor market of introducing temporary contracts at the margin while keeping employment protection the same for most workers.... [A] large consensus-—right or wrong—-has emerged: It holds that modern economies need to constantly reallocate resources, including labor, from old to new products, from bad to good firms. At the same time, workers value security and insurance against major adverse professional events, job loss in particular. While there is a trade-of between efficiency and insurance, the experience of the successful European countries suggests it need not be very steep. What is important in essence is to protect workers, not jobs. This means providing unemployment insurance, generous in level, but conditional on the willingness of the unemployed to train for and accept jobs if available. This means employment protection, but in the form of financial costs to firms to make them internalize the social costs of unemployment, including unemployment insurance, rather than through a complex administrative and judicial process. This means dealing with the need to decrease the cost of low skilled labor through lower social contributions paid by firms at the low wage end, and the need to make work attractive to low skill workers through a negative income tax rather than a minimum wage.

These measures are probably all desirable. If they were to be implemented, would they be enough to eliminate the European problem? I see at least two reasons to worry.

6.3 Collective Bargaining and Trust

The first worry is that these reforms deal only with a subset of the institutions that govern the labor market. An early theme of the research on European unemployment was the importance of collective bargaining. And it is a fact that some of the successful countries, the Scandinavian countries in particular, have very different structures of collective bargaining from, say, France or Italy, with much more of an emphasis on national, trilateral, discussions and negotiations between unions, business representatives, and the state.

This raises two questions. First whether countries such as France or Italy need to also modify the structure of collective bargaining. Second whether, even if they did, the results would be the same as in Sweden or Denmark.... [V]arious measures of trust, from strike intensity in the 1960s to survey measures of trust between firms and workers, [can] explain a substantial fraction of differences in unemployment across European countries. Even if these findings reflect causality from lack of trust to unemployment, it is just a start. The question is whether trust can be created....

6.4 Low Inflation, the Natural and the Actual Rate of Unemployment

Since 2000, European unemployment has been associated with roughly constant inflation. This would suggest that the current high unemployment rate reflects a high natural unemployment rate, rather than a large deviation of the actual unemployment rate above the natural rate. This is indeed the assumption which justifies the focus on inflation by the European Central Bank: Maintaining constant inflation is then equivalent to maintaining unemployment close to its natural rate; this natural rate can only be reduced by labor market reforms, and this is not the responsability of the central bank.

One may however question this assumption. Inflation in the EU15 is now running under 2%, and close to 0% in countries such as Germany. At these low inflation rates, it is not implausible that nominal rigidities matter more, that workers for example are reluctant to accept nominal wage cuts—-a hypothesis explored, for example, by Akerlof et al (1996). In such an environment, it may be that an unemployment rate above the natural rate may lead to low rather than declining inflation. Put another way, it may be that, in fact, an expansion of demand might decrease unemployment without leading to steadily higher inflation. The experience of Spain, where unemployment has steadily decreased without major labor market reforms and without an increase in inflation, can be read in this light.

Another, conceptually different, argument for a more expansionary monetary policy, is that institutional reforms encounter less opposition when economies are growing and unemployment is decreasing.... This argument is an old one (Blanchard et al (1985) already argued for such a “two-handed” approach in Europe) but is still relevant today. One issue however is whether, in fact, growth and the decrease in unemployment do not alleviate the political need for reform, and thus delay rather than encourage reforms. The experience of the late 1990s in Europe, where a cyclical expansion often delayed reforms, is not reassuring in that respect. Developing this last point would take us to the political economy of labor market reform, and this should be the topic of another survey.

Posted by DeLong at November 14, 2005 12:38 PM