Prof. Bryan Caplan

Econ 918

Spring, 1998

Week 14: European Unemployment

  1. European Unemployment and Real Rigidities
    1. Eichengreen and Bernanke note that France was an outlier in the Great Depression: even after France adopted expansionary monetary policy in 1936, it seemed unable to reduce unemployment. Rather, workers just forced up nominal wages to match inflation.
    2. Since the '70's, the same sort of condition has become widespread throughout most of Europe. Basic facts:
      1. Visual inspection: While U.S. unemployment rate has ups and downs, European unemployment rises, then plateaus, then rises again - with only one brief recovery.
      2. Total employment increase from 1970-1996: 58% for U.S., 12% for Europe (47 M vs. 18 M; note European population is greater).
      3. Labor force participation: in the U.S., rise from 65% to 75%; in Europe, fall from 65% to 60%.
    3. What explanations can be ruled out?
      1. Oil shocks
      2. Productivity growth decline
      3. Also: Earlier argument about the U-shaped corporativism curve weakened by drastic rise of Scandinavian unemployment from 1990.
    4. Unemployment is permanently high, as in the Great Depression. Supply shocks don't seem important, so the labor market seems to be the right place to look.
    5. Like France after 1936, expansionary policy seems impotent to solve the problem. The natural theoretical framework to turn to understand this is thus not nominal rigidities, but real rigidities.
  2. Theories of Real Rigidity
    1. In one sense, all involuntary unemployment is the same, since it could be eliminated if real wages were lower. But there is an important difference between real wages that can be easily reduced by purely nominal means, and excessive real wages that are independent of nominal factors.
    2. (Note: One problem can surely turn into the other; with even semi-rational expectations, workers will eventually try to compensate for macro-policy if it is habitually used as an indirect channel for real wage reductions).
    3. Real Rigidities, I: Efficiency wages (Katz). While efficiency wage theory - when discussed in the U.S. - is usually associated with paying higher wages to deter shirking or turnover, other interpretations may be more helpful for understanding Europe:
      1. Shirking
      2. Turnover
      3. Adverse selection
      4. Sociological (morale, loyalty, and fairness)
      5. Union threat
      6. Important point: Make sure you understand the difference between compensating differentials and efficiency wages.
    4. Real Rigidities, II: Insider-outsider (Snower and Lindbeck). Whereas efficiency wage theory says that hard-to-monitor employees may reduce their productivity, insider-outsider theory says that hard-to-monitor incumbent employees may reduce the productivity of other, new employees. Key assumptions:
      1. Period-by-period wage decisions (otherwise lifetime contracts would get around the problem).
      2. Outsiders are perfect competitors for jobs.
      3. Insiders have some market power.
      4. Imperfect monitoring of harassment.
      5. Firms unilaterally determine employment.
    5. Results: Insiders often find it in their interest to harass outsiders, so fewer outsiders are hired. (But not always: If the number of outsiders remaining gets too small, the employer might be better off just firing everyone and starting over!)
    6. A simpler approach the probably gives just as much insight: employment and subgame perfection. Ex ante, workers would pre-commit to competitive conditions, but ex post workers have the upper hand. Hard to contract around this (although note the ban on "yellow dog" contracts).
  3. Exacerbating Real Rigidities: European Unemployment Policies
    1. While real rigidity theories have been generally designed to help understand unemployment in less regulated economies, labor market regulation can make the problem a lot worse - and this is probably what has happened in Europe. (See Nickell, Tables 4&5).
    2. High legal minimum wages. (E.g. 34% of median in U.S. vs. 60% in France).
    3. High unemployment/welfare benefits with long durations.
    4. Firing/layoff regulations.
    5. Mandatory benefits (vacation, sick leave, maternity leave, etc.) (How does the interaction between mandatory benefits and nominal and real rigidity work?)
    6. High unionization rates with strong legal support for unions. (Note: In some countries like France, non-union workers still have their wages determined by union negotiations.)
  4. Arguments Against the Obvious Explanation
    1. Most of the interventions existed for at least a decade before they had any observable impact. During the '70's European unemployment was lower than that in the U.S. Running panel data regressions with time dummies would probably show little impact of labor market policies.
    2. Need to account for pre-existing labor market differences. The standard way to do this is to try correlate changes in policy with changes in unemployment. If you do this with panel data, it is known as "differences-in-differences" estimation, and it too tends to show little impact. Or you could just do panel data regressions with country dummies; the high-unemployment countries with have large positive country dummies, but would not be too likely to show a big impact of regulation/labor market rigidity.
    3. Arguments from Nickell:
      1. Looking at decomposed European countries unemployment rates changes the picture: often the more rigid countries have lower unemployment.
      2. Need to control for demographics, cultural factors, etc.
      3. High replacement rate not a problem so long as the duration of benefits is reasonable.
      4. Unionization not a problem so long as it is offset by coordination between employers and unions.
      5. High taxation combined with high minimum wages is a problem, but strict employment legislation is not.
    4. Rebuttals:
      1. Explanation for delayed effect: unemployment caused by interaction between productivity/supply shocks and labor market rigidities. Makes use of time dummies inappropriate.
      2. Also: much of the impact may be long-term. Developed human capital will be used, but the incentive to develop new human capital falls. Same goes for "cultural capital" like the work ethic. Makes use of country dummies at least suspect.
      3. Scandinavian and UK outliers have disappeared.
      4. Others?
  5. Topics
    1. European unemployment vs. the Great Depression: the danger of over-stating the importance of nominal factors - and the ease of nominal solutions.
    2. Can any case for monetary or RBC theories be made?
    3. Others?