From the end of World War II to the end of the 1960s, European unemployment was
very low. In the 1970s, it started increasing. It continued to increase in the 1980s, to
reach a high plateau in the 1990s. It is still high today, although the average European
unemployment rate hides a high degree of heterogeneity across countries.
This has been a tough learning experience, both for economists and for policy
makers. When the 1970s started, the concept of a natural rate of unemployment was
just born, and still far from operational. The following quote from Milton Friedman
(1968) is revealing:
The natural rate of unemployment is the level which would be ground out by the
Walrasian system of general equilibrium equations, provided that there is imbedded
in them the actual structural characteristics of the labor and commodity markets,
I thank Charlie Bean, Ricardo Caballero, Emmanuel Farhi, Wolfgang Münchau, Thomas Philippon, Steve Nickell, Julio
Rotemberg, Thomas Sargent, and Robert Solow for comments. I also thank the Russell Sage Foundation for financial support,
the OECD and Luca Nunziata for data.
Giuseppe Bertola was the Managing Editor in charge of this paper, which was commissioned to convey the author’s own
experience and views and not subjected to the journal’s complete editorial review process.
8 OLIVIER BLANCHARD
including market imperfections, stochastic variability in demands and supplies,
the cost of gathering information about job vacancies and labor availabilities, the
costs of mobility, and so on.
One might have hoped that, with 30 years of data, with clear differences in the
evolution of unemployment rates and policies across countries, we would now have
an operational theory of unemployment. I do not think that we do. Many theories
have come and – partly – gone. Each has added a layer to our knowledge, but our
knowledge remains very incomplete. To use a well worn formula, we have learned a
lot, but we still have a lot to learn.
The purpose of this paper is to review the developments, both on the unemployment and the theory fronts, and give an assessment of where we are today. Let me
begin with two caveats. I have not tried to be encyclopedic.1 And, because the editors
unwisely encouraged me to do so, I have certainly focused too much on my own
research – one of the results being a Stiglitz-like bibliography. For my defence, I
would argue that it is broadly representative of the twists and turns of our theories
over the last 30 years.
I review the basic facts, across time and across countries, in Section 2. As unemployment increased in the 1970s, the initial focus was on the role of shocks, from oil
price increases to the slowdown in productivity growth. This is the topic of Section
3. As the shocks receded but unemployment remained high, the focus shifted in the
1980s to persistence mechanisms, from the role of capital accumulation, to the role
of insiders in bargaining. This is the topic of Section 4. In the early 1990s, the focus
shifted yet again, this time towards the role of labor market institutions, from employment protection to unemployment insurance. This is the topic of Section 5. Since
then, research has tried to sort out the respective role of shocks, institutions, and
interactions. The main directions of exploration and the open questions are the topic
of Section 6. The state of play, and whether we know enough to usefully guide policy
and reforms, are taken up in Section 7.
2. BASIC FACTS
Figure 1 gives the evolution of the unemployment rate for the EU15 as a whole (the
15 member countries of the European Union) since 1960. It shows the steady
increase in unemployment from 2% in the 1960s to 8% in the 1980s, and a rough
plateau – with cyclical declines at the end of the 1980s and 1990s – since then.
How much of the increase reflects an increase in the natural rate, and how much
reflects an increase of the actual rate over the natural rate? The answer to that
1 A more encyclopedic and very good survey, but now 10 years old, was given by Charles Bean (1994). A more recent one was
given by Stephen Nickell (1997). The standard reference on unemployment in general, and European unemployment in
particular, remains the book by Richard Layard, Stephen Nickell, and Richard Jackman, published in 1991 (2nd edition, 2005).
Another important contribution is the 1994 book by Ned Phelps.
EUROPEAN UNEMPLOYMENT 9
question is relatively straightforward: since 2000, EU15 inflation has been indeed
roughly constant – around 2% using the CPI index. If we take a stable inflation rate
to be an indication that unemployment is roughly at the natural rate, this suggests
that, today, the EU15 actual unemployment rate is close to the natural rate.2 It
follows that the increase in the actual unemployment rate since 1970 reflects, for the
most part, an increase in the natural rate.
Can one tell how the natural rate has increased over time? The answer to that
question is obviously much harder. Despite its limits, I find the following exercise to
be useful: if we are willing to assume that, when unemployment is below the natural
rate, inflation will tend to increase, and when unemployment is above the natural
rate, inflation will tend to decrease, we can construct a series for the natural rate using
the actual rate and the change in inflation. The results of such a construction are
presented in Figure 2.3 They suggest that the natural rate increased in the 1970s and
early 1980s, and has remained roughly stable since then.
2.1. Heterogeneity across countries
Turning from the EU15 average to individual countries, Figure 3 gives the unemployment rates in each of the EU15 countries as of May 2005 (for reference, the evolution
of unemployment rates in each EU15 country is shown in the appendix).
2 One may question, however, whether this relation holds at very low rates of inflation; I return to the issue in the last section
of the paper.
3 The series for the natural rate is constructed as follows: Start from the relation π = π(−1) – a(u – u*) where π is the rate of
inflation, u and u* are the actual and natural rates of unemployment respectively. Rewrite the relation as u* = u + (1/a) ∆π. The
series for u* in Figure 2 is constructed using this relation, using a = 0.5 (a value consistent with econometric estimates for Europe)
and a three-year moving average of the change in CPI inflation for ∆π. (A different value for a would change the amplitude of
the movements in u* relative to u, but not the ordering of the two rates in a given year.)
Figure 1. EU15 unemployment rate, since 1960
Source: OECD database.
10 OLIVIER BLANCHARD
The figure shows the large heterogeneity of unemployment rates across countries.
While this heterogeneity has always been present, it is more marked today, to the point
where talking about ‘European unemployment’ is indeed misleading. Unemployment
is low in many countries: as of mid-2005, the United Kingdom, the Netherlands, Denmark,
Ireland and Austria all have unemployment rates lower than the United States. And
high average European unemployment reflects high unemployment in the four large
continental countries, Germany, France, Italy and Spain. Even among these four countries,
Figure 2. EU15 actual and constructed natural rate
Source: OECD database and see text.
Figure 3. EU15 unemployment rates, 2005
Source: Eurostat.
EUROPEAN UNEMPLOYMENT 11
the differences are striking. Spain’s unemployment rate is down from more than 20% in
the early 1990s.4
Germany’s unemployment rate is instead up from its low pre-reunification
level, and shows sharp regional differences between the West and the East. Italy’s and
France’s unemployment rates have been high since the early 1980s. But Italy’s rate
shows sharp regional differences between the north and the south. France’s does not.
2.2. Unemployment, flows and duration
As a matter of arithmetic, a high unemployment rate may be the result of high flows
in and out of unemployment, or/and a high average duration of unemployment.
Figure 4, which gives the evolution of the unemployment rate and unemployment
duration in France (for which data on the composition of unemployment by duration
exists from 1968 onwards) shows that the increase in the unemployment rate has
come with a large increase in duration. The figure suggests that duration, which was
already higher than that of the United States in the late 1960s, has more than
doubled since then, and now stands at well over a year.5 The proportion of long-term
unemployed (unemployed for more than a year) has increased from 20% in the late
1960s, to more than 40% today. From the point of view of the unemployed, being
unemployed in Europe has always been a different experience from being unemployed in the United States – where mean duration has remained around 3 months
– and has become increasingly so over time.
4 In 1994, the official number for the unemployment rate reached 24%. The definition of unemployment and the numbers have
since been revised, and the current time series have unemployment peaking at 18.4% in 1994.
5 The increase in duration would be even larger, were it not for the increasing role of temporary contracts since the early 1980s,
contracts which are typically associated with shorter ensuing unemployment spells.
Figure 4. Unemployment rate and duration in France
Source: Enquètes Emploi, INSEE, series longues; with adjustment by author for 1968 to 1974.
12 OLIVIER BLANCHARD
2.3. Unemployment rates across workers
Another dimension of unemployment is how it affects different groups, skilled versus
unskilled workers, young versus older workers, men versus women. One often-mentioned characteristic of European unemployment is how high the unemployment rate
is among young workers. This is shown in Figure 5, which plots the unemployment
rate for the 15–24 age group against the overall unemployment rate for each EU15
country for the year 2004. Some countries, such as Italy and Greece, indeed have
very high youth unemployment rates, in excess of 25%. Whether this reflects a
uniquely European pathology is less clear, however. In all countries, high unemployment is associated with higher unemployment for some groups, the young and the
unskilled in particular. To see whether the experience of Europe is unusual in this
respect, I also plot in Figure 5 the corresponding numbers for the United States for
each year since 1960 – each year represented by a small dot. Put simply, the points
for the cross section of European countries are not far off the regression line one
would obtain from US time series. Italy and Greece indeed have much more youth
unemployment than the regression line would predict, Germany much less (because
of its apprenticeship programmes); on average, the experience of the EU15 does not
appear that unusual.6
6 Bertola et al. (2005) provide a detailed description of the patterns of unemployment and employment rates for different age
groups across time and OECD countries. They conclude that decreases in the employment rates of younger (15–24) and older
(55+) have typically been stronger in more unionized countries.
Figure 5. Youth unemployment rate (%): across EU15 countries and across time
for the US
Source: OECD database.
EUROPEAN UNEMPLOYMENT 13
2.4. Unemployment versus other labour market indicators
Yet another question is whether the unemployment rate is in fact a good indicator of
the general state of the labour market. Faced with poor employment prospects, people
may decide not to join the labour force, students may decide to stay longer at the
university; these decisions will show up as lower participation rates, not as higher
unemployment rates. Governments may also want to reduce unemployment numbers; and indeed many governments have. Measures have ranged from training
programmes, real or perfunctory, to generous disability programmes (the example of
the Netherlands being the best known), to subsidized early retirement programmes
(which have played an important role in France since the mid 1980s).
There is thus little question that a complete examination of the labour market
requires looking not only at unemployment rates, but also at participation and
employment rates.7 But it is still the case that, in the case of European unemployment, focusing on the unemployment rate is not misleading. This is because, in
general, depressed labour markets have shown not only higher unemployment, but
also lower participation and employment rates. To take one example, the participation rate of men, aged 55 to 59, in France, went from 85% in the late 1960s to below
70% in the mid 1980s, reflecting subsidized early retirement, precisely at the time
when unemployment was increasing.
Figures 6 and 7 provide more time series and cross-section evidence on this point.
Figure 6 shows the evolution of the unemployment and participation rates for Spain
since 1960. It shows how the large increase in unemployment was associated with a
decrease in participation, and how the more recent decrease has been associated in
turn with a large increase in participation. Figure 7 plots the employment rate against
the unemployment rate across EU15 countries for men for the year 2003, and shows
a strong negative correlation between the two.8
Having laid the basic facts, I now look at the history more closely.
3. THE INITIAL RISE IN UNEMPLOYMENT: THE ROLE OF SHOCKS
Along a balanced growth path, the wage consistent with stable employment must
grow at the rate of Harrod-neutral technological progress.9 In addition, if the prices
of the other factors of production increase, the wage must decrease so as to maintain
zero net profit for firms. Call this wage the ‘warranted wage’. Call the wage set in
bargaining the ‘bargained wage’. If, for given labour market conditions, the bargained
7 The participation rate is defined as the ratio of the sum of the employed and unemployed to the population of working age.
The employment rate is defined as the ratio of employment to the population of working age.
8 The reason for focusing on men in the figure is that cross-country variations in the participation rates of women reflect in part
cultural differences. A low participation rate of women is not, per se, an indication of a badly functioning labour market.
9 Much of our intuition and most of our models are based on the assumption that technological progress is Harrod-neutral and
that there is a balanced growth path. What happens if not is largely unexplored, but may well be relevant.
14 OLIVIER BLANCHARD
wage grows faster than the warranted wage, equilibrium employment will decline,
and the natural rate of unemployment will increase.
This proposition is the key to understanding what happened to unemployment in
the 1970s. European countries were hit by a series of adverse shocks, shocks which
implied a slowdown in the rate of growth of the warranted wage:
Just like the rest of the world, European countries were hit by two major oil price
increases, the first one triggered by the Arab oil embargo of 1973–74, the second by
the Iranian revolution in 1979 and the Iran–Iraq war of 1980. Figure 8 gives the price
Figure 6. Unemployment and participation rate in Spain
Source: OECD database.
Figure 7. Unemployment and employment rates of men: 2003, EU15 countries
Source: OECD database.
EUROPEAN UNEMPLOYMENT 15
of oil, in dollars and in real (US) terms, since 1960. It shows that, by the early 1980s, the
real price of oil, in dollars, stood at nearly four times its level at the start of the 1970s.
Another shock, less visible initially but eventually more important, both in terms
of its impact on growth and on unemployment, was also at work. Total factor productivity (TFP) growth, which had been high in the 1950s and 1960s, slowed down
considerably. By the late 1970s, the rate of Harrod-neutral technological progress
(constructed using the Solow residual, and dividing it by the labour share), which had
run at more than 5% in the 1950s and 1960s, was down to 2%. In other words, the
annual rate of growth of warranted wages had decreased by three percentage points,
a dramatic decline. Figure 9 gives five-year averages of estimates for the five major
EU countries (Germany, France, Spain, Italy, and the UK) – the EU5 for short. It
shows that the decline was largely similar across countries.10
These two shocks would have required slowdowns in the rate of growth of actual
wages to avoid an increase in unemployment. In fact, both came after a period of
labour unrest in many European countries – May 1968 in France, Spring 1969 in
Italy, the end of dictatorships in Portugal and Spain in 1974 and 1975 – in which
workers had asked for increases in wages. Not surprisingly, the joint outcome of lower
growth of warranted wages and higher wage demands was an increase in unemployment. By the end of the 1970s, unemployment for the EU15 had increased to 5%,
up from 2% at the start of the decade; Spain’s unemployment rate exceeded 10%,
France’s and Italy’s exceeded 6%.
The development of a conceptual frame, and the econometric fleshing out of this
story, were largely the work of Michael Bruno and Jeffrey Sachs, who put it together
10 For a tentative explanation, see Temin (2002).
Figure 8. Nominal and real price of crude oil: 2005 dollars
Source: US Department of Energy.
16 OLIVIER BLANCHARD
in a series of articles and then in a book in 1985.11 Their book can be seen as a first
attempt to put together a working theory of movements in the natural rate. They
argued that the rise in unemployment could be explained by shocks interacting with
two types of rigidities, real and nominal (Box 1 gives the basic algebra):
• ‘Real wage rigidities’ captured the speed at which real wages adjusted to changes
in warranted real wages, the speed at which, for given unemployment, workers
would for example accept a slowdown in actual wages in response to a productivity slowdown. The slower the adjustment, the higher and the longer lasting the
effects of adverse shocks on unemployment.
• ‘Nominal wage rigidities’ captured the speed at which nominal wages adjusted to
changes in prices. The slower the adjustment, the larger the decrease in the real
wage in response to an unanticipated increase in prices. And by implication, the
slower the adjustment, the more the monetary authorities could use inflation to
reduce real wages and therefore limit the increase in actual unemployment in
response to an adverse supply shock.
Differences in real and nominal rigidities could explain why, despite largely similar
shocks, different countries experienced different increases in unemployment. A
smaller increase in unemployment could be due to smaller real rigidities, resulting in
a smaller increase in the natural rate; or it could be due to larger nominal rigidities,
allowing policy makers to achieve, through the use of inflation, an unemployment
rate below the natural rate; or it could be due to a more aggressive use of monetary
policy, leading to higher inflation and an unemployment rate below the natural rate.
11 Other researchers share the credit, among them Gordon (1975), Modigliani and Padoa-Schioppa (1977), and Branson and
Rotemberg (1980).
Figure 9. Rate of Harrod-neutral technological progress, EU5: Centred
five-year averages, 1968 onwards
Source: Blanchard and Wolfers (2000) database.
EUROPEAN UNEMPLOYMENT 17
Box 1. Real and nominal rigidities
The purpose of this and the following boxes is to formalize some of the arguments
in the text. I have made the choice of presenting simple, related, but ad-hoc
models. References to explicitly micro-founded models – which are needed if
one wants to derive optimal policy – are given when available.
This box shows the role of real and nominal rigidities in shaping the effects
of adverse shocks to warranted wages on unemployment.
Consider firms with constant returns to labour (we leave aside capital for
the time being), so, using logs:
y = a + n
where y is log output, n is log employment, and a is log productivity (either
TFP or labour productivity; the two are the same here). Assuming either
competition in the goods market or a constant markup, the wage paid by firms,
the warranted real wage, is given by:
w − p = a
where w is the log nominal wage, and p is the price level (constant terms
are left out throughout for notational simplicity). Assume further that a
follows:
a = a(−1) + ε
so we can focus on the effects of a negative realization of ε, a decrease in
productivity.
Assume the bargained wage is given by:
w − p = Ea − βu
The bargained wage depends on expected productivity Ea and is a decreasing
function of the unemployment rate u. Assume that expected productivity
adjusts over time to actual productivity according to:
Ea = λEa(−1) + (1 − λ)a
I take the speed of adjustment of expected to actual productivity, (1 − λ) as
given here. In more explicit models, the λ like parameter has been derived
from learning in a Bayesian environment in which firms and workers have to
assess whether shocks are temporary or permanent, or from staggering of wage
decisions (à la Taylor, 1980, or Calvo, 1983), or both.
Combining the equations for the warranted and the bargained wage gives:
u a Ea =− − ( ) 1
β
18 OLIVIER BLANCHARD
An unexpected decrease in productivity leads to an increase in unemployment.
Combining the equation for expected productivity with the equation above
gives the behaviour of the natural rate of unemployment:
A permanent decrease in productivity increases equilibrium unemployment
(equivalently, the natural rate of unemployment) for some time, but not forever.
λ and β capture the two dimensions of real rigidities. The higher λ, i.e. the
slower the adjustment of expectations, the longer lasting the effects of the shock.
The lower β, the larger the effect of the adverse shock on unemployment.
Now introduce nominal rigidities. To do so, replace the equation for the
bargained wage by:
w = Ep + Ea − βu
The nominal wage is set on the basis both of the expected price level and
expected productivity. Combining the equations for the warranted and the
bargained wage gives:
(Ignoring the unexpected productivity term and moving terms around gives
the conventional expectational Phillips curve, p = Ep − βu). The central implication of this equation is that, in the presence of nominal rigidities, monetary
policy can, to the extent that it can increase p − Ep, potentially offset the
adverse effects of adverse productivity shocks. Put another way, expansionary
monetary policy can offset the increase in the natural rate by maintaining the
actual rate below the natural rate. The precise form of monetary policy
required to do so depends on the formation of price expectations and the rest
of the model; it is not essential to the argument made here.
In short, this box has shown how, in general, the response of unemployment
to adverse supply shocks will depend on real and nominal rigidities. (An
explicitly micro-founded treatment of these issues is given in Blanchard and
Galì, 2005.)
Where did these differences in real and nominal rigidities themselves come from?
Differences in real rigidities were naturally traced to differences in the structure of
collective bargaining. Sweden, with an unemployment rate of 2.2% at the end of
the decade, was seen as a poster child for the case for corporatism, i.e. centralized
bargaining and strong unions. An important contribution here was that of Calmfors
u u = −− λ ( ) λ
β
1 ε
u a Ea =− − + − [( ) ( )] p Ep 1
β
EUROPEAN UNEMPLOYMENT 19
and Driffill (1988), who argued, both theoretically and empirically, that, in the face
of adverse supply shocks, countries with either very centralized bargaining or very
decentralized bargaining would fare better than those with intermediate bargaining
structures. With centralized bargaining in particular, the parties at the bargaining
table could see the need for and implement the wage adjustment required to maintain
employment.
Differences in nominal rigidities were also traced to collective bargaining, albeit
to different aspects of it. The degree of indexation, present in many European
countries, played a central role. High indexation in effect prevented the use of monetary policy to limit the increase in unemployment, or required a very high rate of
inflation.
Overall, this initial strand of research must be seen as a major achievement.
Macroeconomists had entered the 1970s without a model of the natural rate, and had
not anticipated stagflation. By the end of the decade, there was a working model of the
natural rate, and stagflation was well understood. And the increase in unemployment
was explained by adverse shocks interacting with country-specific collective bargaining
structures.
4. CONTINUING UNEMPLOYMENT: SOURCES OF PERSISTENCE
Unemployment continued to increase throughout the 1980s, from 5% for the EU15
in 1980, to 8% at the end of the decade, with a peak of 9.5% in 1986.
The further increase in the first half of the 1980s was still easy to explain. Partly
accommodating monetary policy in response to the adverse shocks of the 1970s had
led to a large increase in inflation: in 1980, EU15 inflation was 12.5%. Throughout
Europe, governments and central banks decided to reduce inflation through tight
monetary policy, starting with Mrs Thatcher in the UK in 1979. By 1986, the EU15
inflation rate was down to 3%. This was achieved, however, through a large increase
in the unemployment rate – reflecting an increase in the actual rate of unemployment
over the natural rate.
For the rest of the decade, however, inflation was roughly stable, an indication that
the actual unemployment rate was now close to the natural unemployment rate –
around 8–9% for the EU15. This high natural rate was more difficult to explain: as
can be seen from Figure 8 earlier, by the mid-1980s, the sharp increases in oil prices
had been largely reversed. The decline in productivity growth was still very much
present, and now well understood and documented. But it appeared increasingly
unlikely, more than ten years after the decline, that wage setters would not have
adjusted to the new reality of lower productivity growth.
This led researchers to focus on persistence mechanisms, on why the initial adverse
shocks might have very long lasting effects on unemployment. Research focused
mainly on two mechanisms, capital accumulation, and the role of insiders in collective bargaining. (See Box 2 for a more formal treatment.)
20 OLIVIER BLANCHARD
Box 2. Persistence mechanisms
The first persistence mechanism focuses on capital accumulation and its implications for the warranted wage. The second focuses on collective bargaining
and its implications for the bargained wage.
Capital accumulation, and the two effects of monetary policy
Assume that, instead of the assumption of constant returns to labour we made
in the previous box, the production function is Cobb–Douglas in capital and
labour, and constant returns to scale:
y = α(a + n) + (1 − α)k
where k is the log of the capital stock, and a is the index of Harrod neutral
technology (technology for short). Assuming perfect competition in the goods
market or a constant markup, the warranted real wage is given by (up to a
constant term that I ignore):
w − p = (α − 1)(n − k + a) + a
For a given capital stock, the higher is employment, the lower is the marginal
product of labour, the lower is the warranted real wage.
The profit rate associated with a given real wage is given by the factor price
frontier relation (up to a constant term, again ignored)
where π is the log of the profit rate.
Let r be the log of the user cost of capital. If π is less than r, k decreases
over time. If π is greater than r, k grows over time. In the long run, the
profit rate must be equal to the user cost, so the warranted real wage is given
by:
Assume the bargained wage is given, as in Box 1, by:
w − Ep = Ea − βu
Let n be the log of the labour force, so u ≈ n − n. Then, using the equation for
the warranted real wage in the short run and the equation for the bargained
wage gives:
p + (α − 1)(n − k + a) − (α − 1)u = Ep + Ea − βu
π
α
α = − ( ) − − − 1 wpa
wpa r −=+
1 − α
α
EUROPEAN UNEMPLOYMENT 21
Or, reorganizing:
In the short run, unemployment depends, as in the previous box, on a − Ea,
and p − Ep. But it also depends on the capital stock. The lower the capital
stock, the lower the demand for labour, the higher the unemployment rate.
Now consider a permanent decrease in productivity, leading, initially, to a
negative a − Ea. For the time being, ignore nominal rigidities and the term p
− Ep. Other things equal, unemployment will initially go up, and then come
down as expectations of productivity adjust to the new lower level. This is what
we saw in the previous box. But, now, another mechanism is at work. So long
as employment is lower, so is profit, and so is capital accumulation. Thus,
unemployment returns to normal, but this may take a long time.
In the context of this model, it is worth returning to the role of monetary
policy. First, and as before, expansionary monetary policy, to the extent it can
affect p − Ep, can reduce real wages and limit the increase in unemployment,
by having actual unemployment remain below the natural rate. Second, to the
extent that it also reduces the real interest rate and therefore the user cost, it
can also reduce the effect on capital accumulation, and thus reduce the
increase in the natural rate over time. What happened in the second half of
the 1970s can be interpreted in this light. Had monetary policy been tighter,
unemployment would have been higher, and the decrease in capital accumulation larger.
If, however, monetary policy turns contractionary, then both effects work in
reverse. Tight money leads to an increase in the unemployment rate over the
natural rate. And high real interest rates lead to a decrease in capital accumulation, and to an increase in the natural rate. This can be seen as what happened during the disinflationary episodes of the early 1980s.
Insider effects, hysteresis, and persistence
Assume that technology, and so the warranted wage, are the same as above.
The real wage paid by firms – equivalently the relation between employment
and the real wage – is given by:
w − p = (α − 1)(n − k + a) + a = (α − 1)(n − k) + αa
To focus on the dynamics of collective bargaining, we turn off the other source
of persistence, and assume the capital stock is fixed.
Turn to wage setting. Think of wages as being set by a monopoly union that
chooses the wage, and then lets the firm decide about employment.
Suppose the nominal wage is chosen so that, in expected value, the
membership of the union is employed:
u a Ea p E p ka = − [( ) ( ) ( )( )] − +
− + − + − −+
1
1
1
α β α n
22 OLIVIER BLANCHARD
w | En = m
where m is log membership. Suppose that membership is given by:
m = n(−1) + θ(n − n(−1))
If θ = 0, then membership is just equal to employment last period: the union
cares only about the employed. If 1 > θ > 0, the union puts some weight on
employment of the unemployed, but less than on the employment of those
already employed.
Assume that the union chooses the nominal wage, based on the warranted
wage relation above, and based on expectations of both technology and the
price level, so
w = Ep + (α − 1)(n(−1) + θ(n − n(−1) − k)) + αEa
Combining the equations for the warranted and the bargained wage, and
reorganizing, using u = n − n(−1), gives:
Unemployment adjusts over time to unexpected movements in prices and
technology. The lower θ – the lower the weight of unemployment in bargaining
– the higher the persistence. The initial Blanchard–Summers (1986) formulation
assumed θ equal to zero. Under that assumption, the process for the unemployment rate has a unit root: the unemployment rate does not return to any
particular value, and where it is depends on the history of surprises to both the
price level and technology. It exhibits hysteresis.
As many pointed out, however, the assumption that θ is equal to zero is too
strong. Even if the union does not care about the unemployed, they care what
could happen to their members if there were adverse shocks and some members
became unemployed. The higher the unemployment rate, the more careful
they will be in their wage demands. Also, unions rarely set the wage unilaterally;
to the extent that there is bargaining, firms can threaten to hire the unemployed. The higher the unemployment rate, the stronger the threat. All these
factors imply a positive value of θ, and thus persistence rather than hysteresis.
Capital accumulation was already one of the themes of Bruno and Sachs. It was the
focus of a major project later on, directed by Bean and Dréze (1991). The basic logic
was straightforward: if, in response to a slowdown in productivity growth or an
increase in the price of non-labour inputs, bargained wages did not adjust fast
enough, employment decreased. If employment decreased, so did the profit rate. And
as long as the profit rate was below the user cost, capital decreased over time, leading
u u p Ep a Ea ( )( ) = − −− [( ) ( )] − 1 1 −+−
1
1
θ
α
α
EUROPEAN UNEMPLOYMENT 23
to a further decrease in employment. The dynamics of capital accumulation could
therefore lead to a long and deep increase in unemployment.12
This had interesting and highly relevant implications for monetary policy. In that
context, expansionary monetary policy potentially played two roles. The first was, as
before, to decrease real wages and limit the decrease in employment for a given
capital stock. The second was to decrease the real interest rate, and by implication
the user cost; by doing so it limited the decrease in capital accumulation, and so the
further decrease in employment over time. Both channels had clearly been at work
in the second half of the 1970s. Inflation steadily increased; ex-post real interest rates
were negative, and – using forecasts of inflation at the time – so were ex-ante real
interest rates in most European countries (Blanchard and Summers, 1984).
By symmetry, a monetary contraction, such as that engineered by most central
banks in the early 1980s, also had two effects. The first one was to increase real
wages, and thus decrease employment given the capital stock. The second was to
increase the real interest rate, and thus decrease capital accumulation, and by implication, further decrease employment. Again, both channels were clearly at work in
the first half of the 1980s. Inflation was sharply lower, and real interest rates were
much higher than they had been earlier.
In short, the delayed reaction of monetary policy, first accommodating and later
contractionary, could explain why the effects of the initial shocks were in effect
delayed. Under this interpretation, with a more neutral monetary policy, the increase
in unemployment would have been higher initially, but shorter in duration.
An interesting twist to the theory was suggested by Hellwig and Neumann (1987) in
their study of Germany. If bargained wages were set by looking at labour productivity
growth rather than at the underlying rate of technological progress, then a vicious
cycle could easily emerge. Suppose workers asked for too high wages. Firms would
respond by reducing employment, thereby increasing the capital-labour ratio, and
thus increasing labour productivity – relative to the underlying rate of technological
progress. This might trigger further wage demands, further decreases in employment,
further increases in labour productivity, and so on, leading to a potentially very large
increase in unemployment.
The second line of research focused on collective bargaining. It was based on the idea
that wage bargaining typically takes place between employed workers (or, more
specifically, their union representatives) and firms, and that the unemployed are not
represented at the bargaining table. This ‘insider-outsider’ theory was developed by
Lindbeck and Snower (as summarized for example in their 1989 book), and applied
to unemployment, first by Gregory (1986), then by Blanchard and Summers (1986)
and by Gottfries and Horn (1987).
12 The focus here is on the effect on the increase in the natural rate. The decrease in investment demand could well lead to an
even larger increase in the actual unemployment rate.
24 OLIVIER BLANCHARD
The basic idea was straightforward. Suppose that unions set the wage subject to
the firms’ demand for labour. And suppose that unions cared only about the employment prospects of the currently employed. Then, they might set the wage so that, in
expected value, employment remained the same. Because of unexpected shocks,
employment would be sometimes smaller and sometimes larger than expected. In
other words, employment would follow a random walk, and for a given labour force,
so would unemployment. There would no longer be a natural rate of unemployment
to which the economy would return; unemployment would exhibit ‘hysteresis’, not
returning to any particular value, but being determined instead by the whole history
of shocks to the economy.
This extreme form of the theory was provocative, and rightly criticized as being
too strong. Empirically, it implied that movements in the labour force would not be
reflected in employment; but a strongly established fact is that, even in economies
with high unemployment, exogenous movements in the labour force – due to demography or repatriation, such as the return of European nationals after the independence of former colonies (for example Hunt, 1992) – translate fairly quickly into
movements in employment. Empirically also, why would hysteresis be relevant for
Europe from the 1970s on, but not elsewhere and at other times?
Theoretically, even if the unemployed do not participate in bargaining, there are
at least two reasons to think unemployment will affect the outcome. The first is that,
given the positive probability of finding themselves unemployed, employed workers
should and will care about the state of the labour market: the higher the unemployment rate, the more careful they will be in setting the wage. The second is that wages
are not set unilaterally by unions, but rather by bargaining between unions and firms.
And firms can threaten to hire the unemployed; the higher the unemployment rate,
the more relevant the threat.
These criticisms suggested that the central role of employed workers in bargaining
implied persistence of unemployment in response to adverse shocks, but typically not
hysteresis. The effect of unemployment on wages might be weak, but was not zero;
even if the unemployed were not present at the bargaining table, high unemployment
still led the economy to return to the natural rate, albeit slowly.
An important extension to this line of argument was provided by Layard and
Nickell (1987), focusing on the effects of high unemployment on human capital –
following an argument first developed by Phelps in 1972. They pointed out that, in
European countries, high unemployment typically implied very high average unemployment duration (recall Figure 4). Such high duration was likely to lead to loss of
skills, loss of morale, and thus make many of the long-term unemployed in effect
unemployable. In that case, the higher the unemployment rate, the higher the duration, the higher the loss of skills, the lower the pressure on wages from a given
unemployment rate. Separating the unemployment rate between short-term unemployment (the ratio of those unemployed less than a year to the labour force) and
long-term unemployment (the ratio of those unemployed for more than a year to the
EUROPEAN UNEMPLOYMENT 25
labour force), Layard and Nickell indeed showed that, in Phillips curve type relations,
what seemed to matter was short-term unemployment, not long-term. This provided
a potential explanation for why persistence was higher in Europe than, say, in the
United States (where the proportion of long-term unemployed was and is very low).
Overall, these developments again represented progress. The focus on the joint
movement on employment and capital, on the role of monetary policy through real
wages and the real interest rate, on the implications of collective bargaining, were
important extensions of the initial framework. They also made clear a number of
holes, theoretical and empirical, in our understanding of wage determination. Were
wages in collective bargaining set with an eye to TFP growth (more specifically, the
rate of Harrod-neutral technological progress) or labour productivity growth? As we
saw earlier, the answer makes a lot of difference to the dynamic effects of capital
accumulation on unemployment for example. Looking at bargaining more closely,
how did unemployment affect wage bargaining? How did employment protection,
which clearly affects the probability that employed workers will find themselves
unemployed, affect the outcome? This takes us to the next stage, the shift in focus
towards labour market institutions.
5. STUBBORNLY HIGH UNEMPLOYMENT: THE ROLE OF INSTITUTIONS
In the 1990s, average European unemployment remained very high, peaking at
10.4% for the EU15 average in 1993, and ending at 7.6% in 2000 (a cyclical peak;
the unemployment rate stands at 8.6% in mid-2005.) But this average reflected an
increasing heterogeneity of evolutions across countries:
• Unemployment remained high in France, Spain and Italy. Germany’s unemployment rate, which had remained relatively low until the early 1990s, steadily
increased after reunification; it now stands (mid 2005) at about 10% (8.5% in
Western Germany, twice as much in Eastern Germany).
• Unemployment decreased to under 5% in the UK, Ireland and the Netherlands,
all from high levels in the early 1990s. (Belgium, with an unemployment rate of
8%, is an interesting case; the unemployment rate in the Flemish provinces –
those close to the Netherlands – is 5%, while the unemployment rate in the
Wallon provinces – those close to France – is 11.0%.)
• Unemployment remained relatively low in Austria, Norway and Portugal. And,
while it went up sharply in Sweden, Denmark and Finland, the behaviour of
inflation suggests that this was mostly a cyclical movement – an increase in the
actual unemployment rate over the natural rate – and unemployment sharply
declined thereafter; of the three countries, only Finland still has high unemployment.
With these evolutions, a clear shift in focus took place, both among policy makers
and among researchers, for two reasons. First, continuing high unemployment in
the major continental countries made the earlier explanations, based on adverse
26 OLIVIER BLANCHARD
shocks and persistence, increasingly implausible: could shocks in the 1970s and the
1980s still have such strong effects in the 1990s and 2000s? And second, given
the continued large commonality of shocks, the differences in unemployment rates
across countries pointed to differences in institutions as central to any explanation of
unemployment.
The most dramatic evidence of this shift in focus was the 1994 OECD ‘Jobs
Study’.13 Ill-adapted labour market institutions, the OECD report argued, were the
source of high unemployment. And the report went on to advocate reforms, from
the design of unemployment insurance and employment protection, to a reduction of the
tax wedge and the minimum wage, to better training and active labour market policy
programmes. The report was – and its general line still is – extremely influential. The
notion that ‘labour market rigidities’ are at the core of European unemployment has
gained wide acceptance among policy makers.
In parallel, on the academic research side, the shift in focus towards institutions
was made easier by the emergence of a new and richer framework to think about
unemployment, a framework based on flows, matching and bargaining. For some
time already, Christopher Pissarides, building on earlier work by Peter Diamond
on search and bargaining (1982), had explored models of the labour market
which explained unemployment in the labour market as a result of a process of
creation and destruction, large flows of workers in the labour market, and a complex
matching and bargaining process between firms and workers (for example, Pissarides,
1985). His 1990 book (with a second edition in 2000), and the development and
extension of the model in a series of articles with Dale Mortensen (for example,
Mortensen and Pissarides, 1994) made the framework extremely influential, and
rightly so. One of its strengths was to allow for a much more specific analysis of the
role of institutions, both theoretically and empirically (Box 3 gives a more formal
description).
The framework started from a basic fact: the labour market is characterized by
large flows – high rates of separations from firms, and high rates of hires by firms. In
France for example, 1.5% of all jobs are destroyed each month and roughly as many
are created – interestingly, this is about the same percentage as in the United States.
As there are many reasons other than job destruction why a worker may separate
from a firm, the flows of workers are typically much higher. In France, they are of
the order of 4% per month (Cahuc and Zylberberg, 2004).
In such a labour market, the process of matching workers and jobs is a complex
one, and there will always be workers looking for jobs (unemployment) and jobs
looking for workers (vacancies). From the point of efficiency, there is an optimal rate
of unemployment, and this rate of unemployment is clearly positive.
13 To be historically fair, the importance of institutions was already an important theme in the first edition (1991) of the book
by Layard et al.
EUROPEAN UNEMPLOYMENT 27
Box 3. Flows, matching, and bargaining: the Beveridge curve and
the Phillips curve
The purpose of this box is to present the basic implications of the flow
approach for understanding unemployment. I have presented it in a way which
makes it most easily comparable to the theories presented in the previous
boxes. For a full treatment, see the book by Pissarides (2000).
Gross flows
The starting point of the theory is that relatively stable aggregate employment
is the result of large gross flows of job creation and job destruction. Let x and
y be respectively the logs of the flows of jobs created and jobs destroyed.
Assume that x and y are given by:
x = −θx(w – p) + zx
y = −θy(w – p) − zy
w and p are the logs of the nominal wage and the price level respectively. Job
creation is decreasing in the real wage, job destruction increasing in the real wage.
zx and zy are the factors that affect creation and destruction given the real wage
(for example, productivity, oil prices, the cost of capital, which we focused on earlier).
In steady state, employment must be stable, so creation must be equal to
destruction: x = y. This implies that the warranted real wage satisfies:
This in turn determines steady state gross flows x and y.
Matching, unemployment, and vacancies
At any point in time, there are workers looking for jobs (the unemployed), and
jobs looking for workers (vacancies). The matching process is characterized by a
matching function, which relates hires to the stock of unemployed and vacancies.
Assume this function is of the form:
h = αU + (1 − α)V + zm
h is the log of hires, U and V are the logs of unemployment and vacancies
respectively. The higher the number of unemployed, or the higher the number
of vacancies, the more matches, the more hires. zm captures all the factors that
affect the efficiency of the matching process. For example, a decrease in the
search intensity of the unemployed, or an increased mismatch between the skills
of the unemployed and the skills desired by firms, both lead to a decrease in zm.
wpz z z x y
x y −=≡ ( ) +
+
1
θ θ
28 OLIVIER BLANCHARD
The relation between unemployment and vacancies for a given h is called
the Beveridge curve. Shifts in the Beveridge curve correspond to changes in zm.
The relation between h, U and V can also be written as:
(h − U ) = (1 − α)(V − U ) + zm
h − U is the log of the ratio of hires to unemployment, thus the log of the
probability per period of finding a job when unemployed, or, put yet another
way, minus the log of average unemployment duration. The relation therefore
says that unemployment duration is a decreasing function of the ratio of vacancies to unemployment.
Bargaining, and the determination of the bargained wage
If we think of wages as being the result of bargains between individual workers
and firms, the outcome will depend on the state of the labour market. The
higher h − U, the easier it is for a worker to find a job if unemployed, and so
the stronger the worker will be in bargaining. Symmetrically, the higher h − V,
the easier it is for a firm to fill a vacancy, and so the stronger the firm will be
in bargaining. This suggests a wage relation of the form:
w − Ep = β[(h − U ) − (h − V )] + zb
where the nominal wage depends, as before, on the expected price level, the
difference between the labor market prospects of the worker, h − U, and of the
firm, h − V. zb stands for all the other factors that affect bargaining; for example,
the level of unemployment benefits if unemployed – which strengthen the
worker in bargaining and increase the wage, or employment protection –
which makes it more costly for the firm to replace a worker by another.
Note that the wage equation can be rewritten as:
w − Ep = −β(U − V ) + zb
Or equivalently, using the relation derived from the matching function:
Note that this suggests the correct labour market variable in the equation for
the bargained wage is not the unemployment rate (the variable traditionally
used in such equations), but either the ratio of unemployment to vacancies, or
the probability of exiting unemployment (or its inverse, average unemployment
duration).
Combining the first of the two wage equations with the equation for the
warranted wage earlier gives a Phillips curve relation:
p − Ep = −β(U − V ) − z + zb
w Ep h U z z m b − = [( ) ] − −− + β
1 α
EUROPEAN UNEMPLOYMENT 29
The natural unemployment rate
Combining this equation and the equation for the warranted wage, and assuming
Ep = p, gives a characterization of equilibrium unemployment duration:
Equilibrium duration (recall that U − h is the log of duration) depends on the
factors that shift the warranted wage, those that shift the matching function,
and those that affect bargaining (some factors may be common to the different
z’s.)
The equilibrium flow h must be equal to job creation, so h = x where x is
determined by the warranted wage. This in turn determines the natural rate
of unemployment as the product of equilibrium duration and the equilibrium
flow.
Note how, in principle, we can learn about the sources of the shifts in the
natural rate by looking both at the Beveridge curve relation – which tells us
about shifts in zm – and at the Phillips curve – which tells us about shifts in z
and zb.
Actual unemployment is unlikely to be optimal, however, and depends on the
nature of bargaining. Even in the absence of collective bargaining, both the firm and
the worker typically have some bargaining power. The worker can threaten to walk
away from the job, but walking away and finding another job is costly, the more so
the higher the unemployment rate. The firm can threaten to fire the worker; but
doing so and replacing the worker by another is also costly, the more so the tighter
the labour market, the lower the unemployment rate. This has two main implications.
First, the bargained wage depends on the labour market prospects of workers and
firms: high unemployment weakens workers and strengthens firms. Second, labour
market institutions also play a central role in wage determination: the more generous
the unemployment insurance, the less costly it is for the worker to look for another
job. The higher the level of employment protection, the more costly it is for the firm
to fire a worker.
From a methodological viewpoint, this framework led to major progress. It allowed
for a more careful analysis of the implications of complex labour market institutions
than could be done before. Take, for example, employment protection. The framework made three broad predictions. First, employment protection, to the extent that
it increased the cost of laying off workers, was likely to decrease layoffs, and thus to
reduce the flow of workers entering unemployment. Second, by increasing the costs
to firms, and more importantly, by strengthening the bargaining power of workers, it
was likely to lead to an increase in bargained wages, and in turn to an increase in
the duration of unemployment. Third, given that the unemployment rate is the
hU z z z m b [( ) ( ) ] − = − + −−
1
1 1
β αβ α
30 OLIVIER BLANCHARD
product of the flows into unemployment and unemployment duration, lower flows
and higher duration implied that the effect of employment protection on the unemployment rate itself was ambiguous. All three implications have proven to fit the facts
well (for example Blanchard and Portugal, 2001). Employment protection is probably
one of the main factors behind the long unemployment duration in Europe; differences in employment protection seem, however, largely unrelated to differences in
unemployment rates across countries.
It allowed for a better mapping between the increasingly available panel-data microeconomic evidence on firms and households, and macroeconomic models. Take, for
example, unemployment insurance. The framework points to two separate effects of
insurance on unemployment. The first is through its effect on search intensity, and
thus the matching between unemployment and vacancies. The second is through the
reservation wage: higher unemployment benefits make unemployment less painful
and are likely to lead to an increase in the bargained wage. Both effects in turn
imply an increase in equilibrium unemployment duration, and thus an increase in
the natural rate. Guided by search theory, much empirical work has looked into the
effects of the schedule of unemployment benefits on search by the unemployed. The
findings in turn allow for a better calibration of our macro models. (There has been,
however, little empirical micro work on the other channel, namely the effects of
unemployment insurance on bargained wages. This reflects a more general shortcoming, a still poor empirical understanding of wage determination in environments
such as Europe where both individual and collective bargaining are likely to play a role.)
It gave new macro tools to interpret facts and look at the sources of unemployment. In particular, it gave a way to combine the evidence from the Phillips curve
with the evidence from the Beveridge curve – the relation between unemployment
and vacancies. Conceptually, the Beveridge curve evidence tells us about factors that
affect matching in the labour market, whereas the Phillips curve evidence tells us also
about factors that affect bargaining. A shift in the Phillips curve not associated with
a shift in the Beveridge curve points to factors related to bargaining; a joint shift
points to factors related to matching. I initially hoped that the joint use of these two
tools would prove powerful (Blanchard and Diamond, 1989; Blanchard, 1990); I have
been disappointed, at least in its application to unemployment in Europe (for a recent
examination, and a slightly more optimistic conclusion, see Nickell et al., 2002). It has
proven hard to learn much from the shifts in the Beveridge curve across countries;
one reason may be that data on vacancies are often of poor quality.
Did the shift in focus towards institutions give us the key to the evolution of
European unemployment, across countries and time? The first systematic look at the
data, at the end of the 1990s, gave a mixed answer.
Differences in institutions appeared able to explain much of the differences in
unemployment rates across countries either in the 1980s or in the 1990s. This was first
shown in a cross-country regression by Stephen Nickell in 1997. Using quantitative
indexes for a number of labour market institutions for the mid- and late-1980s, he
EUROPEAN UNEMPLOYMENT 31
found that, together, they did a good job of explaining differences across 20 OECD
countries. Among the most economically significant variables in his regression were
the duration of unemployment benefits (which increased unemployment), and the
degree of coordination in collective bargaining (which decreased it).
Changes in institutions did not appear able, however, to explain the evolution of
unemployment rates over time. Even if the initial increase in unemployment was due
to shocks rather than institutions, the difference between unemployment today and
unemployment in the 1960s should be explained by much less ‘employment friendly’
institutions than 40 years ago. In 2000, Justin Wolfers and I took a careful look at the
relation between unemployment, shocks and institutions, relying on a panel data
approach over countries and time. We were not the first to do so. In an important
book published in 1994, and building on his earlier work with a number of collaborators (Hian Teck Hoon, George Kanaginis, and Gylfi Zoega in particular), Ned
Phelps had articulated a theory of movements in the natural rate based on shocks
and institutions, and taken it to the data using panel data. Our contribution was in
part to construct and include time series for a larger set of institutions than Phelps.
And our first pass at the time series evolution of institutions was not very encouraging.
Figures 10 and 11 reproduce two of the time series we gave in that paper, for
replacement rates and for employment protection respectively, for each EU5 country,
for each five-year period since 1960. The replacement rates shown in Figure 10 were
constructed from an OECD data set, which measured the ratio of pre-tax social
insurance and social assistance benefits to the pre-tax wage, for various categories of
unemployed workers, depending on income, family status, and duration of unemployment.
Figure 9a gives an unweighted average of these replacement rates, the summary measure
often used by the OECD. What is striking are the different evolutions of the five countries,
and the absence of a common trend. Figure 10b provides a different and more relevant
angle by showing the maximum replacement rate over all categories for each country
and each subperiod. Again, no clear trend emerges. Clearly, some of the maximum
replacement rates increased in the early 1980s, but they have declined since then.
The indexes of employment protection shown in Figure 11 were constructed by
combining two sources, the series constructed by Lazear (1990) for the period before
1985, and the indexes constructed by the OECD for the 1980s and the 1990s. Again,
what is striking is the absence of a clear trend, and the heterogeneity of evolutions
across countries.
A more systematic construction of time varying measures by others (in particular
Belot and van Ours, 2001) suggested roughly similar conclusions. In panel data
regressions of unemployment rates on institutions across 20 countries since 1960, and
allowing for country and time dummies, none of the labour market institutions
appeared significant.
In this context, one variable deserves particular mention because it often comes up
in discussions. The ‘tax wedge’, i.e. the difference between take-home pay for workers
and the cost of labour for firms, divided by the wage, has steadily gone up in most
32 OLIVIER BLANCHARD
European countries since the 1960s. In many countries, it stands at above 30%, and it
is often blamed by firms and policy makers as one of the major sources of unemployment. Most economists are more sceptical (a formal discussion is given in Box 4).
On theoretical grounds, taxes or social contributions that treat income equally
whatever its source (labour income or unemployment benefits) should not affect the
cost of labour to firms, and thus not affect unemployment. The same should be true
for taxes or social contributions which come with corresponding benefits, such as
retirement contributions, so long as they are not redistributive.14 On empirical
14 Major effects of the tax wedge are likely to be present only for wages which are at or close to a minimum wage floor. In this
case, additional contributions by firms cannot be shifted to workers, and thus lead to an increase in cost. For this reason, many
European countries have decreased the tax wedge for low wages since the late 1980s, sometimes by substantial amounts.
Figure 10. Replacement rates, EU5 since 1960
Source: Blanchard and Wolfers (2000).
EUROPEAN UNEMPLOYMENT 33
grounds, while the increase in the tax wedge fits the general increase in unemployment, it does poorly in explaining differences in unemployment across countries. This
is shown in Figure 12, which plots the tax wedge (defined as the sum of payroll taxes
paid by employers and employees and income taxes paid by employees) in 1960 and
2000 for each EU15 country and for the United States.
All the points are above the 45 degree line, indicating that the tax wedge is higher
in all countries in 2000 than it was in 1960. But the ranking of countries shows little
relation to unemployment rates. Three of the four countries with the highest tax
wedge, Finland, Sweden and Austria, are also countries with a low natural rate.
Figure 11. Employment protection index, EU5 since 1960
Source: Blanchard and Wolfers (2000); OECD (courtesy of Luca Nunziata).
Figure 12. Tax wedge, 2000 versus 1960, by country
Source: OECD, and Luca Nunziata.
34 OLIVIER BLANCHARD
Box 4. The tax wedge and unemployment
Suppose that there are two types of taxes. (Assume both are paid by workers
rather than by the firm, but, except in the presence of a binding minimum
wage, it does not matter whether these are paid by the worker or by the firm.)
A tax levied on all income (or consumption; the two are taken to be the
same here), be it unemployment benefits or labour income, τ1. (For example,
an income tax, or a VAT.)
A tax levied on labour income only, τ2, with benefits (in present discounted
value) equal to λτ2. λ may be equal to zero, if the tax is not associated with
any benefit to the worker. It may be close or equal to one if it goes towards
financing a retirement account.
Consider the choice between unemployment and employment. If unemployed, the worker receives b − τ1 − f (u), f (.) > 0, f ′(.) > 0, where b is unemployment benefits, and f (u) captures the private cost of being unemployed, which
is assumed to be increasing in the unemployment rate. If employed, the worker
receives w − τ1 − τ2 + λτ2. His surplus from working for the firm is therefore:
Vw ≡ w − b + f (u) − (1 − λ)τ2
If the firm employs the worker, the firm receives y − w, where y is the productivity of the worker. If it does not, it receives nothing. Thus the firm’s surplus
from employing the worker is:
Vf ≡ y − w
The total surplus from the match is given by:
V = y − b + f (u) − (1 − λ)τ2
If we assume that workers receive a share β of the surplus, so Vw = βV, the
wage (and the cost of labour to the firm) is given by:
w = βy + (1 − β)(b − f (u)) + τ2(1 − λ)(1 − β)
So
dCost/dτ1 = 0 dCost/dτ2 = (1 − λ)(1 − β)
This makes clear that the frequent practice of simply adding all the social
contributions together, plus the VAT and/or the income tax to get a tax wedge
does not make sense (with one exception: if the alternative to work is not
unemployment, but a job in the underground economy, then the VAT rate
becomes again relevant). For each tax, we need to know whether it is levied
on labour income and other benefits, or just on labour income. For each tax,
we also need to know the relevant value of λ. In the case of social security for
example, some redistribution is typically at work, so λ depends on the wage level.
EUROPEAN UNEMPLOYMENT 35
To take stock: we ended the 1990s with a much better framework to study unemployment.
But we also ended with many questions. Even if the earlier shocks were no longer the
main source of unemployment, they clearly were responsible for the initial increase.
If institutions were primarily responsible for unemployment at the end of the century,
is it because they had become steadily less employment friendly? If so, why was it not
reflected in the series we were constructing? One can see the research since then as
exploring different answers to these questions. This is the topic of the next section.
6. INSTITUTIONS AND SHOCKS: CURRENT DIRECTIONS OF RESEARCH
Giving a clear description of current research is always harder than giving one of past
research; research appears to go in many directions, only some of which will eventually pan out. I see roughly three main directions at this point. The first is an exploration of the role of other shocks, other institutions, other interactions. The second is
a more careful exploration and measurement of institutions. The third is an attempt
to look not only at unemployment, but at the joint behaviour of unemployment,
employment, capital, wages and user costs. I take them in turn.
6.1. Other shocks, other institutions, other interactions?
Another line of research has extended the initial panel data examination of institutions and shocks, to look at other shocks, other institutions, other interactions:
• There are potentially many more relevant institutions than those included in the
initial regressions by Nickell and Blanchard and Wolfers. Researchers have examined the effects of many others, from measures of product-market regulation, to
measures of home ownership – a variable suggested by Oswald (1997).
• There are potentially many shocks as well. There used to be a sign at train
crossings in France that said: ‘A train may hide another’. It is not implausible
that, in the same way that oil price increases initially hid the decline in productivity growth, the slowdown in productivity growth also hid other shocks.
Researchers have looked, for example, at shifts in labour demand away from low
skilled workers, or at increased turbulence – due to higher competition in the
world economy, through deregulation of domestic goods markets, the decrease in
trade barriers, and globalization. (I return to this particular theme below.)
• There are potentially many interactions between shocks and institutions. Recall that
the initial focus of research by Bruno and Sachs was on the interaction between
adverse supply shocks and the structure of collective bargaining. Recall that the focus
of the research on persistence was on the strength of insiders; this strength clearly
depends on institutions such as employment protection and unemployment benefits.
• There are also potentially many interactions between institutions, a theme explored,
for example, by Coe and Snower (1997). The effects of taxation may depend, for
36 OLIVIER BLANCHARD
example, on the structure of collective bargaining, a theme explored by Daveri
and Tabellini (2000). The effects of employment protection – which reduce
layoffs – may be partly offset by collective bargaining focused on reducing wage
dispersion – which may increase layoffs – a hypothesis explored by Bertola and
Rogerson (1997) to explain the surprisingly high labour turnover numbers in Europe.
All these and a few more, have been explored through panel data regressions. A
partial summary of the results is given in Baker et al. (2002). Some correlations are
intriguing; the conclusion by Nickell et al. (2005) that time series for institutions do a
better (but still mediocre) job of fitting some of the evolutions of unemployment across
time than initially suggested by the Blanchard–Wolfers series is perhaps the most
interesting. It is clear, however, that the number of potential shocks, institutions, and
interactions is sufficiently large that the ability of such panel data regressions to tell us
what exact combination matters is limited. Such regressions allow us to check for
simple and partial correlations; they are unlikely to tell us about which combination
of shocks and institutions is responsible for unemployment (for a similar view, see
Freeman, 2005).
Of all the hypotheses listed above, at least one deserves a longer treatment.15 It is
the idea that higher competition in the goods market, lower trade barriers and higher
integration of goods markets across countries, higher globalization and outsourcing,
are all leading to a more turbulent environment, an environment with more job
destruction and job creation. When the environment becomes more turbulent, existing labour market institutions may become dysfunctional and lead to substantially
higher unemployment. Employment protection, which was rarely binding before as
firms rarely laid off workers, becomes binding and increases the cost of firms. Unemployment benefits, which were not very costly so long as few workers were laid off,
become costly, requiring higher contributions and leading again to higher costs of
firms. The general story is appealing, and most of us believe that, indeed, there is
more economic turbulence today than there was 30 years ago. There is one catch,
however. We may all believe it, but the data just do not show it.
This puzzle showed up early on, when European unemployment was just rising in
the late 1970s. Increased turbulence already seemed to be a plausible candidate. But
it turned out that the measures of reallocation we could construct then – typically
measures based on the standard deviation of rates of change of employment, either
across sectors or across regions – showed no trend increase. The evidence as of the
early 1980s is well summarized in Johnson and Layard (1986), who construct a table
of standard deviations by industry or by region for a number of countries: half of the
standard deviations are higher in 1979 than they were in 1960, half are lower. In all
cases, the changes are small. I could not locate an update of this table for the 1980s
15 Another hypothesis worthy of a longer treatment is the presence and the role of skilled-biased technological progress. I shall
not do it here, except to mention that, while it is surely relevant, one observes that, in countries with high unemployment,
unemployment is typically high across the skill spectrum (although obviously higher for low-skilled workers).
EUROPEAN UNEMPLOYMENT 37
and 1990s, but the series I have seen for a few countries yield the same conclusion:
there is no apparent increase.
One may reasonably argue that these measures are too raw. Perhaps, the increase
in reallocation is taking place mostly within industries or regions, rather than across
industries or across regions. In that respect, measures of job flows based on plantlevel data, along the lines of the work by Davis et al. (1996) are clearly preferable. The
practical issue is that they typically do not go back far enough in time. But to the
extent that they do, they also show little sign of increased turbulence. Figure 13 gives
the evidence for France, based on two studies, one by Nocke (1994) for 1985 to 1990,
and the other by Duhautois (1999) for 1990 to 1996.16 The lower line shows the
evolution of job destruction (the sum of all employment changes at plants with
decreasing employment, divided by total employment); the upper line shows the
evolution of job reallocation, defined as the sum of job destruction and job creation.
The conclusion is clear: at least starting from when data becomes available, namely
1985, there is no evidence of an increase in turbulence.17
Is the argument therefore settled? No, for two reasons, one empirical, the other
theoretical. The empirical reason is that other – admittedly conceptually less appropriate – measures of turbulence send a different message from job flows. For example,
the measure of sales volatility constructed by Comin and Philippon (2005), based on
the firms in the Compustat data set, show a steady increase in this measure of
16 The juxtaposition of the two series, constructed using slightly different data and methodology, imply that there may be an
artificial break in the series between 1990 and 1991.
17 One might argue that, in the case of France, turbulence has increased, but its effects on flows has been offset by increasing
employment protection. This suggests looking at data for the United States, where employment protection is low and has not
increased. The evidence there is that, if anything, there has been a decrease in flows relative to total employment over the last
30 years (Davis et al., 2005, Figure 4 for the private sector since 1990, and Figure 5 for manufacturing since 1947).
Figure 13. Job destruction and job reallocation: France 1985–96
Source: Blanchard (2000), updated.
38 OLIVIER BLANCHARD
variability over time since the late 1960s. Reconciling the evidence on flat job flows
and increasing sales variability remains to be done.18 Until then, the discrepancy
should make us more careful about conclusions.
The theoretical reason is that one can construct models in which turbulence is not
necessarily reflected in higher job flows. Such models have been explored by Ljunqvist
and Sargent in a series of contributions (for example, 1998, 2005). In their formalization, increased turbulence is reflected in an increase in the specificity of skills
associated with particular jobs. The implication is that an involuntary job change is
associated with a larger drop in the wage distribution facing a laid-off worker than
was the case in the past. In this case, if unemployment benefits are linked to past
wages, the unemployed may have high reservation wages, and remain unemployed
for a long time. Furthermore, if skills deteriorate through unemployment, some of
the unemployed may even become trapped into unemployment. Differences in the
generosity of the unemployment insurance system, Sargent and Ljunqvist argue,
may therefore explain why Europe is doing so much worse than the United States
in facing the same increase in turbulence – an example of the interaction between
institutions and shocks. While the theory is appealing, direct evidence of a larger
decrease in skills for laid-off workers is however so far very limited.
6.2. A closer look at institutions
Labour market institutions are typically multidimensional. Reducing them to quantitative indexes is not easy: how does one compare, for example, two unemployment
insurance systems, if the first has more generous unemployment benefits, but also
more conditionality of benefits on search effort? How does one compare two systems
of employment protection, when the first includes higher protection for some workers,
and lesser protection for others?
In the process of looking at the effects of institutions, I have become less convinced
that existing measures fully capture what is going on. This has led me to explore, in
on-going work with Daniel Cohen and Cyril Nouveau (Blanchard et al., 2005), the
evolution and the determinants of labour market institutions in France since the 1950s.19
What emerges is a more complex picture than that given by quantitative measures.
What we find is that the increase in unemployment in the mid-1970s led to major
changes in institutions. Under the initial assumption that the shock, and therefore the
increase in unemployment, was temporary, unemployment insurance was made substantially more generous, and employment protection was sharply increased. Early
retirement programmes were put in place to ‘make room’ for young workers. As high
unemployment turned out to persist, both financial pressures on the unemployment
18 The two series differ in coverage in many ways – plant versus firm level data, manufacturing for the long series for job flows,
large firms for Compustat, employment versus sales.
19 For an exercise in the same spirit for Germany since 1990, see Wunsch (2005).
EUROPEAN UNEMPLOYMENT 39
system, and the realization that some of the earlier measures probably contributed to
unemployment, have led most of the initial changes to be reversed. But the reversal has
not taken the form of a return to earlier institutions. The decrease in employment protection has come in the form of the introduction of two types of labour contracts, traditional
and highly protected permanent contracts, and new, less protected, temporary contracts.
Whether such a reform actually decreases unemployment is ambiguous; what is certain
is that it has created a dual labour market, with protected and marginal workers.
So, while existing time series for labour market institutions in France show little change
since the 1960s, a closer look at history suggests that, at least for France, institutions
indeed became less employment-friendly in the 1970s and early 1980s. While things
turned around starting in the early 1980s, many of the reforms have had perverse effects,
either because of poor design, unanticipated consequences, or political constraints.20
Institutions today are less employment friendly than they were in the early 1970s.
I do not know whether the conclusions reached from similar studies of other
European countries will be similar. I suspect that the message is more general: one
of the reasons why the shocks of the 1970s and 1980s have led to high unemployment
in some European countries today is that they triggered a change in institutions,
which has been partly and poorly undone in these countries.
6.3. Employment, capital, wages and interest rates
All the theories we have discussed have testable implications not only for unemployment, but also for capital accumulation, wages, profits and interest rates. For example,
an increase in bargained wages, for given labour market conditions, should lead not
only to an increase in unemployment, but also to a decrease in the labour/capital
ratio, a decrease in the profit rate, and, for a given user cost, a decrease in capital
accumulation over time. Yet, few of these theories have been tested using more than
data on unemployment and through the estimation of unemployment equations.
This led me, in the late 1990s, to perform a conceptually simple exercise, that of
looking jointly at capital, employment, wages, profits and user costs, and use this
information to try to identify shifts in either ‘labour demand’ (the relation giving
warranted wages as a function of employment, capital and the level of technology)
or ‘labour supply’ (the relation giving bargained wages as a function of labour market
conditions) (Blanchard 1997, 1998).21 On the labour demand side, I assumed that
firms chose capital and labour subject to convex costs of adjusting both investment
20 In addition, France has suffered from a number of policies based on the lump-of-labour fallacy, from the generous early
retirement programmes put in place in the 1980s – aimed at freeing jobs for new workers – to the 35-hour laws at the end of
the 1990s – aimed at creating jobs by decreasing hours per worker. Both of these programmes have turned out to have large
budgetary costs.
21 Semantics are not settled here. The relation giving warranted wages is often called the ‘price setting relation’ as it gives the
prices set by firms given wages and other variables. The relation giving bargained wages is often called the ‘wage setting’
relation, because it gives the wages set in bargaining, given the price level, actual or expected, and other variables.
40 OLIVIER BLANCHARD
and factor proportions. On the supply side, I assumed that bargained wages
depended on the level of technology, the unemployment rate, with all other factors
showing up as shifts in the relation. I then constructed shifts in labour demand and
labour supply for 14 OECD countries for the period 1970–95. My papers were
primarily an exercise aimed at organizing the empirical evidence in a simple but
interpretable way. A conceptually more ambitious attempt was made by Caballero
and Hammour (1998), who constructed a structural model starting more explicitly
from bargaining and institutions such as employment protection, and allowing for
endogenous technological progress. Their model was not estimated, but calibrated,
and Caballero and Hammour used it to look at the evolution on capital, employment,
productivity and factor prices in France.
Both exercises proved interesting, and the evidence more complex than I had
expected. On the one hand, many of the dynamics suggested by the early work of
Bruno and Sachs and the later work on the role of capital accumulation, were clearly
present in the data. The early 1970s were characterized by ‘adverse labour supply
shifts’ – that is, increases in bargained wages given unemployment. The effect of
profit rates and interest rates on capital accumulation were also clearly visible, with
low interest rates delaying the slowdown in capital accumulation to the 1980s. These
labour supply shifts were largely reversed starting in the mid 1980s. Countries, such
as the Netherlands and Ireland, which had seen a major decrease in unemployment,
also showed a large decrease in wages in efficiency units – wages divided by the index
of Harrod neutral progress.
The reversal of adverse labour supply shifts should have led to a decrease in
unemployment over time. But, the data suggested, something else was at work starting in the early 1980s. At a given wage (in efficiency units) and given capital stock,
employment was lower: there was an adverse shift in labour demand. The result was
a decrease in the labour share in most European countries, starting in the early
1980s. Figure 14a gives the behaviour of the labour share in France, one of the
countries where the decline was the most dramatic, for the business sector, from 1965
to 2001. The labour share, which had gone up by five percentage points from 1970
to 1981, then went down by 12 percentage points from 1980 to the early 2000s; it
has remained roughly at that level since.22 Figures 14b and 14c show the proximate
causes of the evolution of the labour share. Figure 14b shows the evolution of the
wage (in efficiency units), and Figure 14c shows the evolution of the ratio of employment (in efficiency units) to capital, since 1965.
In the second half of the 1970s, the wage (in efficiency units) went up, and the ratio
of employment (in efficiency units) went down over time in response; the result was
22 There are many issues of measurement associated with the labour share. The series used in the figure is adjusted for selfemployment. Labour income includes not only the wage but also payroll taxes and other social contributions paid by firms.
Some of the data have been reconstructed by the OECD since 2000, and the current series for France shows a smaller decrease;
the basic evolution is still the same. Some of the evolution of the labour share is due to composition effects, the result of a shift
to sectors with lower labour shares. Again, for France, this composition effect is small (de Serres et al., 2002).
EUROPEAN UNEMPLOYMENT 41
an increase in the labour share, and this is exactly what we would expect in response
to an adverse labour supply shock – an increase in the bargained wage for given labour
market conditions. Since then, however, the wage has come down; since 1990, it has
remained roughly at its 1970 level. The ratio of employment to capital has not
recovered, however: lower employment at a given wage is what mechanically explains
the lower labour share. (The basic algebra of the labour share is given in Box 5.)
Why is employment lower at a given wage? In my 1997 and 1998 papers, I
considered various candidates and converged on a decrease in ‘labour hoarding’, due
perhaps to higher competition and tougher corporate governance, as the more likely one.
Under this explanation, however, the decrease in excess labour should have led to an
increase in profit, an increase in capital accumulation, and an eventual recovery of
employment; so far the increase in capital and employment has not taken place, at least
not in France or in Germany, where a similar evolution of the labour share has taken place.
Figure 14. Share, employment and real wage: France
Source: OECD database, and author’s computations.
42 OLIVIER BLANCHARD
Box 5. The labour share
Assume that the production function has constant returns to scale, and Harrodneutral technological progress, so:
y = f (k, an)
where y, k, n, and a are the levels of output, capital, employment, and technology respectively.
Let ñ ≡ an and ∑ ≡ w/a denote employment and the wage in efficiency units
(I shall drop in efficiency units in what follows). Then, assuming firms take the
wage as given, labour demand is given by:
The ratio of employment to the capital stock is a decreasing function of the
wage. The share of labour is given in turn by:
Now consider an exogenous increase in the wage ∑. Suppose that in the
short run, there is no scope for substitution between labour and capital, so
g′ = 0. The ratio of labour to capital remains the same, and so does the ratio of
labour to output. Thus, ∑ goes up, ñ/y does not change, and the labour share
goes up.
What happens over time depends on the long-run elasticity of substitution.
If it is less than one, the labour share decreases from its initial peak, but
remains higher than before the increase in the wage; if it is equal to one, the
share returns to its initial value; if it is greater than one, the share returns to
a lower value than before the increase in the wage.
These dynamics can clearly explain why, after the increase in ∑, the labour
share went first up, and then down over time. But they do not easily explain
why the labour share decreased below its initial level. A permanent increase
in ∑, and a long-run elasticity of substitution greater than one would explain
it; but as we saw in the text, ∑ decreased back to or below its original value
from the mid-1980s on.
Another element is therefore needed to explain the combination of a lower
wage and a lower share. One potential explanation is a decrease in labour
hoarding. Extend the equation for the demand for labour to be:
ñ
k
= ≤ g g ( ) ∑ ′(.) 0
s wn
y
ñ
y ≡ = ∑
ñ
k gzgz ( , ) = > ∑ ′ 0
EUROPEAN UNEMPLOYMENT 43
Then, a decrease in z, due for example to the reduction of x-inefficiency, will
decrease labour demand, and decrease the labour share. This is the explanation suggested in Blanchard (1998).
Suppose instead that firms are not wage takers, and that the marginal wage,
call it ∑m, differs from the (measured) average wage. The demand for labour is
therefore given by:
In this case, an increase in the marginal wage for a given average wage, will
lead to a decrease in employment, and thus to a decrease in the labour share.
One can think of a number of institutions which might lead to such an increase
in the marginal wage: for example, additional regulations, additional workers’
rights as the size of the firm increases. This is the line of explanation suggested
by Caballero and Hammour (1998).
An alternative interpretation was given by Caballero and Hammour (1998).
They argued that the decline in the labour share below its initial level reflected
instead an increase in the marginal wage relative to the average wage (an increase in
the marginal wage for a given average wage will lead to a decrease in employment,
and thus a decrease in the labour share). Caballero and Hammour’s conclusion
was therefore that the low labour share reflected the firms’ desire to decrease labour
beyond what the average cost of labour would suggest. And, they argued, this
reluctance of firms to hire labour could be traced to a worsening of labour market
institutions. Their explanation leads to a much less optimistic view of the future:
a low labour share does not lead to higher incentives to invest, nor to an increase in
employment.
I see the labour share puzzle as largely unsolved. The decrease in the labour share
has been much smaller in the UK and the United States than in continental Europe,
pointing indeed to factors specific to continental Europe: institutions are a natural
starting point. At the same time, within continental Europe, the decrease in the
labour share has taken place both in countries that have reduced unemployment
(the Netherlands, for example), and in countries that still have high unemployment
(France, for example). I also see the puzzle as a potentially major piece of the story
of European unemployment, and one on which more work should be done.
7. 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.
ñ
k g m = ( ) ∑
44 OLIVIER BLANCHARD
7.1. A general story line
Going back over the last 30 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 different 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.
There is not much question that the 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.
There is not much question that, since 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.
Despite the twists and turns of research, the sediments from the successive theories
are nearly all relevant. 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.
7.2. Which institutions?
It is one thing to say that labour 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 labour 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. Many researchers, including myself, have tried to trace the
differences to differences in shocks or institutions (for a recent attempt, see Bover et al.,
2000). I am not sure that our explanations are much more than ex-post rationalizations.23
23 Along the same lines, the rapid decrease of the unemployment rate in Spain – which has now fallen below 10% – is also
hard to trace back to either shocks or dramatic changes in institutions. Yet another puzzle is the coincidence of very low
productivity growth – zero measured TFP growth in Spain over the last 15 years – and decreasing unemployment.
EUROPEAN UNEMPLOYMENT 45
And the history of the last 30 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’.24
Nevertheless, even if one cannot pretend to have much confidence about the
optimal overall architecture, much has been learned about the effects of the various
pieces, especially from the large number of empirical micro-studies and natural or
designed experiments. As a review of the relevant research would require another
survey, let me just mention a few directions of research. 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 programmes (see, for example, the surveys by
Fredriksson and Holmlund, 2003, on unemployment insurance, and by Martin and
Grubb, 2001, on active labour market policies). We know more about the effects of
decreasing social contributions on low wages (for example, Crépon and Desplatz,
2001, on the French experience). We know more about the effects of employment
protection, and the effects on the labour market of introducing temporary contracts
at the margin while keeping employment protection the same for most workers
(Blanchard and Landier, 2002, for France).
From both the macro evidence and this body of microeconomic work, a large
consensus – right or wrong – has emerged. It holds that modern economies need to
constantly reallocate resources, including labour, 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-off 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 labour 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.
24 For descriptions of events and reforms see Nickell and van Ours(2000) for the Netherlands and Ireland, Honohan and Walsh
for Ireland (2002), Card and Freeman (2004) for the UK, and Westergaard-Nielsen (2001) for Denmark.
46 OLIVIER BLANCHARD
This consensus underlies most recent reforms or reform proposals, for example in
the recent Hartz reforms in Germany (for a description, see Wunsch 2005), or the
‘Camdessus Report’ on reforms in France (2004).
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.
7.3. Collective bargaining and trust
The first worry is that these reforms deal only with a subset of the institutions that
govern the labour 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. I think we do not know the
answer to either of the two questions. In work with Thomas Philippon (Blanchard
and Philippon, 2003), we explored the hypothesis that differences in trust between
unions and firms, perhaps trackable to differences in economic models between
unions and firms, explain some of the difference in unemployment rates across countries. We found that various measures of trust, from strike intensity in the 1960s to
survey measures of trust between firms and workers, could explain a substantial
fraction of differences in unemployment across European countries.25 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. The example of the UK where the unions
have not only become weaker but have also changed attitudes, suggests that trust
cannot be taken as an immutable country characteristic.26
7.4. 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
25 A recent paper by Cahuc and Algan (2005) takes another step in that direction, and argues, theoretically and empirically,
that the efficiency cost of social insurance depends on civic attitudes.
26 This section can be seen as a variation on the old theme of whether there are different national models, adapted to different
countries, an ‘Anglo-Saxon’ model, a ‘Scandinavian’ model, and so on.
EUROPEAN UNEMPLOYMENT 47
then equivalent to maintaining unemployment close to its natural rate; this natural
rate can only be reduced by labour market reforms, and this is not the responsibility
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 labour 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. In other words, a decrease in unemployment
below the natural rate may actually help decrease the natural rate itself. 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
labour market reform, and this should be the topic of another survey.
Comments
Post a Comment