• The roots of the European unemployment problem lie in the productivity slowdown and commodity price inflation of the 1970s.

• The rise in unemployment led to changes in government policy to protect workers -- more employment protection and more generous unemployment insurance.

• In the 1980s, the unemployment problem was compounded by declining business profits and investment, which reduced labor demand, and conflicts between "insiders" and "outsiders" in the labor market.

• Most countries have partially reversed the labor market policy changes of the 1970s, but only partially, and sometimes with perverse consequences. European labor market institutions are still less employment friendly than they were prior to the 1970s.

• National differences in institutions matter. Countries with well-developed institutions of social partnership, including centralized government-business-labor wage bargaining, seem to have done better than others.

The 1970s: Macroeconomic Shocks

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.

This point seems pretty well settled. The basis for this point is to think about what economists refer to as the "natural rate of unemployment" -- the level of unemployment that is consistent with stable inflation.

Unemployment can be a result of increases in the actual unemployment rate above the natural rate, or due to an increase in the natural rate itself. The European unemployment problem seems mostly to be a case of the latter:

What causes increases in the natural rate? One thing is the difference between what we might call the "warranted wage" - the wage consistent with stable inflation, and the "bargained wage" - the wage set by firm-worker bargaining, whether individual or collective. If the bargained wage grows faster than the warranted wage, the natural rate of unemployment rises.

The warranted wage is affected by changes in productivity - the output of an economy relative to the size of all of its primary factor inputs (labor, capital, raw materials, etc), and by changes in the prices of the non-labor inputs.

Specifically, if productivity growth falls, the growth of the warranted wage falls as well. If factor prices - cost of capital, raw material prices - rise, the growth rate of the warranted must fall as well. As we know, both things were happening in the 1970s:

Total factor productivity (tfp) growth . . . 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 3 percentage points, a dramatic decline. The decline was largely similar across countries.

All of this was happening during the period of labor militancy of the late 1960s and 1970s, meaning that wage demands outpaced growth in the "warranted" wage, and higher unemployment was the result.

So, onto the next point:

Different institutions led to different initial outcomes [amount of increase in unemployment across countries].

The speed of adjustment of wages to changes in productivity, non-wage input prices, and inflation helped determine the extent to which individual countries suffered from high unemployment.

The faster that wages adjusted to higher input prices and slower productivity growth, the less of an increase in the "natural" rate of unemployment a country would get, and the less it would suffer from increases in actual unemployment. One way to get fast adjustment is to let the market take care of things - an environment of weak unions, decentralized (firm-level) wage deals, and so forth.

Another way, however, is to have well-developed tripartite (business-labor-gov't) national wage bargaining institutions. "With centralized bargaining, the parties at the bargaining table could see the need for and implement the wage adjustment required to maintain employment," Blanchard argues. In Austria, for example, unions explicitly emphasized maintaining high employment levels in their wage bargaining strategy.

A second option, for countries in which money wages did not quickly adjust to changes in the inflation rate (i.e. countries in which labor contracts were not indexed to inflation) would be for the central bankers to generate inflation by a monetary expansion. This would increase inflation, which in turn decreased the real (inflation-adjusted) wage and mitigated the employment effects of the shocks. This was a strategy for getting the actual unemployment rate below the natural rate, at least for a time.

Next point:

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.

Again, the evidence for this point is clear. The degree of job protection did rise during the 1970s, no question about it. As Jerome has pointed out, European economic policy makers adopted a strategy of living with high unemployment while easing the pain for workers.

The 1980s: Persistence Mechanisms

By the 1980s, European economies had had plenty of time to adjust to the shocks of the 1970s. Yet the natural rate of unemployment did not come down. Why not?

One reason was that central bankers began to react to high inflation by raising interest rates and slowing the growth of the money supply. For much of the 1980s, as a result, the actual unemployment rate was above the natural rate.

But this was not the whole story. Continued high unemployment generated economic effects that tended to make the problem self-perpetuating:

[T]he role of capital accumulation and insider effects . . . explain important aspects of the evolution of European unemployment.

Capital Accumulation. Slow productivity growth and increases in the price of non-labor inputs, leading to falling employment, also caused the profit rate to fall. As long as the profit rate was below the user cost of capital, the capital stock decreased over time, leading to a further decrease in employment. A monetary contraction, such as that engineered by most central banks in the early 1980s, compounded the problem, as increased real interest rates further decreased the rate of capital accumulation.

Insider/Outsider Effects. One of the interesting things about the European unemployment is the big increase in long-term unemployment:

This is one area where the experience of Europe is unusual - the U.S., for example, has not seen such a large increase in long-term unemployment over the same time period.

Increased employment protection, although its overall effect on employment is ambiguous, almost certainly has played a role in increasing long-term unemployment, as Blanchard explains:

By increasing the costs to firms, and more importantly, by strengthening the bargaining power of workers, [employment protection] was likely to lead to an increase in bargained wages, and in turn to an increase in the duration of unemployment

The result of high long-term unemployment has been the creation of a class of "outsiders" - workers with very tenuous connections to the labor market. For these workers, the loss of skills and the loss of morale may make many of the long term unemployed in effect unemployable.

But there are broader macroeconomic effects of long-term unemployment as well. The higher the unemployment rate, the higher the duration of unemployment, and the greater the loss of skills, the lower the downward pressure on wages from a given high unemployment rate. Any "self-correcting" features of the macroeconomy are thus thwarted, leading to persistently high long-term unemployment.

Furthermore, wage bargaining typically takes place between "insiders" - employed workers (or, more specifically, their union representatives) and firms. The unemployed "outsiders" are not represented at the bargaining table. This means that outcome of the bargaining process may be to stabilize employment at  a level that leaves the unemployment rate high, again perpetuating the problem.

Now, it is true that even insiders, due to the fear that they themselves might become unemployed, will care about the overall state of the labor market. And firms can and do threaten to hire the unemployed, a threat which is greater when the unemployment rate is higher. So the concerns of the outsiders do, if only indirectly, impinge upon the wage bargaining process. Nevertheless, this "insider/outsider" effect probably has played a role in making long-term unemployment a perpetual problem by weakening the link between unemployment and wages.

The outcome of all of these economic factors (and maybe others) seems to be that there has been a decrease in labor demand in Europe since the 1970s: at any given wage and level of capital stock, the level of employment is now lower than it was before the 1970s (this shows up in data as a decrease in the wage relative to productivity and thus as a decline in labor's share of national income). This decline in labor demand may be due to institutions like employment protection, or it may be due to a decrease in "labor hoarding" by firms, perhaps as a result of higher competition and tougher corporate governance. This "adverse labor demand shock" does not seem to have affected the U.S. or the U.K. as much as it has affected continental Europe, and some countries (e.g. the Netherlands) have succeeded in reducing unemployment despite suffering from the shock. The issue is largely unresolved.

The 1990s: Institutions

In the 1990s, European unemployment remained very high, peaking at 10% in 1993, and ending at 7.6% in 2000. But this average reflected an increasing heterogeneity 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%.

• Unemployment decreased to under 5% in the UK, Ireland, and the Netherlands, all from high levels in the early 1990s.

• Even within countries experiences can differ. In Belgium, with an unemployment rate of 8%, the unemployment rate in the Flemish provinces -- those close to the Netherlands -- is 5%, while the unemployment rate in the Walloon provinces --those close to France -- is 11%. In Germany, unemployment is 8.5% in the west, twice as much in the formerly communist eastern states. In Italy, the north enjoys low unemployment while the south suffers from rates near 20%.

• Unemployment remained relatively low in Austria, Norway, and Portugal. And, while it went up sharply in Sweden, Denmark, and Finland, the behavior of inflation suggests that this was mostly a cyclical movement -- unemployment sharply declined thereafter;

Unemployment and Labor Market Institutions: The Failure of the Empirical Case for Deregulation

by Dean Baker, Andrew Glyn, David Howell, and John Schmitt

[T]he evidence [for "the widespread belief that rigidities generated by labor market institutions lie at the heart of the unemployment crisis"] is far from conclusive. [T]here is no simple relationship between any of the labor market institutions and the unemployment rate.

. . .

Countries with very different institutional frameworks have managed to achieve unemployment rates substantially below the OECD average. While the United States and United Kingdom stand out as countries that have achieved low rates of unemployment with relatively weak labor market protections, the OECD also includes examples of countries that have achieved comparable results - Austria, Denmark, Netherlands, Norway, and Sweden - with high levels of labor-market protections.

. . .

. . . the mode of bargaining coordination appears to have a substantial impact on the unemployment rate. . . . Increasing bargaining coordination . . . may allow for lower unemployment without the same welfare costs [as deregulation] for workers.

Other studies have found somewhat more affirmative results. Blanchard:

Differences in institutions appeared able to explain much of the differences in unemployment rates across countries at a given point in time - 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 labor market institutions for the mid- and late-1980s, he 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).

Furthermore, the way that labor market institutions have changed over time has been very different across countries, in ways that confuse the issue:

Changes in institutions did not appear able however to explain the evolution of unemployment rates over time. . . . what is striking are the different evolutions [of labor market policies such as unemployment insurance replacement rates or employment protection levels] of the . . . countries, and the absence of a common trend. . . . In panel data regressions of unemployment rates on institutions across 20 countries since 1960, none of the labor market institutions appeared significant.

The "tax wedge" has often been blamed by business or politicians for rising unemployment, but Blanchard is skeptical, with one proviso:

The difference between take-home pay for workers and the cost of labor for firms, divided by the wage, has steadily gone up in most European countries since the 1960s.

Taxes or social contributions that treat income equally whatever its source (labor income or unemployment benefits) should not affect the cost of labor to firms, and thus not 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.

On empirical grounds, while the increase in the tax wedge fits the general increase in unemployment, it does poorly in explaining differences in unemployment across countries. Three of the four countries with the highest tax wedge, Finland, Sweden, and Austria, are also countries with a low natural rate [of unemployment].

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.

Nevertheless, there has been a movement to at least partially reform labor market regulations over the last two decades:

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. . . . either because of poor design, unanticipated consequences, or political constraints. Institutions today are [still] less employment friendly than they were in the early 1970s.

One example of how some reforms may have had perverse effects - moves to reduce employment protection may have simply exacerbated the insider/outsider problem:

The decrease in employment protection has come in the form of the introduction of two types of labor 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 labor market, with protected and marginal workers.

Recommendations

So what should be done? Blanchard poses the challenge nicely:

[A]llow economies to constantly reallocate . . . labor from old to new products, from bad to good firms, while providing workers the economic security and insurance against major adverse professional events, job loss in particular, that they value.

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 does this mean for the reform of labor market institutions:

What is important in essence is to protect workers, not jobs.

• Unemployment insurance, generous in level, but conditional on the willingness of the unemployed to train for and accept jobs if available.

• 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.

• Low-wage labor: decrease the cost of low skilled labor through lower social contributions paid by firms at the low wage end, and make work attractive to low skill workers through a negative income tax rather than a minimum wage.

This consensus underlies most recent reforms or reform proposals, for example in the recent Hartz reforms in Germany, or the "Camdessus Report" on reforms in France.

Will this be enough to solve Europe's unemployment problem? Blanchard does not think so. There are two other steps that may be needed:

Social Partnership

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.

Various measures of trust between unions and firms, from strike intensity in the 1960s to survey measures of trust between firms and workers, can explain a substantial fraction of differences in unemployment across European countries.

Do countries such as France or Italy need to also modify the structure of collective bargaining? Even if they did, the results would be the same as in Sweden or Denmark?

Expansionary Monetary and Fiscal Policy

It may be that, in fact, an expansion of demand might decrease unemployment without leading to steadily higher inflation.

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 . . . workers are reluctant to accept nominal wage cuts.

In such an environment, it may be that an unemployment rate above the natural rate may lead to low rather than declining inflation, so Europe's current stable inflation rate does not mean that the European unemployment rate is at the natural rate.

The experience of Spain, where unemployment has steadily decreased without major labor market reforms and without an increase in inflation, can be read in this light.