W/P BRW1
BRW0
PRW
E1 E0 Employment
Figure 1: The figure shows the leftward shift of the Bargained Real Wage (BRW) while the Price-determined Real Wage (PRW) is constant. This causes employment, on the horizontal axis, to fall to E1. This raises the equilibrium level of unemployment.
Trade union power cannot solely account for the disparity in experience across the OECD countries. Firstly, union density was also rising in the small non-EC European countries whilst unemployment was not taking off. Secondly, during the 1980s despite Thatcher’s deconstruction the UK unions, unemployment persisted at a high level. Camplors and Drifill suggest that relationship between centralisation and unemployment is as follows:
Wage Inflexibility
US Denmark Degree of Centralisation
Figure 2: This figure shows that countries at the extremes of centralisation will have similar levels of wage inflexibility, US and Denmark for example. In this model, countries which have elements of a centralised economy, will experience the highest rates of unemployment.
Another key factor in explaining the divergence across the OECD at this time is participation in the ERM. This caused increased price and wage flexibility because governments were forced to relinquish control of monetary policy. This caused many problems for the UK and more erratic economies such as Italy and Spain, due to their lack of harmonization with the driving economies of the ERM: Germany and France for example. When the interest rate rose, due to the UK’s exit from the ERM, it created massive debts among the growing number of home-owners: this further increased inflexibility in the labour market. The private rental sector, common in the US, is associated with the most mobile labour.
The institutional differences may account for unemployment rates today but why did they fail to explain trends in the past? Countries within Europe have such differing experiences it is difficult to formulate a relationship between the level of unemployment and their institutions. Examples of two countries with high levels of benefits for a long duration are Denmark and Sweden. Yet both experience very different trends in unemployment over the last two decades.
Labour market inflexibility goes some way to explain the divergence in unemployment experience across the OECD but how great is the effect of adverse shocks? The major global shocks of the 1970s and early 1980s were the rise in Oil prices and high world interest rates. A rise in the price of an imported material will have the effect of causing unemployment to rise if profit margins are to be maintained.
W/P
BRW 0
PRW 0
PRW 1
E1 E0 Employment
Figure 3: The figure shows the downward shift of the Price-determined Real Wage (PRW) while the Bargained Real Wage (PRW) is constant. This causes employment, on the horizontal axis, to fall to E1. This raises the equilibrium level of unemployment.
Bruno and Sachs contend that this diverted attention away from the most significant factor in determining unemployment, total factor productivity (TFP). Through the 1980s, when the price effects of the Oil shocks were reversed, the high level of interest rates kept unemployment high when the effect of a declining TFP was diminishing. Macroeconomic policy probably delayed some of the increase in unemployment from the 1970s to the 1980s. Partially due to the declining TFP, adverse labour demand shifts can potentially account for why unemployment has remained high into the 1990s.
High world interest rates had a severe effect on the unemployment rate in the UK due to a simultaneous structural shift in the labour market: the discovery of North Sea Oil in the late 1980s caused the current account balance to improve which led to an appreciation of sterling. Manufacturers find capturing and retaining export markets difficult with a ‘strong’ pound, which causes redundancies in the manufacturing industry. However, because the UK is still in the ERM, the government was powerless to bring the economy back towards equilibrium. Combined with the Thatcherite policies on the Trade unions and industry, the problem of unemployment was exacerbated. This underlines the importance of the interplay between adverse shocks and labour market flexibility.
According to Blanchard and Wolfers, the explanations of OECD unemployment since 1960 fall into three categories: role of economic shocks; adverse labour market institutions; interactions of market shocks with adverse market institutions. It is only the latter that has potential to explain the increase in unemployment over time (through adverse shocks), but also the heterogeneity of unemployment evolutions (through the interaction of shocks with different labour market institutions). The role of economic shocks is empirically insufficient as it fails to explain cross-country differences in unemployment. Adverse labour market institutions are not able to explain the general evolution of unemployment over time: they can potentially generate high unemployment but many institutions existed when unemployment was low.
The concept of unemployment hysteresis helps us to explain the divergent employment experiences of OECD countries in the 1980s. It describes the situation where an equilibrium rate of unemployment is path-dependent. There are varying degrees of hysteresis. ‘Pure’ hysteresis exists when there is no long run or underlying equilibrium rate of unemployment at all. ‘Impure’ hysteresis (or persistence) describes a situation where there is a medium-term deviation from long run equilibrium with persistent unemployment and inflation. There are many channels through which changes in aggregate demand may bring about changes in the equilibrium rate of unemployment:
- The ‘insider-outsider’ effect
There are two groups of workers. The insiders are those currently employed, who are in a strong bargaining position because of their possession of firm specific skills means that the firm cannot simply fire them and hire new workers. Insiders are presumed to be interested only in their real wage not the level of employment. Insiders can undercut outsiders because of the cost involved in hiring outsiders: high costs and inconvenience of drawing up contracts and re-training staff.
This is a pure hysteresis effect which means that there is no tendency for unemployment to converge to an equilibrium level. It can be formulated as follows:
(1)
It can also be modelled as a random walk process:
(2)
Where ρ = 1, the change in unemployment is simply equal to the stochastic error term, εt. Where ρ < 1, there is mean reversion. That is, there is a tendency for the economy to gravitate towards a long run equilibrium.
- The relationship between the short-term and long-term unemployed in the pool of unemployed
The empirical evidence suggests a rise in unemployment that persists has the effect of raising the proportion of long-term unemployed. This is due to the fact that the unemployed become less employable over time due to skills atrophy: their ‘on-the-job’ knowledge quickly diminishes. The result is that union bargaining power is increased at each rate of unemployment: the bargaining real wage rate shifts upwards. In this example, there is short to medium-term persistence with a long-term equilibrium level of unemployment. This can be formulated as follows:
(3)
- Capacity scrapping
Lower investment induced by lower rates of capital utilisation leads in the medium run to a rundown in the size of the capital stock. Thus rates of capacity utilisation begin to rise again. High rates of capacity utilisation widen profit margins. Because the firm lacks ability to take advantage of this due to its lack of capacity, prices rise. As prices respond, the equilibrium rate of unemployment will be shifted up as prices respond to the shortage of capacity in the economy. This disparity is eventually redressed through fluctuations in prices.
In conclusion, higher European unemployment rates tend to be a reflection of a lower level of institutional flexibility and also adjustment flexibility rather than a greater degree of shocks. Predominantly global shocks have affected the OECD area and thus should have had a unilateral affect on unemployment rates. Therefore, it is the adjustment process in the response to these global shocks that determines a country’s unemployment performance. Pure hysteresis effects could account for some of the unemployment present in the 1970s. Impure hysteresis effects have greater explanatory power through the 1980s when trade union power was in decline: between, 1979-86, long-term unemployment rose from 20 to 40 per cent in the UK and Europe. This is due to the reduced search effectiveness of the unemployed ‘outsiders’, rather than the effect of ‘insiders’. The capacity scrapping form of unemployment persistence is a possible explanation for the twin observations of a return to ‘normal’ levels of capacity utilisation in 1979 and 1985 in the UK despite the presence of continuing rises in unemployment over the period as a whole. The concept of hysteresis is still in its infancy and requires further empirical and theoretical extension.
