## Chronic Unemployment in the Euro Area: Causes and Cures ## Source details **Canonical URL:** [Chronic Unemployment in the Euro Area: Causes and Cures](https://www.imf.org/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/weo/1999/01/_0599ch4pdf.pdf) ## Other formats - [Markdown version](/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/weo/1999/01/_0599ch4pdf.pdf.md) - [Structured JSON version](/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/weo/1999/01/_0599ch4pdf.pdf.json) --- ### Overview and urgency - Election of new governments and formation of monetary union renewed policy discussions to reduce joblessness and promote employment growth. - Short-term concern: recent slowdown of growth reduced the likelihood of a decline in cyclical unemployment in 1999 and threatens to exacerbate unsustainable global current account imbalances. - Medium- and long-term concern: dramatic increase in the old-age dependency ratio makes low employment ratios increasingly costly and unsustainable. - Key quantitative estimate: - Reducing unemployment from the current level of 11 percent to around 5 percent would increase GDP by around 4 percent. - Given prevailing tax rates and unemployment-related benefits, this increase would suffice to eliminate remaining structural budget deficits in the area or allow substantial reductions in average income tax or value-added tax rates. ### Labor market performance: empirical findings and key statistics - Long-term trends: - Unemployment rate rose from around half the average U.S. rate during the 1960s to more than twice the U.S. rate in the 1990s. - Private (nongovernment) employment growth, 1970–1998: - United States: increased by 70 percent between 1970 and 1998. - Euro area: increase was well below 5 percent over the same period. - Participation and underutilization: - Relatively low participation rate in the euro area suggests the standard unemployment rate underrepresents the problem. - Government training, employment, and early retirement schemes have kept the unemployment rate artificially low; many discouraged workers have dropped out of the labor force. - Underutilization estimates (OECD Jobs Study follow-up examples): - Netherlands (1996): 27 percent. - Germany (1997): 23 percent. - Belgium (1998): 23 percent. - Cross-country dispersion in 1997 unemployment rates: - Luxembourg: under 4 percent. - Spain: close to 20 percent. - Figure summary: rising unemployment rates, stagnant private sector employment, and flat participation rates document weak job creation in euro-area countries. ### Social and fiscal costs - High unemployment implications: - Major loss of output and potential to raise domestic standards of living or provide resources for other purposes. - Fiscal pressures from lost tax revenue, transfer payments to the unemployed, and high taxation on employed persons to finance transfers to the jobless. - Major source of inequality in current income and opportunities for human development, threatening social cohesion. - Note on black/gray market activity: - Reduces welfare cost of official unemployment for individuals but contributes little to alleviating the fiscal burden. ### Structural versus cyclical unemployment: decomposition and policy implications - Most estimates imply the bulk of European unemployment is structural and cannot be eliminated by cyclical recovery alone. - Figure 4.2 summary: Most unemployment in the euro area is structural rather than cyclical. - Policy implications: - Structural reforms are required to restore reasonable labor market performance. - Attempts to reduce unemployment beyond its cyclical component via demand management risk resurgence of macroeconomic imbalances (inflation or fiscal deficits) seen in the 1970s and 1980s. - Key objective of structural reform: increase flexibility of European labor markets—responsiveness and ability to adapt rapidly to changing economic conditions. - Particularly urgent for the 11 countries that entered monetary union on January 1, 1999, because nominal exchange rates are no longer available as national adjustment instruments. ### Measurement, concepts, and persistence (“hysteresis”) - Measurement issues: - Official national measures and standardized unemployment rates differ; standardized rates (labor market surveys) improve comparability but exclude discouraged workers and involuntary part-time workers. - Broader underutilization measures indicate considerable differences among countries; e.g., percent of working-age people not employed is more than twice as high in Italy as in Switzerland. - Definitions: - Structural unemployment rate (SUR) ≡ equilibrium rate of unemployment; SUR = NAIRU. - Cyclical unemployment = deviation of actual unemployment from SUR. - Phillips curve and persistence specifications (verbatim formulations): - Standard (no persistence): P = L(P) – a(U – SUR), where P = rate of inflation; L(...) = lag operator; U = actual unemployment; SUR = structural rate. - Full hysteresis: P = L(P) – a[U – L(U)]; under full hysteresis the SUR is not uniquely defined; the NAIRU equals the lagged unemployment rate. - Intermediate (SUR and persistence): P = L(P) – a(U – SUR) – b[U – L(U)]; implies NAIRU = a/(a + b) SUR + b/(a + b) L(U). - Consequences: - Persistence (speed-limit) effects mean the SUR and NAIRU can diverge and rapid reductions in unemployment can raise inflation even when U > SUR. - Empirically, the specification including both SUR and persistence often fits data best. - The persistence parameter b is influenced by structural and institutional features (wage-setting variables, job protection legislation, benefit generosity) that determine the SUR. ### A sequence of adverse shocks (historical drivers) - Major adverse shocks affecting Europe and the United States included: - a fall in productivity growth that started at the beginning of the 1970s; - large deterioration in the terms of trade from steep oil price increases in 1973 and 1979; - a rise in real interest rates, especially at the long end of the term structure, at the beginning of the 1980s. - Post-shock developments: - Deterioration in the terms of trade partially and gradually reversed since 1985. - Slowdown in productivity growth persists. - Rise in the real interest rate—compared with rates prevailing during the low unemployment decade of the 1960s—has only recently shown signs of abatement, partly for cyclical reasons. - Differential real wage and employment responses: - United States: real wage growth lagged labor productivity increases, translating productivity gains into rising employment. - Europe: real cost of labor increased in line with labor productivity growth, raising real wages with little employment growth. - Consequences in Europe: - High labor costs encouraged capital-intensive production and reduced investment in activities rendered unprofitable, contributing to rising structural unemployment. - The unemployment rate associated with full capacity utilization steadily crept upward in Europe; the U.S. relationship between output gap and unemployment clustered around a stable “Okun curve.” - Labor market cycle difference: - U.S. recoveries returned unemployment close to preshock levels; European recoveries exhibited a ratchet effect with successive unemployment troughs above previous cycles. - Measurement caveat: - Slowdown in measured total factor productivity growth may reflect measurement difficulties in services (now well over 60 percent of aggregate output in advanced countries). ### Labor market rigidities and wage-bargaining structures - Institutional factors affecting outcomes: - Degree of centralization of wage bargaining. - Severity of labor market regulations (job protection legislation, flexibility of work arrangements). - Generosity of income replacement in unemployment benefit or welfare schemes. - Centralization spectrum examples: - United States and Canada: highly decentralized wage formation. - Some Scandinavian countries, Belgium, Austria: highly centralized wage negotiations. - Other European countries occupy intermediate positions. - Dimensions of centralization: - Union density; bargaining level (enterprise, sectoral, national); degree of coordination across bargaining units. - Nonlinear relationship: - Degree of centralization vs labor market outcomes is stylized as “hump-shaped”: good outcomes when bargaining is either decentralized (e.g., United States) or highly centralized (e.g., Austria and Ireland); intermediate positions (e.g., France and Spain) show less satisfactory outcomes. - Administrative extension and coverage: - Many euro-area countries apply negotiated wage agreements beyond parties involved, producing “excess coverage”; stricter job protection correlates with higher excess coverage and insider protection. ### EMU, policy constraints, and adjustment mechanisms - As of January 1, 1999: - 11 of the 15 EU member countries entered the third and final stage of EMU. - Exchange rates between participating countries’ currencies were irrevocably fixed in relation to the euro. - The European Central Bank (ECB) took over responsibility for monetary policy in the euro area. - Policy implications: - National monetary and exchange rate policies no longer available to cushion cyclical differences or asymmetric shocks. - Fiscal policy for demand management constrained by the Stability and Growth Pact (SGP), which imposes financial penalties on countries exceeding a 3 percent fiscal deficit limit. - Given large structural deficits, the SGP may constrain built-in stabilizers in a near-term weakening of activity. - Adjustment channels under EMU: - Real exchange rate changes must be achieved through real wage changes rather than nominal depreciation. - Increased reliance on labor market and product market flexibility to correct macroeconomic imbalances. - Low geographic labor mobility reduces migration as an adjustment mechanism. - Risks: - Asymmetric shocks may cause prolonged depressed employment in adversely affected countries or regions. ### Tax wedge, unemployment insurance, job search, and incentives - Tax wedge and labor costs: - Three revenue components drive the wedge: income taxes, social security contributions (employers’ and employees’), and indirect consumption taxes. - Differences in overall tax wedge across countries matter more than differences in composition. - A tax wedge of 55 percent—the average for euro-area countries—implies production for market needs must be more than twice as efficient (as measured by hourly labor productivity) as own production to make market exchange advantageous. - Large tax wedges likely reduce formal employment, increase home production and black market activities, and help explain relatively low participation rates. - Unemployment insurance and incentives: - Benefits protect incomes, facilitate job search and mobility, and can improve matching efficiency. - Offsetting effects: benefits reduce cost of unemployment and can lengthen average unemployment durations and raise average unemployment. - Administrative design matters: strict eligibility, availability-for-work rules, and periodic review can mitigate negative job-search effects (examples: Denmark, the Netherlands, Switzerland, United Kingdom reforms). - Use of a limited waiting period before benefits are granted introduces self-insurance and reduces adverse incentives. - Interaction with means-tested transfers: - Means-tested transfers and tax systems can generate very high marginal effective tax rates (METRs), reducing incentives to take up or upgrade employment. ### Econometric evidence on institutions and structural unemployment - Cross-section/time-series analysis for 17 advanced economies finds: - Generosity of unemployment benefits has a strong impact on the SUR. - Institutional factors (wage-bargaining framework and job protection legislation) have statistically significant and quantitatively important effects on the SUR. - Active labor market policies may reduce the SUR. - On the rise in SUR between 1973 and 1993: rise in real interest rates contributed more than one-third of the observed average increase in the SUR. - Changes in terms of trade were significant but less important; trend decline in total factor productivity growth was not included. - Declining union membership implied a negative average contribution of changes in union density to changes in the SUR. - Empirical findings confirm prior work (Layard, Nickell, Jackman) though quantitative importance varies with specification and coverage. ### Hysteresis, persistence, and mechanisms - Hysteresis hypothesis: shock-induced changes in actual unemployment can become permanent because SUR follows actual unemployment. - Mechanisms generating hysteresis: - Insider-outsider wage-setting. - Loss of human capital from prolonged unemployment. - Capital constraints from subdued investment during recessions. - Empirical conclusions: - Strong version of hysteresis (complete history dependence) is rejected. - NAIRU behaves as a weighted average of SUR and lagged actual unemployment, producing persistence and a “speed limit effect.” - Institutional arrangements—union power, job protection, benefit generosity—are central to hysteresis dynamics. ### OECD Jobs Study and policy recommendations - Jobs Strategy core recommendations (selected verbatim objectives): - Set macroeconomic policy to encourage growth and make it sustainable. - Enhance creation and diffusion of technological know-how. - Increase flexibility of working time voluntarily sought by workers and employers. - Nurture an entrepreneurial climate by eliminating impediments to enterprise creation and expansion. - Make wage and labor costs more flexible, remove restrictions preventing wages from reflecting local conditions and individual skill levels. - Reform employment security provisions that inhibit private sector employment expansion. - Strengthen active labor market policies (ALMPs) and reinforce their effectiveness. - Improve labor force skills and competencies via education and training reforms. - Reform unemployment and related benefit systems to achieve equity goals with less adverse labor market effects. - Enhance product market competition to reduce monopolistic tendencies and weaken insider-outsider mechanisms. - Country-specific follow-up emphasized reducing incentives for nonparticipation, reducing taxation of labor, reforming unemployment benefits, increasing work-time flexibility, liberalizing job protection, facilitating wage dispersion and decentralization, and reinforcing ALMPs. ### Country experiences and outcomes, 1990–97 (selected illustrations) - Groups of countries by SUR change, 1990–97: - Countries that lowered SUR: Ireland, the Netherlands, the United Kingdom, Denmark, Spain. - Countries where SUR increased by more than 2.5 percentage points: Finland, Germany, Sweden. - Intermediate group: relatively small increases in SUR. - Country-specific shocks explaining large SUR increases: - Finland: collapse of traditional export markets related to disintegration of the Soviet Union. - Germany: unification shock and integration of East Germany. - Sweden: abandonment of public sector as “employer of last resort” amid severe recession. - Selected country reform elements: - United Kingdom: curtailment of trade union power; decentralization of wage bargaining; active labor market policies; reduced generosity of unemployment benefits; shift to in-work benefits (family credit/working families tax credit); national minimum wage to be introduced in April 1999 with a lower minimum for youth. - Netherlands: 1982 Wassenaar Agreement; wage moderation; cuts in taxes on labor; lowering of real minimum wages for youth; tightening eligibility for unemployment and disability benefits. - Denmark: tightened eligibility and availability-for-work requirements; “compulsory activation”; reduced maximum benefit duration for youth; enterprise flexibility and minimal job protection aided rapid success. - Spain: 1992–1997 reforms tightening eligibility and reducing benefit duration; reduced restrictions on firing and working time; creation of a new permanent contract with reduced severance pay; aimed to decentralize wage formation. ### Microeconomic reform agenda and implementation lessons - Objective: remove rigidities preventing rapid reentry of the unemployed into profitable employment. - Reform thrust: - Eliminate or reduce distortions in incentives. - Remove regulatory constraints preventing mutually beneficial employer-employee contracts. - Reintegrate the unemployed and disenfranchised into the working population. - Complementarity and comprehensiveness: - Structural reforms are often complementary; comprehensive reform can produce benefits exceeding the sum of isolated measures. - Many piecemeal reforms in the 1990s had little impact; significant reductions in structural unemployment occurred where reforms were radical and comprehensive. - Political economy: - Implementation is difficult because targeted arrangements (income protection, equity, job security) create insiders and outsiders. - Strategies to build consensus include opt-out arrangements for outsiders, transforming passive benefits into in-work benefits, and tripartite agreements combining wage moderation with measures for displaced workers. - Role of macro policy in supporting reform: - Structural reform raises potential output but capital stock and demand must adjust; accommodative macro policy can facilitate demand expansion to match rising potential output. - Fiscal constraints (high public expenditure and taxation ratios, incomplete consolidation) limit public spending as a demand instrument. - Monetary policy emphasis on price stability suggests a role for accommodative monetary policy during transition if inflationary indicators remain benign; successful reform will reduce wage pressure. - Euro precludes independent national monetary policy; countries can proceed at different speeds though this creates asymmetric national supply shocks. ### Supporting measures and risks of quick fixes - Incomes policies: - Tripartite agreements can reduce the “sacrifice ratio” and help employment during transition but may hinder relative wage adjustment. - Active labor market policies (ALMPs): - Include placement assistance, counseling, mobility support, training, employment subsidies, direct job creation. - Most successful: intensive placement assistance and on-the-job training for disadvantaged groups. - Less effective: classroom training and direct government job creation; employment subsidies can have deadweight costs. - Costs can be moderated by redirecting funds from passive transfers to ALMPs. - Questionable policies: - Early retirement and invalidity schemes reduced labor supply but added fiscal burdens and likely contributed to higher unemployment indirectly. - Work sharing (mandatory reductions in statutory hours) and universal minimum interventions risk raising unit labor costs, may not address skill mismatches, and can increase wage pressure unless accompanied by structural policies. - Macroeconomic quick fixes (demand stimulus without structural reform) risk reigniting inflation and fiscal imbalance and historically have not sustainably reduced structural unemployment. ### Overcoming political and institutional obstacles - Political constraints: - Voter preference for welfare state and resistance to attacks on accrued rights (“acquis sociaux”). - Insiders (employed, protected) are politically powerful relative to outsiders. - Rationale and strategies: - Aging populations and rising dependency ratios make generous benefits and early retirement unsustainable; high employment ratios are essential. - Consensus-building approaches include crisis-driven reform, opt-out arrangements for outsiders, in-work benefit transformation, and tripartite agreements combining wage moderation with social measures. - Timing and persistence: - Benefits of reform take time to materialize; strong job creation concentrated in dynamic, flexible sectors. - Structural changes and labor force composition shifts can build political support for reforms over the long horizon. ### Conclusion: interaction of macro and structural factors - The rise in unemployment in Europe is characterized primarily as structural rather than cyclical. - Hysteresis and insider–outsider dynamics can make demand expansions ineffective unless reforms surprise insiders or change institutional constraints. - Skill-biased technological change is a major driver of shifts in labor demand in favor of skilled workers; only a small part of deindustrialization is attributable to competition from developing countries. - Policy implications: - Structural reforms are central to achieving sustained reductions in unemployment and typically need to be comprehensive. - Macroeconomic stabilization and demand management play a supporting role to facilitate reform implementation and absorb rising potential output. - Addressing skill-biased technological change requires policies that improve labor redeployment and skill acquisition. - Globalization is not identified as the primary cause of deindustrialization or rising unemployment; focus should be on removing rigidities and supporting skill upgrading. *Italic: Source — _0599ch4pdf, "Chronic Unemployment in the Euro Area: Causes and Cures" (IMF staff chapter text, 1999).* ### 1999. The election of new governments in many of ### Chronic Unemployment in the Euro Area: Causes and Cures ### Overview and urgency - The election of new governments and the change in the policy framework associated with the formation of monetary union have renewed policy discussions to reduce joblessness and promote employment growth. - Short-term concern: recent slowdown of growth has reduced the likelihood of a decline in cyclical unemployment in 1999 and threatens to exacerbate unsustainable global current account imbalances. - Medium- and long-term concern: the dramatic increase in the old-age dependency ratio makes low employment ratios increasingly costly and unsustainable. - Reducing unemployment from the current level of 11 percent to around 5 percent would increase GDP by around 4 percent. - Given prevailing tax rates and unemployment-related benefits, this increase would suffice, apart from other benefits, to eliminate the remaining structural budget deficits in the area or allow substantial reductions in average income tax or value-added tax rates. ### Labor market performance: empirical findings and key statistics - Trend deterioration over three decades: the unemployment rate rose from around half the average U.S. rate during the 1960s to more than twice the U.S. rate in the 1990s. - Private (nongovernment) employment growth, 1970–1998: - United States: increased by 70 percent between 1970 and 1998. - Euro area: increase was well below 5 percent over the same period. - Participation and underutilization: - Relatively low participation rate in the euro area suggests the standard unemployment rate underrepresents the problem. - Government training, employment, and early retirement schemes have kept the unemployment rate artificially low; many discouraged workers have dropped out of the labor force. - Underutilization estimates (OECD Jobs Study follow-up examples): - Netherlands (1996): 27 percent. - Germany (1997): 23 percent. - Belgium (1998): 23 percent. - Cross-country dispersion in 1997 unemployment rates: - Luxembourg: under 4 percent. - Spain: close to 20 percent. - Figure summary: rising unemployment rates, stagnant private sector employment, and flat participation rates document weak record of job creation in countries forming the euro area. ### Social and fiscal costs - High unemployment represents: - A major loss of output and potential to raise domestic standards of living or provide resources for other purposes. - Fiscal pressures: lost tax revenue, transfer payments to the unemployed, and high taxation on employed persons to finance transfers to the jobless, which distort incentives. - Major source of inequality in current income and opportunities for human development, threatening social cohesion. - Black (or gray) market activity by the nominally unemployed reduces the welfare cost of official unemployment but contributes little to alleviating the fiscal burden. ### Structural versus cyclical unemployment: decomposition and policy implications - Most estimates imply the bulk of European unemployment is structural and cannot be eliminated by cyclical recovery alone. - Figure 4.2 summary: Most unemployment in the euro area is structural rather than cyclical. - Policy implication: - Structural reforms are required to restore reasonable labor market performance. - Attempts to reduce unemployment beyond its cyclical component via demand management risk resurgence of macroeconomic imbalances (inflation or fiscal deficits) that troubled advanced economies in the 1970s and 1980s. - Key objective of structural labor market reform: increase the flexibility of European labor markets — their responsiveness and ability to adapt rapidly to changing economic conditions. - Particularly urgent for the 11 countries that entered monetary union on January 1, 1999, since nominal exchange rates are no longer available as national adjustment instruments. ### Measurement, concepts, and persistence (“hysteresis”) - Measurement issues: - Official national measures and standardized unemployment rates differ; standardized rates (labor market surveys) improve comparability but exclude discouraged workers and involuntary part-time workers. - Broader measures of underutilization (discouraged workers and involuntary part-time workers as percent of the labor force) indicate considerable differences among countries. - An even broader measure — percentage of working-age people not employed — shows international differences: e.g., rate more than twice as high in Italy as in Switzerland. - Definitions: - Structural unemployment rate (SUR) ≡ equilibrium rate of unemployment (the rate at which there is no tendency from the labor market for inflation to increase or decrease); SUR = NAIRU. - Cyclical unemployment = deviation of actual unemployment from SUR. - Hysteresis / persistence and the Phillips curve: - Standard Phillips curve formulation (no persistence): - P = L(P) – a(U – SUR), where P = rate of inflation; L(...) = lag operator; U = actual unemployment; SUR = structural rate of unemployment. - Full hysteresis specification: - P = L(P) – a[U – L(U)]. - Under full hysteresis the SUR is not uniquely defined; the NAIRU equals the lagged unemployment rate. - Intermediate specification (SUR and persistence): - P = L(P) – a(U – SUR) – b[U – L(U)]. - Implies NAIRU = a/(a + b) SUR + b/(a + b) L(U). - Consequences: - Persistence (speed-limit) effects mean the SUR and NAIRU can diverge and that rapid reductions in unemployment can raise inflation even when U > SUR. - Empirically, the version that includes both a (possibly time-variant) SUR and persistence effects (equation above) often fits data best for most countries. - The size of the persistence parameter b is influenced by the same structural and institutional features (wage-setting variables, job protection legislation, benefit generosity) that determine the SUR. ### Underlying causes and conventional interpretation - Dominant view: current unsatisfactory labor market outcomes in Europe result from the interaction of: - Labor market rigidities (institutional/structural features). - A series of adverse shocks since the early 1970s. - Rationale: - Structural rigidities alone are insufficient: many rigidities existed in the 1960s when European unemployment was lower than U.S. unemployment. - Shocks alone are insufficient: similar shocks hit the United States and Japan without comparable trend increases in unemployment. - Policy conclusion: - Both structural reform to increase labor market flexibility and appropriate macroeconomic policy are necessary to restore better labor market equilibrium and avoid undesirable macroeconomic side effects. *Italicized source: IMF staff chapter text (1999), "Chronic Unemployment in the Euro Area: Causes and Cures."* ### Box 4.1 (concluded) ### Box 4.1 (concluded) ### A Sequence of Adverse Shocks - Major adverse shocks affecting Europe and the United States included: - a fall in productivity growth that started at the beginning of the 1970s; - large deterioration in the terms of trade stemming from the steep oil price increases in 1973 and 1979; - a rise in real interest rates, especially at the long end of the term structure, at the beginning of the 1980s. - Post-shock developments: - The deterioration in the terms of trade has been partially and gradually reversed since 1985. - The slowdown in productivity growth persists. - The rise in the real interest rate—compared with rates prevailing during the low unemployment decade of the 1960s—has only recently shown signs of abatement, albeit partly for cyclical reasons. - Real wage and employment responses differed between the United States and Europe: - United States: real wage growth lagged behind labor productivity increases, translating productivity gains primarily into rising employment, with only a modest increase in the real wage. - Europe: real cost of labor continued to increase in line with labor productivity growth, so rising labor efficiency was “used” to raise real wages with little growth in employment. - Consequences in Europe: - High labor costs encouraged capital-intensive production where employment remained profitable, raising capital-labor ratios for employed workers. - High labor costs also made many activities unprofitable, reducing investment in those areas (“capital shortage” interpretation). - Because marginal productivity of low-skilled labor did not match high real wage demands, structural unemployment rose. - The unemployment rate associated with full (or “normal”) degrees of capacity utilization has steadily crept upward in Europe, implying rising structural unemployment; by contrast, the U.S. relationship between output gap and unemployment is clustered around a stable “Okun curve.” - Labor market cycle differences: - Both regions saw unemployment increases after the 1973 and 1979 oil shocks, but in recoveries: - United States: unemployment rate fell back close to its preshock level. - Europe: unemployment exhibited a ratchet effect, with successive unemployment troughs above previous cycles. - Measurement and interpretation notes: - The slowdown in measured total factor productivity growth contrasts with perceived technical change; measurement difficulties in services (now well over 60 percent of aggregate output in advanced countries) may explain part of the puzzle. - The differing post-shock unemployment behavior of Japan is noted: several years of output stagnation and a record negative output gap caused an increase in the open unemployment rate of only 1 percentage point, implying rising hidden unemployment. ### Labor Market Rigidities - Key institutional factors affecting differing labor market outcomes include: - degree of centralization of wage bargaining; - severity of labor market regulations (job protection legislation, flexibility of work arrangements); - generosity of income replacement in unemployment benefit or welfare schemes. - Centralization spectrum: - United States and Canada: highly decentralized wage formation across industries and within firms. - Some Scandinavian countries, Belgium, Austria: highly centralized wage negotiations determining wage levels and relatives for the great majority of workers. - Other European countries occupy intermediate positions. - Dimensions of centralization: - union density (extent of unionization); - bargaining level (enterprise, sectoral, national); - degree of coordination across bargaining units. - Institutional rigidities reduce the flexibility needed to adjust to shocks and help explain why Europe’s outward shift in aggregate labor demand translated into real wage growth rather than employment growth. ### EMU, Policy Constraints, and Adjustment Mechanisms - As of January 1, 1999: - 11 of the 15 member countries of the EU entered the third and final stage of the process leading to the formation of the European Economic and Monetary Union (EMU). - Exchange rates between participating countries’ currencies were irrevocably fixed in relation to the euro. - The European Central Bank (ECB) took over responsibility for monetary policy in the euro area. - Policy implications of EMU membership: - Individual member countries no longer have national monetary policy or exchange rate policy to cushion differences in cyclical positions or adjust to asymmetric shocks. - Countries also face constraints on fiscal policy for demand management from the Stability and Growth Pact (SGP), which imposes financial penalties on countries exceeding a 3 percent fiscal deficit limit. - Given large structural deficits in member countries, the SGP may constrain the operation of built-in stabilizers in the case of a near-term weakening of activity. - Adjustment channels under EMU: - Nominal exchange rate changes can no longer be used to correct misalignments; required real exchange rate changes must be achieved through real wage changes directly rather than indirectly via nominal depreciation. - This increases the reliance on labor market and product market flexibility to achieve efficient correction of macroeconomic imbalances. - Low geographic mobility of labor both among and within member countries reduces migration as an adjustment mechanism. - Risks: - Asymmetric shocks may entail prolonged depressed employment in the most adversely affected country or region because national monetary and exchange rate policies are no longer available and fiscal policy is constrained by the SGP. *Italic: Source — _0599ch4pdf - Box 4.1 (concluded)_.* ### Box 4.2. EMU and European LaborMarkets ### Box 4.2. EMU and European LaborMarkets ### EMU membership, policy context, and asymmetric shocks - Of the four EU countries not joining the monetary union on January 1, Greece did not meet the entry requirements, while Denmark, Sweden, and the United Kingdom decided not to join at this stage. - The SGP and its implications for the conduct of fiscal policy in the EU are noted as discussed elsewhere in the World Economic Outlook. - The potential burden on member countries from the loss of country-specific monetary and exchange rate policies will partly depend on the likelihood of asymmetric shocks in the area. - Historical analysis (period 1962–88) indicates that asymmetry of shocks was more pronounced in the euro area than in the continental United States; within the euro area, shocks were more symmetric for a core group comprising Germany, France, Austria, and the Benelux countries than for periphery countries (Finland, Ireland, Italy, Portugal, and Spain). - Establishment of monetary union has eliminated a major cause of asymmetric shocks—inconsistent monetary policies and resulting exchange rate fluctuations. - Differences in sensitivity to a unified monetary policy may persist because of differences in monetary transmission mechanisms; Ramaswamy and Sloek find differences in real effects of monetary policy but conclude they do not seem to be very large and may diminish over time. ### Labor mobility, market flexibility, and non-wage impediments - Apart from labor market regulations, language/cultural barriers and high transaction costs in the housing market (linked to regulation and taxation) contribute to low regional and international labor mobility in the euro area. - Labor mobility among different states of the United States has been estimated to be three times larger than labor mobility between France and Germany. - Strengthening goods and—especially—labor markets to adjust more rapidly to economic change is desirable and has increased urgency with the formation of monetary union. ### Wage-bargaining structure, centralization, and labor market outcomes - Wage-bargaining structures vary by negotiating level and degree of coordination; Table 4.1 classifies 18 advanced economies for the period 1980–94 by predominant negotiating level and degree of coordination. - The relationship between the degree of centralization in wage formation and labor market outcomes is nonlinear: at low degrees of centralization (for example, in the United States), outcomes approximate competitive market conditions with market-clearing real wages; as centralization rises, outcomes tend toward higher real wages and increased structural unemployment due to increased union (or “insider”) power. - In countries with high degrees of unionization and centralization (or high coordination), bargaining may internalize negative externalities and produce real wage moderation and lower unemployment—producing a stylized “hump-shaped” relationship between centralization of wage bargaining and labor market outcomes. - Empirical implication: superior labor market outcomes are observed where bargaining is either decentralized (for example, the United States) or highly centralized (for example, Austria and Ireland); intermediate positions (for example, France and Spain) show less satisfactory outcomes. ### Administrative extension, coverage, and job protection - Many euro-area countries exhibit “administrative extension” of wage agreements: negotiated results reached for a subset of the labor market are applied to other parts of the economy not directly involved in the negotiations. - In all euro-area countries, the coverage of collective wage agreements greatly exceeds labor union representation (see Figure 4.6). (All data are for 1990, except for France (1985), Germany (1992), Italy (1992), and Portugal (1991).) - The danger of administrative extension is that the interests of employers and employees not involved in bargaining may not be adequately taken into account; this risk seems high in countries like Belgium, France, and Spain, and reduced in countries like Austria and the Netherlands that use a national consensus approach. - A positive correlation exists between strictness of job protection legislation and “excess coverage” of wage contracts, suggesting insiders protected by such legislation press for administrative extension to prevent underbidding by outsiders. ### Labor market regulation, enterprise-level flexibility, and adjustment - Labor market flexibility is not only linked to wage formation but also to a wide set of regulations and legislation constraining labor market contracting; while some regulations ensure minimum health and safety standards, they can limit adaptability of employment structures and in some cases protect employed individuals from competition by the unemployed, weakening an adjustment mechanism. - The wage-setting schedule (WS) framework: the WS shows how the real wage acceptable to labor varies with the unemployment rate; its location is influenced by trade union monopoly power, generosity of unemployment benefits, severity of benefit conditions, stringency of job protection legislation, etc. - Long-run labor demand (DL) is horizontal under constant returns to scale, implying that in the long run the equilibrium real wage is independent of the position of the wage-setting curve; the wage-setting curve will determine the equilibrium unemployment rate but not the real wage level. ### Policy implications and recommendations - Remove barriers preventing employers and employees from reaching mutually beneficial employment and wage contracts at the local level to achieve rapid reduction in unemployment. - Where locally determined wage levels are deemed unsatisfactory on equity grounds, supplement them with in-work benefits financed from reductions in passive transfer payments. - Decentralized wage policy is reinforced by ongoing business organization reforms that increase enterprise heterogeneity and require idiosyncratic employment contracts covering wages and working conditions. - Promote performance-oriented pay systems, more flexible organization of working hours, agreements on employment and location security, and long-term manpower policies implemented effectively at the enterprise level. - Guard against risks that increasing competitive pressure will induce protectionist responses (sheltering labor markets, “wage dumping” concerns) and avoid uniform labor standards (for example, uniform minimum wages) that may raise unemployment in low-productivity regions and stimulate advocacy for compensatory EU regional assistance. *Source: Box 4.2. EMU and European LaborMarkets.* ### Box 4.3.LaborMarkets—An Analytical Framework ### Box 4.3.LaborMarkets—An Analytical Framework ### The analytical framework - The framework depicts: - Wage-setting curves, WS. - Labor demand curves (short-term), DS, and (long-term), DL. - Unemployment rate (1 – e) = u and employment rate (e). (Adjusted for trend growth in labor efficiency.) - Key conceptual points: - The traditional labor supply schedule is represented by the vertical full employment line where e = unity. - The short-run labor demand schedule is downward-sloping because of decreasing marginal returns to labor for a given capital stock. - The labor market equilibrium is at the intersection of WS and DL and DS (point A). At A the capital stock has adjusted to its optimal level consistent with the target rate of return on capital (the supply price of capital), which together with production technology determines the equilibrium real wage. - The locations of WS and DL schedules are determined by exogenous (structural) factors; the DS schedule shifts endogenously with investment and capital stock adjustments. - The equilibrium unemployment rate is unity minus the equilibrium employment rate and is the result of structural factors determining WS and DL. - In the short run, a leftward shift of WS (to WS′) can raise the real wage temporarily at the cost of higher unemployment (point B); lower investment then shifts DS down (to DS′), restoring the real wage at a new point with higher unemployment (point C). - Long-run shifts in WS alone do not change the real wage (adjusted for labor-efficiency trend), since capital-labor ratios adjust via investment responses. ### Effect of shocks on equilibrium (framework summary and table) - The table presents how various external shocks (all defined so as to increase the unemployment rate) affect long- and short-run equilibrium values of: - Labor demand schedules (DL), - Wage-setting schedule (WS), - Capital-Labor Ratio (K/N), - Product Wage (W/P) (real product wage, adjusted for trend labor-efficiency growth), - Unemployment Rate (UNR). - The header and notes: - "All shocks are defined as increasing long-term unemployment; opposite shocks would have symmetric effects on the real wage and the unemployment rate." - "The short run is defined as the period during which the capital stock remains constant." - Note on the tax wedge: "An increase in the tax wedge can be alternatively depicted as an upward shift in the WS schedule or a downward shift in the DL schedule (or some combination of the two), with identical effects on unemployment and the real wage." - Notes on terms of trade and consumption wage vs product wage and on causes of increased "wage pushiness." - Effect table entries (verbatim lines as presented): - "Increase in the real interest rateDownNoneNoneFallNoneFallNoneRise" - "Fall in labor efficiency growthDownNoneNoneFallNoneFallNoneRise" - "Increase in 'tax wedge'Down (none)None (up)RiseNoneFallFallRiseRise" - "Terms of trade lossNoneUpRiseNoneRiseNoneRiseRise" - "Increase in 'wage pushiness'NoneUpRiseNoneRiseNoneRiseRise" - Footnotes/comments associated with the table: - "If the consumption wage (rather than the product wage) were measured along the ordinate in the figure, a terms of trade deterioration would lead to a downward shift in the DL schedule (rather than an upward shift in the WS schedule); the effect on unemployment would be identical." - "In the short run, the increase in the product wage compensates (partly) for the loss in purchasing power owing to the terms of trade deterioration. In the long run, the consumption wage (product wage) will fall (remain constant)." - "The increase in 'wage pushiness' (upward shift in WS) can be caused by various factors—for example, an increase in union militancy, an increase in unemployment benefits, and the like." ### Applications and scenarios (European experience) - Historical scenario described for Europe: - Initial equilibrium at point A. - Decline in trend growth of labor efficiency (technical progress) during the 1970s reduced the "warranted" real wage, corresponding to a downward shift in the long-term labor demand schedule. - Increase in the real interest rate in the early 1980s raised the target rate of return on capital, also shifting DL downward. - Gradual increase in the "tax wedge" can be depicted as a downward shift in DL (from employees’ perspective). - Combined effect produced a new DL position (DL′) and, for a given WS, an increased equilibrium unemployment at a new point D. - If labor’s "wage pushiness" or benefit generosity also increased, WS would shift left and unemployment increase further (equilibrium point E). - These DL shifts were followed by reduced investment as capital adjusted to the new equilibrium, producing a gradual downward shift in short-run DS to DS′′, consistent with observed weakness of business investment after the 1970s shocks (decline in labor-efficiency growth and adverse oil shocks). - Reversals and implications: - Acceleration of labor efficiency growth or a fall in the real interest rate should shift DL upward, raising the rate of return on capital, increasing investment and the capital stock; DS′′ will shift upward gradually, allowing higher equilibrium real wages and lower unemployment (movement from D toward A along WS). - Reversal of adverse terms of trade can shift WS downward and reduce unemployment—unless insiders appropriate the windfall to raise consumption wages, in which case unemployment need not decline. - Reconciling long-run real-wage invariance with trade-off in main text: - The apparent contradiction is explained by labor-force heterogeneity across skill levels. - If relative wages are rigid, biased technical progress favoring skilled workers raises unemployment among low-skilled workers; their employment share falls while the average real wage increases—this is the scenario underlying Figure 4.4. ### Institutional and regulatory factors reported (summary) - Aspects judged of primary importance for labor market outcomes (reported in Table 4.2) include: - Working time regulation (legislation on maximum length of the work week, minimum number of holidays, regulations on work at night, on weekends, and on official holidays). - Regulation of part-time work and time-limited employment. - Job protection legislation (regulating conditions under which employees can be laid off). - Minimum wages (enforced either through legislation or administrative extension of collective bargaining results). - Comparative observation: - The most tightly regulated labor markets by these criteria are Greece, Italy, and Spain; the least regulated are the United States, the United Kingdom, and Denmark. - On average, euro-area countries have more regulated labor markets than other advanced economies outside the area. - Additional institutional factors (not fully covered in the table): - Job safety legislation and workers’ codetermination (giving workers or their representatives a limited role in enterprise decision making) are noted as other influences; a detailed country-by-country listing is referenced (David Grubb and William Wells), but not reproduced here. *Source: Box 4.3, "LaborMarkets—An Analytical Framework," IV Chronic Unemployment in the Euro Area: Causes and Cures.* ### Box 4.3(concluded) ### Box 4.3 (concluded) ### Unemployment insurance, job search, and labor market incentives - Unemployment benefits protect workers from complete loss of income after job loss and can: - facilitate more careful job search, - raise labor mobility, - encourage risk taking, - improve the matching process in the labor market and increase allocative efficiency. - Offsetting effects: benefits reduce the cost of unemployment to recipients, which can lengthen average unemployment durations and raise average unemployment. - Cross-country comparisons are complicated by heterogeneity in replacement ratios, maximum benefit duration, and variation by family status, age, and other recipient characteristics. - Administrative design matters: countries with relatively generous benefits that also maintain strict eligibility, availability-for-work rules, or periodic review of job-search efforts (examples cited: Denmark, the Netherlands, Switzerland, and United Kingdom reforms replacing unemployment benefits with a “job seeker allowance”) can mitigate negative job-search effects. - Use of a limited waiting period before benefits are granted introduces self-insurance and reduces adverse incentives. ### Tax wedge, labor costs, and effects on employment - Three government revenue components drive a wedge between after-tax consumption wage and employer labor cost: income taxes, social security contributions (employers’ and employees’), and indirect consumption taxes. - Differences in the overall tax wedge across countries are more important than differences in its composition because income taxes and social security contributions are close substitutes. - The level of labor taxation affects aggregate employment and output by hampering the exchange of labor services for income. - A tax wedge of 55 percent—the average for euro-area countries—implies production for market needs must be more than twice as efficient (as measured by hourly labor productivity) as own production (“do it yourself”) to make market exchange advantageous. - Large tax wedges are likely to: - reduce formal employment, - increase home production and “black market” activities that evade taxation, - help explain relatively low participation rates and higher prevalence of small-scale service activities in Europe versus the United States. - The ultimate impact on unemployment and real wages depends on wage elasticities of the wage-setting schedule, labor supply, and labor demand. The more elastic the wage-setting schedule, the more the tax wedge will be reflected in lower employment rather than lower real wages. - Interaction of means-tested transfers and the tax system can generate very high marginal effective tax rates (METRs), reducing incentives to take up or upgrade employment. High METRs are prevalent throughout advanced economies, including the United States (though somewhat lower there than in Europe). ### Econometric evidence on institutions and structural unemployment - Cross-section/time-series econometric analysis for 17 advanced economies finds: - generosity of unemployment benefits has a strong impact on the structural unemployment rate (SUR); - institutional factors (wage-bargaining framework and job protection legislation) have statistically significant and quantitatively important effects on the SUR; - for some countries (Belgium, France, Portugal, Spain), sizable country-specific components indicate omitted factors are important; - active labor market policies may reduce the SUR. - On the rise in SUR between 1973 and 1993, the analysis suggests that the rise in real interest rates contributed more than one-third of the observed average increase in the SUR. - Changes in terms of trade were statistically significant but less important; trend decline in total factor productivity growth was not included. - Changes in unemployment benefit generosity and union density helped explain measured changes in the SUR in many countries; the United Kingdom’s curtailment of generosity contributed negatively, while generosity increased in other European countries (notably Finland, Ireland, Spain). - Declining union membership in many countries implied a negative average contribution of changes in union density to changes in the SUR over the observation period. - Findings confirm and expand prior work (Layard, Nickell, Jackman), though quantitative importance of individual institutional characteristics can differ across studies because of specification, country coverage, interaction effects, and nonlinearities. ### Hysteresis, unemployment persistence, and mechanisms - Hysteresis hypothesis: shock-induced changes in the actual unemployment rate can become permanent because the SUR follows the actual rate; equilibrium unemployment is influenced by the sequence of past shocks. - Mechanisms that can generate hysteresis: - insider-outsider mechanisms (wages set to stabilize employment at current/postshock levels); - loss of human capital from prolonged unemployment (skills, work habits); - capital constraints from subdued investment during recessions, creating supply bottlenecks and inflation before prior unemployment troughs are reached. - Two of these mechanisms (insider-outsider and human-capital loss) produce asymmetric hysteresis: negative demand shocks raise unemployment, while positive demand shocks raise real wages rather than employment. - Empirical analysis rejects the strong version of hysteresis (complete history dependence) but finds sluggish labor-market adjustment: the NAIRU behaves as a weighted average of the SUR and lagged actual unemployment, producing unemployment persistence and a “speed limit effect” (attempts to reduce unemployment too rapidly can raise inflation even when unemployment remains above the SUR). - Hysteresis complements the dominant view by highlighting risks of human-capital loss and endogenous capital adjustment to real labor costs; institutional arrangements—union power, job protection, and generosity of unemployment benefits—are central to these dynamics. ### Dissenting views - Two alternative explanations that downplay market imperfections: - chronic shortfall of effective demand from capacity output; - globalization and increased competition from low-wage countries. - The persistent-demand-deficiency view faces empirical challenges: slack in labor and goods markets did not persistently lead to falling prices or wages; in several periods since 1970 Europe experienced rising labor costs and inflation despite unemployment above earlier NAIRU estimates, suggesting the NAIRU itself rose over time. *Source: Box 4.3 (concluded), _0599ch4pdf - Box 4.3(concluded).* ### conclusion: the unemployment rate has moved up con- ### _0599ch4pdf - conclusion: the unemployment rate has moved up con- ### Underlying causes - The rise in unemployment in Europe is characterized as structural rather than cyclical: “the rising slack in the labor market was not associated with any rising slack in output markets—that is, that the increase in unemployment was of a structural and not a cyclical nature.” - Hysteresis and insider–outsider dynamics can make demand expansions ineffective at reducing unemployment unless they are surprising to insiders (reference to Blanchard and Summers, “Hysteresis in Unemployment,” European Economic Review, Vol. 31 (February–March, 1987), pp. 288–95). - Models combining accelerated structural change, generous unemployment compensation, and skill loss from prolonged unemployment can replicate the European unemployment experience (Ljungqvist and Sargent, “The European Unemployment Dilemma,” Journal of Political Economy, Vol. 106 (June 1998), pp. 514–50). - Globalization (import competition and capital mobility) is widely perceived to contribute to deindustrialization and rising unemployment among low-skilled workers, but the chapter finds: - The output shift from manufacturing to services is largely a secular change driven by faster productivity growth in manufacturing and relatively income-inelastic demand for manufactured goods. - “Only a small part of the deindustrialization that has occurred in the advanced economies is attributable to competition from developing countries.” - Empirical evidence indicates only small effects of import competition on wages and employment in advanced economies. - Much change in European manufacturing employment reflects reallocation from low-skilled to high-skilled workers within industries rather than across industries. - Skill-biased technological change is a major driver: it shifted labor demand strongly in favor of skilled workers and accounted for a large portion of rising wage and employment inequality in advanced economies. - Increased capital mobility and outsourcing tend to favor skilled jobs in advanced economies (design, management) and shift low-skilled production to developing countries; U.S. evidence shows employment in U.S. multinationals’ domestic plants moves together with employment in affiliates in developing countries rather than being negatively correlated (Riker and Brainard, NBER Working Paper 5959, March 1997). ### Interaction of macro and structural factors - Structural reforms are central to achieving significant and sustainable reductions in unemployment; countries that reduced structural unemployment in the 1990s did so where measured output gaps were small or output was above capacity, consistent with: - Structural reforms being easier to implement under buoyant demand, and/or - Hysteresis effects being less asymmetric than some analyses suggest. - Macroeconomic policy must support structural reform because: - A significant cyclical component to unemployment remains and persistence effects blur structural/cyclical distinctions. - Eliminating cyclical slack will lead to a gradual reduction in the unemployment rate consistent with stable inflation (the NAIRU; see Box 4.1). - Public debt affects structural unemployment via real interest rates. - Self-adjustment mechanisms in labor markets are weak; macro management may be required to translate structural reforms into improved labor market outcomes. - Political constraints on reform vary over the cycle: job protection legislation may be easier to curtail when unemployment is low; reforms increasing wage flexibility may be easier during a recession. ### Microeconomic (structural) reform agenda - The objective: remove rigidities that prevent rapid reentry of the unemployed into profitable employment. - Overall thrust of reforms aims at: - eliminating (or at least reducing) distortions in incentives; - removing regulatory constraints that prevent employers and employees from reaching mutually beneficial contracts; and - reintegrating the unemployed and disenfranchised workers into the working population. - Structural reforms are often complementary; comprehensive reform can produce benefits that exceed the sum of isolated measures (reference to Coe and Snower, IMF Staff Papers, Vol. 44 (March 1997), pp. 1–35). - Many piecemeal reforms in the 1990s had little impact; significant reductions in structural unemployment occurred only in countries where reforms were radical and comprehensive. - Implementation is difficult because targeted arrangements were introduced to achieve other objectives (income protection, equity, job security), producing “insiders” and “outsiders.” ### OECD Jobs Study and policy recommendations - The OECD launched a major project in 1992 to analyze deteriorating labor market performance and published initial results in 1994. - The Jobs Study concluded the root problem was failure to adapt quickly to rapid, technology-driven transformation of the world economy. - The OECD Jobs Study produced: - over 60 detailed policy recommendations; and - a list of 10 basic policy guidelines referred to as the “Jobs Strategy.” - The Jobs Strategy covers labor market policies, fostering technical progress, raising product and service market competition, promoting entrepreneurship, and macroeconomic policies to stimulate noninflationary growth; the interdependence and complementarity of recommendations were emphasized. - Follow-up work was mandated to elaborate detailed policy recommendations for individual countries, but country responses to the Jobs Study proposals have been timid: only a minority of proposals have been fully implemented, and some countries have taken backward steps. ### Key implications for policy - Structural reforms are necessary and typically need to be comprehensive to be effective. - Macroeconomic stabilization and demand management play a supporting role and can facilitate the political and practical implementation of structural reforms. - Addressing skill-biased technological change requires policies that improve labor redeployment and skill acquisition to reintegrate workers displaced by structural transformation. - Globalization per se is not the primary cause of deindustrialization or rising unemployment in advanced economies; policy focus should be on removing rigidities that limit worker redeployment and on complementary measures to support skill upgrading. *Italic line: Source: _0599ch4pdf - conclusion: the unemployment rate has moved up con-* ### Box 4.4.The OECD Jobs Study ### Box 4.4. The OECD Jobs Study ### The OECD Jobs Strategy — core policy recommendations - Set macroeconomic policy such that it will both encourage growth and, in conjunction with good structural policies, make it sustainable, i.e. noninflationary. - Enhance the creation and diffusion of technological know-how by improving frameworks for its development. - Increase flexibility of working time (both short-term and lifetime) voluntarily sought by workers and employers. - Nurture an entrepreneurial climate by eliminating impediments to, and restrictions on, the creation and expansion of enterprises. - Make wage and labor costs more flexible by removing restrictions that prevent wages from reflecting local conditions and individual skill levels, in particular of younger workers. - Reform employment security provisions that inhibit the expansion of employment in the private sector. - Strengthen the emphasis on active labor market policies and reinforce their effectiveness. - Improve labor force skills and competencies through wide-ranging changes in education and training systems. - Reform unemployment and related benefit systems—and their interactions with the tax system—such that societies’ fundamental equity goals are achieved in ways that impinge far less on the efficient functioning of the labor markets. - Enhance product market competition so as to reduce monopolistic tendencies and weaken insider-outsider mechanisms while also contributing to a more innovative and dynamic economy. ### Country-specific follow-up and recommended structural reforms - OECD Jobs Study follow-up recommendations were formulated in OECD Economic Surveys published following the 1994 publication of the OECD Jobs Study. - Country-specific recommendations addressed areas including: - Reduce Incentives for nonparticipation. - Reduce Taxation of Labor (income and payroll taxes). - Reform of Unemployment Benefits (replacement rate, maximum duration, or both). - Tighten generosity and availability tests for unemployment benefits and early retirement/invalidity schemes. - Increase work-time flexibility, liberalize job protection legislation, facilitate greater wage dispersion, decentralize wage determination, facilitate “opting out,” reduce minimum wage, and facilitate part-time work. - The OECD’s Job Strategy surveillance work paid attention to differences among countries in labor market performance, problem manifestation, and feasible remedies; country responses to recommendations are recorded in Table 4.6 (in the source). ### Country experiences and outcomes, 1990–97 - Changes in total and structural unemployment rates between 1990 and 1997 varied substantially across EU countries. - Three broad groups of countries are identified: - Countries that succeeded in lowering their structural rate of unemployment (SUR): Ireland, the Netherlands, the United Kingdom, Denmark, and Spain. - Countries where the SUR increased by a large amount (more than 2.5 percentage points): Finland, Germany, and Sweden. - An intermediate group where the increase in SURs was relatively small. - Changes in SURs were highly correlated with changes in actual unemployment rates (the correlation coefficient is 0.9). - Countries with the largest increases in both structural and actual unemployment experienced identifiable idiosyncratic shocks: - Finland: collapse of traditional export markets related to the disintegration of the Soviet Union in the early 1990s. - Germany: the unification shock and modalities of integration of the east German economy into west Germany. - Sweden: abandonment of a policy under which the public sector acted as the “employer of last resort,” which became unsustainable amid a severe recession in the early 1990s. - Another country noted (not shown in the figure) where structural unemployment increased significantly was Switzerland, where SUR rose from 0.5 percent to 2.9 percent. ### Selected country case studies - United Kingdom - Undertook deep and comprehensive labor market reforms beginning in the early 1980s; the decline in the structural rate of unemployment has been uninterrupted since 1984. - Key elements: curtailment of trade union power; decentralization of wage bargaining; stepped-up active labor market policies to integrate the long-term unemployed and young people. - Reduced generosity of unemployment benefits accompanied by a shift from passive benefits to in-work benefits (e.g., “family credit,” recently replaced by the “working families tax credit”). - Welfare reform under the Labour government from 1997 continued reforms to shift people off benefits and into employment; the “New Deal” emphasizes wage subsidies, educational opportunities, and public employment to promote transition from welfare to work. - A national minimum wage to be introduced in April 1999 may have adverse effects on employment, but a lower minimum for youth is intended to mitigate this effect. - Netherlands - Initiated a comprehensive, tripartite-consensus reform approach beginning with the 1982 “Wassenaar Agreement”; SUR declined steadily since 1985. - Early policy focus on expanding labor demand; over time shifted toward strengthening labor supply. - Measures: wage moderation, cuts in taxes on labor, lowering of real minimum wages (in particular for youth), tightening of eligibility for and generosity of unemployment and disability benefits. - Labor cost restraint improved international competitiveness; initially increased profitability and since the mid-1980s has also been reflected in more labor-... (text continues in source). *Source: OECD, Implementing the OECD Jobs Strategy—Lessons from Member Countries’ Experience (Paris, 1997), condensed from annex tables A1–A6; OECD, The OECD Jobs Study—Evidence and Explanations (Paris, 1994); OECD, Analytical Database.* ### introduction or extension of unemployment insurance arrange- ### introduction or extension of unemployment insurance arrangements ### Country experiences with labor market reform - United Kingdom: Structural unemployment (NAIRU) increased in early years of reform when actual unemployment rose to a postwar high of 11.8 percent in 1986; subsequently the United Kingdom reversed the upward trend in successive cyclical unemployment peaks. - New Zealand: Among advanced economies outside the EU, embarked on labor market reforms of similar depth and scope to the United Kingdom, resulting in a significant decline in the SUR comparable to that experienced in the United Kingdom. - Netherlands: - Two major components: tightening entry conditions to early retirement and disability schemes, and liberalization of working-time arrangements. - Facilitated a sizable increase in (female) labor participation. - In 1997, percentage of (voluntary) part-time employees: 11 percent of male employment and 55 percent of female employment. - Denmark: - SUR peaked in 1993 after a gradual rise since 1969. - Reforms tightened eligibility and availability-for-work requirements, supported by “compulsory activation.” - Maximum duration of benefits drastically reduced for unemployed youth, lowering youth unemployment from 13 percent to 5 percent, below the national average. - High enterprise flexibility and minimal job protection legislation aided rapid success. - Spain: - Structural unemployment rose continuously until 1994, peaking at around 20 percent. - 1992 reforms: tightened eligibility requirements and reduced maximum benefit duration. - 1994 reforms: reduced administrative restrictions on firing, virtually eliminated certain job-demarcation rules (ordenanzas laborales), softened working time restrictions, and eased opting-out of collective wage agreements. - 1997 reforms: created a new permanent contract with reduced (but still relatively high) severance pay and aimed to enhance decentralization of wage formation to reduce labor market segmentation. - Ireland: - Largest decline in structural unemployment during the 1990s, primarily due to extraordinary spurt in economic growth. - Over the last decade, Irish GDP increased by 93 percent, compared with an average increase of 27 percent in the entire euro area. - Policies included renewable three-yearly tripartite incomes policy agreements, reductions in marginal tax rates on low-income earners, reduced benefit withdrawal rates, and improvements in workers’ skills. ### Summary of lessons from European experience - Main conclusions: - Structural unemployment can be significantly reduced by determined and persistent policy action, but it generally requires major effort rather than marginal tinkering, and positive results are slow to manifest. - Significant progress can be made under different approaches, none easy politically. - Reform of unemployment benefits has been integral to successful labor market reform, but reducing generosity is not necessary: negative incentive effects of high generosity can be reduced by strict eligibility and availability-for-work conditions. - Most progress occurred in countries implementing substantial structural reforms under robust growth, though causality direction is unclear. - Additional observations: - In the United Kingdom and the Netherlands, despite more than a decade of gradual decline, the SUR in 1997 was still above its 1980 level. - Even postreform UK unemployment benefit generosity greatly exceeds that in the United States, as does the scale of active labor market policies (as a percentage of GDP) for vulnerable segments (long-term unemployed and young people). ### The role of macroeconomic management - Ultimate objective of structural labor market reforms: reduce equilibrium unemployment to around 5 percent or lower and increase productive employment by a corresponding—or probably larger—amount. - Capital and demand considerations: - Since capital stock has adjusted to current high structural unemployment, an increase in the capital stock may be required to create jobs for the increased effective labor force resulting from reform. - Potential output will rise with increased effective labor and productive capital, requiring corresponding increase in effective demand for reform to translate into output and employment gains. - Self-adjustment vs. active demand management: - Structural reform strengthens automatic adjustment mechanisms and reduces need for demand management, but history suggests automatic mechanisms may work only slowly; accommodative policies are often required to permit expansion of demand to match rising potential output. - Accommodative demand management should be cautiously timed because beneficial impact on potential output materializes gradually due to reengagement lags for long-term unemployed and investment response lags. - Fiscal constraints: - Ratios of public expenditure and taxation to GDP are already high in most European countries, and fiscal consolidation is incomplete, making it difficult to argue for public spending to play a substantial role in demand growth. - Household saving ratio is still high and can be expected to decline if unemployment falls; reintegration of idle labor may require sizable business fixed investment that can match the increase in potential output. - Current external balance is in significant surplus, posing no obstacle to domestic expansion. - Increased output from reintegrating jobless workers will eventually relieve fiscal predicaments, offering opportunity for accelerating fiscal consolidation or reducing excessive tax burdens. - Monetary policy implications: - Emphasis on price stability suggests a potentially greater role for monetary policy in facilitating aggregate demand expansion in step with rising potential output from reforms. - Preconditions for accommodative monetary policy are satisfied: inflation has been reduced well below the 2 percent ceiling of the target range in the euro area, and leading indicators of inflation are benign. - Successful labor market reform will reduce wage pressure further; monetary management may need to prevent deflation and could require growth of monetary aggregates in excess of past trend growth of potential output plus the target inflation rate during transition. - Expansionary monetary policy without structural reform risks reigniting inflation as cyclical unemployment is absorbed. - Euro introduction and coordination: - The euro precludes participating countries from pursuing independent monetary policies; desirable for European countries to proceed jointly with labor market reform, but insisting on coordinated joint action risks delaying reforms or reducing them to the lowest common denominator. - Proceeding at different speeds is equivalent to asymmetric national supply shocks in the euro area, complicating optimal monetary policy response. - Real exchange rate can still operate as an adjustment mechanism: relative wage restraint in a member country will improve cost competitiveness and structural reform aims to revitalize this mechanism. ### Supporting policy measures: incomes policies and ALMPs - Incomes policies: - Used to reduce the “sacrifice ratio” in transition to lower inflation and may help raise employment with less inflationary pressure during wage moderation transitions. - Tripartite agreements on wage restraint have played a prominent role in several successful reformers. - Incomes policies can be a useful second-best while institutional arrangements underpinning insider power are progressively reformed; however, they may hinder relative wage adjustment. - Active labor market policies (ALMPs): - Include job placement assistance, counseling and vocational guidance, mobility support, training, employment subsidies, and direct job creation. - Efficiency rationale: correct market imperfections and informational asymmetries; especially valuable in initial phase of reform when long-term unemployed need reintegration. - Empirical evidence suggests ALMPs have, on average, made a positive contribution to reducing structural unemployment in reforming countries. - Most successful measures: intensive placement assistance and on-the-job training for disadvantaged categories of unemployed. - Less effective measures: classroom training and direct government job creation; employment subsidies can have sizable deadweight costs; large-scale public employment schemes risk increased private sector wage pressure unless accompanied by reforms lowering equilibrium unemployment. - Incremental cost of programs can be kept low in countries with generous passive transfers by redirecting those funds to support effective ALMP measures. ### Questionable policies and risks of quick fixes - Supply-curtailing measures (early retirement and invalidity schemes): - Pursued in the 1970s to curb unemployment by reducing labor supply; initially moderated unemployment but did not address underlying causes and added fiscal burdens by raising dependency ratio and transfer payments. - By reducing labor market slack and increasing public debt, these policies likely contributed indirectly to higher unemployment via increased real wage pressure and higher real interest rates. - Such policies have been deemphasized or abandoned during the 1980s and 1990s; some countries increased statutory retirement ages. - Work sharing (reduced statutory working time or splitting full-time jobs into part-time): - France aiming for 35-hour work week; similar initiatives discussed in Italy; German unions advocate reduced hours to create jobs. - Obstacles: - If skills of unemployed differ from employed and substitutability is low, reduced statutory hours will do little to induce employment. - Structural unemployment implies work sharing will increase wage pressure unless accompanied by structural policies that lower equilibrium unemployment. - Mandatory reductions in work hours, especially if not matched by income reductions, risk raising unit labor costs and reducing labor demand. - Part-time work: - Growth in part-time employment partly reflects worker preferences (two-earner families) and increased flexibility. - In the Netherlands about 35 percent of total employment is in part-time occupations. - Institutional arrangements (fixed employment costs, income thresholds for taxation) influence part-time work incidence. - Recommendation: decentralize decision making on working time arrangements, making them subject to individual employment contracts rather than universal legislation. - Macroeconomic “quick fixes”: - Temptation to use demand stimulus to reduce unemployment is risky; experience of past three decades shows demand stimulation without structural reform cannot sustainably reduce structural unemployment and risks inflation or fiscal deficits. - Historical examples: - 1970s and early 1980s: attempts to return unemployment to preshock levels via expansionary policies led to rising inflation and fiscal deficits with little unemployment reduction. - Early 1980s France: aggressive expansionary policies were aborted due to inflation, external balance deterioration, and exchange rate pressure; government reversed stance in 1983. ### Overcoming political and institutional obstacles to reform - Political economy constraints: - Major obstacle: fear reforms will harm income distribution and social cohesion forming the core of the welfare state. - Many voters prefer existing welfare state; politicians reluctant to adopt measures seen as direct attacks on accrued rights (acquis sociaux). - Insiders (employed with protected positions) are more numerous and politically powerful than outsiders (unemployed, discouraged, precariously employed), creating resistance to reforms that weaken insider protection or reduce benefit disincentives. - Rationale for reform: - Aging populations and rising dependency ratios make current generous benefits and early retirement unsustainable in coming years; achieving high employment ratios is an important ingredient of any comprehensive solution. - Flexible labor markets are needed to maximize benefits of monetary union and avoid asymmetric shocks producing persistent disequilibria blamed on the union. - Strategies to build consensus: - National consensus sometimes forged by crisis (e.g., Spain’s 24 percent unemployment in 1984 led to hiring-facilitating measures). - Examples where majorities supported reforms: United Kingdom (1980s), Ireland and New Zealand (1980s). - Possible approaches to reduce resistance: - Allow outsiders to opt out of existing arrangements and conclude mutually beneficial contracts with willing employers, leaving existing contracts intact for insiders. - Transform passive unemployment benefits into in-work benefits conditional on accepting employment, subsidizing work rather than unemployment. - Use tripartite agreements (government, firms, workers) to combine wage moderation with tax/business measures and social assistance to displaced workers (example: Netherlands). - Timing and persistence: - Full benefits of reform can take considerable time to materialize (United Kingdom, Netherlands, Spain). - Job creation has been strongest in dynamic sectors (information technology) where flexibility is the norm. - With benefits spread over a long horizon, structural changes in the economy and labor force composition may be Europe’s best chance to generate political support for comprehensive reform. *Italic source: _0599ch4pdf - introduction or extension of unemployment insurance arrange-* --- _Source: https://www.imf.org/-/media/websites/imf/imported-flagship-issues/external/pubs/ft/weo/1999/01/_0599ch4pdf.pdf_