1. Policy predictability

The market-clearing variant of the natural rate theory is an obvious vehicle for rationalizing the importance of policy predictability. In this theory, unemployment is at its “natural rate” when people’s expectations about wages and prices are correct. Under conditions of perfect competition and perfect information, this natural rate depends only on people’s tastes, technologies, and resource endowments. ^1/ When people’s wage-price expectations are out of line with actual wages and prices, then unemployment deviates from its natural rate.

Provided that tastes, technologies, and endowments do not fluctuate cyclically, fluctuations in unemployment--according to this theory--must be explained by fluctuations in expected wages and prices around their actual values. ^2/ In order for this theory to have predictive power, it needs to be combined with a theory of how expectations are formed. The dominant one is the rational expectations theory, which asserts--quite plausibly--that people are not fooled in ways that they themselves could have predicted. To test this hypothesis, a description of people’s “information sets” is required, from which expected wages and prices could be inferred. In practice this is, of course, an impossible task; so empirical models generally assume that everyone has the same information as the authors of the models, except that the authors have more recent data.

The combination of the natural rate theory with this variant of rational expectations theory has a well-known implication: since people make no systematic expectational errors (errors they could have predicted), then unemployment cannot diverge systematically from its natural rate. Just as expected wages and prices will fluctuate randomly around their actual values, so unemployment will fluctuate randomly around the natural rate.

It is not hard to see why policy predictability is advisable in this context. With well-functioning markets, there is clearly no efficiency case to be made for interfering with the natural rate of unemployment. Policies which have no influence on this natural rate--such as monetary policies--can affect unemployment only by driving a wedge between actual and expected wages and prices. This can be done through unexpected policy variations, such as unexpected changes in the money supply. Put simply, demand-management policies are effective only when they are deceptive. But deceptive policies are generally not in the public interest: if people were initially pursuing their own interests in well-functioning markets--and thereby promoting the public interest as well--unexpected changes in policy will only reduce individual and social welfare. Thus stabilization policy is reduced to the limited task of being predictable.

The problem with this theory is that it fails to address many of the features of European unemployment over the past decade. In many OECD countries over the 1980s, union density remained constant or even declined, the expansion of unemployment benefits and other forms for welfare state support was arrested or even reversed, and deregulation, privatization, and liberalization of labor markets were not uncommon. On this account, it is difficult to argue that the natural rate of unemployment could have risen significantly. Some have maintained that the expansion of the welfare state in Europe over the 1950s, 1960s, and the first part of the 1970s may have been responsible for the growing unemployment in the 1980s since people adjusted their behavior only gradually to the more generous social provision. ^1/ But it is hard to imagine that these lagged responses should have been so powerful and so delayed as to be responsible for the large increases in European unemployment over a decade after most welfare states had ceased to expand.

Furthermore, given the stable rates of inflation over much of the decade, it cannot be argued that people’s wage-price expectations were getting further and further out of line with actual wages and prices; nor is it plausible to suppose that these misperceptions could have persisted for so long.

In short, there is nothing in the market-clearing variant of the natural rate theory that provides a clue as to why European unemployment should have risen so massively through the 1980s. Nor does this theory shed useful light on why unemployment has been so much more persistent in Europe than in the United States, or why European unemployment rose with each major recession of the 1970s, 1980s, and early 1990s while U.S. unemployment has always tended to return to its pre-recession level. Can we honestly believe that Europeans are much slower than Americans to adjust their expectations, so that expectational errors are more persistent in Europe than the U.S.? Beyond that, theories based on expectational errors tell us little, if anything, about why unemployment spells tend to be longer in Europe than the U.S. (for given unemployment rates), why U.S. unemployment rates are more variable than most European ones, why unemployment falls unequally among different population groups, and why labor and product markets move so much more closely in tandem in the United States than in Europe.

2. Noninterference with business cycles

The case against stabilization policies in the labor market is made quite explicit in the intertemporal substitution theory and the real business cycle theory.

As the name implies, the intertemporal substitution theory ^1/ is concerned with workers’ desire to engage in intertemporal substitution of work for leisure in response to changing economic incentives. For example, if workers believe that real wages are temporarily depressed and will rise in the future, they may wish to take more leisure now and work harder later. The same may be true if they perceive real interest rates to be temporarily low, since that means that their current wage income cannot be transferred into the future at an advantageous rate.

The implication is that cyclical swings in employment may be the optimal response--by individual agents and society at large--to temporary shocks to tastes, technologies, and endowments. ^2/ Whereas most economists used to see business cycles as undesirable, needing to be damped through stabilization policies, the intertemporal substitution theory suggests that this is not so. It is not in the public interest to implement counter-cyclical monetary and fiscal policies, since these would prevent people from making their optimal dynamic responses to external shocks.

Although this theory can be used to generate an empirical account of much of the unemployment persistence and variability observed in the United States and other OECD countries, ^3/ it is hard to see how it could provide a reasonable explanation of European unemployment over the past 25 years. Is it plausible to believe that the many millions of Europeans who joined the unemployment register in the mid-1970s, early 1980s, and early 1990s were merely trying to take advantage of high real wages or high real interest rates expected to occur in the future? Regarding the upward trend in European unemployment rates since the mid-1970s, is it plausible to believe that we are observing a very long-term intertemporal substitution, whereby workers have decided to enjoy a lot of free time for two decades, perhaps with the intention of working very long hours for the next two decades?

Furthermore, the available empirical evidence indicates that people’s hours of work are unresponsive to real wage and real interest rate variations, ^1/ and that much of these variations tend to be permanent rather than temporary.

The real business cycle theory ^2/ builds on the intertemporal substitution theory and identifies technological shocks as the main source of macroeconomic fluctuations. Much effort has been expended attempting to establish that these fluctuations arise when perfectly informed individuals, all maximizing their utility subject to technological and resource constraints, respond to technological shocks by intertemporally substituting labor, leisure, and consumption. But beyond the predictive problems of the intertemporal substitution theory, it is hard to get an intuitive interpretation of the technological shocks. Whereas technological advances (that the real business cycle theory associates with the booms) are relatively easy to identify, the technological setbacks (that allegedly give rise to the recessions) are not. ^3/ It is hard to see how knowledge and expertise gets lost, particularly on the large scale that is necessary to account for the deep recessions we have witnessed over the past two decades. Some argue that the negative technological shocks reflect such adverse macroeconomic events as oil price hikes or inappropriate investment (such as machinery that turns out not to work or that produces goods for which demand did not materialize). But the downturns in European labor market activity over the past two decades have lasted much longer than the price hikes for oil and other resources did, and it would be strange--in the real business cycle world of rational expectations in clearing, perfectly functioning markets--for these shocks to generate investment fluctuations that are large enough to pull the massive OECD recessions in their wake.

Beyond that, the long-term increase in European unemployment since the mid-1970s cannot plausibly be explained as the market-clearing outcome of technological shocks.

1. Job search support and information dissemination

This general policy approach covers such measures as counselling the unemployed, assisting them with personal problems such as alcoholism and drug addiction, and alerting them to available training opportunities. ^1/ It also involves disseminating information about available labor services to firms and about available vacancies to workers.

Many of the market failures addressed by these policies can be analyzed effectively through the theory of search and matching. ^2/ In this theory, workers are not perfectly informed about the available jobs, and firms are not perfectly informed about the available workers. Thus both sides of the market engage in search. Each agent acquires information up to the point at which the cost of searching for an additional job (or worker) is equal to the discounted stream of expected future returns from that job (or worker). Unemployment arises because jobless workers know that there are vacant jobs with wages sufficiently high to make the return from search exceed the cost, but since they don’t know precisely where these jobs are, they may not find them right away. The result is “frictional unemployment,” which is never eliminated in aggregate since there are always some workers getting fired, some quitting, some entering the labor force, and some retiring from it. At center-stage in all search models lies a “matching function,” which specifies how the expected number of matches is related to the number of unemployed workers and the number of vacant jobs.

It is not possible, of course, to attribute the rise in European unemployment to a deterioration of this matching technology, because the dissemination of labor market information has, if anything, improved with the passage of time. Nor are the recent periods of high unemployment related to comparatively high degrees of labor market “turbulence,” i.e., sectoral imbalances responsible for job creation and job destruction. ^3/

Thus, if imperfect information about vacant jobs and unemployed workers were the only problem for job search support and information dissemination to overcome, its potential would probably be quite limited. However, this policy may also be useful in overcoming the discouragement and demoralization that prevents many long-term unemployed people from seeking jobs effectively. The search and matching theory views this problem as the consequence of a decline in unemployed people’s returns from job search as their unemployment spells lengthen. The declining returns could be due to the depreciation or obsolescence of their skills and to a resulting fall in firms’ efforts to attract these workers. Another reason why workers’ search intensity may decline is that their preferences gradually change. In particular, the long-term unemployed can become accustomed and reconciled to remaining jobless, adopt it as a way of life, and stop searching seriously at all. ^1/ Counselling and personal assistance may help to mitigate these problems by restoring the attitudes and expectations necessary for successful job search strategies.

The potential importance of this policy approach may be highlighted by the recognition that the decline of search intensity with unemployment duration undoubtedly plays a significant role in explaining unemployment persistence (viz, the dependence of current unemployment rates on past unemployment rates). ^2/ It also helps explain why the burden of unemployment is distributed unequally. If people’s search intensity falls the longer they remain unemployed, and if the corresponding search intensity of potential employers falls as well, then the expected future length of these workers’ unemployment spells will depend positively on how long they have been unemployed already.

Aside from the search and matching theory, another rationale for job search support and improving information dissemination--as well as various other policies to be discussed below--comes from the efficiency wage theory. Here firms are assumed to have imperfect information about individual employees’ productivities and are thus unable to make their wage offer contingent on their employees’ performance. The firms, as wage setters, observe that by raising their wage offers they are able to increase the average productivity of their workforce, because higher wage offers enable a firm to recruit more highly qualified employees or motivate employees to work harder. ^3/ In other variants of the theory, higher wages discourage workers from quitting the firm, thereby reducing the firm’s labor turnover costs. ^4/ Consequently firms may have an incentive to keep the wage above the level that would be necessary to ensure full employment. The unemployed are unable to get jobs by offering to work for less than the prevailing wage, because it is not in the firms’ interests to allow the wage to fall.

In this context, policies that improve the dissemination of information about workers’ ability, motivation, and quit behavior would enable firms to base their wage offers more closely on workers’ individual productivities and potential labor turnover costs, thereby reducing the role of wages as an incentive mechanism and bringing down the associated level of unemployment.

The great strength of the efficiency wage theory is that it provides one conceivable explanation for why, even under perfectly flexible wages, people may be unemployed even though they would prefer to do the jobs of the current job holders at less than the prevailing wage. ^1/ Beyond that, however, it is not clear that the theory can shed much light on why EC unemployment has risen over the past two decades. It might be argued that with the decline in assembly line production, which is fairly easy to monitor, firms have placed increasing reliance on wages as an incentive mechanism. But if that were an important consideration, it would apply to both the EC and the United States, leaving us with the open question of why unemployment in the EC has risen so much relative to that in the United States. Moreover, the advance of computer technology has improved firms’ monitoring capabilities in many sectors of the economy, making them less reliant on wages to motivate and attract employees.

It could also be argued that the use of wages as an incentive mechanism is more important in countries with more stringent job security legislation. After all, the more costly it is for firms to fire their employees, the lower are the chances a shirking or incompetent worker will be dismissed, and thus the greater the wages that firms have to pay (relative to unemployment benefits) in order to stimulate productivity. However, if this interaction between labor turnover costs and efficiency wages were significant in practice, it would be hard to explain why the EC unemployment rate averaged less than the U.S. unemployment rate over the 1950s and 1960s, even though job security legislation tended to be more stringent in the EC than in the United States over the entire postwar period.

Nor does the efficiency wage theory explain why the average duration of unemployment in Europe has significantly exceeded that in the United States and Japan since the mid-1970s, why labor and product market activities tend to move together in the United States but not in Europe, or why unemployment in many countries varies less within a business cycle than from one cycle to the next. These phenomena clearly cannot be ascribed to differences in monitoring technologies through time and across countries.

Of course many efficiency wage models also explain how unemployment may rise in response to a drop in labor productivity, a rise in the real interest rate, or a rise in the unemployment benefit. But as with the search models, the efficiency wage models cannot lay unique claim to these predictions. The efficiency wage models do not add much to what other theories have to say in this respect. Similarly, the inclusion of labor turnover costs in an efficiency wage setting can provide an explanation of why unemployment rates tend to be serially correlated, and differences in the magnitude of these costs can help account for inter-country differences in such serial correlation as well as inter-country differences in unemployment durations. But labor turnover costs are not an intrinsic building-block of efficiency wage models. These models can rationalize the existence of unemployment even in the absence of labor turnover costs, and the addition of these costs to a wide variety of other theories would yield equivalent insights into unemployment dynamics.

2. Policies to stimulate worker mobility

Some policies that are meant to reduce the burden of housing costs to the poor--such as rent control or low-cost public housing--reduce worker mobility by inhibiting workers from moving to the available jobs, thereby creating unemployment. This is a potentially significant problem in a number of OECD countries containing both booming and slumping regions and large house-price and rent differentials across these regions.

These differentials may be incorporated in models of search and matching to provide an explanation for regional differences in unemployment rates. Although there is little if any evidence, as noted, that the rising European unemployment rates over the past two decades can be attributed to greater volatility of sectoral labor market shocks or to reduced availability of information about unemployed people or vacancies, house-price and rent differentials can become an especially serious source of “mismatch” in the labor market, since they often expand when the degree of sectoral imbalance rises. ^1/ In particular, the greater is the discrepancy between the excess of vacancies over unemployment in the booming regions, and the excess of unemployment over vacancies in the slumping ones, the greater these differentials are likely to be. The reason, of course, is that the greater is the discrepancy in excess demand across regions, the greater will the house-price and rent differentials across these regions be as well. Thus, as the degree of mismatch rises, the impediments to matching may rise in tandem.

Rent control and housing subsidies tied to the current place of residence give further leverage to this obstacle to matching. Replacing these policy interventions by more efficient ways of redistributing income (such as conditional negative income taxes, discussed in Section V.3) could therefore help reduce unemployment. A similar argument can be made for policies that increase the portability of health insurance and pensions between firms.

3. Policies centering on human capital formation

Policies which focus on human capital formation include government training programs, training subsidies to firms or workers, ^1/ as well as policies that reduce the rate of interest and thereby reduce the rate at which future returns to human capital formation are discounted. ^2/

These policies may be analyzed through a special breed of search and matching models that explain how unemployment can arise on account of market failures in the demand for and supply of training. ^3/ First, since unemployed people have relatively few firm-specific skills, training them may involve a relatively large poaching externality. Specifically, if unemployed people were given training, a relatively large share of the benefits from that training, in imperfectly competitive labor markets, would fall neither on the firms supplying the training nor on the workers receiving it, but on third parties, namely, the firms that may poach the workers after they have been trained. In that event, the social benefit from training will exceed the private benefit, regardless of how the costs of training are distributed between the trainer and trainee. Then the market will generate too few matches between firms and currently unemployed workers, whereby the workers are made productive and profitable through training. As result, an inefficiently large number of these workers remains jobless. ^4/ This problem may become magnified considerably through the “low-skill, bad-job trap:” a deficient supply of trained job seekers induces firms to create an excessive number of unskilled vacancies, and these in turn further reduce workers’ incentives to acquire training; this leads to even more unskilled vacancies, and so on. ^5/

These market failures are likely to be especially pronounced with regard to the long-term unemployed. They tend to be particularly poorly endowed with firm-specific skills and thus particularly prone to the poaching externality and the low-skill, bad-job trap.

Some of the rise in European unemployment over the past two decades might arguably be due to the interaction between these market failures on the one hand, and the joint pull of skill-biased technological change and international trade on the other. Both technological developments that raise the productivity of skilled relative to unskilled workers, as well as rising trade with countries that have a comparative advantage in producing goods which are relatively intensive in unskilled labor, reduce the demand for unskilled labor relative to the demand for skilled labor. And if the market failures above are responsible for a deficiency in the acquisition of skills and an excessive number of unskilled workers without jobs, then these two factors could lead to a rise in unemployment.

In addition, an expansion of trade or an increased rate of technological change could generate unemployment by raising the amount of labor market “turbulence,” particularly by increasing the rate of job creation and destruction. ^1/ This, of course, is not an argument for policies limiting the degree of technological change or trade, for--as is well-known--the latter generally permit a given amount of goods and services to be produced with less labor input, and thereby could improve everyone’s material standard of living, provided that the appropriate redistributions from the winners to the losers can be made without substantial loss of efficiency. Rather, the above diagnosis is an argument for job search support in order to improve the effectiveness of the matching process.

Thus, government training programs or training subsidies to the unemployed--particularly the long-term unemployed--may have a role to play in combatting unemployment. Many government training programs, however, are ill-suited to firms’ needs. This is scarcely surprising, since these needs are extremely diverse while government training programs are inevitably standardized and limited in variety. In this regard, training subsidies granted to firms appear preferable, for the firms then have the incentive to make the resulting training maximally appropriate to their available jobs. To keep firms from illicitly diverting the training funds to other purposes, it may be necessary to provide the training subsidies only for programs leading to nationally recognized qualifications, granted by institutions independent of the firms receiving the subsidies. ^2/

1. Policies centering on physical capital formation

These policies range from government infrastructure investment to policies that raise the rate of capital utilization, stimulate the entry of firms, or promote physical capital formation by reducing the user cost of capital. What they all have in common is that they raise the level of capital services provided in the economy and consequently, if labor and capital are complementary in the production process, they increase the marginal product of labor, thereby raising employment and reducing unemployment. By simultaneously increasing investment demand and capital supply, these policies work on both the demand- and supply-side. In so doing, they illustrate how demand management policies can be effective in the “longer run,” that is, over a time span long enough to permit full adjustment of wages and prices.

A growing number of economists has come to suspect that the effectiveness of demand-management policy is undersold by the short-run Keynesian mechanisms described in Section III, which rest on wage-price sluggishness. Many believe that aggregate demand had a role to play in sustaining the periods of prolonged low European unemployment in the 1960s and prolonged high European unemployment in the 1980s. But for that to be the case, of course, the influence of aggregate demand on employment must extend well beyond the span over which wages and prices can be presumed sluggish.

The long-run effectiveness of demand management policy may be analyzed through theories of imperfect labor market competition. In this vein, it is useful to picture labor market equilibrium in terms of the intersection of a downward-sloping aggregate labor demand curve and an upward-sloping wage setting curve in real wage-employment space. The aggregate labor demand curve depicts the horizontal sum of firms’ profit-maximizing relations between labor demand and the real wage under imperfect competition, and the wage setting curve represents the real wage that emerges, at any given level of employment, from wage bargaining or efficiency wage minimization. Furthermore, picture the labor supply curve as lying to the right of the wage setting curve. The difference between labor supply and equilibrium employment is the equilibrium level of unemployment.

In this context, an increase in product demand can reduce unemployment by shifting the wage setting curve or the labor demand curve outwards. If it was only the wage setting function that shifted (along an unchanged labor demand curve), then the real wage would move countercyclically. But since real wage movements are often acyclical or even pro-cyclical (particularly in the United States), it is important to explore how demand-management policy can shift the labor demand curve, thereby allowing for the possibility of pro-cyclical real wage movements. ^1/ It turns out that the most likely channels whereby demand management could affect unemployment in the long run involve significant supply-side effects. Moreover, the interaction between demand- and supply-side policies becomes crucial in this regard.

Since the labor demand curve is the set of real wage-employment combinations at which the real marginal value product of labor is equal to the real wage, a change in product demand can shift the labor demand curve only if it affects the real marginal value product of labor at any given level of employment. It is easy to show that this occurs whenever the product demand change affects (i) the price elasticity of product demand, (ii) the imperfectly competitive interactions among firms, (iii) the user cost of capital, (iv) the degree of capital utilization, (v) the number of firms in operation, and (vi) the marginal product of labor. ^2/

Of the channels whereby product demand changes can be transmitted to employment, the first two do not appear to provide a firm foundation for the effectiveness of product demand management policy:

• Price elasticity of product demand: Some authors have suggested that changes in government spending can affect employment by changing the composition of product demand and thereby changing the associated price elasticity of aggregate demand. ^3/ There are, however, good reasons to believe that this would be a tenuous basis for government policy. First, an increase in government spending would shift the labor demand curve outwards through this channel only when the public-sector price elasticity of demand exceeds the private-sector elasticity, but there is no evidence that in practice this is consistently the case across sectors and through time. Second, this transmission mechanism has the implausible implication that if an increase in government expenditures shifts the labor demand curve outwards, then a tax reduction must shift that curve inwards; for whereas the former policy raises public-sector spending relative to private-sector spending (thereby raising the aggregate price elasticity), the latter policy has the opposite effect. Affecting the price elasticity through changes in the composition of domestic versus foreign expenditures does not put us on firmer ground. In fact, if--as appears plausible--the foreign price elasticity exceeds the domestic one, an increase in domestic demand will reduce the aggregate elasticity and thereby move the labor demand curve inwards!

• Imperfectly competitive interactions among firms: Others have suggested that oligopolists may behave more competitively in a boom, so that a rise in product demand could shift the labor demand curve outwards via its influence on competition. ^1/ But Rotemberg and Saloner (1986) that show this effect holds only when firms are implicitly colluding oligopolists, and this induced-competition channel is a weak foundation for demand management policy.

That leaves the other four channels, which appear to be more promising avenues for the transmission of product demand management policies to employment. What these four channels have in common is that they all make the employment impact of demand management policies depend on their supply-side effects. Supply-side policies therefore gain a special role in enhancing the effectiveness of demand management.

• The degree of capital utilization: It can be shown that when there is excess capital capacity, demand management policy can affect the marginal product of labor by influencing the degree of capital utilization. ^2/ To fix ideas, consider the following sequence of labor market decisions. First, each firm sets its supply of physical capital and determines, from the range of its available technologies, those that are to become accessible through its capital stock (where, say, the range of accessible technologies may be characterized by an interval of capital-labor ratios within its ex ante production function). Next, the nominal wage is determined (say, through bargaining between the firms and its employees). Then the firms observe the position of their product demand curves and, finally, they make their employment decisions. Under these circumstances, an unanticipated, adverse product demand shock could make it unprofitable for firms to operate at full capacity. ^1/ A subsequent, favorable demand shock would induce firms not only to hire more labor at the existing level of capital services, but also to raise the degree of capital utilization. When economies emerge from recessions in this way, with workers recalled to man vacant machines and restart idle assembly lines, the capital brought back into use is often highly complementary to labor. Through this channel expansionary demand management policy may raise the marginal value product of labor, leading to pro-cyclical movements of the real wage.

• The user cost of capital: It is widely recognized that if an increase in product demand reduces the real interest rate, it will thereby reduce the user cost of capital, increasing the size of the capital stock and shifting the labor demand curve outwards, provided that labor and capital are Edgeworth complements in production (so that the marginal product of labor depends positively on the capital stock). This could happen either through expansionary monetary policy, or through a decline in the risk premium on investment ^2/ brought about by the expansion of demand. Naturally, if the rise in demand takes the form of an increase in government spending, the real interest rate may rise (rather than fall); shifting the labor demand curve inwards through the above mechanism. Moreover, even if the real interest rate falls, the labor demand curve still will shift inwards when labor and capital are Edgeworth substitutes.

• Entry and exit of firms: Increases in product demand can induce entry of new firms, which shifts the labor demand curve outwards--both directly and indirectly by increasing the degree of product market competition. ^3/ Specifically, if nominal wages are temporarily rigid, a rise in product demand can reduce the real wage by raising prices, leading to the entry of new firms. Once nominal wages adjust, this entry ceases, but the recently entered firms remain operative. In this way, a temporary nominal wage rigidity can give product demand management policy an influence on employment in the longer run. ^4/

• The marginal product of labor: If the increase in government spending takes the form of industrial infrastructure investment, there may obviously be a direct stimulus to the marginal product of labor. In this case, expansionary demand management policy shifts the labor demand curve outwards through its effect on the capital stock.

The policy implications regarding these four channels are potentially of considerable significance: the longer-term influence of product demand management policy on employment depends on the availability of a limited number of supply-side channels of transmission. Supply-side policies--such as those which reduce barriers to the entry of new firms, ^1/ or those which augment industrial infrastructure--can help open these supply-side channels and thereby improve the long-term effectiveness of demand management. In the long run, therefore, demand- and supply-side policies are interdependent.

Although it is always difficult to assess the empirical importance of long-term policy effects, the analysis above does offer some potentially interesting explanations of some long-run stylized facts about OECD unemployment. First, the relatively low unemployment rates experienced in Europe and the United States during the 1950s and 1960s came at a time of significant build-up of industrial infrastructure, whereas the period of higher unemployment since the mid-1970s was associated with a general run-down of this infrastructure in these areas. The analysis above suggests that these two developments may in some degree be related to one another. Second, the analysis also implies that the greater ease of entry and exit of firms in the United States than in Europe may help, in part, to explain why the rise in aggregate demand in the aftermath of the recent recessions has had a greater impact in reducing unemployment in the United States than in Europe. And finally, the theory helps explain why the influence of demand-management on unemployment appears to be particularly pronounced when this policy is associated with a decline in real interest rates and the availability of ample excess capital capacity.

2. Low-wage subsidies and payroll tax reductions

This set of policies is meant to address the problem that, in many OECD countries, the relative position of workers at the bottom of the earnings distribution has worsened over the past two decades. ^2/ This deterioration has taken the form of lower relative real wages in the United States (and, to a lesser degree, in the United Kingdom) and higher relative unemployment rates in many continental European countries. Providing subsidies or payroll tax reductions to low-wage workers is meant to raise firms’ demand for these workers, thereby reducing their unemployment rates and raising their take-home pay. ^3/ It has been suggested that these policy measures be financed through a rise in VAT or the CO₂ tax. Econometric simulations, such as those reported in Drèze, Malinvaud, et al. (1994), suggest that the expansionary employment effect of a drop in the payroll tax on low-wage earners may substantially outweigh the contractionary effect of a corresponding rise in the VAT.

Since these policies reduce unemployment by reducing employers’ labor costs at the bottom of the wage spectrum, their effectiveness does not appear to be very sensitive to the precise underlying cause of the unemployment (in contrast to profit-sharing subsidies). For example, regardless of whether unemployment is generated by union pressures, efficiency wage considerations, or insider-outsider conflict, a drop in labor costs is bound to raise employment, since it permits firms to substitute labor for capital and enables them to reduce product prices and thereby create more demand.

There are, however, three major factors limiting the effectiveness of these policies: (i) “deadweight” (subsidies or tax reductions received by workers who would have become employed anyway), (ii) “displacement” (incumbent employees displaced by the subsidized new recruits), and (iii) “substitution” (firms that benefit from the policies driving firms that don’t benefit out of business). Clearly, the more closely the subsidies and the payroll tax reductions are targeted at the low-wage workers, the smaller is deadweight and substitution, but the larger is displacement.

Another potential drawback of these policies is that, by raising the take-home pay of unskilled workers relative to skilled workers, they reduce the returns to training. Insofar as labor and capital are complementary in production, the resulting fall in human capital acquisition may also lead to a fall in physical capital formation. For this reason, it appears desirable that these policies be supplemented by subsidies to education and training. This additional element, however, would substantially increase the cost of the intervention. Another drawback is that these policies may encourage excessive creation of unsatisfying, dead-end jobs, providing little potential for advancement. In that event, the unemployment trap would be replaced by the “trap of the working poor.” But even so, workers would experience a rise in their living standards: since the take-up is voluntary, workers and firms will avail themselves of these policy measures only if it is to their advantage.

3. Recruitment subsidies

The case for recruitment subsidies is similar to that for low-wage subsidies and payroll tax reductions: they bring down labor costs and thereby promote employment and reduce unemployment. ^1/ In fact, they are better targeted, since they are granted only to new. recruits.

Once again, deadweight, displacement, and substitution limit the employment effect of recruitment subsidies. Obviously, deadweight is generally lower for recruitment subsidies than for low-wage subsidies or payroll tax reductions, but the displacement and substitution effects are likely to be higher. In any event, the aggregate employment impact of recruitment subsidies is invariably less than the number of jobs subsidized. Beyond that, their effectiveness is likely to be further reduced by the ways in which they are financed. Employer-based taxes will directly discourage employment, and income taxes will reduce product demand and thus indirectly discourage employment. In either case, however, the positive effect of the recruitment subsidies on employment will generally outweigh the negative effect of the taxes.

It is sometimes alleged that another deficiency of recruitment subsidies--once again shared by low-wage subsidies and payroll tax reductions--is that they distort firms’ decisions concerning factor composition, encouraging labor at the expense of capital, for example. This matter is quite unlikely to be macroeconomic significance. The inefficiencies resulting from a distorted labor-capital mix are generally insignificant in comparison with the inefficiencies associated with long-term unemployment. Besides, as the efficiency wage, insider-outsider, and union theories suggest, free market activity may often be associated with market failures that give rise to excessive wages and deficient unemployment. In this context, recruitment subsidies may correct for an existing distortion, rather than create a distortion itself.

4. Benefit transfers

The “benefit transfers program” involves giving long-term unemployed people the opportunity to use part of their unemployment benefits to provide vouchers for firms that hire them. ^1/ The longer a person is unemployed, the greater is the voucher. Larger vouchers are also granted to firms that use them entirely on training. Once the worker finds a job, the voucher gradually falls as the period of employment proceeds.

In this way, benefit transfers are a combination of several different structural policies: the vouchers are equivalent to a special type of recruitment subsidy; the voucher supplement for training is a special type of training subsidy; and the transfer of unemployment benefit amounts to a reform of the unemployment benefit system.

The rationale for benefit transfers are various. First, they permit people to transfer funds out of a system that discourages employment in order to give firms an incentive to create employment. Second, they extend the choice sets of workers and firms. Workers offer the vouchers to potential employers when their expected wage offers are sufficiently high; the employers accept the vouchers when the resulting labor costs are sufficiently low. Thus the scheme is used only when both parties are made better off. Third, the scheme is costless to the government, since the vouchers are financed through the foregone unemployment benefits. Fourth, it is not inflationary, since the long-term unemployed have no significant effect on wage inflation, and since the voucher reduce labor costs and thereby exerts downward pressure on prices. Fifth, the scheme functions as an automatic stabilizer, since a fall in unemployment reduces the amount spent on unemployment benefits, which in turn reduces the funds available for the employment vouchers. Sixth, by providing generous vouchers to firms that use them for training, the scheme gives these firms an incentive to maximize the productivity-enhancing effect of this training. Finally, the scheme could help to overcome regional unemployment problems. Regions with high unemployment would command a disproportionate share of training subsidies, which may give firms an incentive to relocate there and give the unemployed the requisite skills, even in the face of existing barriers to mobility.

In view of these advantages, benefit transfers appear desirable as a first line of attack against long-term unemployment. Once the employment-creating potential of unemployment benefits has been exploited in this way, further measures may well be necessary to bring European unemployment down to socially acceptable levels.

1. Policies to reduce the power of labor unions

Policies to reduce the power of labor unions include restrictions on secondary picketing, laws prohibiting closed shop agreements, regulations restricting the coverage of union wage agreements, and much more. These policies may be analyzed straightforwardly through the theory of labor unions. In the traditional variants of this theory, ^1/ all union members are assumed to have identical preferences and an equal share in the available work. Then the union represents the interest of its members by exerting its monopoly power in wage setting, much like sellers of goods or services exert their monopoly power in price setting. The resulting wages will be higher and employment will be lower than would otherwise have been the case. If all workers in the economy belong to unions, then aggregate employment will be less than it would have been under full employment. The difference is unemployment (or under-employment).

More recent theories recognize that unions take greater account of the interests of their employed members than of the unemployed and that the employed workers have greater access to work than the unemployed do. The unemployment arising in this setting may be voluntary from the vantage point of the employed union members, but is generally involuntary from the vantage point of the unemployed, since the latter could be made better off by a wage reduction associated with a rise in employment.

The main theoretical weakness of this theory lies not in what it tells us, but in what it doesn’t. It doesn’t tell us why the unemployed don’t leave unions that don’t represent their interests, and start new unions making lower wage claims. Nor does it tell us what gives unions their clout. Since union coverage in most market economies is far below 100 percent, why don’t employers simply throw out high-wage union members and hire low-wage non-members instead? ^1/

On the empirical front, there is some evidence of an inverse relation between inter-country differences in unemployment rates (on the one hand) and inter-country differences in indexes of union power and union coverage (on the other) over the postwar period. Yet the union theories have not performed well over the past decade in predicting movements of unemployment through time. In the first part of the 1980s, for example, union membership in the United Kingdom and several other European countries fell while unemployment rose. For this reason, it is certainly premature to say that unemployment policies designed to reduce union power are on a firm predictive foundation.

2. Reforming the wage bargaining system

In recent years there has been a growing call to strengthen firm-level and national-level bargaining at the expense of bargaining at the sectoral level. ^2/ This policy strategy is based on the analysis of Calmfors and Driffill (1988), who explore how the economic efficiency of wage bargaining depends on the number of independent agents engaged in bargaining. They argue that when there is a high degree of centralization in bargaining--with few unions confronting few employers confederations, such as in Austria and Sweden--the negotiating partners internalize most of the effects of their claims; in particular, the unions take account of the price increases associated with their wage claims, and the employers take account of the wage increases associated with their employment and pricing decisions. The resulting wage-employment outcome is therefore reasonably efficient. On the other hand, when there are large number of negotiating workers and firms, each occupying a small portion of the market, the resulting activity is efficient for the standard competitive reasons. The United States approximates this setup. Calmfors and Driffill claim that it is only in the intermediate range, where the independent negotiators are sufficiently few in number to have market power, but sufficiently numerous to ignore the external effects of their decisions, that gross inefficiencies arise. Calmfors and Driffill adduce some empirical evidence in favor of this thesis, and Layard, Nickell, and Jackman (1991, p. 55) provide cross-section evidence that the unemployment rates in 20 OECD countries tend to be inversely related to the degrees of union and employer coordination.

On this account, it has been argued, wage bargaining systems need to be either highly centralized or highly decentralized. ^1/ Policies that reduce the power of labor unions, reduce labor turnover costs, and promote international trade are all likely to strengthen decentralized, firm-level bargaining. Government sponsorship of “social pacts”--whereby unions accept targets for nominal wage growth (based on productivity growth and price inflation), firms accept targets for price increases (based on wage inflation), the central bank sets the growth of the money supply with a view to non-inflationary growth, and fiscal authority aims to control unemployment--encourages centralized, national-level bargaining. As a practical matter, however, wage bargaining systems are very difficult to reform and thus this structural policy should be seen more as a long-term desideratum than as a short-term tool.

3. Reforming the unemployment benefit system

The main deficiency of all unemployment benefit systems is that, in helping to cushion the blow of unemployment, they make the underlying problem worse. The reasons are that unemployment benefits (i) discourage job search because when an unemployed person finds a job the unemployment benefits are withdrawn and taxes are imposed, and (ii) put upward pressure on wages by improving incumbent workers’ negotiating positions. The first effect lies in the domain of search and matching theory, the second is the province of bargaining theory. Together, these effects make unemployment benefit systems inherently inefficient and inequitable.

In reforming unemployment benefit systems, it is important to distinguish carefully between the equity and efficiency objectives of these systems. The equity goal is simply to redistribute income from the rich to the poor. The efficiency goal is to respond to market failures in the provision of unemployment insurance. ^1/ But unemployment benefits are generally a very poor tool to accomplish these objectives.

With regard to equity, it is worth keeping in mind that, for most poor people, employment is the best--often the only--way to overcome poverty. Thus it is particularly unfortunate that unemployment benefits discourage employment, since they thereby make the distribution of employment opportunities more unequal. Clearly, a more effective way to redistribute income from rich to poor is to use income as the criterion of redistribution; the employment criterion is obviously a blunt instrument for this purpose since some employed people are poor while some unemployed people are well-off.

With regard to efficiency, the gains from provision of unemployment insurance must be set against the efficiency losses that arise when unemployment benefits discourage employment and encourage unemployment. It is by no means a foregone conclusion that the efficiency gains will invariably exceed the associated losses. In any case, the unemployment benefit schemes that predominate in Europe--characterized by either flat-rate components or ceilings on benefits that depend on past wages--have much less in common with optimal unemployment insurance schedules than with standard redistributive schemes. In short, the unemployment benefits encountered in practice are not designed to yield major efficiency gains by correcting for failures in the unemployment insurance market.

But that is nowhere near the end of the problem. The efficiency wage, labor union, and insider-outsider theories identify market failures that give free market activity a tendency to yield excessively high wages and excessively low employment. Unemployment benefit systems exacerbate these market failures by driving wages up further and discouraging employment even more. Furthermore, these market failures are perpetuated through various dynamic effects. As noted above, the longer people are unemployed, the more their skills depreciate and become obsolescent, the more discouraged and ineffective they become in the process of job search, and the more wary firms become of hiring them. When the government rewards unemployment through unemployment benefits and penalizes employment through income taxes, it amplifies these dynamic effects by keeping unemployed people from competing for jobs and becoming “enfranchised” in the wage determination process. As result, their unemployment becomes less effective in moderating wages or raising firms’ return from searching for new recruits. In this way, unemployment benefit systems make unemployment more persistent, and put the long-term unemployed at a greater disadvantage in competing for jobs.

For all these reasons, unemployment benefit reform has become a topic of growing policy interest throughout Europe. But while it is relatively easy to recognize the need for reform, it is frightfully difficult to agree on its content. The critical question is how to provide a safety net for the disadvantaged and the unfortunates without dramatically reducing people’s incentives to fend for themselves, thereby creating more disadvantaged and unfortunates in the process.

A growing number of European economists argue that unemployment benefits should be generous, but for a limited period of time. ^1/ The generosity is allegedly required to give people the opportunity to make judicious job matches, which credit constraints may keep them from doing. Limited benefit duration, it is claimed, is necessary to induce people to find work quickly, before they become discouraged, stigmatized, and deskilled. This advice sounds eminently sensible, but little attempt has been made thus far to explore whether the theory behind this advice captures empirically important determinants of unemployment. It seems doubtful that workers’ credit constraints are an important aspect of the European unemployment problem. If they were, then the problem would be that unemployment durations are too short, resulting in over-full employment. This, it appears, is the least of Europe’s worries.

Beyond that, the prescription to shorten benefit duration characteristically becomes vague once we ask what happens to people who remain jobless after their unemployment benefits have expired. Some recommend that they be given training, while others put more emphasis on job counselling. But that still leaves us with the question of how to treat those who are left unemployed even after the training and counselling. At that point many European economists revert to the popular European opinion that the social safety net cannot be withdrawn from these hapless individuals; income support and a range of welfare state benefits are then required to keep them from destitution. But then a nominally short benefit duration may cease to give unemployed people an effective incentive to find jobs promptly.

This is in fact the problem that the current, unreformed European benefit systems face. Many European countries--such as Germany, France, Greece, Ireland, and the Netherlands--grant some form of unemployment insurance of limited duration, followed by unemployment assistance that is frequently unlimited. It is hard to see how the disincentive effects generated by these systems could be overcome simply by shortening the time-span for unemployment insurance and inserting a period of training and counselling prior to the receipt of open-ended unemployment assistance.

Overall, it is safe to say that unemployment benefit reform should be guided by the objective to overcome its two biggest deficiencies, namely, the disincentive effects and the imperfections in targeting the poor. It is arguable that both could be mitigated by simply replacing unemployment benefit systems by a conditional negative income tax program, ^1/ whereby people’s receipt of negative income taxes is made to depend on their ability to pass stringent tests on their willingness and readiness to work. ^2/

4. Worksharing and early retirement

Worksharing and early retirement has begun to look attractive to an increasing number of European policy makers, particularly in Germany. It is based on the view that there is a fixed amount of work to be done in an economy in any given period of time, and thus it is the job of the policy makers to decide how this work is to be distributed across the available workforce. If it is currently distributed unequally, with most people in the workforce working full-time and some remaining unemployed for prolonged periods, worksharing and early retirement could spread the job opportunities more equitably.

But to call this a “theory” is an overstatement. Most economists would rather call it the “lump-of-labor fallacy,” since it is well understood that the amount of work to be done in an economy is not a fixed number of hours, beyond the influence of the policy makers. ^3/ Keynesian theory drives this point home particularly forcefully: the more people are employed, the more they earn, the greater their purchasing power, the more they spend, and the more people firms will seek to employ.

Moving beyond their nonexistent theoretical foundation, job sharing and early retirement schemes suffer from a number of serious problems. First, they tend, in practice, to increase nonwage labor costs, particularly those associated with hiring, screening, training, and administration. Thus they may be expected to discourage employment and create more unemployment. Second, insofar as they are successful in reducing the pain from unemployment by distributing it among more people, they lessen the political pressure on governments to address the unemployment problem through more promising means. Third, in reducing the number of unemployed people competing for jobs, they may well drive up wages and stimulate price inflation. This may induce governments to implement restrictive macroeconomic policies, which would raise unemployment, possibly creating a further perceived need to redistribute job opportunities through yet more worksharing and early retirement. The main advantage of worksharing and early retirement schemes is that they may “enfranchise” a larger number of people in the wage determination process and thereby moderate the insiders’ wage demands. It appears unlikely, however, that this advantage would dominate the disadvantages above.

5. Policies centered on labor turnover costs

Policies to reduce unemployment by mitigating the harmful effects of labor turnover costs are as varied as the turnover costs themselves. Some involve dismantling job security legislation (such as laws reducing statutory severance pay or simplifying mandated firing procedures); others reduce the ability of incumbent workers to exploit existing labor turnover costs in order to boost their wages (such as legal restrictions on strikes and picketing); yet others help the unemployed surmount the obstacles created by turnover costs (such as training subsidies, recruitment subsidies, profit-sharing schemes, policies to reduce the barriers to the entry of new firms, and reform of wage bargaining systems). This section focuses attention on the first two groups of policies; policies in the third group have been discussed in Section V.

What the first two groups of policies have in common is that they reduce the market power of the “insiders” (incumbent employees whose jobs are protected by significant labor turnover costs) and thereby strengthen the position of the “outsiders” (who are either unemployed or have jobs that are not protected in this way). In the process, insiders become less insulated from the forces of labor demand and supply and firms find it easier to hire and fire employees. The upshot is that insider wages face downward pressure, since insiders now face greater competition from outsiders, and that employment becomes more responsive to variations in revenue and cost conditions. The first effect stimulates employment, ^1/ for as insiders’ wages fall, firms raise their demand for new recruits, who eventually turn into insiders. The second effect reduces the degree of employment and unemployment persistence.

This policy approach lies in the domain of the insider-outsider theory. ^1/ Here labor turnover costs, falling at least in part on firms, give market power to the insiders, who know that their employers would find it costly to replace them. The insiders are assumed to use this power to pursue their own interests in the wage setting process. Although the resulting insider wages are higher than they otherwise would have been, the labor turnover costs discourage firms from firing the insiders. Of course, firms are also discouraged from hiring new entrants by the excessive wages.

Some of the labor turnover costs (such as training costs) are an intrinsic part of the production process; others (like severance payments) are primarily associated with rent-seeking activities. The rent-related turnover costs give the insiders preferential conditions of employment over the outsiders. Then unemployment can arise on account of the outsiders’ inferior employment opportunities. In this context, policies that reduce labor turnover costs, or that check insiders’ ability to exploit them in wage setting, will generally lead to a reduction in unemployment.

The insider-outsider theory is able to account for a variety of empirical regularities in unemployment behavior. The relatively high labor turnover costs in Europe--both in their own right and through their influence on insiders’ wages--play a role in making European unemployment more persistent (serially correlated) than U.S. unemployment. Since high labor turnover costs make firms reluctant both to hire and to fire employees, they raise the duration of unemployment. In this way, Europe’s relatively high labor turnover costs can lead to its relatively high unemployment durations and relatively low unemployment variability, in comparison with the United States. Furthermore, since labor turnover costs raise insiders’ job retention rates relative to outsiders’ job acquisition rates, they imply that unemployment falls relatively heavily on population groups whose work patterns are relatively unstable (with relatively high entry and exit rates in the job market), such as young people.

Insofar as many of the full-time unskilled jobs in the traditional industrial sectors are associated with significant labor turnover costs, the insider-outsider theory also accounts for why wages in these sectors have not fallen with falling demand. It also helps explain why much service-sector employment and temporary employment--associated with relatively low turnover costs--has been buoyant in comparison with industrial employment in the OECD.

When business cycles are short-lived and mild, most European countries--facing comparatively high labor turnover costs--may be expected to do relatively little hiring or firing, hoarding labor in the slumps and bringing it back into use in the booms. But in the face of deep, prolonged recessions, these countries will stop hoarding and start firing labor. In the subsequent recovery, firms will then be comparatively slow to rehire, fearing that they may incur further firing costs should the recovery not materialize. Investment in labor-saving capital equipment may then take the place of new employment. This’ helps explain why unemployment rates in Europe were significantly lower than in the United States in the 1950s and 1960s (when business cycles were short-lived and mild), but significantly higher since the mid-1970s; why U.S. unemployment has been more variable than European unemployment; and why production and employment move together to a greater degree in the United States than in Europe.

6. Profit sharing

Under profit sharing contracts, a part of workers’ remuneration is paid as a fraction of the profits earned by their firms (or specific teams within those firms). ^1/ For any given level of remuneration, it is clear that a firm’s marginal cost of employment is lower under profit sharing than under a fixed wage, since (under diminishing returns to labor) the profit share declines as employment rises, whereas a fixed wage, by definition, doesn’t. Consequently, it is alleged, profit-sharing contracts lead to lower unemployment than do wage contracts. Weitzman has suggested that, in a world where wages seldom involve profit sharing, firms have deficient incentives to offer profit sharing contracts, and thus government subsides for profit sharing are called for.

The claim that profit sharing contracts reduce unemployment is less general than it may appear at first sight. It turns out that the effectiveness of profit sharing depends crucially on what is generating the unemployment. If, for instance, the unemployment is an efficiency-wage phenomenon, the switch from wage contracts to profit-sharing ones will do little, if anything, to reduce unemployment, since workers’ incentives to shirk and quit depend on the total amount of remuneration, but not on how this amount is divided between wages and profit shares. The same may be said of firms’ ability to attract workers of relatively high productivity.

Yet if the unemployment is predominantly generated by insider-outsider considerations, profit sharing may have an effective role to play. In the insider-outsider theory, the outsiders are unable to “bribe” insiders to forego the rent-seeking activities that keep the outsiders from getting jobs. The insiders may, for example, boost their wages and protect themselves from competition with outsiders by refusing to cooperate with them in the process of production, thereby creating an insider-outsider productivity differential; or they may harass outsiders who offer to work for less than the prevailing wages and thereby make the available jobs more disagreeable for those outsiders than for the insiders. Alternatively, the insiders may be involved in determining the wages of new entrants, and may use their market power to drive entrant wages up, thereby discouraging the employment of entrants that would drive down the insiders’ marginal products.

In this context, profit-sharing contracts may be construed as a device that permits the outsiders to bribe the insiders to stop these activities, so that everyone--the insiders, the outsiders, and their employers--can be made better off. In particular, if insiders were given a bonus for consenting to profit-sharing contracts for new entrants, the firm’s marginal cost of hiring new entrants would fall, the entrants would receive more than they did when they were unemployed, and the firm’s profits would rise. In the process, of course, unemployment would fall.

But while profit-sharing schemes are promising in this context, it is important to be aware of some potential difficulties. First, it may be impossible to induce the insiders to consent because their renting-seeking activities--like their harassment activities--may not be objectively monitorable. Second, to make profit sharing operational may require implementing costly monitoring procedures that enable workers to gain access to profit information. ^1/ Third, the extra profit generated through the introduction of profit sharing may be insufficient to compensate the insiders for their loss of market power resulting from the inflow of new entrants. Fourth, the extra profit generated may be insufficient to pay the premium that the new entrants would require to induce them to bear the income risk associated with profit sharing. And finally, the insiders may refuse to be bribed because that would create a two-tier remuneration system that would give firms an incentive to lay off the insiders and retain the entrants, once the latter had been fully trained.