“Any reasonable reader of the data has to recognize that this financial crisis has confirmed the doctrine of hysteresis more strongly than anyone could have anticipated.”
— Larry Summers, April 2, 2014. Speech at Center for Budget and Policy Priorities
Amisano, Gianni and Massimiliano Serati (2003). “What Goes Up Sometimes Stays Up: Shocks and Institutions as Determinants of Unemployment Persistence”. In: Scottish Journal of Political Economy 50.4, pp. 440–470.
Ball, Laurence M (2009). “Hysteresis in Unemployment: Old and New Evidence”. In: National Bureau of Economic Research Working Paper No. 14818.
Balmaseda, Manuel, Juan José Dolado, and J David Lopez-Salido (2000). “The Dynamic Effects of Shocks to Labour Markets: Evidence from OECD Countries”. In: Oxford Economic Papers 52.1, pp. 3–23.
Bassanini, Andrea and Romain Duval (2006). “Employment Patterns in OECD Countries”. In: OECD Economic Department Working Paper 486, Organisation for Economic Co-operation and Development, Paris, France.
Blanchard, Olivier J (2018). “Should We Reject the Natural Rate Hypothesis?” In: Journal of Economic Perspectives 32.1, pp. 97–120.
Blanchard, Olivier J and Lawrence H Summers (1987). “Hysteresis in Unemployment”. In: European Economic Review 31.1–2, pp. 288–295.
Blanchard, Olivier J and Justin Wolfers (2000). “The Role of Shocks and Institutions in the Rise of European Unemployment: the Aaggregate Evidence”. In: The Economic Journal 110.462, pp. 1–33.
Cerra, Valerie and Sweta Chaman Saxena (2008). “Growth Dynamics: The Myth of Economic Recovery”. In: American Economic Review 98.1, pp. 439–57.
Cerra, Valerie and Sweta Chaman Saxena (2008) (2017). “Business Cycle and its Policy Implications”. In: International Monetary Fund Working Paper 17/250.
Christiano, Lawrence J, Martin S Eichenbaum, and Mathias Trabandt (2016). “Unemployment and Business Cycles”. In: Econometrica 84.4, pp. 1523–1569.
Cœuré, B (2017). “Scars or Scratches? Hysteresis in the Euro Area”. In: speech at the International Center for Monetary and Banking Studies, Geneva.
De Resende, Carlos (2014). “An Assessment of IMF Medium-Term Forecasts of GDP Growth”. In: IEO Background Paper No. BP/14/01 (Washington: Independent Evaluation Office of the IMF).
Gal, Peter and Adam Theising (2015). “The Macroeconomic Impact of Policies on Labour Market Outcomes in OECD Countries: A Reassessment”. In: OECD Economic Department Working Papers 1271, 0_1.
Galí, Jordi (2015). “Hysteresis and the European Unemployment Problem Revisited”. In: National Bureau of Economic Research Working Paper No. 21430.
Im, Kyung So, M Hashem Pesaran, and Yongcheol Shin (2003). “Testing for Unit Roots in Heterogeneous Panels”. In: Journal of Econometrics 115.1, pp. 53–74.
IMF (2016). “Time for a Supply-Side Boost? Macroeconomic Effects of Labor and Product Market Reforms in Advanced Economies”. In: World Economic Outlook, Chapter 3, April, International Monetary Fund.
Johansen, Søren (1991). “Estimation and Hypothesis Testing of Cointegration Vectors in Gaussian Vector Autoregressive Models”. In: Econometrica: Journal of the Econometric Society, pp. 1551–1580.
Kao, Chihwa (1999). “Spurious Regression and Residual-Based Tests for Cointegration in Panel Data”. In: Journal of Econometrics 90.1, pp. 1–44.
Lewis, Jeffrey B and Drew A Linzer (2005). “Estimating Regression Models in which the Dependent Variable is based on Estimates”. In: Political Analysis 13.4, pp. 345–364.
Lindbeck, Assar and Dennis J Snower (1986). “Wage Setting, Unemployment, and Insider-Outsider Relations”. In: The American Economic Review 76.2, pp. 235–239.
Maddala, Gangadharrao S and Shaowen Wu (1999). “A Comparative Study of Unit Root Tests with Panel Data and a New Simple Test”. In: Oxford Bulletin of Economics and Statistics 61.S1, pp. 631–652.
Mortensen, Dale T and Christopher A Pissarides (1999). “Unemployment Responses to ‘Skill-Biased’ Technology Shocks: The Role of Labour Market Policy”. In: The Economic Journal 109.455, pp. 242–265.
Nickell, Stephen, Luca Nunziata, and Wolfgang Ochel (2005). “Unemployment in the OECD Since the 1960s. What Do We Know?” In: The Economic Journal 115.500, pp. 1–27.
Osterwald-Lenum, Michael (1992). “A Note with Quantiles of the Asymptotic Distribution of the Maximum Likelihood Cointegration Rank Test Statistics”. In: Oxford Bulletin of Economics and statistics 54.3, pp. 461–472.
Pedroni, Peter (1999). “Critical Values for Cointegration Tests in Heterogeneous Panels with Multiple Regressors”. In: Oxford Bulletin of Economics and statistics 61.s 1, pp. 653–670.
Pedroni, Peter (2004). “Panel Cointegration: Asymptotic and Finite Sample Properties of Pooled Time Series Tests with an Application to the PPP Hypothesis”. In: Econometric Theory 20.03, pp. 597–625.
Pesaran, M Hashem and Ron Smith (1995). “Estimating Long-Run Relationships from Dynamic Heterogeneous Panels”. In: Journal of Econometrics 68.1, pp. 79–113.
White, Halbert (1980). “A Heteroskedasticity-Consistent Covariance Matrix Estimator and a Direct Test for Heteroskedasticity”. In: Econometrica, pp. 817–838.
Appendix A. Sample
The sample for the first stage of the analysis (and the stylized facts) is composed by the following countries: Austria, Czech Republic, Denmark, Estonia, Finland, France, Germany, Greece, Hungary, Ireland, Italy, Latvia, Luxembourg, Netherlands, Norway, Poland, Portugal, Slovak Republic, Slovenia, Spain, Sweden, United Kingdom, and the United States.
The sample for the second stage of the analysis excludes Estonia, Hungary, Latvia, Poland, and Slovenia due to missing data for some explanatory variables.
Appendix B. Data Sources
In the following, we report how we construct the variables entering the second stage of the empirical analysis and the original data sources:
Unemployment rates are defined as the seasonally-adjusted share of unemployed to the labor force. Source: OECD, Employment database; and FRED, Economic Data.
Real wages are calculated by deflating the seasonally-adjusted hourly nominal wages in nominal currency by the GDP deflator. Source: OECD, Employment database and Benefits and Wages database; and FRED, Economic Data.
Real GDP is measured in constant local currency. Source: OECD, National Accounts Statistics; and Fred, Economic Data.
The labor tax wedge is defined as the ratio between the average tax paid by a single-earner family (one parent at 100 percent of average earnings with two children) and the corresponding total labor cost for the employer. The labor tax wedge is available from the OECD for 2000 to 2016, and was extended back to 1980 using Bassanini and Duval (2006) and IMF (2016). The latter series is available only in uneven years; the value of the labor tax wedge in even years is obtained by linear interpolation. Sources: OECD, Tax database; Bassanini and Duval (2006); and IMF (2016).
The generosity of the unemployment benefits system is measured as the gross replacement rate, which, in turn, is computed as the gross unemployment benefit levels as a percentage of previous gross earnings. The summary measure with the best coverage is the average of the gross unemployment benefit replacement rates for two earnings levels, three family situations, and three durations of unemployment. Such measures are available in uneven years, and are interpolated to obtain their values for even years. The reported values are for the average worker from 2001 to 2011, and average production worker from 1961 to 2005. The two series are spliced. Source: OECD, Benefits and Wages database.
Public expenditure on ALMP is calculated as ALMP spending per unemployed person in percent of GDP per capita, following Gal and Theising (2015). Source: OECD, Employment database.
Restrictiveness of migration policy is an index with information about all changes to the existing legal framework relevant for migration (see also De Resende, 2014). We focus on major changes in policies guiding the post-entry rights or other aspects of migrants’ integration. Source: International Migration Institute, DEMIG POLICY database.
Union density is measured as net union membership as a proportion of wage earners in employment. Source: OECD, Employment database.
Coordination of wage setting is an index of the centralization of bargaining. The index runs from 1 to 5 with values defined as (1) Fragmented wage bargaining, confined largely to individual firms or plants, (2) mixed industry and firm-level bargaining, weak government coordination through minimum wage setting or wage indexation, (3) negotiation guidelines based on centralized bargaining, (4) wage norms based on centralized bargaining by peak association with or without government involvement, and (5) maximum or minimum wage rates/increases based on centralized bargaining. Source: Amsterdam Institute for Advanced Labour Studies, Database on Institutional Characteristics of Trade Unions, Wage Setting, State Intervention, and Social Pacts.
Part-time employment is measured as the proportion of employees with a part-time contract to total employees. Source: OECD, Employment database.
Job-protected maternity leave is defined as the total number of weeks of job-protected maternity, parental, and extended leave available to mothers, regardless of income support. Source: OECD, Family database.
The statutory retirement age is defined as the population-weighted average at which workers can retire. Source: Social Security Programs throughout the World.
To capture the generosity of pension schemes, we rely on the measure with the best country and time coverage, which is public spending on old-age pensions as a percent of GDP. Source: OECD, Social protection database.
The views expressed in this Working Paper are those of the authors and do not necessarily represent those of the IMF or IMF policy. Working Papers describe research in progress by the authors and are published to elicit comments and to encourage debate. We thank, without implicating, Valerie Cerra, Bertrand Gruss, Alvar Kangur, Lin Li, Malhar Nabar, Peter Pedroni, and Jiri Podpiera for their comments and suggestions.
Blanchard (2018) notes that even if the insiders do not care about the outsiders, they still risk to become unemployed if economic conditions deteriorate, hence they might accept lower wages, especially if unemployment is high. Also, high levels of unemployment strengthen the bargaining position of firms at the moment of hiring, as they can draw from a larger pool of candidates.
Galí (2015) also notes that the long-run trade-off hypothesis can account for the secular rise in unemployment during the 1970s and 1980s.
A full literature review is beyond the scope of the paper.
If unemployment is low and fixed costs to hire outsiders are also low, new firms may hire outsiders generating competition in the goods markets and lowering wages. If unemployment is high, re-employment prospects are gloomier for workers if laid off, forcing insiders to accept lower wages. In this case, however, insiders may harass the outsiders as replacing the whole labor force is not likely to be cost effective (Lindbeck and Snower, 1986).
As in Amisano and Serati (2003), we model current labor force as a function of expected real wages rather than actual real wages and past unemployment rather than contemporaneous unemployment, providing a better characterization of how long-term unemployment strengthens the bargaining position of the insiders.
In this framework, oil price shocks are captured as negative productivity shocks, which increase prices (thereby lowering real wages) and raise unemployment.
Galí (2015) shows that the natural rate hypothesis cannot account for the patterns of unemployment and wage inflation observed in the euro area between 1970 and 2014. Specifically, the strong persistence in unemployment cannot be reconciled with a mean reverting behavior implied by the theory.
Real wages and real output are unambiguously integrated of order one. The results of the unit root tests for these series are available upon request.
These tests differ in that Im et al. (2003) treat the parameter of interest as varying across countries and focus on the between-country dimension, while Maddala and Wu (1999) treat all the parameters as potentially varying across countries and test by pooling significance values across members of the panels.
Galí (2011) provides the theoretical underpinnings of the reduced form of the New-Keynesian Wage Phillips curve. In this paper, we estimate a similar specification, also estimated in Galí (2015) for the United States and the euro area. Adding the change in the unemployment rate to the regressors and substituting the unemployment rate with a measure of the unemployment gap obtained by filtering the original series do not alter the conclusions. Estimating a hybrid version of the wage Phillips curve at the country-level is complicated by data availability for inflation expectations.
In the case of Luxembourg, the cointegration results are not reliable given that we reject the presence of a unit root in Table 2.
Failing to account for such heterogeneity by simply pooling data as in conventional dynamic panel methods may result in inconsistent estimation and inference of the relationships (see Pesaran and Smith, 1995).
Amisano and Serati (2003) include labor taxes and unemployment benefits in the exogenous block of the VAR. However, this choice could be questioned as these variable may not be really exogenous to any of the variables in the endogenous bloc.
This is in contrast with the identification scheme used by Balmaseda et al. (2000) and Amisano and Serati (2003), in which the partial hysteresis hypothesis supported by the evidence of stationary unemployment rates leads to impose the restriction for which aggregate demand shocks have no permanent effects on output.
Balmaseda et al. (2000) finds a positive effect for the United States and a negative one for the OECD countries in the sample. They note that the popularity of Real Business Cycle theories in the United States and the extensive use of models based on sticky wages in OECD countries could be associated to this finding.
A negative IRF coefficient describes a fall in unemployment in response to an aggregate demand shock.
Lewis and Linzer (2005) show that if the White (1980) correction for heteroscedasticity is used, simple unweighted OLS to estimate the second stage generates conservative inferences of the second-stage parameters.
When demand shocks are allowed to have a long-run effect on unemployment as in our baseline specification, the impact turns negative also for the United Kingdom, further raising concerns about an identification strategy that restricts the long-run effect to zero.