Shorter Paper and Comment Unemployment Hysteresis, Wage Determination, and Labor Market Flexibility: The Case of Belgium

This paper examines unemployment hysteresis in the Belgian labor market. It estimates models of wage determination using aggregate and firm-level panel data. The conclusions are: (i) the long-term unemployed do not exert a negative impact on wages; and (ii) the incumbent workers, the “insiders,” exercise market power in wage determination, taking greater account of their own interests than those of the unemployed “outsiders;” and (Hi) the wage indexation system can cause a downward rigidity in real wages. Recent initiatives, including programs aimed at the long-term unemployed and the young, are appropriate in view of the existence of insider power.


This paper examines unemployment hysteresis in the Belgian labor market. It estimates models of wage determination using aggregate and firm-level panel data. The conclusions are: (i) the long-term unemployed do not exert a negative impact on wages; and (ii) the incumbent workers, the “insiders,” exercise market power in wage determination, taking greater account of their own interests than those of the unemployed “outsiders;” and (Hi) the wage indexation system can cause a downward rigidity in real wages. Recent initiatives, including programs aimed at the long-term unemployed and the young, are appropriate in view of the existence of insider power.

THE IDEA OF UNEMPLOYMENT HYSTERESIS can be traced to Phelps (1972), who argued that economic shocks could have long, lingering effects on the labor market. Accordingly, a rise in unemployment, by itself, could cause a temporary, or even permanent, increase in the non-accelerating inflation rate of unemployment (NAIRU). The history of unemployment can affect the NAIRU in a number of ways. First, if wage bargainers are primarily concerned with the interests of those who are employed—the “insiders”—rather than those who seek employment—the “outsiders”—then they may use union power or take advantage of high turnover costs or the uncertainties associated with employing an outsider to maintain high wages in the face of adverse shocks.1

A second way in which the history of unemployment can affect the NAIRU is through the composition of the pool of job seekers. According to this hypothesis, those who experience a long period of unemployment may lose their human capital through enforced inactivity and thereby become less attractive to employers. The long-term unemployed may also become less active job seekers if the unemployment benefit system does not provide adequate incentives to seek employment.

Finally, past unemployment—associated with a slowdown in economic activity—can affect the NAIRU because a higher level of unemployment is associated with a lower level of capital formation and, therefore, with a lower rate of growth of the warranted real wage. Consequently, it may take a long period of high unemployment before wage expectations are brought down to a sustainable level.

I. Empirical Evidence

The presence of high and persistent unemployment, low employment growth, and a high incidence of long-term unemployment suggests that hysteresis theories can contribute to the understanding of the Belgian labor market.2 In order to assess the contribution of these theories, we carried out empirical tests of two theoretical models of wage determination using both aggregate time series and a panel of firm-level data.

The Data

The aggregate time-series data cover the period 1970:1-1990:4 and were kindly provided by the Belgian National Bank.3 The disaggregate panel data for employment, wages, and sales by enterprise were obtained from a sample of 312 manufacturing firms for the period 1978-84. They were collected by the ASLK, the Belgian savings bank. The data cover 19 industries in the 9 provinces. The sample covers 190,000 blue-collar and 79,000 white-collar workers, about one third of those in manufacturing employment. The firm-level data were supplemented by industry level employment, wages, and unemployment data.

Time-Series Results

Table 1 presents direct estimates of the Blanchard and Summers (1986) insider-outsider wage equation using 84 quarterly observations from aggregate data for the period 1970:1-1990:4. This equation gives the rate of wage inflation, w — w-1, as a function of price inflation, Δp, and employment, n, lagged once and twice. The strong insider-outsider hypothesis—under which union members care only about the utility of currently employed members—implies that wage growth depends on the change rather than on the level of employment.4 The estimated coefficients appear to lend support to the strong insider-outsider theory: employment lagged both once and twice is significant (although the latter only marginally), and the hypothesis that the coefficients of employment lagged once and twice are equal in magnitude and opposite in sign cannot be rejected. The second equation replaces employment lagged once and twice with the lagged change in employment; the third equation adds a time trend. The conclusions remain unchanged: in both equations the change in employment is significant.

Table 1.

Insider-Outsider Wage Equation, 1970:1-1990:4 OLS with Δw as dependent variable

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Ramsey’s RESET test is based on the square of the fitted values.

The normality test is based on a test of skewness and kurtosis of residuals.

The last two wage equations in Table 1 have the change in the real wage as the dependent variable rather than the change in the nominal wage. The results again appear to support the strong insider-outsider hypothesis. However, the results in Table 1 are not conclusive evidence of the insider-outsider theory because: (1) the pure insider-outsider wage equations do not allow for a rich set of economic variables, particularly outsider variables such as the long-term unemployment rate; (2) the equations in Table 1 are all dynamic with no long-run properties; and (3) the diagnostic tests imply that the equations in Table 1 have poor econometric properties.5

Before turning to panel data analysis, we explore hysteresis further in the time-series context by estimating an alternative wage equation based on the bargaining model of Nickell (1987). In this model real wages depend on productivity (output per person), y - n; employer-employee social security tax and indirect tax wedges (t1, t2, t3); the import price wedge, pm — p; and unemployment. Here we separate out unemployment into short-run, SUR, and long-run, LUR, unemployment rates to test the impact of hysteresis through the duration of unemployment.

We first estimate a long-run level equation and then derive the dynamics. In our preliminary estimates, we typically found that the replacement ratio and the employers’ tax wedge were incorrectly signed. Excluding these variables gives the long-run, or co-integrating, vector reported in Table 2.6 All the coefficients are correctly signed and have plausible magnitudes. The equation also appears to have satisfactory long-run properties judging by the test statistics.

Table 2.

Long-Run Wage Equations, 1970:1-1990:4a OLS estimates with w - p as dependent variable

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In this table w - p (the real wage); y - n (smoothed productivity); and pm - p (the import wedge) are in logs, while t2 (the direct tax wedge); t3 (the indirect tax wedge); SUR (the short-term unemployment rate); and LUR (the long-term unemployment rate) are in percent.

Dickey-Fuller test of stationarity of the residuals.

Augmented Dickey-Fuller test of stationarity of the residuals.

The coefficient on the productivity term is close to unity and the equation indicates that if the import price wedge rises, wage earners would push up the real consumption wage. The interesting coefficients are those of the short-term and long-term unemployment rates. Short-term unemployment has the expected negative impact on wages. However, this impact is rather small: if the short-term unemployment rate rose by 1 percentage point, wages would only fall by 1 percent. Furthermore, the impact of the unemployment rate is considerably diminished by the long-term unemployment rate, which has a positive impact on wages.7 This evidence supports the unemployment hysteresis argument based on the duration composition of unemployment.

We now turn to the dynamics of wage determination in Belgium. The existence of indexation suggests that it is proper to model real rather than nominal wages; moreover, indexation also implies that wages are backward rather than forward looking with potentially long lags (Banque Nationale de Belgique (1991)). Also, since indexation and collective bargaining were suspended in 1982 and only fully restored in 1987, it is necessary to investigate how differently wages behaved during this period relative to the rest of the sample period.

Table 3 presents our estimated dynamic model for real wages. The equation is estimated using the instrumental variable technique because the change in productivity term is a contemporaneous determinant. In addition to this variable, the model contains lagged dependent variables; changes in the tax wedge variables; the lagged residual from Table 2, res-i; and a zero-one dummy for the 1982-86 period, D.

Table 3.

Dynamic Wage Equations, 1970:4-1990:4 Instrumental variables estimation

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A number of features of this model are worth noting. The suspension of indexation during 1982-86 had a significant and negative long-run impact on real wages and, as expected, the two-yearly bargaining round and the indexation system induce long lags in wage determination. In contrast to the pure insider-outsider models of Table 1, the dynamic model of Table 3 has very satisfactory diagnostics: tests for the validity of instruments, serial correlation, functional form, normality, and heteroscedasticity give very satisfactory results.

When we included the lagged change in employment on the right-hand side to test the insider-outsider hypothesis, it was insignificant (t-statistic = 0.7). The same result was obtained when including the lagged change in the level of unemployment (t-statistic = -0.5) or the lagged change in the unemployment rate (t-statistic = -0.5).

In summary, the time-series results suggest that there is unemployment hysteresis, caused mainly by the duration composition of unemployment. Furthermore, the negative impact of unemployment on wages is very moderate in Belgium in comparison with other industrial countries. However, the time-series results were not conclusive in assessing the relevance of the insider-outsider model in Belgium. Therefore, it is useful to explore this model further using micro data. In fact, since the insider-outsider model is based on wage determination at the firm level, cross-section or panel analysis can lead to a more conclusive test of the hypothesis. In the next section we use micro data and consider the wages paid by an individual firm in view of the insider variables such as firm level productivity and profitability, and outsider variables such as unemployment, in order to be able to test appropriately for the relevance of this theory to the Belgian labor market.

Firm-Level Results

We now attempt to test for the unemployment hysteresis theories by using the firm-level data set described above. These data are from a sample of 312 manufacturing firms for the period 1978-84. The data set provides us with 2,184 observations; however, since there are some gaps in a few industry-level variables, the regressions utilize about 1,520 observations.

The firm-level results are presented in Table 4. The first panel wage equation contains mainly lagged variables and is estimated using OLS. The second panel includes current employment, n, and is therefore estimated using the instrumental variables (IV) technique. All the variables are at the firm level apart from aggregate real wages (wagg), and industry-level unemployment rate (UIND). The other explanatory variables are the firm’s productivity (y — n), measured as sales per worker; and the firm’s real profit (π). To test the insider-outsider hypothesis, the OLS equation also contains employment lagged once and twice and the IV equation has current and lagged employment. All the variables apart from the industry level unemployment rate, UIND, are in logs.

A number of features of the regressions in Table 4 are worth noting. The industry-wide unemployment rate exerts downward pressure on firm-level wages even though we allow the firm’s employment to enter the regression. This is at variance with the pure insider view of wage determination. At the same time, both employment lagged once and twice (or current and lagged employment in the instrumental variable case) as well as the insider variables such as the firm’s profits and productivity, are significant. In both the OLS and the IV estimates, the hypothesis that employment lagged once and twice (current and lagged in the IV case) have equal and opposite coefficients cannot be rejected. This implies the existence of some insider power.

To test for the hysteresis effect through the duration composition of unemployment, we added the proportion of those who have been out of work for more than a year, LTU, to the equations in Table 4.8 The results of this exercise are presented in Table 5. The long-term unemployment variable is highly significant and positive in both the OLS and the IV estimates.

Table 4.

Wages Equation Using Firm Level Data: Observations from 312 Firms over 7 Years (1978-84)

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Past values of n and (w — p) were used as instruments.

A number of variations on the results presented in Tables 4 and 5 were also attempted. Instead of aggregate wages, we included industry-level wages. This variable was highly significant and the results remained unchanged but the diagnostics were not as good as those in Tables 4 and 5. When we substituted the aggregate unemployment rate for the industry-level unemployment rate, the results remained identical except for the coefficient of the aggregate unemployment rate, which was much lower (-0.01, t-statistic = 4.3). Since our data spanned only seven years, we chose to keep the industry-level variable, which provides more variation over the data set. Finally, the long-term unemployment variable was highly significant and positive in every single regression that we estimated regardless of the method of estimation or the other variables included.

Table 5.

Wage Equation Using Firm-Level Data: Observations from 312 Firms over 7 Years (1978-84)

(including the long-term unemployment variable)

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Past values of n and (w — p) were used as instruments.

In short, the firm-level investigation supports the time-series result of hysteresis occurring through the duration composition of unemployment in Belgium. Furthermore, although the results reject the strong insider-outsider hypothesis, they do indicate the existence of some insider power in wage determination.

II. Conclusion and Policy Implications

The empirical investigation of the previous section is very preliminary and further analysis is necessary for concrete policy implications to emerge. However, the results imply: (1) that the long-term unemployed do not have a negative impact on wages; and (2) that the incumbent workers, the “insiders,” exercise market power in wage determination. The latter is not surprising given the high degree of unionization and coverage of wage bargaining in Belgium. How should labor market policy respond to these characteristics in order to effectively generate employment, reduce unemployment, and, more generally, lower the underutilization of labor?

Given the presence of insider power and the large pool of long-term unemployed, market forces by themselves cannot be expected to lead to a quick reduction in unemployment; thus there is a need for government action in reducing unemployment, and particularly long-term unemployment. This can be achieved in two ways: tightening up the unemployment benefit system for the long-term unemployed in order to encourage job search; and providing targeted training and employment opportunities for the long-term unemployed. The Belgian Government has recently taken a number of measures to this end. The benefit eligibility rules for the part-time or temporarily unemployed have been tightened. Also, in cooperation with the regions and communities, the Government has introduced the plan d’accompagnement, which provides training or employment opportunities for all the full-time unemployed under the age of 46 after they have been unemployed for ten months. Although these are positive developments, the following further steps could be taken to reduce long-term unemployment:9

(1) In spite of tighter unemployment benefit regulations, benefits are still available for a longer duration in Belgium than in most other industrial countries. In this respect, unemployment compensation also acts as a form of long-term income support. However, unlike the income support system, MINIMEX, unemployment compensation is not means tested. Also, a large fraction of individuals receiving unemployment benefits are employed part-time, are on career breaks, or have retired early. This imposes a heavy financing burden on unemployment insurance, leading to a high wage wedge. There is a need for more transparency here. This could be achieved by separating the cyclical, short-term, function of unemployment insurance from its permanent and redistributive income support function.

(2) The plan d’accompagnement could be extended. For example, the suspension of benefits for those whose duration of unemployment exceeds twice the regional average could become automatic rather than being left to the discretion of regional unemployment offices (unemployment benefits are financed by the central government but are administered locally). Currently, the initiative applies to those who commence their tenth month of unemployment, but it could be extended to all those who have been unemployed for over ten months.

Another conclusion of this paper is the need to reduce insider power in order to help employment generation. Lindbeck and Snower (1988) discuss in some depth the policies that could be effective in this respect. They include: (1) reducing hiring and firing costs and relaxing job security regulations; (2) lowering the cost of employing outsiders through, for example, reduced employer payroll taxes for the young and the long-term unemployed;10 (3) enhancing competition in the product market through reducing the barriers to the entry of new firms by, say, providing tax incentives and business startup funds to hire the unemployed; (4) vocational training schemes that provide marketable skills to the unemployed, making them more attractive to firms; and finally, (5) profit sharing, which reduces the marginal cost of employment.

An additional complicating factor is wage indexation. In Belgium there is a consensus among the social partners in favor of indexation as a means of maintaining stable pay expectations and the competitiveness law is a way of taking action if necessary.11 The empirical results of Section I demonstrate that the suspension of indexation in 1982, in the wake of the devaluation of the Belgian franc, was effective in reducing the real wage. The recent decision of the Belgian Government—announced in the “global plan”—to exclude petrol, tobacco, and alcohol prices from indexation and to freeze real wages for the period 1995-96 will help in restraining wages and improving competitiveness. With multiyear contracts, indexation prevents an adjustment in real wages during the contract period. Thus, the existence of hysteresis implies that an adverse shock leads to a permanent increase in unemployment. Therefore, it may also be desirable to strengthen the competitiveness law, so that the suspension or modification of indexation becomes automatic in the event of an adverse shock or a loss of competitiveness.


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Reza Moghadam is an Economist in the European I Department and holds a Ph.D. from Warwick University. Caroline Van Rijckeghem is an Economist in the Research Department and holds a Ph.D. from the University of California at Berkeley. This paper was written while she was in the Fiscal Affairs Department. The paper is a condensed version of Moghadam and Van Rijckeghem (1994). The authors would like to thank, without implication, Ke-Young Chu, Paul Masson, and the researchers at the National Bank of Belgium for helpful comments and suggestions.


Mulkay and Van Audenroae (1993) show that the Belgian labor market is characterized by a low rate of employment growth.


The short-term and long-term unemployment variables only exist from 1987:1. The earlier data were interpolated from annual observations.


This test is strictly valid only if labor demand follows a random walk.


All the equations fail the normality test and the Lagrange multiplier test for serial correlation. Equations (3) and (5) also fail Ramsey’s test for functional form.


We found that all the variables appearing in Table 2 were nonstationary; in fact, they were all integrated of order one. The long-run equation is estimated using ordinary least squares (OLS).


We also tested for cointegration of SUR and LUR. This was rejected.


The aggregate wage variable, wagg, was left out of these regressions because of collinearity with LTU.


Reforms along the following lines may have been put in place after the paper was written.


Some payroll tax reductions for the young have been put into effect since this paper was written.


Under this law the Government can suspend indexation if competitiveness deteriorates significantly.