Marcello M. Estevão

Unemployment rates surged in Western Europe in the 1970s and 1980s and have declined since the mid-1990s, though at different speeds across countries. In addition, the recent economic slowdown has not affected European labor markets with the same severity as previous downturns. Many studies have sought to show that structural factors likely underlie these developments, and to identify appropriate government responses to structured unemployment. This article selectively surveys recent IMF research on the topic.

IMF researchers have attempted to assess the role of labor market institutions in explaining variation in unemployment over time and across countries, with a focus on the potential for government policies to correct labor market rigidities. Debrun (2003) shows that structural unemployment rates would decline significantly in the long run if comprehensive labor market reforms were introduced in Europe.

In addition, a more competitive labor market, the author argues, allows the economy to react more quickly to interest rate changes, which facilitates countercyclical monetary policies. Using data for 21 OECD countries and focusing on the wide range of experiences within the European Union, Garibaldi and Mauro (2002) show that a policy package including low dismissal costs and low taxation is significantly associated with high net employment growth and can account for a substantial share of cross-country differences in labor market performance.

Other studies analyze more specific policies, such as tax reforms aimed at increasing take-home pay, lowering labor costs, and ameliorating the negative work incentives of generous benefit systems. Prasad (2003) uses microeconomic data to shed light on the work disincentive effects of the German tax and transfer system. Lockwood, Sløk, and Tranœs (2000) show that changes in the extent to which the income tax system provides for progressive rates can affect wage setting, though the exact impact will differ depending on workers’ initial income levels. In practice, key tax parameters do not seem to have changed significantly in most European countries in the 1990s. For instance, Estevão (2001) shows that tax reforms in Belgium did little to lower the wedge between labor costs and take-home pay, or to affect wage bargaining.

Active labor market policies have also been considered important tools to lower structural mismatches between labor demand and supply by either increasing workers’ productivity or improving the job search process. Using data for a panel of 15 developed countries, Estevão (2003a) finds that business employment rates rise in response to increases in expenditures on active labor market policies such as targeted direct subsidies to job creation, though expenditures on training do not seem to have a significant impact. He also shows that the positive contribution of active labor market policies partly results from wage moderation, maybe because the unemployed remain more attached to the labor market. Of course, a thorough cost-benefit analysis of active labor market policies would also consider their impact on the fiscal budget.

While government policies may help reduce structural unemployment, they may backfire if they are not well thought out. That might be the case with work-sharing policies, which are typically proposed on the grounds that the hours of work needed to produce a certain output level could be shared by more people if the standard workweek were reduced. Most theoretical work has emphasized potential fallacies behind this argument, though Erbas and Sayers (2001) suggest that workweek reduction laws could increase employment in the short run, if combined with employment subsidies. De Coninck and Estevão (2003) use microeconomic data and the characteristics of the 35-hour workweek laws in France to show that they significantly increased the transition probability from employment to unemployment of workers directly affected by them, that is, employees of large firms who were forced to adopt the new workweek in February 2000. However, large subsidies to the employment of low-wage earners did protect them from the negative effects of the law, proving that increased labor costs can be counteracted by significant government transfers.

Governments often resort to direct employment in an effort to reduce unemployment rates. Demekas and Kontolemis (2000) develop a model of the labor market with endogenous unemployment and government and private sector employers competing for workers but making employment and wage decisions on the basis of different objective functions. They find that governments’ direct hiring could be counterproductive because of its impact on wage and employment decisions by private sector employers and workers. Alesina, Danninger, and Rostagno (2001) study the Italian case and conclude that nationally set wages for public employees make public sector employment especially attractive in the south of Italy, where private sector job opportunities are relatively scarce. According to the authors, this leads the south to be caught in an equilibrium of dependency in which public jobs are a critical source of disposable income and private sector opportunities fail to materialize. A system is perpetuated in which public employment is used to redistribute income and reduce regional disparities but the deep causes for geographic disparities are not resolved.

More generally, several studies have found low mobility of workers across regions to be an important dimension of labor market rigidity for several European countries. Mauro, Prasad, and Spilimbergo (1999) analyze the Spanish and Italian cases and broader evidence on the extent of the problem in a panel of countries. Estevão (2003b) examines regional disparities in Belgium, which are particularly pronounced because of cultural and linguistic differences, and shows how they affect labor market dynamics. Institutional changes toward linking wage determination and unemployment benefits to local labor market conditions and away from highly centralized arrangements, better matching between vacancies and job-searchers across regions through more efficient employment agencies, and more flexible housing markets to spur migration are among the main policy suggestions coming out of this line of research.

The structure of wage bargaining and social benefits has also been analyzed. Thomas (2002) argues that the costs resulting from lack of wage flexibility across sectors and regions—necessary to smooth labor market adjustments—outweigh the benefits of wage bargaining centralization, including increased wage sensitivity to changes in unemployment. At the same time, Horvath (2001) points out that the system of centralized bargaining in Norway was instrumental to relatively tranquil labor market relations, strong employment growth, and record low unemployment. Thakur and others (2003) document how changes in wage bargaining centralization are related to labor market performance in Sweden, taking into account other macroeconomic policies enacted in each period.

Other papers have shown that structural changes in wage bargaining were probably at the heart of medium-term variations in unemployment rates. Decressin and others (2001) conclude that wage moderation during bargaining (defined as a downward shift in the negative equilibrium relationship between real wages adjusted for technological improvements and the unemployment rate—a “wage curve”) likely was an important reason for labor market improvements in France, Spain, and Italy during the 1990s. Such a shift constitutes a reversal of the trend observed in the 1970s and 1980s, when European trade unions seemed to either misperceive the room created for wage growth by changes in technology or had a higher preference for wages rather than employment. Estevão and Nargis (2002) use French microeconomic data to estimate downward shifts in the wage curve and provide more rigorous evidence of an improving trade-off between wages and unemployment in France in the 1990s. Detragiache and Estevão (2002) extend this analysis and show that the observed change in the wage curve will curb equilibrium unemployment further as firms increase investment to reestablish optimal long-run capital-labor ratios.