The unemployment rate in the EC increased sharply in the early 1980s, rising from 5.7 percent in 1979 to 10.9 percent in 1985. Why it increased is not mysterious: it was the result of a general shift toward anti-inflation policies, adopted first in England and then a couple of years later on the Continent. Indeed, the increase in unemployment was associated with a large decrease in inflation, from 10.7 percent in 1979 to only 5.5 percent in 1985. The mystery came later, in the second part of the 1980s, as unemployment remained high and no longer was associated with disinflation. Today, the EC unemployment rate stands close to 11 percent, and inflation remains at about 4 percent, only 1.5 percentage points down from 1985.
Lawrence H. Summers and I first took up this issue in 1986.(1) We were struck by the failure of traditional theories to explain continuing high unemployment. On the one hand, the fact that high unemployment no longer was associated with disinflation suggested an increase in the equilibrium rate of unemployment. But, reviewing the list of "usual suspects," we found little evidence of major increases in either structural change and reallocation activity, or union activity, or generosity of unemployment benefits, or explicit and implicit labor costs.(2) On the other hand, if continuing unemployment was caused by a continued lack of aggregate demand, and thus was far above equilibrium unemployment, why was disinflation coming to an end? To cut the Gordian knot, Summers and I suggested an alternative answer: unemployment remained high mainly because it had been high for so long. Put another way, continued high unemployment had led to high equilibrium unemployment.
Our basic theory was simple, even simplistic. We viewed wage bargaining as a process that demonstrated that employed workers cared about their own employment prospects but did not care much, if at all, about the unemployed. Thus, after a sequence of adverse shocks leading to higher unemployment, those who still had jobs chose wages low enough to keep them employed, but not so low as to create jobs for the unemployed. The implication was straightforward: once unemployment was high, it showed no tendency to decrease, and remained high until some favorable shocks came along. To capture this dependence of equilibrium unemployment on history, we called our theory a "hysteresis" theory of unemployment.(3)
The theory made a very relevant point, namely that the unemployed are...