Explaining European unemployment.

• Author: Blanchard, Olivier J.
• Position: Research Summaries

Unemployment, Shocks, and Institutions

Anybody attempting to explain the evolution of unemployment in Europe over the last 30 years must confront the following set of facts: First, high unemployment is not a European trait. Until the end of the 1960s, unemployment was very low in Europe and the talk then was of the "European unemployment miracle." The miracle came to an end in the 1970s, when unemployment steadily increased. It kept increasing in the 1980s. It appeared to turn around in the mid-1990s, but the decline is (temporarily?) on hold. For the European Union as a whole, the current unemployment rate is still very high, around 8 percent.

Second, the evolution of the average European unemployment rate hides large cross-country differences. In the four large continental countries--France, Germany, Spain, and Italy--the unemployment rate has increased steadily and remains very high, around 10 percent. (The Spanish unemployment rate has been cut in half since its peak, but remains above 10 percent.) In a number of smaller countries, notably Ireland and the Netherlands, unemployment increased until the early 1980s, but has steadily decreased since then. Unemployment is less than 5 percent in both countries today. In a number of other countries, notably Sweden and Denmark, unemployment has remained consistently low--except for a bout of high cyclical unemployment at the start of the 1990s. Unemployment is below 5 percent in both countries today.

Third, at a given unemployment rate, individual unemployment duration is substantially longer, and flows in and out of unemployment substantially lower, in Europe than in the United States. (1) And, the increase in European unemployment reflects an increase in duration rather than an increase in flows. As a result, duration is high. In Germany and Italy for example, more than half of the unemployed today have been unemployed for more than one year.

Finally, if one takes the change in inflation as a rough indicator of whether the rate of unemployment is above or below the natural rate, one must conclude that, apart from cyclical movements in the early 1980s and early 1990s, the broad movements in the unemployment rate have reflected movements in the natural rate of unemployment. In particular, over the last few years, inflation has declined only slightly, suggesting that the natural rate today is lower than, but close to, the actual unemployment rate.

Shocks

The initial increase in unemployment in the 1970s coincided with a number of adverse shocks--some worldwide, some specific to Europe. Thus, much of the initial research naturally focused on the role of shocks in explaining the increase in the natural rate of unemployment. In the 1970s, raw materials prices rose sharply. More importantly, but less visibly at the time, the high rate of productivity growth that had characterized the post-war period came to an end. To the extent that workers did not fully adjust to these changes, these shocks plausibly could have led to an increase in the cost of labor, and so to the increase in unemployment. In the 1980s, tight money led to a prolonged period of high real interest rates, and so to a large increase in the user cost of capital. This in turn could have led to low capital accumulation, and by implication, lower employment growth and higher unemployment.

That is why initial explanations focused on shocks. However, looking at it from today's vantage point, an explanation of unemployment based on shocks runs into two main difficulties: first, shocks were largely similar across countries. The decline in productivity growth was largely common to all European countries. The same is true of most other shocks: while the increase in interest rates varied across countries, real interest rates increased in all countries from the early 1980s on. Yet, as we have seen, the evolutions of unemployment have been very different across countries.

Second, the oil price increases of the 1970s turned into decreases in the 1980s. Underlying productivity growth has...