Long-run economic performance and the labor market.

• Author: Alonso, Alberto

1. Introduction

   This article studies growth when the economy is not using all its productive resources to establish a bridge among two subdisciplines in economics: growth theory and unemployment theory. The former is dynamic and considers the impact on output of the growth in inputs under the assumption that unemployment is nonexistent. The latter is static and considers the determination of the rate of unemployment under the assumption that the growth of capital is nonexistent. Our goal herein is twofold. On one hand, we want to modify slightly the growth models to include the effects of persistent unemployment on long-run growth. On the other, we want to analyze the role played by the accumulation of capital in determining the unemployment rate.

   The underlying assumption in the neoclassical growth model is that, even if we admit sticky wages in the short run, in the long run, the labor market should have time to clear and the economy should return to full employment, understood as the level of employment compatible with frictional unemployment. Therefore, what is relevant when talking about growth is the growth of the labor force, not the growth of the employed labor force. However, if the equilibrium employment level in the labor market persistently differs from the more desirable frictional level, it is conceivable that this persistent deviation will have an impact on long-run growth. The average U.S. unemployment rate during the 1990s was 5.8% while countries such as France and Spain maintained double-digit unemployment rates in the 1980s and 1990s. It seems intuitive that double-digit unemployment during two decades should have long-lasting effects on standards of living. The disparate experiences of some European countries as opposed to the United States in terms of employment rates are due to very different institutional factors in the corresponding labor markets. This article studies the impact of labor market institutional variables on long-ran growth.

   Despite a very large literature on both growth and unemployment, few papers have jointly studied these two phenomena. The exceptions are Furuya (1998) and Daveri and Tabellini (2000). Daveri and Tabellini study the implications of an increase in labor taxes on both unemployment and economic growth. The models in these two papers are of the overlapping generation class, but whereas in Furuya's, the labor market does not clear because of the existence of efficiency wages, in Daveri and Tabellini's, the labor market does not clear because of the existence of a union. Our model is a simple variation of the standard Solow model suitable for a first approximation to an empirical investigation of the interrelationship between economic growth and the labor market.

   We use a variation of Blanchflower and Oswald's (1995) wage curve, which is more suitable for integration with a growth model. The wage curve shows an empirical inverse relation between unemployment and wage levels. This inverse relation is consistent with models of noncompetitive wage determination. Basically, we use a reduced form of the open-trade-union Layard-Nickell (Layard and Nickell 1985, 1986) model of wage determination to explain why the equilibrium unemployment level differs from the frictional level. A weakness of relying on trade union behavior to explain unemployment is that, in most countries, not all workers are unionized. Union membership varies greatly across countries, but in most countries, a large part of the labor force is nonunionized. However, Blanchard and Summers (1986) argue that the trade union model can be interpreted as describing the behavior of a group of workers that acts as a group even if there is no formal trade union. The fact that both capital intensity and productivity affect the equilibrium unemployment rate is implicit in the Layard-Nickell model. We emphasize the importance of capital intensity in the determination of unemployment and incorporate unemployment into a growth model.

   We distinguish between potential growth and feasible growth and describe the potential growth path for a given savings rate as the one that could be followed if all resources were utilized. The feasible growth path for a given savings rate, on the other hand, is that that can be followed given the institutional conditions regarding the labor market. These conditions imply that some labor may not be employed. The first path is a potential one because a different labor market would make this path possible. The feasible growth path, thus, implies some underachievement. We show that both income and capital per worker are lower in the feasible steady state than in the potential steady state. Both income and capital per worker depend positively on labor market flexibility.

   The conclusions regarding the effects of the labor market on steady-state variables are no different from the ones of a simpler Solow model in which the production function in period t is [Y.sub.t] = [K.sup.[alpha].sub.t][(1 - [u.sup.*])[[A.sub.t][L.sub.t]].sup.(1-[alpha])], where, as usual, K denotes capital, Y denotes output, L denotes the labor force, A is an indicator of labor efficiency, and [u.sup.*] refers to the natural rate of unemployment. What is different is that our model studies the interrelations between economic growth and the labor market, that is, the effect of variables affecting the steady state, such as capital accumulation, on unemployment. This model also predicts that a decrease in the savings rate, an increase in the rate of growth of the labor force, or an increase in the rate of technical progress increase the rate of unemployment in the steady state. Finally, there is a third and novel prediction of the model: Lack of labor market flexibility slows convergence of the economy toward its steady state. Lack of flexibility implies that the economy produces below its potential every period.

   From the empirical point of view, using OECD data, Furuya shows that a decrease in the savings rate, an increase in the rate of growth of the labor force, or an increase in the rate of technical progress increase the rate of unemployment in the steady state. Using a combination of OECD and World Bank data, the Penn Worm Tables, and data on labor market institutional variables from Blanchard and Wolfers (2001), we show not only that a lower saving rate, a higher growth rate of the labor force, or a higher rate of technical progress results in higher unemployment but also that labor market institutional variables have the predicted effects on steady-state output per worker and that labor market flexibility affects convergence toward the steady state. Although we consider these results somewhat preliminary, partially due to the quality of our data, we regard them as very encouraging. Our results can be viewed as stylized facts that grant further work, mostly at the theoretical level, toward the construction of another model that, preserving the conclusions of this simpler model, has better microeconomic foundations. We believe that more work is needed on the interrelation between economic growth and unemployment.

   Section 2 specifies the model. Section 3 tests the implications of the model concerning how technical progress and investment affect long-run employment. Section 4, on the other hand, tests the implications of the model pertaining to the long-run impact of labor market variables. Section 5 tests the implications regarding convergence toward the steady state. Section 6 concludes.

2. The Model

   Herein, we abstract from household behavior concerning savings to concentrate on the production side of the growth model. Both the overlapping generations or the infinite-horizon, intertemporally-optimizing, representative-agent frameworks have problems, and their results are similar to those in the simpler Solow model. As Solow (1994, p. 49) phrases it, "... the use made of the intertemporally-optimizing representative agent.... adds little or nothing to the story anyway, while encumbering it with unnecessary implausibilities and complexities." Furthermore, for empirical purposes, it is useful to maintain the assumption of exogenous (and different across-countries) saving rates.

   Blanchflower and Oswald (1995) deem the empirical inverse relation between unemployment and the level of wages the wage curve. Our starting point is a variation of Blanchflower and Oswald's (1995) wage curve more suitable for integration with a growth model. By using a wage curve, we are following a tradition in the growth literature of using aggregate functions that replicate stylized facts, such as the Cobb-Douglas production function or the use of the Mincer wage regression to introduce years of schooling into the aggregate production function (e.g., Hall and Jones 1999). We deviate from Blanchflower and Oswald in that they claim the unemployment elasticity of earning to be basically the same all over, while we assume this elasticity to be a function of labor market institutional variables. As Card (1995) points out, this is probably their most contentious claim.

   We assume that contracts are negotiated between employers and employees. Workers' bargaining power depends inversely on the unemployment ratio. Rather than modeling the bargaining process, we just assume that, consistent with a wage curve, the real wage [omega] resulting from this negotiation can be expressed as the following function of the rate of employment, [epsilon],

   (1) [omega] = [bar.[omega]][[epsilon].sup.[beta]],

   where [beta] denotes the elasticity of agreed wages to employment and [bar.[omega]] denotes the real wage demanded at full employment. (1) Workers supply labor infinitely elastically at this wage.

   Firms maximize profits and employ workers as long as the marginal product exceeds the real wage. Because workers supply labor elastically at the agreed wage, firms' demand sets the employment level. We assume a Cobb-Douglas production function. Let L...