The Role of Shocks and Institutions in the Rise of European Unemployment: The Aggregate Evidence

Abstract

Two key facts about European unemployment must be explained: the rise in unemployment since the 1960s, and the heterogeneity of individual country experiences. While adverse shocks can potentially explain much of the rise in unemployment, there is insufficient heterogeneity in these shocks to explain cross-country differences. Alternatively, while explanations focusing on labor market institutions explain cross-country differences explain current heterogeneity well, many of these institutions pre-date the rise in unemployment. Based on a panel of institutions and shocks for 20 OECD nations since 1960, we find that the interaction between shocks and institutions is crucial to explaining both stylized facts. We test two specifications, and each offers significant support for our interactions hypothesis. The first speculation assumes that there are common but unobservable shocks across countries, and that these shocks have a larger and more persistent effect in countries with poor labor market institutions. The second constructs series for the macro shocks, and again finds evidence that the same size shock has differential effects on unemployment when labor market institutions differ. We interpret this as suggesting that institutions determine the relevance of the unemployed to wage-setting, thereby determining the evolution of equilibrium unemployment rates following a shock.

Labour Market Performance in EU Member States: A Panel Regression Approach

“…Another high cited work is the paper of Blanchard and Wolfers [4]. Author investigated the role of shocks and labour market institutions in increasing the unemployment rate in Western Europe countries.…”

Productivity growth, on-the-job search, and unemployment

“…It is assumed that wages can be revised continuously at no cost, so the long-run contracts are ruled out. 5 Furthermore, we assume that matches cannot be recalled. Note that the outside option of the worker is unemployment.…”

“…This is far from the estimated magnitude in the empirical literature. Blanchard and Wolfers (2000) estimate that a 1% decline in the growth rate leads to 0.25%-0.7% increase in the unemployment rate. Pissarides and Vallanti (2007) find the effect to be 1.3% to 1.5%.…”

Job turnover, unemployment and labor market institutions

“…A number of empirical papers suggest that cross country differences in job dynamics and employment may be related to institutional differences by generating distinct responses to similar shocks (see for instance Nickell [18], Blanchard and Wolfers [4], Bertola et al [3]). It is also now well-known that there is no simple relationship between the dynamic behavior of the labor market and the aggregate unemployment level.…”