Interwar Unemployment
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Interwar unemployment in Britain has been attributed to a variety of factors. Keynes and Beveridge ascribed it to a deficiency of aggregate demand. More recent explanations by Benjamin and Kochin have placed the emphasis firmly on the supply side. The supply of labour contracted, it is argued, because of the effects on individual incentives of the generous rates of benefit provided by the unemployment insurance system. A third view, favoured by many economic historians, attributes as much as half the unemployment in interwar Britain to 'structural' causes, chiefly the decline of the traditional industries. High regional unemployment differentials arose because of the geographical concentration of these ailing industries, combined with the regional and industrial immobility of the workforce.

Previous analyses of the interwar period, based on annual data, have proved somewhat inconclusive. In Discussion Paper No. 186, Research Fellow Tim Hatton uses a quarterly data set, constructed from Ministry of Labour statistics for the period 1924-39, to estimate a structural model of the interwar labour market. The model includes equations which determine employment, the size of the labour force and the wage. Hatton argues that this structural approach is essential: collapsing two or more of these equations into a single equation will obscure the processes at work in the labour market. Benjamin and Kochin, for example, do not estimate labour supply and demand separately, so that it remains unclear to what extent the benefit rate affected the wage. Efforts have been made to distinguish supply and demand using annual data, but the results have been rather disappointing.

Employment in Hatton's model depends on the product wage, the price of raw materials, the capital stock, lagged employment, and US industrial output (representing the level of aggregate demand). The participation equation, which explains the size of the insured labour force, includes demographic variables such as the size and age composition of the population; economic variables, such as the real wage and the ratio of employment to the labour force (reflecting discouraged worker effects); and 'insurance' variables, such as the real benefit rate. Hatton's estimates suggest that the real wage and the unemployment rate had insignificant effects on the size of the labour force, but that the unemployment insurance system had significant effects through the rates of benefit offered and the application of the eligibility rules. There was also a strong short-run effect from the number of juveniles entering the market.

Hatton's wage equation incorporates a short-run wage adjustment mechanism in which is embedded a long-run labour supply relation between levels of variables such as wages and employment. This type of wage equation was first used by Sargan in his 1964 study of interwar wages and prices. Employers are assumed to set employment according to the marginal productivity condition, while the union selects a target wage to maximize the utility of its members. In Hatton's formulation, target wages depend on the employment rate and real benefits, while in the short run actual wages depend on the lagged change in the cost of living and in the deviation of the real wage from its target value.

Hatton concludes that the use of quarterly data in a structural model does shed more light on the workings of the labour market. The insurance system, for example, emerges as an important determinant of labour force participation. Despite the more detailed data set used by Hatton, however, it is not possible to distinguish between the competing explanations of interwar unemployment. Each can be interpreted as a special case of Hatton's general model and each performs reasonably well in comparison with this general model. Hence it is not surprising that such widely divergent views of the causes of unemployment continue to be maintained.

A Quarterly Model of the Labour Market in Interwar Britain
T J Hatton

Discussion Paper No. 186, July 1987 (HR)