Unemployment has risen throughout the developed countries in the 1980s, but this rise has been distributed unevenly. The biggest puzzle concerns the main European economies. In France, Germany and the United Kingdom, unemployment rose very sharply in the early 1980s, and since then has shown only a weak tendency to fall. Austria, the rest of the Nordic countries, Switzerland and Italy, on the other hand, have escaped with relatively small rises.
Until recently, most explanations of the behaviour of unemployment focused on the determinants of the equilibrium rate of unemployment. Persistence in unemployment can be attributed to persistence in the shocks affecting the economy, and cross-country differences would be explained by differences in the type and size of these shocks, as well as in factors such as institutional organization which affect the equilibrium rate. Blanchard and Summers followed a different approach, suggesting that the differences in unemployment persistence between Europe and the United States may result from differences in the dynamic response to temporary shocks, due to the market power of `insiders' in wage determination.
In Discussion Paper No. 232, Alan Manning and Research Fellow George Alogoskoufis generalize the model of Blanchard and Summers. Alogoskoufis and Manning examine not only the dynamics of employment targets, but also their interactions with sluggishness in labour demand and persistence in the real wage aspirations of insiders. This allows the authors to assess the relative importance of the various sources of dynamics in the labour market in explaining cross-country differences in the persistence of unemployment. In addition they base their analyses on (annual) data from a wider selection of countries, including fourteen European economies as well as the United States and Japan.
The authors find little evidence of strong `hysteresis' effects in unemployment. Cross-country differences in the persistence of employment targets and wage aspirations of insiders appear to have contributed very little to the cross-country variations in unemployment. Other aspects of labour market flexibility, such as the lack of full indexation to anticipated inflation, were also relatively unimportant in explaining cross-country differences. The estimated equations suggest that the most important factors in explaining cross-country differences in unemployment persistence appear to be sluggishness in labour demand and the relative importance of wages relative to employment in the preferences of wage-setters. The latter may be affected by institutional factors in the labour market, and Alogoskoufis and Manning find that it is correlated significantly with the degree of centralization in wage-setting. The more corporatist Nordic countries and Austria appear to have based their good performance on the readiness of their wage-setters to sacrifice real wage targets more easily than employment targets, while in the United States the absence of persistent high unemployment seems due mainly to the lack of persistence in labour demand.

Wage-Setting and Labour Market Adjustment in Europe, Japan and the USA George Alogoskoufis and Alan Manning

Discussion Paper No. 232, June 1988 (IM/ATE)