High and persistent unemployment has been a major economic problem for Western Europe in the 1970s and 1980s, and much econometric and theoretical research focusing on structural differences in labour markets has found real wages less responsive to unemployment in EC member countries than in the EFTA countries or Japan. Real wages and employment have adjusted more slowly in Europe than in the US.

In Discussion Paper No. 469, Research Fellow George Alogoskoufis and Chris Martin argue that these differences in unemployment patterns can also be explained by the different responses of macroeconomic policies to increasing unemployment and by the interdependence of these policies. The authors seek to account for: the significant rise in average EC and US unemployment in the mid-1970s and early 1980s; the much smaller rise in unemployment in the EFTA countries and Japan; the rapid falls in US unemployment after 1975 and again after 1982 (compared to a continued rise in the EC until 1986); and the simultaneous fall of EC and US unemployment in 1986-9.

They first present a static equilibrium model of unemployment, which attributes the rise in OECD unemployment in the 1970s and early 1980s to a productivity slow-down, supply shocks and the rise in EC marginal tax rates; the fall in US unemployment after 1982 is due to the fiscal expansion. Extending the model to include commodity imports from LDCs accounts for the relative fall in US unemployment after 1975 and the simultaneous fall in US and European unemployment after 1986. An OECD fiscal expansion reduces their relative prices, which affects the wedge between consumer and producer prices and allows a fall in OECD unemployment.

By incorporating sluggish adjustment of manufactures prices, the authors show that an OECD monetary expansion temporarily reduces unemployment and raises real commodity prices but leads to opposite trends on both, while a fiscal expansion has permanent effects on both unemployment and relative commodity prices. A US monetary expansion leads to a transitory real dollar depreciation and a persistent relative fall in US unemployment, which explains the events of 1976-8. A US fiscal expansion leads to a persistent real dollar appreciation and a persistent relative fall in US unemployment, which accounts for the events of the 1980s. This eclectic model therefore satisfactorily explains the differing unemployment patterns without reference to any structural differences in labour or product markets.

Alogoskoufis and Martin also find that the contractionary macroeconomic policies followed by the four largest EC economies after the oil shocks of the 1970s were conditioned by real rather than perceived external constraints. The main constraint was that foreign exchange markets' reaction to expansionary monetary and fiscal policies forced policy reversals. The external constraint faced by the European economies (other than Germany) stems in part from Germany's uncompromising aversion to inflation and current account deficits, which contrasts markedly with the US authorities' willingness to tolerate higher inflation in the 1970s and persistent current account deficits in the 1980s.

External Constraints on European Unemployment
George S Alogoskoufis and Chris Martin

Discussion Paper No. 469, September 1990 (IM)