UNEMPLOYMENT in Europe has fallen now for six years in a row. France, Spain, Britain, the Netherlands and Ireland are all at, or near, a two-decade low. Yet this is no occasion to break out the champagne, for European unemployment still averages a hefty 8.3%, almost twice the rate in America, and that after an unusually prosperous decade. Is this really the best that Europe can do?

Why Europe appears cursed with high unemployment in both good times and bad has vexed economists for more than 20 years. Recently, however, a loose consensus has formed about which factors drive unemployment, though not about their relative magnitudes. A series of recent papers* by Olivier Blanchard and various co-authors provides a useful framework in which to summarise the current state of knowledge.

A series of “negative shocks”—notably, slowing productivity growth in the 1970s, followed by a period of high interest rates in the 1980s—largely explain rising levels of European unemployment up until the mid-1980s. When productivity slows, the story goes, workers do not immediately react, continuing instead to demand wage increases in line with the old rate of productivity growth. When wages are therefore too high, two things happen. First, profits are squeezed, so firms cut jobs and switch to more capital-intensive production, increasing unemployment. Second, since costs are higher, firms not only use less labour relative to capital, but also cut investment. In the long run, this further reduces the demand for labour, because firms have less machinery and equipment to operate.

Negative real interest rates during part of the 1970s softened this second effect on unemployment, because firms did not cut investment, and therefore employment, by as much as they otherwise would have done. But some of the unemployment probably shifted into the 1980s, when interest rates rose sharply.

Two developments in the mid-1980s, however, threw a wrench into this “shocks-based” story. First, high unemployment persisted into the early 1990s for much of Europe yet, second, unemployment rates started to diverge. Some countries, for instance, Ireland and the Netherlands, brought unemployment down to extremely low levels. Others, notably Spain, withered under unemployment rates of over 20%. This prompted economists to begin looking to labour-market institutions to help explain cross-country differences in unemployment.

At 1.8%, the Netherlands today has the lowest unemployment rate in the euro area. It was not always thus. In 1984, Dutch unemployment stood at 9.3%, just about average for Europe. At around this time, wages fell sharply relative to productivity, and firms responded by increasing their use of labour relative to capital. That is the superficial explanation of the Netherlands' success; the deeper question is, what led to this wage moderation? Mr Blanchard argues that the secret was the Wassenaar agreement of 1982 between unions, business and government. In it, unions agreed to limit wage demands in exchange for more generous financing of early retirement and a shorter work-week.

Still, excessive wage pressure cannot by itself explain high unemployment elsewhere. For one thing, wages moderated all over Europe. By the late 1980s, wages were back in line with productivity in Germany, France, Spain and Italy, and they have remained there since. Despite this, the ratio of labour to capital did not recover in these countries, shifting instead to a new, lower level.

Perhaps other labour-market institutions are at work that may not directly increase the equilibrium unemployment rate (as excessive wages do, for instance), but may nonetheless influence the speed at which an economy can return to its equilibrium rate following a negative shock. Laws designed to protect employees against easy firing offer an example. In themselves, such laws have no clear implications for the unemployment rate. They do, however, increase the average time a worker spends in unemployment. Why? They make it difficult for firms to fire workers, so firms hesitate to hire them in the first place, strengthening the hand of workers who already have jobs. Fewer workers become unemployed, but those unlucky few are also less likely to find a job. Compare Portugal and America. Both countries have had similar unemployment rates over the past 15 years (respectively, 4.2% and 4.5% today), yet trips through the unemployment pool are far less common, and far more protracted, in Portugal, where worker-protection laws are much stricter.

In theory, such laws do not imply a higher equilibrium rate of unemployment. But when firms are hit with, say, a fall in productivity and are forced to fire employees, laid-off workers have a more difficult time finding jobs. The result is that it will take a regulated labour market much longer to get back to its equilibrium unemployment rate after a shock.

A sharp slowdown in the world economy may be about to deliver to Europe its next big shock. Does this mean another decade of rising unemployment? Recent labour-market reforms leave Europe slightly better prepared this time around. Since the introduction of fixed-term labour contracts in France, Spain and Italy, unemployment has declined—for instance, from 24.1% in Spain in 1994 to 12.8% today. Yet this was a half-hearted reform, designed to make hiring easier with the least amount of disruption to “insiders”—those with stable jobs already. Europe will need far more sweeping reforms of its labour-market institutions if it wishes to be rid of the threat of double-digit unemployment.

Copyright © 2001 The Economist Newspaper and The Economist Group. All rights reserved.

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