Chapter 9

Why High Unemployment Persists

Successes and Failures

Over the past two decades, governments have generally learned how to control inflation. The rate of inflation is now near zero in most industrialized countries, and hyperinflation has virtually disappeared. Conversely, except for the U.S., the quest for full employment has remained elusive, and the unemployment rate in Europe and Asia is now far higher than before 1990.

Basic Labor Market Model

Suppose there is an exogenous decrease in aggregate demand. Labor markets can be affected in one of four ways. 1. Workers agree to a lower real wage, which boosts the demand for labor, ceteris paribus. 2. People drop out of the labor force 3. Government uses stimulatory measures to offset the decline in demand 4. None of the above, so the unemployment rate moves to a permanently higher level.

Unemployment in the Short and Long Run

It is generally agreed that in the short run, a decline in demand will result in some increase in unemployment. The question is what happens in the long run. Some economists argue that because markets clear, workers will eventually accept a lower wage, and full employment will return. Yet we know that is not necessarily the case, since the unemployment rate averaged 15% throughout the 1930s in the U.S., and has remained in double digits in many European countries for over a decade.

Why Not Use Stimulatory Policies?

It isnt that they havent been tried; they simply dont work all the time. Since 1991, Japan has had numerous fiscal stimulus programs and tax cuts, and interest rates have been reduced to zero, yet real growth has averaged less than 1% per year for over a decade. Consumers remain pessimistic, capital spending has declined, and export markets have dried up. Hence stimulus moves have been ineffective.

Why Stagnation Occurs

Assume two countries, M (mature) and D (developing). In M, wage rates and fringe benefits are high, regulation is severe, and the government generally treats business executives and investors like criminals. In D, wage rates are 10% of their level in M, regulation is benign, and foreign investors are welcomed. Investors in M decide to invest their money in D, so capital spending in M declines, the country stagnates, and the unemployment rate continues to rise.

Stagnation, Slide 2
That is the main reason the unemployment rate rises. It one sense it has little to do with how labor markets work. In another sense, though, government policies that contribute to high wage rates and low productivity gains are at the root of high unemployment and stagnation. Seen in this light, government interference with free markets is the major cause of stagnation and high unemployment.

Imperfections in Labor Markets

Economists generally identify six types of imperfections in labor markets that lead to high unemployment. One is the lag of wage rates behind changes in output and employment, but that is only temporary and is considered only in passing. The other five types of imperfections could cause unemployment to remain well above equilibrium for an extended period of time.

Long-Term Imperfections
Sticky Real Wages: Efficiency Wage Sticky Real Wages: Insider/Outsider Models Government Restrictions Wedge Between Private and Social Costs Barriers to Firing and Overly Generous Unemployment Benefits

The Efficiency Wage

Workers are paid more than the going wage. In return for that they will (a) work harder, (b) are less likely to slack off on the job, and (c) are less likely to quit for another position at an inopportune time. There is not much empirical evidence that such workers actually are more productive. It is more likely that in such situations, the higher labor costs are passed along in the form of higher prices. When competitive pressures intensify, the efficiency wage premium disappears. At least in the U.S., that has been accompanied by a decline in the unemployment rate, as more jobs become available.

Insider/Outsider Models
Applies mainly to unions, both in the private and public sectors Unions negotiate wage rates and fringe benefits that are well above market levels. Many other people would like to have such well-paying jobs, but they are not available. The insiders have their jobs, while the outsiders remain unemployed. In the private sector, jobs will eventually move to other countries. However, this can still be an important factor in the public sector, in which case consumers pay more in taxes and hence have less money to purchase other goods and services, thus boosting unemployment.

Government Restrictions
Most of the time, these refer to various barriers raised by the government to keep people out of various professions, such as irrelevant and costly licensing agreements. An important special case is the minimum wage, which might keep workers with low skills and productivity from finding jobs at all.

Economic Impact of the Minimum Wage

The impact of the minimum wage depends on the level at which it is set. If it is set low enough that very few workers are affected, it has virtually no effect; if it is set well above market rates, it has a much larger effect. Maybe that seems obvious, but many politically motivated studies on both sides have ignored this. In certain cases, an increase in the minimum wage could actually boost employment, if it attracted some people who would not otherwise be looking for a job at all. An increase in the minimum wage is much more likely to have a negative impact in manufacturing, where jobs can go overseas, than in service industries.

Wedge Between Private and Social Costs

Workers may receive only a moderate wage, but employers may be required to pay an additional 50% to 100% in terms of pension and health care benefits. In such cases, the total cost of labor is so high that fewer workers are hired and the unemployment rate rises. Some workers would be willing to accept lower fringe benefits, but they are not permitted to choose that option (for example, no one has the choice of not paying social security taxes).

Barriers to Firing and Overly Generous Unemployment Benefits

To a certain extent, these are similar to the previous factor. If a firm must pay (say) one years severance to employees who have only worked for the company for two years, they probably will not be hired in the first place. However, employees do not have the option of waiving that severance pay, so they are unable to find jobs at all.

Can High Unemployment Be Reversed?

Some economists have argued that once the unemployment rate rises for an extended period of time, it cannot decline again even if fiscal and monetary stimulus are used because in the meantime, productivity and technology have stagnated, capital stock has decreased, high-skill workers have not been properly educated, and the best and brightest have left the country (brain drain).

Reversing High Unemployment, Slide 2

This is true to the extent that if a country has been stagnating, it will take longer to reduce the unemployment rate substantially. However, all these factors can be reversed by recreating investor confidence, reducing the stranglehold of overregulation, and undoing the imperfections in labor markets.

Reversing High Unemployment, Slide 3

The key is reestablishing investor confidence so capital spending will rise again. However, that will occur only if businesses and investors believe that the government will follow pro-market policies, including dampening the excesses of labor. Also, government spending must be held in check. Hence the steps toward reducing unemployment are primarily political in nature.