A supply-side explanation of European unemployment

In this article, we offer a supply-side explanation of two striking patterns in European unemployment as compared with that of other member countries of the OECD (Organization for Economic Cooperation and Development). (See figure 1 and table 1.) The first pattern is that of average unemployment rates. These were similar for European and non-European OECD countries during the 1960s and 1970s, but in the 1980s and 1990s average unemployment in Europe has persistently exceeded the average in the OECD by about 2 percentage points. Second, since the 1980s, the average duration of unemployment in Europe has greatly exceeded that in the rest of the OECD. We attribute these patterns to the incentive effects on labor supply of unemployment compensation arrangements, which are far more generous in Europe than in the rest of the OECD. However, this view is challenged by the observation that unemployment compensation arrangements have been more generous in Europe throughout the post-World War II period, during the first part of which European unemployment was not higher than that for the rest of the OECD. We attribute the rise in unemployment in Europe after 1980 to a change in the environment that required increased adaptability of those workers forced to change jobs. We show that during tranquil times, with less need for adaptability, unemployment rates were the same with a generous unemployment compensation system as they would have been without such a system. However, in turbulent times, when greater adaptability is required, a generous unemployment compensation system could propel the economy into a state of persistently high unemployment. The economic environment is generally perceived to have become more turbulent in the last two decades. The OECD (1994) sums it up as follows: In the stable post-World War II economic environment, standards of living in most OECD countries grew rapidly, narrowing the gap with the area’s highest per capita income country, the United States. The OECD area’s terms of trade evolved favorably; trade and payments systems were progressively liberalized, without major problems; GDP and international trade grew strongly. In the 1970s, the economic environment became turbulent. The two oil price rises, in 1973/74 and 1979/80, imparted major terms-of-trade shocks, each of the order of 2 percent of OECDarea GDP, and each sending large relative price changes through all OECD economies. Exchange rates became volatile after the breakdown of the Bretton Woods system of fixed exchange rates. Then there came, mainly in the 1980s, waves of financial-market liberalization and product market deregulation which greatly enhanced the potential efficiency of OECD economies, and also accelerated