sargent.pdf

European Unemployment: From A Worker’s Perspective

Lars Ljunqvist

Stockholm School of Economics

and

Thomas J. Sargent

Stanford University and Hoover Institution

∗ Ljungqvist: Stockholm School of Economics;Sargent: Hoover Institution, Stanford,

and Stanford University. We are grateful to Cristina De Nardi, Juha Seppala and Christo-

pher Sleet for excellent research assistance. Ljungqvist’s research was supported by a grant

from the Bank of Sweden Tercentenary Foundation. Sargent’s research was supported by a

grant to the National Bureau of Economic Research from the National Science Foundation.

September 14, 2001

European Unemployment: From A Worker’s Perspective

Abstract:

After several decades of low unemployment rates and low mean durations of unemployment,

European countries experienced high rates and average durations of unemployment during

the 1980’s and 1990’s. We impute these outcomes to the eﬀects of increasing economic

turbulence confronting displaced workers combined with the incentive eﬀects on labor

supply of generous European unemployment compensation systems. We use a general

equilibrium search model where workers accumulate skills on the job and lose skills during

unemployment. To highlight the forces at work, we perform an artiﬁcial natural experiment

by comparing the decisions and life-time employment experiences of two initially identical

workers. Although subjected to identical shocks, they make diﬀerent decisions because

they confront diﬀerent unemployment compensation systems.

European Unemployment: From A Worker’s Perspective

1. Introduction

This paper summarizes and extends our supply side explanation of two striking patterns

in unemployment for Europe and the rest of the OECD (see Figure 1 and Table 1). 1

First, average unemployment performances for Europe were similar to the rest of the

OECD during the nineteen sixties and seventies, but since the eighties unemployment in

Europe has persistently exceeded the average unemployment rate in the OECD by around

two percentage points. Several European countries have in fact seen their unemployment

rates double between those periods. Second, since the eighties, the average duration of

unemployment spells in Europe has greatly exceeded that in the rest of the OECD. We

attribute these patterns to the incentive eﬀects on labor supply of the far more generous

unemployment compensation arrangements in Europe. 2

Our explanation of the broad patterns is in terms of how shocks and institutions shape

workers’ incentives to supply labor: random shocks that end workers’ jobs and diminish

their human capital when jobs end, and public institutions that subsidize unemployed

workers. We confront 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 for the rest of the

OECD. We attribute the rise in unemployment in Europe after 1980 to a change in the

environment that raised the value of adaptability by workers who are forced to change

1 This paper builds on Ljungqvist and Sargent (1998), which contains a rigorous description of our model.

2 The notion of unemployment compensation should be interpreted broadly in our framework.The

welfare states have various programs assisting individuals out of work.For example, totally disabled

persons in the Netherlands in the 1980s were entitled to 70 % (80 % prior to 1984) of last earned gross

wage until the age of 65 – after which they moved into the state pension system.At the end of 1990,

disability beneﬁts were paid to 14 % of the Dutch labor force and 80 % of them were reported to be totally

disabled.(See OECD, 1992b.)

European Unemployment: From A Worker’s Perspective

jobs by changing conditions. During the more tranquil times before 1980, there was a

less role for adaptability, so that then a generous unemployment compensation system was

consistent with similar unemployment rates that would have been observed with little or

no assistance to the unemployed. However, when the required adaptability increased after

1980, that generous unemployment compensation system propelled European economies

into persistently high unemployment. 3

Long-term unemployment is the heart of the European unemployment problem. Ac-

cording to Table 1, workers unemployed for one year or more today constitute around half

of all unemployment in the European OECD countries. This stands in sharp contrast to

earlier decades that saw much lower long-term unemployment and also a lower duration

of unemployment. Sinﬁeld’s (1968) study established that, except for Belgium, long term

unemployment was not much of a problem in Europe in the 1960s. Deﬁning ‘long-term’ as

six months and over, Sinﬁeld concluded that long-term unemployment typically aﬀected

half a percent of a country’s labor force. In countries such as former West Germany and

the Scandinavian countries, it was less than two tenths of a percent.

2. A Search Model of Unemployment

To study the level and duration of unemployment, we use a ‘lake and streams’ model (see

ﬁgure 6 below for an example with several lakes). We posit enough lakes and streams, i.e.,

3 In contrast to our labor supply explanation, early theories of European unemployment focused on a

shortfall in the demand for labor due to insu5cient aggregate demand (Blanchard et al, 1986), trade union

behavior driven by insider-outsider conﬂicts (Blanchard and Summers, 1986, Lindbeck and Snower, 1988),

hiring and ﬁring costs (Bentolila and Bertola, 1990), and capital shortages (Malinvaud, 1994).Our analysis

will instead bear out the assertion by Layard, Nickell and Jackman (1991, page 62) that the “unconditional

payment of beneﬁts for an indeﬁnite period is clearly a major cause of high European unemployment.”

However, our model diﬀers sharply from their framework, which emphasizes hysteresis and nominal inertia

in wage and price setting.Independently of our work, Bertola and Ichino (1995) pursued the same idea

that increased economic turbulence might explain the outbreak of high European unemployment but once

again their mechanism hinged on rigid wages and high ﬁring costs that reduced labor demand.Since then,

there have been several studies focusing on the interaction between a change in the economic environment

and welfare-state institutions, and some of those have emphasized negative labor-supply eﬀects of generous

beneﬁts, e.g., Mortensen and Pissarides’ (1999) model of skill-biased technology shocks.However, these

models commonly fail to produce long-term unemployment or falling hazard rates of individual unemployed

workers, features that we think are crucial for understanding high European unemployment.

2. A Search Model of Unemployment

states , to capture what we see as important aspects of the situation confronting European

workers. We begin with McCall’s simple two-lake, two-streams (two state) model, then

describe our extensions of it.

The McCall worker

A simple version of John McCall’s (1970) search model sees workers moving between the

two states of being employed and being unemployed. Each state deﬁnes a ‘lake’. The ﬂows

between them deﬁne ‘streams’. At the beginning of each period that he is unemployed, a

worker receives one oﬀer to work at a job with a ﬁxed wage drawn from a time-invariant

cumulative distribution function F ( w ) . He can take or leave the oﬀer, with no opportunity

to recall rejected oﬀers. Successive draws from F are independent. At the beginning of

each period that he is employed, the worker is exposed to a probability λ ∈ (0 , 1) of being

cast into unemployment that period. If the worker lives forever and sets reservation wage

w for accepting wage oﬀers, he spends a fraction

U =

1 −F ( w )

(1)

+ 1

1 −F ( w )

. If the economy is populated by a

ﬁxed large number of ex ante identical such workers who make independent draws from the

wage oﬀer distribution F and the Bernoulli job-extinguishing distribution with parameter

λ ,then U is also the aggregate unemployment rate in every period. Thus, equation

(1) justiﬁes an analysis of the unemployment rate, like the one of Layard, Nickell, and

Jackman (1991) described below, in terms of an entry rate into unemployment λ and a

mean duration of unemployment 1

1 −F ( w )

. Given the wage distribution F ,boththelevel

and duration of unemployment are inﬂuenced by the reservation wage w .

McCall theorized about how workers choose w . McCall derived a Bellman equation for

the reservation wage w , above which all wage oﬀers are accepted. For the present setting

with ﬁring probability λ , the reservation wage w satiﬁes

w + βλQ

= b + βQ

− β (1

− λ )

and average spells of unemployment of 1

of his life unemployed. In this two state model, workers have average spells of employment

of λ

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