Roots of the Recent Recoveries: Labor Reforms or Private Sector Forces?

From the mid-1970s to the mid-1980s, most of the industrial economies of the Organization for Economic Cooperation and Development (OECD) suffered a sharp slide in economic activity, as measured both by employment in relation to the labor force and by male labor force participation in relation to the working-age population. This decline sparked new structuralist modeling of the determinants of employment and supplied an empirical record for testing the models. Some consensus has now emerged on the main mechanisms and causal forces behind the deep slump.¹

In the 1990s, however, structural recovery became evident in many OECD countries. Structural unemployment in Ireland, the Netherlands, and the United Kingdom appears to have improved in the first half of the 1990s and again in the second half. Australia, Canada, Denmark, New Zealand, Spain, and the United States showed structural gains in the second half.² Finland, Norway, and Sweden have begun to rebound from the loss of export markets and banking crises early in the 1990s. For the other OECD members, any recovery during the 1990s was too little and too late to make much difference in their record for the decade as a whole. Austria, France, Germany, Greece, Italy, and Switzerland actually suffered net setbacks over the decade, and Belgium and Portugal made scant progress.

In searching for the principal causes of the great slump-the shift of equilibrium unemployment rates onto higher paths in the 1980s-researchers had some idea where to look. Unemployment rates in the OECD countries had risen roughly in unison from the mid-1970s to the mid-1980s-any deviations were mostly in the timing. Thus all the favored candidates to explain the phenomenon were OECD-wide shocks. Models of the equilibrium employment path set out by Edmund Phelps, with their emphasis on the profitability of business assets and the reward to work relative to workers' other support, pointed to five common shocks during that period.³ The first, emerging in the 1970s, was reduced expectations of productivity growth leading to increases in the effective cost of capital. The second, in the early 1980s, was an increase in the expected world real rate of interest, which likewise raised the effective cost of capital. The third was increases in income and services from workers' private assets. The fourth was increases in benefits from social entitlements relative to after-tax wage levels, resulting from the 1970s productivity slowdown and from the growth of the welfare state in the 1960s and 1970s. The fifth shock was the hikes in the world real price of oil during the 1970s.⁴ A model by Richard Layard, Richard Jackman, and Stephen Nickell pointed to an important role for new or expanded institutions in the postwar era, especially in Europe, such as unemployment insurance benefits and job protections, which heightened the sensitivity of unemployment to shocks.⁵

Accounting for the selective and uneven recoveries that began in the 1990s is a different sort of problem. Did the recovering countries experience some shock or other development that the nonrecovering countries did not? Or was there an OECD-wide shock or trend that powered recovery in some economies but was somehow blocked from doing so in the nonrecovering economies? In either case, do the causal forces and mechanisms fall within the compass of existing theory, and can they be accommodated by existing models?

The first hypotheses to be examined in this paper credit progress in the recovering countries to their adoption of structural reforms and blame the continued stagnation elsewhere to a failure to enact similar programs. One such hypothesis, developed by Nickell and the OECD Secretariat, points to reforms in labor policy by several OECD members. In this thesis, anti-market labor policies sowed the seeds of the huge rise in unemployment in Europe, and the remedy lies in reversing those policies. The chief areas for reform in this view are unemployment insurance benefits, which are often generous and of long duration; the high density and wide coverage of unions in wage...