Comments and Discussion

Olivier Blanchard:

This is an ambitious paper.¹ It extends the general framework developed by Edmund Phelps and a number of coauthors in the past, and it reexamines the evolution of unemployment in the OECD countries over the past forty years. It then offers a new mechanism through which the emergence of the "new economy" may be affecting equilibrium unemployment. Finally, it examines whether this new mechanism can indeed explain the declines in unemployment observed in a number of OECD countries in the 1990s. My comments will follow a parallel structure, starting with a discussion of the general framework, then turning to a discussion of the new mechanism, and finally offering my own interpretation of the decline in unemployment in two countries, Ireland and the Netherlands.

The emerging consensus.

A reading of this and other recent papers on the evolution of unemployment reveals the emergence of a broad consensus—good news after some thirty years of research on the increase in European unemployment. The consensus focuses on the joint role of shocks and institutions and on their interactions. It goes roughly as follows.

Far from being an immutable constant, the natural rate of unemployment (also called the NAIRU, or the structural rate, or the equilibrium rate; the semantics are far from settled here) moves in response to shocks. Labor market institutions also matter. They do so directly, by affecting the under lying mean to which the natural rate eventually returns. Also, and more important, they do so by affecting the size and the persistence of movements in the natural rate in response to shocks.

This consensus encompasses many approaches that were once seen as largely incompatible, for example:

—The work by Michael Bruno and Jeffrey Sachs,² which focused on the effects of adverse oil and productivity shocks and their interaction with real and nominal wage rigidities. For example, the effect of an increase in the price of oil on the natural rate of unemployment is likely to depend on whether wage negotiations are centralized or decentralized. Centralized negotiations make it easier to coordinate a slowdown in wages in response to an aggregate shock.

—The work by Phelps himself on structural slumps,³ which resulted in a model of the labor market based on imperfections on both the supply and the demand sides. Phelps used this approach to look at the effects of a number of shocks on unemployment. The argument developed in this paper is an example of how this approach can be used to think about movements in unemployment. The authors of this paper argue that, in a number of countries, the desire of firms to build a consumer base and a pool of trained workers for the future has led them to increase hiring at a given real wage, leading to a decline in unemployment today.

—The work by Lawrence Summers and myself on hysteresis,⁴ which focused on the persistence of deviations of the unemployment rate from its mean. Our initial focus was on the objective function of the employed workers and its effect on bargaining outcomes. Under the influence of Richard Layard and Stephen Nickell, in particular, this line of research has increasingly focused on the role of the unemployed and, in particular, of long-term unemployment, in wage determination. If, for example, labor market institutions lead to unemployment characterized by individual spells of long duration, the risk that sustained high unemployment will lead to the disenfranchising of the long-term unemployed and, by implication, low upward pressure on wages and a slow decrease in unemployment, is higher. Our initial focus was on the persistent effects of shifts in aggregate demand on unemployment. But the argument extends to the effects of any shock that increases unemployment, from oil to productivity shocks.

This broad "consensus" approach has proved useful in describing trends in unemployment across the OECD countries over the last forty or so years. Let me briefly review what has been done, what has been learned, and how the specification offered in this paper relates to other specifications in the literature.

Denote the unemployment rate in country i in year...