During the economic downturn, unemployment rates rose significantly in most Member States. Although these increases were primarily cyclical, the crisis carries significant risks for further increases in the structural unemployment rate due to hysteresis effects (see Box 10).
A central thesis of classical economic theory(1) is that the structural unemployment rate (or ‘natural rate of unemployment’) is solely determined by supply factors, such as minimum wages, the tax wedge, the user cost of capital, employment protection laws, barriers to labour mobility, product market competition and frictions in matching the unemployed with job vacancies, and not by demand. When the unemployment rate is higher than the structural unemployment rate, wages will decrease so that labour demand increases and unemployment decreases. This wage adjustment will occur until unemployment has returned to its structural level (see Layard et al. 2005).
Ball (2009) is one of those who reject the hypothesis that the natural rate of unemployment is independent of the level of aggregate demand, and argues that hysteresis effects may be operating in times of economic downturn in ways that prevent unemployment returning to its initial structural rate. Indeed, when unemployment is above its initial structural level, wages will decrease but they will decrease by less than in the case of the neo-classical model. This is due to the fact that, when workers become unemployed their disconnection from work produces a diminution and degeneration of their skills, a reduction in their motivation to search for a job and a general social stigmatisation. As a result, there will be less downward pressure on wages than there would otherwise be (as above) causing the unemployment rate to settle at a new but higher rate than predicted by the model without hysteresis effects.
In this context, Furceri and Mourougane (2009) identify institutional factors such as Employment Protection Legislation, average replacement ratio and product market regulation as important determinants of the adjustment pattern in the aftermath of a downturn.
(1) | See for instance Friedman (1968). |
In order to avoid that unemployed people become long-term unemployed once the economy recovers, it is recommended that policy reforms develop along flexicurity lines by strengthening active labour market policies, promoting life-long learning, and modernising labour laws as well as social security systems.
Moreover, temporary measures such as the crisis-related increases in the level and duration of unemployment benefits need to be scaled-down once the recovery gathers momentum in order to strengthen the incentives to search for a job. This phasing out should be accompanied, however, by a strengthening of activation and training policies so that the adjustment costs can be tempered, and should be made conditional upon the developments in overall economic activity. In any case, activation and training policies should aim at reducing long-term welfare benefit dependency and equip the workforce with the skills required for new jobs so as to facilitate the transition to areas of growing activity.
Preventing such hysteresis effects will not be sufficient to promote strong employment growth when the economy recovers. Indeed, as a significant number of Member States have made extensive use of short time working arrangements during the downturn, it is to be expected that, when the economy recovers, a significant part of the increases in effective labour demand will be met by adjustments in the stock of hoarded labour. To temper the impact of this on employment opportunities for the unemployed, targeting employees at the margin of the labour market with, for example, temporary wage subsidies and cuts in non-wage costs, might be considered.
Alongside the problem of containing rises in unemployment, is the challenge of increasing the supply of labour overall. So far, the effects of the crisis in reducing total labour supply have been rather modest. However there are important feedbacks between the levels of unemployment and employment -as high unemployment rates persist, some of the unemployed get discouraged and leave the labour force. Moreover, as unemployment increases, other people get discouraged and do not enter the labour market at all.
Policies to support increases in labour force participation include making work pay policies, promoting active ageing, gender equality and labour market integration of young people, disabled, migrants and other vulnerable groups.
Finally, it should also be noted that, as firms remain uncertain about the sustainability of the recovery and liquidity constraints continue to prevail, the use of temporary work contracts is likely to remain significant, despite the weaknesses associated with them, as described in detail in Chapter 3. This may then limit the productivity growth potential during and after the recovery as temporary contracts are usually associated with limited training opportunities for workers.
All in all, setting the conditions that can limit any further increase in structural unemployment may strengthen the recovery as it will have a positive effect on aggregate demand through higher consumer confidence, thereby reinforcing the increase in employment.