Evaluating unemployment policies: what do the underlying theories tell us?

I. INTRODUCTION

This paper is motivated by a simple idea that has received lamentably little attention in the literature on unemployment policy: different unemployment policies are generally based on different theories of unemployment, and our confidence in a policy should depend - at least in part - on the ability of the underlying theory to account for some prominent empirical regularities in unemployment behaviour.

Some theories depict unemployment as the efficient outcome of market activity. These usually serve to rationalize a laissez-faire policy stance. Others depict unemployment as the product of market failures. Here unemployment must be seen as the symptom of many possible diseases: many different market failures can produce the same problem of joblessness. And just like different diseases require different treatments, so different market failures may call for different government policies.(2)

It is difficult to evaluate the various unemployment policies through a direct empirical assessment of the market failures identified by the underlying theories. After all, market failures arise when people are not fully compensated for the costs and benefits they impose on one another, and uncompensated costs and benefits are inherently difficult to measure. For this reason, it is natural to evaluate unemployment policies by investigating the predictive power of the underlying theories. And a first step in this direction is to examine the degree to which these theories are able to account for some generally recognized regularities in the movement of unemployment rates in OECD countries over the post-war period. This approach would perhaps be too obvious for words were it not so frequently at variance with the standard rationalizations of unemployment policies.

Admittedly, the suggested criterion is highly simplistic. In practice, unemployment may generally be expected to arise from several different causes operating simultaneously. Then it would not be reasonable to expect any single theory to explain all the salient empirical features of unemployment behaviour in the OECD. But all that this paper claims is that confronting unemployment policies with these empirical features can give a useful preliminary indication of how significant these policies are likely to be. It would surely be unwise to have a heavy stake in a policy whose underlying theory explains little of how unemployment has evolved in the post-war period.

The paper is organized as follows. Section II deals with the laissez-faire policy stance, based on theories of voluntary unemployment. Section III deals with demand-management policies, resting on Keynesian theory. Section IV turns to supply-side policies, aimed at raising workers' productivity. Section V considers the interaction between demand-and supply-side policies. Section VI surveys institutional policies, designed to change labour-market institutions. Finally, section VII concludes.

II. LAISSEZ-FAIRE

The laissez-faire policy stance - for the government to do little or nothing to influence unemployment - is based primarily on models in which the observed swings in unemployment are viewed as the outcome of the optimizing decisions by job-seekers and job-providers in efficient markets. In this context, active unemployment policy is generally undesirable since it only disturbs the workings of well-functioning markets and interferes with people's free choices to accept or reject employment.

There are two main types of laissez-faire stances. One argues that government interventions aimed at influencing the long-run equilibrium unemployment rate would be ineffective or undesirable, but acknowledges the possible effectiveness and desirability of policies to deal with cyclical swings in unemployment. In particular, it advocates predictable policies, whose effects can be readily foreseen by economic agents. This view receives its most forceful expression in the market-clearing variant of the natural-rate theory. The other laissez-faire stance discourages intervention not only with the long-run equilibrium unemployment rate, but also with cyclical unemployment swings. It rests primarily on intertemporal substitution theory and real business-cycle theory.

(i) Policy Predictability

The market-clearing variant of the natural-rate theory(3) is an obvious vehicle for rationalizing the importance of policy predictability. Unemployment is at its `natural rate' when people's expectations about wages and prices are correct. Under conditions of perfect competition and perfect information, this natural rate depends only on people's tastes, on technologies, and on resource endowments. When people's wage-price expectations are out of line with actual wages and prices, it unemployment will deviate from its natural rate.

Provided that tastes, technologies, and endowments(4) do not fluctuate cyclically, fluctuations in unemployment - according to this theory - must be explained by fluctuations in expected wages and prices around their actual values. In order for this theory to have predictive power, it needs to be combined with a theory of how expectations are formed. The dominant one is the rational expectations theory, which assert - quite plausibly - that people are not fooled in ways that they themselves could have predicted. To test this hypothesis, a description of people's `information sets' is required, from which expected wages and prices could be inferred. In practice this is, of course, an impossible task; so empirical models generally assume that everyone has the same information sets as the authors of these models, except that the authors have more recent data.

The combination of the natural-rate theory with this variant of the rational-expectations theories has a well-known implication: since people make no systematic expectational errors (errors they could have predicted), then unemployment cannot diverge systematically from its natural rate. Just as expected wages and prices will fluctuate randomly around their actual values, so unemployment will fluctuate randomly around the natural rate.

It is not hard to see why policy predictability is advisable in this context. Under well-functioning markets, there is clearly no efficiency case to be made for interfering with the natural rate of unemployment. Policies which have no influence on this natural rate - such as monetary policies - an only affect unemployment by driving a wedge between actual and expected wages and prices. This can be done through unexpected policy variations, such as unexpected changes in the money supply. Put simply, demand-management policies are effective only when they are deceptive. But deceptive policies are generally not in the public interest: if people were initially pursuing their own interests in well-functioning markets - and thereby promoting the public interest as well - unexpected changes in policy would only reduce individual and social welfare. Thus stabilization policy is reduced to the limited task of being predictable.

The problem with this theory is that it fails to address many of the features of European unemployment over the past decade. In many OECD countries over the 1980s, union density remained constant or even declined, the expansion of unemployment benefits and other forms for welfare state support was arrested or even reversed, and deregulation, privatization, and liberalization of labour markets were not uncommon. On this account, it is difficult to argue that the natural rate of unemployment could have risen significantly. Some have maintained that the expansion of the welfare state in Europe over the 1950s, 1960s, and the first part of the 1970s may have been responsible for the growing unemployment in the 1980s, since people adjusted their behaviour only gradually to the more generous social provision.(5) But it is hard to see that these lagged responses should have been so powerful and so delayed is to be solely responsible for the large increases in European unemployment over a decade after most welfare states had ceased to expand.

Furthermore, given the stable rates of inflation over much of the decade, it cannot be argued that people's wage-price expectations were getting further and further out of line with actual wages and prices; nor is it plausible to suppose that these misperceptions could have persisted for so long.

In short, there is nothing in the market-clearing variant of the natural-rate theory that provides a clue as to why European unemployment should have risen so massively through the 1980s. Nor does this theory shed useful light on why unemployment has been so much more persistent in Europe than in the US, or why European unemployment rose with each major recession of the 1970s, 1980s, and early 1990s while US unemployment has always tended to return to its pre-recession level. Can we honestly believe that Europeans are much slower than Americans to adjust their expectations, so that expectational errors are more persistent in Europe than the US? Beyond that, the theory tells us little, if anything, about why unemployment spells tend to be longer in Europe than the US (for given unemployment rates), why US unemployment rates are more variable than most European ones, why unemployment falls unequally among different population groups, and why labour and product markets move so much more closely in tandem in the US than in Europe. Expectational errors provide few insights in these domains.

(ii) Non-interference with Business Cycles

The case against stabilization policies in the labour market is made quite explicit in the intertemporal substitution theory and the real business-cycle theory.

As the name implies, the intertemporal substitution theory(6) is concerned with workers' desire to engage in intertemporal substitution of work for leisure, in response to changing economic incentives. For example, if workers believe that real wages are temporarily depressed and will rise in the future, they may wish to take more leisure now and work harder later. The same may be true if they perceive real interest rates to be temporarily low, since that means that their current wage income cannot be transferred into the future at an advantageous rate.

The implication is that cyclical swings in employment may be the optimal response - by individual agents and society at large - to temporary shocks to tastes, technologies, and endowments.(7) Whereas most economists used to see business cycles as undesirable, needing to be damped through stabilization policies, the intertemporal substitution theory suggests that this is not so. It is not in the public interest to implement counter-cyclical monetary and fiscal policies, since these would prevent people from making their optimal dynamic responses to external shocks.

Although this theory can be used to generate an empirical account of much of the unemployment persistence and variability observed in the US and other OECD countries,(8) it is hard to see how it could provide a reasonable explanation of European unemployment over the past 25 years. Is it plausible to believe that the many millions of Europeans who joined the unemployment register in the mid-1970s, early 1980s, and early 1990s were merely trying to take advantage of high real wages or high real interest rates expected to occur in the future? Regarding the upward trend in European unemployment rates since the mid-1970s, is it plausible to believe that we are observing a very long-term intertemporal substitution, whereby workers have decided to enjoy a lot of free time for two decades, perhaps with the intention of working very long hours for the next two decades?

Furthermore, the available empirical evidence indicates that people's hours of work are unresponsive to real wage and real interest-rate variations,(9) and that many of these variations tend to be permanent rather than temporary.

The real business-cycle theory(10) builds on the intertemporal substitution theory and identifies technological shocks as the main source of macroeconomic fluctuations. Much effort has been expended in the attempt to establish that these fluctuations arise when perfectly informed individuals, all maximizing their utility subject to technological and resource constraints, respond to technological shocks by intertemporally substituting labour, leisure, and consumption. But beyond the predictive problems of the intertemporal substitution theory, it is hard to get an intuitive interpretation of the technological shocks. Whereas technological advances (that the real business-cycle theory associates with the booms) are relatively easy to identify, the technological setbacks (that allegedly give rise to the recessions) are not.(11) It is hard to see how knowledge and expertise gets lost, particularly on the large scale that is necessary to account for the deep recessions we have witnessed over the past two decades. Some argue that the negative technological shocks reflect such adverse macroeconomic events as oil price hikes or inappropriate investment (such as machinery that turns out not to work or that produces goods for which the demand did not materialize). But the downturns in European labour-market activity over the past two decades have lasted much longer than the price hikes for oil and other resources did, and it would be strange - in the real business-cycle world of rational expectations in clearing, perfectly functioning markets - for these shocks to generate investment fluctuations that are large enough to pull the massive OECD recessions in their wake. Beyond that, the long-term increase in European unemployment since the mid- 1970s cannot plausibly be explained as the market-clearing outcome of technological shocks.

III. DEMAND-MANAGEMENT

POLICIES

Demand-management policies to reduce unemployment fall into two broad categories: (a) government employment policies, whereby the government stimulates employment directly by hiring people into the public sector, and (b) product demand policies, which stimulate employment by raising aggregate product demand (e.g. through tax reductions, increases in government spending on goods and services, or increases in the money supply).

For the `short run', in which wages and prices respond sluggishly to demand fluctuations, the main underpinning for both types of policies is the Keynesian theory.(12) Here recessions are characterized by deficient labour and product demand reinforcing one another: workers are unemployed because firms are not producing enough goods and services; firms are not doing so because there is too little demand; and demand is deficient because people are unemployed. lip short, deficient demand in the labour market originates in the product market and deficient demand in the product market originates in the labour market. Activity in these two markets goes up and down at the same time. The mechanism that couples these two markets is wage-price sluggishness. A fall in product demand will reduce labour demand if wages do not fall sufficiently; a fall in labour demand will reduce product demand if prices are sluggish downwards.

This interaction between product and labour markets gives demand-management policy a lot of leverage in the Keynesian theory. A rise in government employment will raise the purchasing power of the newly employed people who, in turn, will demand more goods and services, thereby inducing firms to employ yet more people, and so on. In the same vein, a stimulus to product demand (resulting, say, from a tax reduction) gives firms the incentive to raise employment, which creates more purchasing power, which raises product demand even further, and so on. The more sluggish wages and prices are, the greater these multiplier effects become.

Of course, in practice wages and prices are not sluggish indefinitely, and thus the critical question is how short the Keynesian `short run' really is. Clearly, if it were shorter than the time it takes for most firms to make and implement their employment …