Institutional incentives to prevent unemployment: unemployment insurance and active labor market policy in a comparative perspective.

INTRODUCTION

Unemployment is a social construct which solves the problem of uncertainty in the employment relationship. There are alternative solutions. A system of flexible prices, wages, and profits is one example. Others include work-sharing and training, codetermination at the work place, spatial mobility or public job creation, and deficit spending.

Public debate on unemployment as a viable choice has been characterized by two unacceptable extremes. At one extreme are the "hawks," who prefer to deal with a "visible enemy," which means unemployment. The hawks argue that (some) open unemployment is a useful disciplinary device that promotes hard work and acceptance of wage flexibility and spatial mobility. Hawks believe that unemployment benefits should be low and should serve only as a short-term buffer.

At the other extreme are the "doves," who prefer active labor market policy to dismissals. The doves see unemployment benefits as a last resort, but one which should be generously given with minimal restrictions.

The hawks ignore the disastrous consequences of unemployment not only for the individuals actually concerned but also for their families, their communities, the economy, and society as a whole. With regard to the broader costs of unemployment, it is worth quoting the classic Marienthal study which concluded that unemployment led to a "decline from a higher cultural level of political confrontation [to] a rise in more primitive hostilities motivated by personal malice" (Jahoda, Lazarsfeld, & Zeisel, 1972 [1933], p. 43). Recent studies on the psychological, health, financial, economic, and political consequences of unemployment basically confirm the results of this classic study (Elkeles & Seifert, 1993; Starrin et al., 1989).

Conversely, the position of the doves is made untenable by the recent economic and political breakdown of Eastern Europe. The centrally planned economies demonstrated the unacceptable costs of preventing unemployment at all costs. Unemployment was forbidden and wages were not linked to productivity. Labor thus became a minor part of the production costs in the political economy of communism, a "soft budget constraint" instead of a "productivity whip." The result was hidden unemployment of between 25% and 50% (Gora, 1991; Kornai, 1992; Schmelev & Popov, 1989).

It is clear that catastrophy will be the result of either extreme - unemployment prevention at any cost or laissez faire. What is needed is a solution that achieves an acceptable balance.

The choice of a solution by individuals, firms, or whole societies depends largely on institutions. Institutions are habits or rules of the game (North, 1991). Because human behavior is never completely determined, it is appropriate to analyze choice in terms of institutional incentives. Thus, the question becomes, "What are the most effective institutional incentives to prevent unemployment?"

This article proceeds to answer this question in six steps. First, "institutional choice" as a concept rather different from "rational choice" is discussed. Second, various choices of unemployment equilibria are demonstrated empirically with data from OECD countries. Third, the incentives of various unemployment insurance systems are analyzed. The fourth section analyzes institutional incentives for financing jobs or training and education (active labor market policy) instead of financing idle human resources (unemployment benefits). The fifth section presents evidence on the effectiveness of active labor market policy. The sixth section presents general conclusions and points out specific possible lessons for the United States.

INSTITUTIONAL CHOICE AND FLEXIBLE COORDINATION

The first step in this section is to come to grips with the concept of "institutional incentives." This will result in a theoretical framework quite different from the mainstream model of rational choice. The second step is to define the "institutional menu" of labor market policy from which individuals, organizations, and societies can choose. The third step is to develop general criteria for choosing the "right" institutional incentives to prevent unemployment.

Another Lesson from Ulysses and the Sirens

The myth of Ulysses and the Sirens nicely illustrates the concept of institutional incentives. As Ulysses' ship approached the sirens, he had himself bound to the mast of his ship in order to prevent him from yielding to their temptations. He thus resolved a decision-making problem prospectively in a rational way which would not have been possible if he had waited until the problem itself occurred (Elster, 1979, p. 36).

This function of self-binding is performed in social life by institutions. Through norms, regulations, and the allocation of tasks and responsibilities, institutions determine how one is to behave in yet-unknown decision-making situations. If it is not possible to formulate such a rule in advance, then institutions determine who decides what and when (Schmid et al., 1992, p. 21).

Institutions may be based on Ulysses' clever foresight - that because of weakness, confusion, or magical powers, one's own decisions in critical moments can be false. "Fore-sight" thus becomes "pre-caution," the self-binding function of institutions. Such precautionary measures can also be taken to protect oneself against the erroneous decisions of others, the other-binding function of institutions.

However, the tale of Ulysses and the Sirens also reveals the ambivalent nature of institutions. If the "fore-sight" had been wrong or something unexpected were to come in between - such as a heavy storm that would require all hands at the helm of the ship - then the supportive function of institutions would turn into a handicap. Thus, Ulysses and the Sirens reveals a paradox - institutions need to be stable and flexible at the same time. This property can be called "flexible coordination."

There are several other common functions of institutions. Institutions may arise from the desire to reduce transaction costs (Coase, 1992; North, 1991) or for the purpose of specifying the locus of authority and responsibility. In both cases, institutions serve the function of bringing about behavior predictable by others. That is, institutions stabilize expectations and reduce uncertainty.

Institutions may be established in order to regulate the settlement of future conflicts that cannot be rationally resolved in advance. The necessary consensus for future decision making under unknown circumstances and uncertain outcomes can be attained by establishing in advance procedures and conditions that are perceived as being fair.

Whatever the form and combination of institutions, they always act as a filter for information and interests, as incentives for individual or collective decision-makers, or as norms for individual or collective behavior. They delimit the spectrum of possible decisions and actions and, as a result, favor certain solutions while impeding or excluding others.

Institutions are not historically neutral. Nations develop idiosyncratic institutions as a result of historical accidents, such as a traumatic strike, or inflation, or a revolutionary change in the political system (Flanagan et al., 1992). Institutions are not politically neutral. They reflect power relationships. They represent a congealed form of political will.

Institutions are in principle changeable when political will changes or collective memories weaken. Nevertheless, once established, institutions acquire their own dynamics and display unanticipated effects. Because of their steering function, which is in part indirect (the invisible hand) and because of their own institutional momentum, they may come into conflict with new socioeconomic constellations and policy goals.

Thus, institutional choice theory is fundamentally different from rational choice theory (Elster, 1986). Although ultimately an individual decision, institutional choice is at best a decision restricted by "intended and bounded rationality" (Simon, 1976, p. xxviii). In many cases, however, institutional choice is an unconscious decision, a taking over of traditions. If called into question, it often turns into a "rationalization" of choice instead of a "rational" choice that calculates benefit-cost ratios sine ira et studio. But it is probably safe to say that most institutional choices are a-rational. Their rationality or irrationality has to be detected like a vein of gold in a mine.

The preceding considerations put the problem of dealing with unemployment in a new light. Industrialization and capitalism set labor free from feudal bonds. But labor paid a price in the form of increased risk of unemployment and poverty. Clearly, capitalist nations had to develop new solidaristic institutions to deal with these problems. The questions for socioeconomics is: "what was involved in the choice of the new institutions?"

Labor Market Policy as an Institution

"Labor market policy" has not yet been clearly recognized as an institution of its own. One current connotation of the term is that it is a kind of social policy to alleviate the harmful consequences of unemployment. Another current understanding is that labor market policy is a narrow supply-side measure (training, placement, counseling) to improve the situation of unemployed job seekers or other disadvantaged groups in the labor market.

From the institutional choice perspective, this is a much too narrow definition. It is too narrow because it excludes the interrelations of these measures with other determinants of labor market dynamics and it does not properly account for the reasons for their evolution.

We define labor market policy in a broader sense than usual. We distinguish four basic forms:

1. Individual and collective agreements on wages, working time, and other working conditions. For any institutional analysis, it is important to distinguish between implicit and explicit contracts.

2. Regulation by laws setting standards, norms, and procedures for employment contracting. Labor market policy examples are employment protection regulation, legal quality standards to enter a vocational profession, and collective bargaining laws.

3. Redistribution by taxing wage income or by compensating lack of wage income by transfer payments. The most prominent example of this type of redistributive labor market policy is unemployment insurance. However, the impact of taxes and other forms of social security on the demand and supply of labor should not be neglected. Wage subsidies also belong in this category.

4. Public services and public investment. The state itself can play a role as employer or entrepreneur in the areas of public goods, merit goods, and mixed goods. The most prominent public services for labor markets are placement services and labor market information or counseling. Temporary public job creation and education and training are typical forms of public investments. They may be complementary or competitive with private investments. As far as these forms of public intervention are aimed at preventing or fighting unemployment, they are subsumed under the heading of active labor market policy.

Institutional Equivalents of Flexible Coordination

Can we now find some general principles which distinguish "good" institutional incentives from "bad" incentives with respect to unemployment prevention? There do appear to be at least three principles.

The first principle is derived from general systems theory. From this point of view, institutional choice has to follow the cybernetic principle of "requisite variety."(1) In other words, labor market institutions and policy interventions have to reflect the amount and nature of variety in their environment. For labor markets, the relevant environments are the product and capital markets and the sociocultural subsystem. With respect to the latter, in liberal and social democracies, this means that flexibility underlies "civilized constraints" such as free choice of profession, free spatial mobility, social security in terms of a continuous and decent income stream, and certain values and feelings about social justice. The importance of this principle of "bounded requisite variety" by civilized constraints has been pointed out by the game theorist Oskar Morgenstern:

The history of mankind manifests frequent changes in the means that society regards as being permissible for solving its problems. For example, one could eliminate unemployment very easily if enslavement of the unemployed, simply shooting them, confining them to a labor camp, or drafting them into military service were regarded as being suitable methods. On the other hand, in the present state of economic theory it is almost impossible to employ the unemployed. Neither a temporary reduction in wages nor an allocation of workers to industries or to other geographic districts is permissible. There may possibly be solutions given these constraints, but clearly the situation is fundamentally more complicated and only distantly resembles the "purely theoretical" situation in which wage reductions and labor mobility are unrestrictedly permissible (Morgenstern, 1966, p. 18).

These constraints vary considerably across countries and therefore lead to different institutional constraints of unemployment prevention. Elsewhere, it has been argued that flexibility of weekly working time, real wages, and internal work organization is consistently higher in Japan and Germany than in the United States. In the United States, employment flexibility, including unemployment or layoff volatility and interfirm mobility, play a more dominant role (Hashimoto, 1992; Kazutoshi, 1992; Sengenberger, 1992).(2)

Second, institutional choice for the prevention of unemployment without disastrous side effects requires institutional consistency and coherence. This principle means a complementary, or at least compatible, combination of the various forms of labor market policy. One example of complementarity would be the autonomy of employers' and employee associations in wage negotions and the legal acknowledgment or even extension, of collective agreements by the state. Another example is the prevailing social norm not to undercut the going wage as a strategy for unemployed workers to capture a new job. This norm would not survive without the institutional coexistence of unemployment insurance and other public assistance or benefits (Solow, 1990, p. 39). An example of inconsistency would be the legal prohibition of dismissing certain target groups such as the disabled and the refusal by the state to support firms employing disabled persons by providing wage subsidies or sharing the cost of workplace adjustments for the handicapped.

Whereas institutional consistency relates more to objective relationships, institutional coherence refers to the subjective capabilities of using the regulatory framework of institutions. The development of such capabilities is a social learning process which entails a lot of implicit knowledge. It is especially this condition of flexible coordination, together with the consistency principle, which prevents the easy transfer of institutions from one country to another. This also calls into question technocratic visions of designing and implementing an optimal institutional mix out of the best elements from diverse countries (Edwards & Garonna, 1991).

Third, institutional consistency and coherence force researchers to resist the temptation of technocratic design and to look instead at institutional equivalents which perform the same or a comparable role in the labor market. Labor market policy regimes work like communicating pipelines. If one policy is underdeveloped, others very likely will replace or offset it. In the United States, for example, the state restrains from regulating employment contracts through universal norms or standards. There is, for instance, little if any limitation on the termination of employment contracts. However, management is restricted in its ability to change internal worker assignments, particularly in the unionized sector. In Japan and Germany, the regulatory relationship tends to be the reverse. There is substantial legal protection against dismissal of workers. But in general, management is fairly free to organize work and allocate workers internally on the basis of skill and performance (Buchtemann, 1991, p. 46; Sengenberger, 1992, p. 156).

Another striking example of institutional equivalence is the restricted role of the state as employer, compared to its role as an entrepreneur in Japan and Switzerland. In Japan, the Ministry of International Trade and Industry (MITI) works with industry representatives to produce "visions" of where the economy and industries should be going. These visions serve as guides for the allocation of scare foreign exchange or capital and for public research and development spending for key industries.

Sweden and the Netherlands are good examples of the contrasting roles of the state as employer and redistributor. The Swedish welfare state developed mainly by extending public services with resultant employment. The Dutch welfare state was realized mainly by increasing and extending transfer payments (Rein & Freeman, 1988).

Institutional equivalents thus remind us that labor markets can be evaluated and dealt with in various ways. From an institutional point of view, the labor market can be in equilibrium with any one of a range of unemployment rates (Solow, 1990, p. 59). …