The persistent rise in unemployment levels recorded in the developed world, particularly in continental Europe, ever since the first great oil shock has brought about a renewed interest among macroeconomists and labor economists in understanding the dynamic behavior of unemployment rates. It is often argued that major postwar macroeconomic shocks such as the slowdown in productivity growth (Hoon and Phelps, 1997), the steep rises in oil prices in the 1970s (Carruth, Hooker, and Oswald, 1998) and the changes in world interest rates (Phelps, 1994) could be responsible for the persistent rise in unemployment. However, this provides an incomplete picture since the U.S. unemployment rate--which has also been subject to these shocks--has reverted back to preshock levels rather than steadily rising as in Europe. Thus, authors have turned their attention to a line of argument related to the degree of labor market flexibility. Blanchard and Wolfers (2000) and Phelps and Zoega (1998), among others, have claimed that more stringent job-security legislation, higher impediments to hiring and firing, higher levels and duration of unemployment benefits, and a higher degree of wage indexation in the European Union (European Union) relative to the United States may have contributed to the marked differences in unemployment levels recorded in both economic areas.
At the theoretical level, three main hypotheses have been entertained in accordance with the evolution of unemployment levels over the postwar era. The traditional natural rate theory pioneered by the work of Friedman (1968) and Phelps (1967, 1968) holds the view that the unemployment rate tends to fluctuate around some equilibrium level associated with a fully equilibrated labor market where all adjustments have worked themselves out. This natural rate is set depending on fundamentals of the economy, which are taken to be exogenous. Shocks to unemployment are assumed to be temporary, which implies that unemployment is path independent and reverts to its preshock level. However, the difficulties in interpreting European unemployment movements since the first oil shock in terms of the natural rate theory gave rise to two alternative views: the structuralist and hysteresis hypotheses.
The structuralist hypothesis--see Phelps (1994) and Phelps and Zoega (1998)--tries to explain the rise in European unemployment through the adjustment to an underlying equilibrium rate of unemployment which has increased in response to structural factors of the labor market and the economy in general. Some of the factors trying to explain the "movement" of the natural rate of unemployment are labor productivity, technological change, world real interest rates, real exchange rates, stock prices, and energy prices. Other factors specific to the functioning and adjustment of labor markets are the level and duration of unemployment benefits and employment protection legislation. According to the structuralist view, most shocks to unemployment are temporary, but infrequently large variations in the aforementioned structural factors occur, which lead to shifts in the now endogenous natural rate of unemployment.
In contrast to the natural rate and structuralist approaches, the hysteresis hypothesis--see Blanchard and Summers (1986, 1987) that focused on insider-outsider dynamics in wage formation--implies that the unemployment rate is path dependent as its current level shows high dependence on past levels. As a result, temporary shocks can affect unemployment permanently. (1) Hysteresis' defenders claim that the key to the rise in European unemployment should not be sought on the occurrence of adverse supply shocks--such as the productivity slowdown or the oil crises--or demand shocks--such as those caused by tight monetary policies leading to sharp rises in interest rates. Instead, the answer is in the way countries adjust to shocks. For these authors, unemployment rates can remain at a new higher level indefinitely even if the recession causing the unemployment rise has ended. …