How Do Labor Market Institutions Affect the Link between Growth and Unemployment: The Case of the European Countries

Article excerpt

1. Introduction

The observed high unemployment in continental Europe and the slowdown in economic growth in the last decades naturally raise the question of whether these two phenomena are related. On the empirical side, there is no consensus regarding the sign of the correlation between growth and unemployment, either across countries or over time within a country. (4) The same is true on the theoretical side. (5) Nevertheless, the endogenous growth theory predicts that distortions due to fiscal instruments lead to a lower growth whereas the equilibrium unemployment theory predicts that these distortions lead to a higher unemployment rate. This suggests that economic growth and long-run unemployment are linked through the labor market institutions.

In this paper we investigate the issue of the long run link between growth and unemployment at two levels. First, we construct a theoretical economy to study the role of labor-market variables on the bad performance of European regions. The three main hypotheses of our model are the following: (i) Innovations are the engine of growth. (ii) Agents have the choice of being employed or being trying their hand at R&D. (iii) Unemployment is largely caused both by the wage-setting behavior of unions, and by the labor costs associated to the tax/benefit system. (6) Second, at the light of this model, we explore the growth and unemployment experiences across 183 European regions. The observed heterogeneity is so large that it is difficult to distinguish some relation between these two variables, relation that is often found at national level. Hence, we try to recover a link through the expected effects of several institutions present on the labor market. To this end, we assess the effect of institutions on the (regional) growth and unemployment rates. (7)

The key implications of the theoretical model are the following. First, the bargaining power of unions, the unemployment compensation, the taxes on labor and the employment protection have a positive effect on unemployment and a negative effect on the economic growth. Second, a more coordinated bargaining process increases employment, at the price of a lower economic growth. The first result clearly contrast with the results of Lingens (2003) or Mortensen (2005): Lingens (2003) treats the impact of unions in a model with two kind of skills, and shows that the bargain over the low-skilled labor wage causes unemployment but the growth effect is ambiguous. Similarly, in a matching model of schumpeterian growth, Mortensen (2005) finds a negative effect of labor market policy on unemployment, but an ambiguous effect on growth.

On the other side, the main insights from the empirical exercise are twofold. First, the tax wedge and the unemployment benefits are positively correlated with the regional unemployment rates. Conversely, the employment protection and the level of coordination in the wage bargaining process are negatively correlated with the regional unemployment rates. Second, the tax wedge and the unemployment benefits are negatively correlated with the regional growth rates of the Gross Domestic Product (GDP) per capita. Conversely, more coordination in the wage bargaining process is associated to lower regional growth rates. This points to the existence of a trade-off between unemployment and growth, if we focus on the impact of coordination in the wage bargaining process.

These results are in accordance with the Daveri and Tabellini (2000)' results, who using aggregate (national) data, find that most continental European countries exhibit a strong positive correlation between the unemployment rate and both, the effective tax rate on labor income and the average replacement rate. Conversely, they find a strong negative correlation between the growth rate of GDP per capita and the tax on labor income, either over time and across countries.

2. The model economy

In this section we develop a theoretical model to study the equilibrium link of economic growth and the long run unemployment at the light of the labor market institutions. …