Equilibrium Unemployment

Philip OConnell stresses the importance of activation measures for preventing long-term unemployment in today’s instalment of the Irish Times series on the jobs crisis.

Although the series has in part focused on ways to limit the rise in cyclical unemployment, the main focus is on policies to limit the rise in the equilibrium (or natural) rate of unemployment.   A crude characterisation of the equilibrium rate is that it is the rate that persists even when the economy returns to potential output.   

The IMF estimated in its Article IV Consultation Report in July that Irelands output gap would average 6.3 percent this year, and that this gap would not be completely eliminated until 2015 (see Table 4, p. 31).   However, the unemployment rate is forecast to still average 9.5 percent in 2015, which can be taken as the IMFs estimate of the equilibrium rate.  The unemployment rate averaged just 4.4 percent in 2005; a point at which the IMF believes the economy was operating close to potential.  A likely legacy of this recession, therefore, will be a more than doubling of equilibrium unemployment rate. 

The persistent rise in unemployment rates in many European countries in the 1970s and 1980s led to a major research effort to understand its causes.   One of the most interesting empirical papers to emerge from this effort is by Olivier Blanchard and Justin Wolfers* (paper here).   They set out to explain the striking diversity in the unemployment experiences across countries over these decades, with countries such as the Netherlands at one end of the spectrum and Spain at the other.   It is generally believed that the sorts of policies and institutions that are the focus of the Irish Times series matter, but the puzzle was that there had not been large changes in these policies/institutions over the period when the average unemployment rate had risen so dramatically.   Their paper focuses instead on the interaction between policies/institutions and macroeconomic shocks, hypothesising that some systems are more resilient to shocks than others.  

The Blanchard and Wolfers findings are worrying in the context of the massive macroeconomic shock we have just experienced.   Running down through the list of policies/institutions associated with weak resilience, Ireland generally scores poorly: high replacement rates and long-duration benefits, weak activation policies, relatively strong unions, etc.   Moreover, even on some measures where Ireland had an advantage notably nationally focused wage bargaining and a low tax wedge this advantage eroded as the recession hit.   The combination of the massive macro shock and less-than ideal labour market policies and institutions presents a serious policy challenge.   The Irish Times series is certainly timely. 

*Blanchard, Olivier, and Justin Wolfers.  2000.   “The Role of Shocks and Institutions in the Rise of European Unemployment: The Aggregate Evidence”.   The Economic Journal, 110 (March): C1-C33.