THE ‘NATURAL RATE OF UNEMPLOYMENT’:

AN IDEA WHOSE TIME HAS GONE

Among economists nowadays, the dominant view of unemployment is that it consists of two separate, independent components: the ‘natural rate of unemployment’ (describing long-run, structural unemployment) and business cycle fluctuations around it (cyclical unemployment). This overwhelmingly accepted theory has powerful implications for Europe: since the long climb in European unemployment since the mid-1970s couldn’t have been due to business cycles, the natural rate itself must have risen.

But according to Marika Karanassou and Professor Dennis Snower, this view is becoming increasingly difficult to defend. Where did the rise in the natural rate of unemployment come from?, they ask. Over the past 20 years, many European countries have experienced deregulation, privatization, declining union density, and partial dismantling of job protection. Under these circumstances, one would have expected the natural rate to have fallen, if anything.

Writing in the latest issue of the Economic Journal, Karanassou and Snower take a different approach. They deny that cyclical and structural unemployment are largely independent of one another and instead focus on the links between the two. Specifically, they see movements in unemployment as the outcome of two interacting phenomena: labour market shocks (such as oil price rises or changes in interest rates and unemployment benefits) and ‘lagged adjustments’ (such as inertia in employment due to training costs).

Both shocks and lagged adjustments are many and varied. What’s more, the lagged adjustments reinforce one another. For example, a temporary recession may lead to a prolonged fall in employment when firms face large costs of hiring and firing; the prolonged drop in unemployment will increase the number of long-term unemployed workers, who devote little effort to job search and thereby keep employment low for even longer. When there is such a network of lagged adjustments, unemployment may diverge from its long-run, structural level for long periods of time, even a decade. In this context, each labour market shock can be shown to have a ‘chain reaction’ of unemployment effects.

This is the basic idea underlying the ‘chain reaction theory’ of unemployment and it implies a quite distinct policy focus from natural rate theory. The latter focuses attention on policies that affect the long-term structure of the labour market - labour demand and supply once the adjustment processes have been completed. From this vantage point, various economists have suggested that European unemployment could be reduced through reductions in taxes on employers and employees, in real interest rates, and in the duration and generosity of unemployment benefits.

Chain reaction theory, by contrast, focuses attention on policies that affect the lagged adjustment processes and thereby make the labour market more resilient in the aftermath of shocks. For example, reductions in legislated firing costs could reduce the degree to which firm's current employment decisions depend on past employment, or reductions in the degree of wage indexation could reduce the degree to which wages depend on their past levels.

But these researchers’ analysis goes further than showing how unemployment may deviate from its long-run, structural level for long periods of time. They demonstrate that in a growing economy, even the structural level of unemployment depends on the lagged adjustment processes. For example, in the presence of technological progress, capital accumulation and population growth, labour demand and supply are continually drifting upwards, and thus some lagged adjustment processes - such as the effect of past employment on current employment, or of the past labour force on the current labour force - never have a chance to work themselves out entirely.

Instead, employment and the labour force are chasing after moving targets, continually adjusting to the growth of technology, capital and population (the ‘exogenous variables’). Under these conditions, the long-run, structural unemployment rate (in any year) depends not only on the values of the exogenous variables (in that year), but also on the lagged adjustment processes, which determine how close employment and the labour force come to their moving targets.

In this way, chain reaction theory sheds light on how labour market flexibility affects unemployment, not only in the short and medium run, but also in the long run, where flexibility is understood in terms of the speed with which labour market participants react to the never-ending sequence of labour market changes.

In this context, high-unemployment countries require not only policies to reduce structural unemployment, but also policies that improve labour market adjustment processes, such as employment vouchers to help speed up the rate at which the long-term unemployed find jobs, reductions in legislated firing costs to make firms' employment decisions more responsive to external shocks, or the removal of regulations that inhibit the entry and exit of firms in the economy.

Note: ‘How Labour Market Flexibility Affects Unemployment: Long-term Implications of the Chain Reaction Theory’ by Marika Karanassou and Dennis J. Snower is published in the May 1998 issue of the Economic Journal. Karanassou is in the Department of Economics at Queen Mary and Westfield College, London; Snower is Professor of Economics at Birkbeck College, London.

For Further Information: contact Dennis Snower on 0171-631-6408 (fax: 0171-631-6416; email: dsnower@economics.bbk.ac.uk ); or RES Media Consultant Romesh Vaitilingam on 0117-983-9770 or mobile 0468-661095.