In memory of Dr. Andreas Höfert

Hysteresis and resolving Eurosclerosis

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In a contrast that could not be more pronounced, the statistical office of the EU announced a record high unemployment rate for the Eurozone, 12.1% in May 2013 with no trend reversal in sight, on the same day the Bavarian Business Association released a report on the bright future of employment in Germany.

In a contrast that could not be more pronounced, the statistical office of the EU announced a record high unemployment rate for the Eurozone, 12.1% in May 2013 with no trend reversal in sight, on the same day the Bavarian Business Association released a report on the bright future of employment in Germany.

This latter report stunningly states that Germany could face full employment (meaning an unemployment rate slightly over 4%) by 2030, with many sectors under stress due to low labor supply. One can question analysis which extrapolates trends well into the future. Usually such forecasting is plainly wrong, but because it aims at the very long run, in years almost no one remembers it anymore.

Nonetheless, Germany’s present concern with a possible labor shortage, while other Eurozone countries are struggling with high overall unemployment rates and appalling youth unemployment rates, shows how far the Eurozone countries have drifted apart since the beginning of the euro crisis. Consider these unemployment figures: Greece 27.4% (59.2% youth unemployment), Spain 26.9% (56.5%) and Portugal 17.6% (42.1%) on the one side of the spectrum, and the Netherlands at 6.6% (10.6%), Germany 5.3% (7.6%) and Austria 4.7% (8.7%) on the other.

Besides the sheer size of current European unemployment, also quite worrisome is experience with high unemployment rates in European countries. This does not suggest a strong or rapid reversal of the present situation.

Indeed, 25 years ago in the early 1980s, the much smaller European Communities (then 10 member countries, compared with 28 now) were also struggling with high unemployment rates after several recessions from the mid-1970s to the early 1980s. Striking was this unemployment’s persistence, quite the opposite of what happened in the US, where even more severe recessions during the same period then saw rather rapid reduction of unemployment rates once the recovery started. Europe instead got stuck in the so-called Eurosclerosis.

This puzzle led many economists back then to explore new theories of labor market behavior. In 1986 Olivier Blanchard, the current Chief Economist of the International Monetary Fund, and Larry Summers, the former US Secretary of the Treasury, at that time economics professors at MIT and Harvard respectively, co-authored a famous paper and brought the term “hysteresis” (i.e. the path dependency of a variable and therefore the persistence of a state) from the physical sciences into economics.

One explanation of hysteresis in European unemployment was that as soon as recovery was underway, the employed had sufficient bargaining power to push wages higher, thus keeping the still unemployed out of the labor market.

Another possible cause of hysteresis was the depreciation of human capital which befalls the unemployed. The longer one remains unemployed, the less attractive a worker one becomes.

This explanation, should it be the right one, gives us a dismal perspective for the current situation in the European periphery, where many young, newly educated people are unemployed and seeing their labor market attractiveness vanish the longer they stay so.

The Eurosclerosis of the early 1980s was painfully and slowly overcome in the late 1980s and early 1990s. European politicians may argue that deepening European integration boosted growth quite strongly. I don’t know whether this is the right answer but if it is, then clearly in today’s situation the fate of the unemployed in the European periphery will be determined not by quick fixes, like spending more on young unemployed people as was agreed during the last EuroSummit, but ultimately by the willingness of European politicians to solve the euro crisis with more integration.