Edmund Phelps on the 80's High Unemployment Problem in Europe

In 2006, Edmund S. Phelps from Columbia was awarded the Nobel Prize "for his analysis of intertemporal tradeoffs in macroeconomic policy".  Phelps works have brought micro economics analysis in incentives of employers and employees to explain macro economic phenomena, unemployment and a natural rate of unemployment.

While studying his works, I was amused by his study on the 1980's Europe. During the first half of the decade, European countries experienced increasing unemployment rate.

His interest in the 80's Europe rests on a fact that there was no evidence of unexpected disinflation or deflation while unemployment rate was rising in the Europe. Rise in unemployment rate in Europe started when the most of the world experienced recession in the early 1980's. However, the unemployment rate in the Europe prevailed at the higher rate while unemployment in the US continuously decreased following a hike during the recession.

Then Phelps tried to solve this puzzle of high unemployment rate together with not so much deflation in Europe. First, he gave an argument on why this surge in the unemployment rate couldn't be explained by some fiscal tightening in Europe if it had one. He disproves fiscal austerity explanation for the unemployment rise by two parts. First, he just looks at the budget deficits of the leading countries in the area. He found that, in fact, there wasn't an evidence of fiscal tightening on the budget balance sheet. The following table shows that the following countries were having an easier fiscal policy than they had in 1980, when the unemployment wasn't high, during the first half of the 80s.  Moreover, he temporarily borrows a Keynesian hat and tries to see what Keynesian theory would say if there was indeed a fiscal tightening, and the the unemployed surge was caused by it. If there was a fiscal tightening during this period, decrease in the government spending or increase in tax would lower nominal interest rate according to IS-LM model "assuming that the supply of money is not permitted to change course in response." However, the empirical evidence doesn't support this Keynesian argument for high unemployment rate because the nominal interest rates in leading European countries except Denmark were higher during the period than they were in 1977.

Phelps further states:

"The evidence is all the more crucial when we reflect that, whatever the
cause, the resulting contraction of employment per se would tend to
slow the growth of nominal wages, thus to reduce the inflation premium
in nominal interest rates that borrowers are willing to pay, and hence,
other things equal, to lower interest rates. The rise of the average
European nominal interest rate is thus doubly hard to square with the
Keynesian fiscal hypothesis."

He finally gives some hope for Keynesian theory by offering a counterfactual argument that if there hadn't been fiscal tightening, the nominal interest rate, output and velocity of money would have been even higher. Therefore, according to Keynesian explanation, there was indeed fiscal tightening, that in fact lowered the nominal interest rate even though the nominal interest rate increased in absolute value. Therefore, Keynesian theory has no problem of telling the story of high unemployment in Europe. However, Phelps argues that in order for this Keynesian explanation to work, there has to be another contractionary shock other than fiscal tightening that raises the nominal interest rate while it contracts employment. If, according to him, there is not such another shock, a lone fiscal tightening would only lower the nominal interest rate in absolute term, but the nominal interest rate increased. To me, the interesting part of his argument is whether there could be a such contractionary shock that raises the nominal interest rate while contracts employment.

To explain this high unemployment period, Phelps proposed broader explanation for it which says that there was a change in the natural rate of unemployment. I will write about his explanation for rise in the natural rate of unemployment in a later post. To prepare my readers for that, I will end this post by quoting the conclusion of his paper (Phelps 1986, 509):

Our vision of the persistence of unemployment in Europe posits a
considerable degree of real wage stickiness, whether loosely imple-
mented through private understandings or enforced by public provisions
for indexation. If, to take the extreme case, the real wage of an employee
is a constant and if, as a consequence, the real cost savings (also
expressed in consumer goods) to the firm of laying off an employee,
which is the true cost of using the employee in production in view of any
benefits paid to the laid off, is likewise a constant, in the sense of having
been earlier predetermined for the course of his employment, a decline
in the real marginal-revenue productivity of labor as a result of devel-
opments such as a rise of markups, a real depreciation of the currency,
a fall of the real price of capital goods output, or a contraction of the
capital stock will cause some employees to be laid off. Further, unless
the real marginal productivity schedule is restored, laid-off workers will
remain laid off for the balance of their years as employees. In this extreme
case of real wage stickiness, it is only the entrance of new workers,
insofar as they can make deals for employment at reduced real wages in
view of the reduced marginal-revenue productivity of labor, that will
erode the average value of the real wage; but this statistical adjustment
will do nothing to put laid-off workers back to work. To the extent that
customer markets inhibit the rise of new firms to absorb the young while
contracts protect existing laid-off employees from being passed over for
recall in favor of hires of cheaper workers from the outside, new entrants
will end up bearing a share of the economy's unemployment-indeed an
increasing share as new entrants accumulate and the laid-off take the
places of retiring workers.

In the expectational sense, the equilibrium unemployment rate is thus
increased, and the natural rate with it. Yet their "long-run" values need
not have increased. (Also, it is not implied that the equilibrium rate
increased as much as the actual rate.)