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Unemployment hysteresis and structural change in Europe

“...at present the situation is different. The risks of ‘doing too little’—i.e. that cyclical unemployment becomes structural—outweigh those of ‘doing too much’—that is, excessive upward wage and price pressures.”

Mario Mario Draghi (2014), President of the ECB, Jackson Hole Speech.

Abstract

We examine the unemployment hysteresis hypothesis for 31 European countries, the USA and Japan, using alternative linear and nonlinear unit root tests, taking into account possible structural breaks. Two types of smooth transition models—Exponential Smooth Transition Autoregressive and Asymmetric Exponential Smooth Transition Autoregressive—are employed to account for the nonlinear mean-reverting behaviour in unemployment due to heterogeneity in hiring and firing costs across firms. Four main results emerge: first, the hysteresis hypothesis is rejected for 60 % of the countries in our sample. Second, nonlinear models capture the asymmetries in unemployment dynamics over the business cycle for some countries. Third, many of the series display multiple structural breaks which might point out shifts in mean level of unemployment. Fourth, forecasting powers of our nonlinear models display poor performance against the linear AR specification. The results have policy implications for the debate on the benefits of demand or supply-side policies for tackling the current unemployment problem in Europe.

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Notes

  1. Blanchard and Summers (1986) point out asymmetries in wage setting process between insiders and outsiders as the main driver of a propagation mechanism in unemployment. They argue that negative shocks contracting number of workers could increase the bargaining power of insiders due to their increasing marginal product. This would lead to a new equilibrium wage rate. This line of reasoning is later critisized in Lindbeck and Snower (2001) which argues that the remaining insiders are not necessarily more secure because in case of negative shocks (i) firms might decide to contract capital and labour services simultaneously provided that they have excess capacity and (ii) the relation between the wage negotiation and employment is not unambiguous due to changes in reservation wage.

  2. In general, short-term demand shocks are considered to have cyclical impacts on unemployment while supply shocks might lead to long-term changes in labour market conditions.

  3. Obviously, as Bean (1997) argues, a “fine tuning” is almost impossible due to high level of uncertainty regarding the economy. However, offsetting policy actions would lead to a “coarse tune” of the economy by means of smoothing the economic activity.

  4. In a similar manner, Yellen (2012) motivates a loose monetary policy stance with FED’s concerns over hysteresis: “To date, I have not seen evidence that hysteresis is occurring to any substantial degree... Nonetheless, the risk that continued high unemployment could eventually lead to more-persistent structural problems underscores the case for maintaining a highly accommodative stance of monetary policy.”

  5. Another reason for unemployment persistence could be the stigmatization of unemployed workers (Blanchard and Diamond 1994).

  6. Blanchard and Summers (1986) also favour a looser form of the definition where coefficients do not add up to one but very close to one (a near unit root process). These two cases are also referred later in the literature as pure hysteresis or partial hysteresis (see Layard et al. 1991; León-Ledesma and McAdam 2004). In this study, the hysteresis term is used to refer to the case where the autoregressive parameter is unity (i.e. a unit root process or pure hysteresis).

  7. Phelps and Zoega (1998) point out other structural factors behind unemployment such as technological change, labour productivity or educational composition of the labour force.

  8. Davis and Haltiwanger (1991) show that job destruction and job creation by US firms display heterogeneity for both cross-sectional and time dimensions for US firms. They argue that job destruction is relatively more volatile over the business cycle and job reallocation displays a countercyclical movement.

  9. Moreover, these causes could be a result of government policies such as compulsory advance notice of layoffs or changes in the financing structure of unemployment compensation dynamics (Hamermesh and Pfann 1996).

  10. In a recent study, Galí (2016) analyses the implications of this framework on optimal monetary policy design.

  11. Koop and Potter (1999) corroborate with these result using TAR model with Bayesian methods. Coakley et al. (2001) also detect nonlinear behaviour in US, UK and Germany unemployment series using Momentum-TAR framework introduced by Enders and Granger (1998).

  12. Recently, Cheng et al. (2014) employs flexible Fourier unit root test; Caporale and Gil-Alana (2007) and Cuestas et al. (2011) use fractional integration along with nonlinear techniques; Pérez-Alonso and Di Sanzo (2011) propose a nonlinear unobserved component model to test for hysteresis. Cuestas and Ordóñez (2011) explore the nonlinearities in unemployment rates of Central and Eastern European countries with ESTAR and LSTAR models. Gustavsson and Österholm (2006) also employ ESTAR model for testing the unemployment hysteresis for five developed countries. Bolat et al. (2014) apply nonlinear panel unit root tests for the Eurozone area.

  13. Later on, Lumsdaine and Papell (1997) extend this methodology with two structural breakpoints alternative, emphasizing that the unit-root test results are sensitive to the number of breaks in the alternative hypothesis.

  14. This correction behaviour could also be motivated as a reflection of the business cycles. A long-run mean reversion would imply that recessions will be followed by a recovery which could be the result of an improvement in expectations, corresponding to a positive demand shock in Bentolila and Bertola (1990). An ESTAR-type adjustment imposes that these countercyclical movements that would move the unemployment level back to equilibrium are not that strong when the series is close to its mean but gets stronger when it gets far away from it. Also, note that employment is a nonstationary process in Bentolila and Bertola (1990) since they conduct their analysis for a given level of demand in order to examine the comparative dynamics. Instead, our study focuses on long-term time series characteristics of unemployment, i.e. considering alternative phases of the cycle, testing the presence of a long-run mean reversion.

  15. The \({B}_\mathrm{L }\) level could also move depending on the magnitude of the impact of the change in severance payments on the threshold levels \({B}_\mathrm{LL}\) or \({B}_{\mathrm{LL'}}\) in the lower regions.

  16. We follow the three-step testing procedure that is described in detail at page 1082 of Christopoulos and León-Ledesma (2010), using Eq. (7) as our base model. The footnotes of the Table 3 also provide details of the estimation.

  17. For the current period, the source of the differences requires an in-depth analysis for the individual countries, which is beyond the scope of this exercise and stands as a good research question for the future.

  18. Hence, we only present the estimation results for AESTAR model in this section. The ESTAR estimation results are not presented due to space considerations but are available upon request.

  19. The nonlinear problem is solved by the sequential quadratic programming method of Gauss 14. The estimation returns the smallest value to fulfil with the restrictions for some parameters. Standard errors are very close to zero for these cases.

  20. For a review of this literature and examples see Teräsvirta et al. (2005) and Ferrara et al. (2015).

  21. For time-inconsistency and resulting free-rider problems in a monetary union that would negatively affect the structural reform incentives, see Chari and Kehoe (2008).

  22. For the impacts of economic governance of Europe on European labour markets, see Ioannou and Stracca (2014).

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Correspondence to Kurmaş Akdoğan.

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Akdoğan, K. Unemployment hysteresis and structural change in Europe. Empir Econ 53, 1415–1440 (2017). https://doi.org/10.1007/s00181-016-1171-8

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Keywords

  • Unemployment hysteresis
  • Nonlinear adjustment
  • Structural breaks
  • Forecasting

JEL Classification

  • E24
  • C22
  • E27