Causes of High Unemployment - Essay Example

Running Head: EMPLOYMENT Employment of Employment Causes Of High Unemployment Paul Krugman presented a somewhat different perspective on the causes of high unemployment. He emphasized the distortions caused by the United Kingdom welfare state as the principal culprit. High payroll taxes, in addition to such stringent labor market regulations as the employment protection guarantees stressed by Martin and Snower, reduce the wages firms are willing to offer to attract employees. At the same time, generous welfare benefits for the unemployed reduce their incentive to accept jobs at these low wages. The resulting wedge between what employers are willing to offer and what workers are willing to accept explains why United Kingdom unemployment is so much higher than in the United States, where taxes and benefits are considerably lower. The interaction between the welfare state and a changed economic environment, Krugman argued, can also explain why unemployment has increased so much in United Kingdom. The change he emphasized was declining demand for low, skilled workers in industrial nations. Such a change would tend to increase income inequality by depressing the wages of low-skilled workers. But large disparities in incomes are what the United Kingdom welfare state was designed to prevent. The collision of market forces pushing toward greater income inequality with government policies that prevented such inequality has resulted in growing unemployment in United Kingdom, especially among low-skilled workers. In analyzing the reasons for declining demand for these workers, Krugman expressed skepticism about the importance of increased competition from newly industrializing nations. Although intuitively plausible, this explanation has been found to have little empirical support according to Krugman. Instead, he attributed the declining demand for low-skilled workers to technological change that devalues the market value of manual labor. The same forces raising unemployment in United Kingdom, Krugman claimed, have caused rising poverty and income inequality in the United States. With less generous social service benefits, low-skilled workers in the United States have seen their real incomes decline. Krugman did not see any painless way out of the tradeoff between more poverty and more joblessness. Transforming low-skilled workers into high-skilled workers through improved education and training might seem the obvious solution. But raising education levels can be done only gradually, and government training programs are not particularly effective. Some modest improvement in United Kingdom might result from restructuring the welfare state to reduce distortions. Only a major "pruning" of the welfare state, however, is likely to reduce United Kingdom unemployment substantially, and then at the expense of increased poverty. Krugman concluded policymakers in both United Kingdom and the United States confront the harsh choice of accepting either high unemployment or widespread poverty. Edmond Phelps explained why he thought the causes of unemployment are more diverse than implied by Krugmans paper. His research indicated OPEC oil shocks, increased taxes on labor, and higher real interest rates have contributed importantly over the past several years to the rise in the natural rate of unemployment--that is, the unemployment rate consistent with stable inflation. He agreed with Krugman that growth of the welfare state and a decline in demand for low-skilled workers have contributed to high unemployment in most industrial countries. He was skeptical regarding Krugmans claim that increased competition from newly industrializing economies had not contributed importantly to the declining demand for low-skilled workers. Accordingly, he advocated redistributing the overall gains from free trade through subsidies to employers who hire such workers. The first step in this direction should be a tax credit to offset the payroll taxes paid for low-wage workers, financed in part by reducing the most distortionary elements of the welfare state. If tax credits prove insufficient, governments should consider cash subsidies to firms that employ low-skilled workers. Like Phelps, Christopher Pissarides felt Krugman put too much of the blame for unemployment on welfare state policies. He did, however, advocate less restrictive employment protection laws in United Kingdom. In his view, laws making it costly for firms to fire workers merely stifle necessary labor market adjustments, thus benefiting neither employers nor workers. Other improvements would be to limit the duration of unemployment compensation and to spend more on active labor market policies to help the unemployed find jobs. While such pruning of welfare benefits can and should be used to reduce United Kingdom unemployment, Pissarides was emphatic that income support for low-skilled workers should remain. In his view, minimal government support for the disadvantaged, as in the United States, is a "cruel route" not to be followed in United Kingdom. Monetary Policy And Unemployment The focus of the symposium next shifted to the relation between monetary policies and unemployment. Topics addressed included whether expansionary monetary policies in United Kingdom should be used to complement needed labor market reforms, the differences between Japanese and United Kingdom labor markets, the unique legislative mandate guiding New Zealands monetary policy, and the pressures on central banks to pursue more stimulative monetary policies when unemployment is high. The Role Of Monetary Policy In his paper, Charles Bean explained what role monetary policy could play in reducing United Kingdom unemployment. He argued the main reason unemployment has risen so much more in United Kingdom than in the United States is that United Kingdom labor markets create long-term persistence of unemployment. His empirical estimates show that shocks with only temporary effects on unemployment in the United States have permanently raised unemployment in United Kingdom. Due to various persistence mechanisms, any increase in United Kingdom unemployment is quickly translated into a higher equilibrium (or natural) unemployment rate. Lasting reduction of unemployment in United Kingdom can only be achieved with structural reforms to improve the functioning of labor markets. Bean maintained expansionary monetary policies should nonetheless be used to complement labor market reforms. Such reforms could prove so politically unpopular they would soon be reversed unless their benefits are realized quickly. Macroeconomic policies should thus be used to ensure aggregate demand grows rapidly enough to take full advantage of the expanding aggregate supply resulting from labor market reforms. Expansionary fiscal policy is effectively precluded by the large structural budget deficits in most United Kingdom countries. The responsibility for demand stimulus, therefore, falls to monetary policies. In Beans view, United Kingdom central banks should be willing to tolerate slightly higher inflation for the next few years if necessary to achieve the goal of reducing the United Kingdom unemployment rate five percentage points by the end of the decade. In countries where employment growth is stifled by insiders aggressive wage demands, a temporary incomes policy might prove a useful adjunct to labor market reforms and stimulative monetary policies. Bean cautioned against coordinating national monetary policies to achieve exchange rate stability. If labor market reform proceeds at different rates, exchange rates may need to adjust to ensure that each country can realize the full benefit of its reforms. Exchange rate fluctuations within the current wide bands of the United Kingdom Monetary System should provide adequate scope to pursue independent monetary policies. But an attempt to narrow exchange rate bands or to move rapidly to monetary union would prevent an efficient transition to lower levels of unemployment. Stanley Fischer disagreed that tolerating higher inflation was necessary to realize the benefits of United Kingdom labor market reforms. Although real wages in United Kingdom may need to decline modestly to reduce unemployment, this decline could occur without higher inflation. Labor market reforms will themselves increase wage flexibility enough to accomplish slower growth in wages without higher inflation. Fischer nonetheless endorsed Beans plea that central banks in United Kingdom accommodate the higher economic growth potential accompanying labor market reforms. Takatoshi Ito explained how Japan has managed to avoid the high and rising unemployment observed in United Kingdom. One important factor has been a steadfast Japanese commitment to low inflation. Ito was skeptical of Beans contention that tolerating higher inflation could reduce United Kingdom unemployment. The major reason unemployment has remained low in Japan, however, is Japanese labor market institutions have allowed shocks to be absorbed without laying off workers. Whether this will remain so in the face of a severe recession and strong yen is uncertain. Major Japanese companies have increasingly shifted production abroad, raising the prospect unemployment will trend upward in Japan in the years ahead, as it did in United Kingdom during the 1980s. In Allan Meltzers view, the upward trend in United Kingdom unemployment has been due almost entirely to the corrosive effects of the United Kingdom welfare state. Imposing high taxes on the income of those who work, and using the proceeds to subsidize those who do not, reduces incentives to seek employment, thereby raising the measured unemployment rate. Meltzer presented evidence the United Kingdom countries which had increased welfare spending most had also experienced the largest increase in unemployment. He found this a compelling reason for eschewing the monetary stimulus recommended by Bean, concentrating instead on supply-side remedies to "welfare state unemployment." In summarizing the discussions of the first day of the symposium, Nigel Lawson also emphasized the importance of supply-side remedies for reducing unemployment. He emphasized such remedies would be difficult politically because they would cause painful adjustment. Lawson nonetheless urged economists to be forthright in recommending the uncomfortable policy changes necessary to reduce unemployment, "because I dont know where politicians and policymakers are going to get their guidance from if these things arent spelled out clearly." The Importance Of Price Stability In his luncheon address, Donald Brash explained what he thought monetary policy could--and could not--contribute to reducing unemployment. In his view, monetary policy can best contribute to minimizing unemployment by maintaining price stability. He cited New Zealands experience as support for this view. In the 1970s and early 1980s, monetary policy was used to stimulate the economy. The resulting burst of inflation caused consumer prices to increase fivefold from 1970 to 1984. This high inflation was accompanied by an upward trend in the unemployment rate. The ultimate result of stimulative monetary policy, therefore, was higher rather than lower unemployment. This period of stagflation in New Zealand led monetary policy to be reoriented toward price stability. The new orientation was codified in 1989 with passage of a new Reserve Bank Act. The Act instructs the Reserve Bank of New Zealand to focus exclusively on achieving and maintaining stability in the general level of prices. The Government and the Reserve Bank have agreed that maintaining consumer price inflation in a range of 0 to 2 percent fulfilled that mandate. Steadfast pursuit of price stability has kept New Zealands inflation rate in that range since 1991. Although experiencing a prolonged recession during the period of disinflation, the New Zealand economy has subsequently rebounded. The unemployment rate has already come down substantially from its recession peak and is expected to decline further. Based in part on New Zealands experience, Brash argued that focusing on price stability is not antithetical to reducing unemployment but is a prerequisite for doing so in a lasting way. This unique legislative mandate for price stability has not, Brash said, entirely shielded the Reserve Bank from political pressures to pursue a more stimulative monetary policy. Critics have attacked the Reserve Bank Act for its alleged callous disregard for the unemployed. Brash views one of his most important functions to be convincing these critics that "attempting to trade-off just a little more inflation for a little less unemployment, however tempting, just isnt a workable proposition." Structural Policies To Reduce Unempl0yment In the next two sessions of the symposium, participants evaluated the effectiveness of alternative policy reforms in reducing structural unemployment. Among the reforms discussed were reducing unemployment insurance benefits, imposing a tax on firms that lay off workers, offering subsidies to firms that hire workers, investing more in education and training, and increasing job search assistance to dislocated workers. Evaluating Alternative Policy Reforms In his paper, Dale Mortensen evaluated alternative labor market policies using a theoretical model of job creation and job destruction. According to the model, unemployment could be reduced by cutting back on the generosity of government payments to the jobless or by reducing payroll taxes. The effects of other prospective policy changes are less clean Imposing a tax on firms that lay off workers, for example, would reduce the incidence of layoffs but could also make firms less willing to hire new workers. Similarly, a tax credit for firms that hire workers would increase job creation but might also increase job destruction if firms lay off some workers in order to get the tax credit when replacement workers are hired. The net effect of both tax credits for hiring and tax penalties for firing on the overall level of unemployment are therefore ambiguous in the theoretical model. Only by using an empirical version of the model can such ambiguities be resolved. Mortensen thus presented numerical estimates using an empirical version of the theoretical model to evaluate prospective U.S. policy changes. Using values he considered realistic for the parameters of the model, Mortensen estimated that a firing tax would rise rather than lower unemployment. Such a tax would so impede workers mobility that aggregate output would also suffer. In contrast, reducing unemployment benefits would be effective in substantially reducing U.S. unemployment, but only at the expense of forcing many of those who could not find jobs into poverty. Similarly, cutting such payroll taxes as the social security tax would not have a large enough beneficial effect on unemployment to justify the accompanying adverse effect of lowering pension and health care for the elderly. A more promising labor market reform in the United States, Mortensen concluded, is a hiring subsidy to employers. According to his estimates, such subsidies would substantially reduce U.S. unemployment without imposing hardships on the poor or the elderly. This and similar active labor market policies might best be financed with a payroll tax since, according to the model, such taxes have minimal disincentive effects on hiring. Martin Feldstein was less sanguine than Mortensen about the prospective benefits of hiring subsidies. In Feldsteins view, Mortensens model does not provide a reliable basis for estimating the likely effects of actual policy changes. Other studies have found that hiring subsidies are a waste of taxpayers dollars. Feldstein recommended instead the U.S. unemployment insurance system be reformed to reduce structural unemployment. Such reforms, if carefully designed, could substantially increase incentives for finding a job without imposing hardships on the truly disadvantaged. Subjecting unemployment insurance benefits to the income tax, which the United States now does, reduces disincentives for job seeking but does not reduce benefits for those too poor to pay taxes. A more radical reform would be to set a maximum weekly benefit of about $200, thereby reducing the benefit levels for those who previously had a high-paying job but retaining current benefit levels for others. This type of reform would be much more effective in reducing unemployment, Feldstein argued, than would hire subsidies. Assar Lindbeck also expressed skepticism about the advisability of hiring subsidies. He pointed out both workers and firms would have powerful incentives to find ways to exploit the subsidies. Firms that previously transferred workers from one plant to another, for example, could benefit by splitting into two companies in order to reap the benefits of hiring subsidies to the plant that was increasing employment. Lindbeck also argued that Mortensens policy prescription of more government involvement in labor markets through hiring subsidies and higher payroll taxes should be compared with less government involvement in labor markets before concluding how best to reduce unemployment. Active Labor Market Policies In his paper, Lawrence Katz evaluated the effectiveness of active labor market policies in solving the jobs problem, which he defined as "too few decent employment opportunities to go around." The problem has led to higher unemployment in United Kingdom and to increased poverty among working families in the United States. Government programs to enhance the skills and adaptability of the work force could, in Katzs view, help solve the jobs problem on both sides of the Atlantic. He identified three key elements to such a strategy. The first element is to create "a system of life-long learning." Katz cited several studies showing investment in human capital has large payoffs both for the aggregate economy and for individuals. Because the jobs problem has disproportionately affected the employment prospects for less-skilled workers, government programs to improve education and training must be an integral part of any long-run solution to the problem. Keeping more young people in school, enabling less-educated adults to return to school, and encouraging employers to invest in their workers are all essential for enhancing the skill level of the work forces in America and most other industrial countries. A second major element in solving the jobs problem, according to Katz, is to help displaced workers get new jobs. Most studies suggest job search assistance for such workers is an inexpensive way to reduce the amount of time between jobs. Helping workers start their own businesses has also been shown worthwhile for the minority of displaced workers who have both the willingness and ability to do so. Other forms of government retraining programs have been less successful in part because the programs were not well designed. Overall, Katz strongly advocated a comprehensive "reemployment system" intended to assist displaced workers in getting jobs rather than the current system of merely providing income support during the job search process. The final element for solving the jobs problem, Katz argued, includes policies to ensure low-skilled individuals can earn more by working than by not working. One such policy is a minimum wage set high enough to increase earnings of low-skilled workers but not so high that they are priced out of the market. Direct government subsidies for the working poor, such as the earned income tax credit in the United States, can also "make work pay" for those whose earning power is minimal. In his comments, James Heckman emphasized the importance of identifying the most effective programs for improving the lot of less-skilled workers. His reading of the evidence suggests that the returns to government training programs are generally very low. Rather than using scarce budget resources for training displaced workers, in Heckmans view, government programs should focus on early childhood intervention to increase the chances that youth from disadvantaged backgrounds stay in school. A "super-Headstart" program for preschool children has proven effective in raising their educational attainment and reducing their criminal activity in subsequent years. Such programs would yield benefits, however, only in the long run. The short-run problems of less-skilled, adult workers might be more effectively addressed through government subsidies to their employers rather than through government training programs in part because such workers are less malleable than youth. In his comments, John Morley emphasized the importance of striking a balance between employment growth and equitable distribution of income. The 1993 White Paper issued by the United Kingdom Commission recommended supply-side obstacles to job creation be removed in a way that avoids increased wage inequality. The historical evidence is clear, Morley contended, that unfettered operation of labor markets produces wide disparities in income which are socially unacceptable in developed countries. As a result, governments in most United Kingdom countries have faced serious political and social constraints on how much to deregulate labor markets. The sharp rise of wage inequality in the UK which accompanied deregulation has discouraged similar policies elsewhere in United Kingdom. In Morleys view, how much employment growth in United Kingdom can be achieved without unacceptable income inequality remains an open question. Reforming tax systems, Andriessen argued, must also be an integral part of reducing European unemployment. To support the generous benefits available under the European welfare state, taxes on earned income are very high. These taxes have raised the cost of labor so much that many low-skilled individuals have been priced out of the market. Lowering the labor cost for low-skilled jobs should, in Andriessens view, be the first priority in reducing European unemployment. This could be done, for example, by lowering taxes on low-income workers, including the payroll taxes paid by their employees. The resulting revenue loss might be offset by additional energy taxes, which would have the ancillary benefit of encouraging conservation. Especially if supplemented by active labor market policies and perhaps additional public sector jobs, this type of tax reform could substantially reduce European unemployment. In his overview remarks, Alan Blinder discussed the role of macroeconomic policy, especially monetary policy, in reducing unemployment. While agreeing monetary policy had little if any role in reducing structural unemployment, he also pointed out monetary policy could affect short-run cyclical fluctuations in unemployment. Moreover, he argued that central banks should attempt to guide the unemployment rate to the natural rate. He thus viewed the legislative mandate calling upon the Federal Reserve to pursue both maximum employment and stable prices as being an appropriate charge for central banks. Because he considered U.S. unemployment to be near the natural rate at the time, Blinder saw little the Federal Reserve could do to reduce unemployment further. Blinder did see a role for monetary policies in reducing European unemployment. Blinder interpreted the consensus among symposium participants to be that macroeconomic policies might be able to pare the unemployment rate in the European Un-ion-which was close to 11 percent at the time--by two or three percentage points in the short run without igniting inflation. In addition, the natural rate of unemployment in Europe might be further reduced two or three percentage points in the long run by structural labor market reforms. He agreed with other symposium participants that the success of structural labor market reforms could well depend on the macroeconomic environment. If so, macroeconomic policies and labor market policies should be viewed as complementary rather than unrelated approaches to reducing unemployment. Michel Hansenne urged in his comments that the unemployment problem be viewed in a global context. 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