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Unemployment today in Europe and Japan: Lessons from the U.S. Great Depression

Seventy years after the start of the Great Depression, economists are still arguing about its cause and duration; recent research by two Minneapolis Fed economists offers new insight into that era and may also shed light on current events

V. V. Chari - Consultant

Published July 1, 1999  |  July 1999 issue

Unemployment rates in much of Europe have been stubbornly high through much of the 1990s, averaging around 10 percent. In some countries, such as Spain, jobless rates have averaged higher than 20 percent in this period.

The unemployment rate in Japan, around 5 percent, has been steadily rising, exceeding the U.S. level of 4.3 percent. If unemployment rates were measured in Japan the way they are in the United States, Japanese unemployment rates could well be closer to 10 percent.

The problems of the Japanese economy have led to repeated calls to pursue expansionary monetary and fiscal policy. In terms of fiscal policy, Japan has been running substantial budget deficits for the last decade. National debt has risen to more than 100 percent of its gross domestic product, from around 30 percent. (The comparable figures for the United States during the last decade are a rise from 42 percent to 46 percent.) Similar calls have been made for European governments and the European Central Bank to pursue expansionary fiscal and monetary policies.

Will such policies help the economics of Japan and Europe and thus the world as a whole? Recent research in economics raises serious doubts that they will. European countries impose substantially more restrictions than the United States on the ability of businesses to fire or lay off workers. Interestingly, and perhaps paradoxically, preventing businesses from reducing their workforces may actually raise the number of unemployed people. A business that knows it can't fire its workers will often be reluctant to hire new workers for fear it will be stuck with a larger workforce. Without the ability to reduce its future workforce, businesses will hire only when they are convinced demand for their products will grow rapidly.

A more subtle problem can also restrict unemployment rates and worsen people's economic situation. A modern, dynamic economy involves a constant reshuffling of people from one job to another and from one business to another. In the United States, for example, each year around 12 million new jobs are created and about 10 million jobs are destroyed. The process of reallocation is substantially larger than the number of net new jobs created. Restrictions on layoffs and workforce reductions can impede this process and lead to a less efficient economy.

Recent research by Harold Cole and Lee Ohanian (of the University of Minnesota and the Federal Reserve Bank of Minneapolis) on the Great Depression in the United States suggests similar forces were at work then. During the Depression, the economy contracted severely from 1929 to 1933 and then grew modestly from 1933 until the start of World War II. Cole and Ohanian show that an important component of the Great Depression is that unemployment rates remained stubbornly high all through the 1930s as the economy recovered slowly.

The conventional wisdom is that the Depression was a consequence of bank failures and protective trade policies (such as the infamous Smoot-Hawley tariffs of the late 1920s). But bank failures were not important after 1934, and trade is too small a part of the U.S. economy to play a central role. Instead, Cole and Ohanian point to the National Industrial Recovery Act of 1933 that allowed industries to form cartels and monopolize substantial sectors of the economy. They also point to the rise of unionization in the 1930s. They focus attention on the factors that prevented businesses and individuals from reallocating resources efficiently. (See the Federal Reserve Bank of Minneapolis Quarterly Review, Winter 1999)

Their findings are sure to be debated and ought to be. That said, the two economists and Edward Prescott of the University of Minnesota (also writing in the same issue of the Quarterly Review) are focusing on the right issue. Europe and Japan might be better off thinking about how to improve the functioning of labor markets than tinkering with fiscal and monetary policy.

Policies that severely retard the reallocation of workers and interfere with the national operation of the labor market can have profound and grave consequences.

Chari's commentary originally appeared in the St. Paul Pioneer Press.

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