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Wednesday, July 09, 2008

"Luck and Unemployment Rates"

I'll let Richard Baldwin introduce this one. From Free exchange:

Luck and unemployment rates, by Richard Baldwin: Remember when unemployment rates over 10% were normal in Europe? Now the average for the EU is under 7%, with only two members in double-digit range (Spain and Slovakia). Sixteen of the 27 have rates at 6% or less, nine with 5% or less and three have rates that would make America jealous (Cyprus, the Netherlands and Denmark). The full list is here.

What happened? Liberal market economists would love to argue that their persistent clamour for more flexible labour market policies is finally bearing fruit. But on Vox today, Patrick Minford and his co-authors make a more subtle argument that I find rings true.

Mr Minford and his colleagues start from the assumption that distortionary big government policies are the source of the sort of equilibrium unemployment Europe has now. The trick then is to explain why these distortionary policies fluctuate according to very long waves that let us think of the 1970s and 1980s as high unemployment decades and the current decade as one of low unemployment.

Good and bad luck magnified by special interest group policies is their argument.

Prolonged high and low unemployment periods are supported by supply-side changes driven indirectly by shocks to the economy. Negative shocks generate political economy pressure which yields reinforcing distortionary supply-side responses such as increased political demands for social protection. These distortions produce a high unemployment equilibrium underpinned by distortionary policies that enjoy political support due to the high unemployment rate.

Similarly, a string of good shocks produces a more liberal supply-side policy as voters and pressure groups are less concerned about unemployment. A self-reinforcing political process favours supply-side reform that keeps the economy in a virtuous circle of low-unemployment, high-output and pro-market policies.

The result? The economy has two stable equilibria. One like the 1980s. One like the current decade.

Here's the full article:

Vicious and Virtuous cycles – the political economy of unemployment in interwar UK and US, by Kent Matthews, Patrick Minford, and  Ruthira Naraidoo

    Posted by on Wednesday, July 9, 2008 at 12:42 AM in Economics, Politics, Unemployment | Permalink  TrackBack (0)  Comments (12)

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