Explaining unemployment developments in Europe : the role of wage-setting institutions and macroeconomic policies

This study seeks to explain unemployment patterns in western European countries prior to the Great Recession. Criticising the standard view that good unemployment performance is primarily due to liberal labour market institutions, the argument advanced here is that different unemployment trajectories can be explained by the different ability or willingness of policymakers in the countries, at different points in time, to influence two key variables: nominal aggregate demand and nominal wages. In a mixture of theoretical and empirical analysis, the scope for, the constraints on, and the institutional and structural prerequisites for policymakers to exert influence on nominal output and wages are identified. Time series analysis suggests that countries that ensure or experience relatively stable growth of nominal output or demand and (less so) wage variables enjoy better labour market performance (especially since 1981). On the other hand, given demand/output volatility, an adaptive wage strategy might be desirable. A fuzzy set qualitative comparative analysis (fsQCA) is conducted for OECD countries for three twelve-year periods: 1970-1981, 1982-1993 and 1994-2005. Main findings include: Coordinated collective wage bargaining and flexible labour market institutions constitute functional equivalents. The former performed better in the first two periods, the latter in the third period. In the anti-inflationary struggle characterising the second period, there is strong evidence that a lack of collective wage setting was associated with particularly poor labour market performance, and somewhat weaker evidence that its presence helped deliver relatively good performance. From a longitudinal perspective monetary policies oriented towards employment are closely associated with favourable unemployment trends; cross-sectionally the picture is more complex, however. In most specifications counter-cyclical fiscal or monetary policies to stabilise demand prove favourable to labour market outcomes. Almost no systematic relationship between labour market performance and the degree of openness of an economy was found. Overall the findings of this analysis suggest that the existing literature has unjustifiably focused, in a one-sided manner, on the importance of liberal labour market institutions, while it has underplayed the role for both employment-oriented macroeconomic policies and coordinated wage-setting.