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Back to the Future: European Unemployment Today Viewed from America in 1939

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Back to the Future: European Unemployment Today Viewed from America in 1939 ROBERT J. GORDON Northwestern University Back to the Future: European Unemployment Today Viewedfrom America in 1939 MANY ECONOMISTSwould agree that the two greatest macroeconomic puzzles of the twentieth century are the persistence of unemployment in the United States in the 1930s and in Europe in the 1980s. High unemployment in 1939 America was cured by a sharp expansion in aggregate demand, with a notable absence of supply bottlenecks.' Although there are significant differences in the situations faced by America in 1939and Europe today, the similaritiesare strikingenough to warrant asking whether European unemploymentcould also melt away in response to an expansion in aggregatedemand. Withinflation in Europeno longerdecelerating, many analysts believe that Europe must today be operatingat or close to its nonaccelerating inflationrate of unemployment,and that today's NAIRU is muchhigher than it was in the 1960sand early 1970s.Two differentinterpretations of the high NAIRU have been offered, each with quite different policy implications.Perhaps the dominantview, which I call "structuralist," explains high unemploymentby supply constraints,including high real I am grateful to members of the Brookings Panel for helpful suggestions, to the NationalScience Foundationfor financialsupport, and to DanielShiman for indispensable researchassistance. A completedata appendix is availablefrom the authorupon request. GabrielSensenbrenner helped to pull togetherdata from diverse sources, and Charles Schultze generously providedhis update of the EuropeanCommission data on capital stocks and other variables. 1. Throughoutthe paper, I treat only the peacetime expansion extending through December 1941,during which prices were free to adjust.I make a sharpdistinction with the portionof the expansionthat took place afterwar was declared,because pricecontrols were imposedin early 1942. 271 272 Brookings Papers on Economic Activity, 1:1988 wages, government intervention in the free operation of labor markets, and other structuralmaladjustments, most notably inadequatecapacity available to equip presently unemployed workers. According to this view, unemploymentcannot be reduceduntil the supply-sideconstraints are directly addressedby supply-orientedchanges in governmentpoli- cies. The more optimistic "hysteresis" view is that the NAIRU auto- maticallyfollows in the path of the actualunemployment rate. Thus, the NAIRU in Europeis highbecause actualunemployment is high, and the best way to make the NAIRU decline is to pursueexpansionary demand policies. The analogy with 1939America offers some insights into the validity of the two competing views of the currentEuropean situation. During 1939, more than any other year in the dismal Depression decade, the American economy exhibited every evidence of slipping into a low- employmentequilibrium trap. Prices were on a plateau,with no tendency to decline, despite high unemployment.In every other year duringthe decade, outputwas either fallingrapidly or risingrapidly. As in Europe today, numerous supply-side constraints, including high real wages, union militancy, and a declining capital stock, afflicted the economy. That these supply barriersmelted in the face of demand expansion in 1939-41 is evidence against much of the structuralistinterpretation of contemporaryEuropean problems. Again, as in Europetoday, the interwarU. S. Phillipscur-ve relation- ship showed signs of hysteresis; that is, inflationdepended not on the level of detrendedoutput but on its rate of change. A low level of output did not exert continuingdownward pressure on the inflationrate.2 But 2. I have previouslypointed out the disappearancein the United States between 1929 and 1941,and in the United Kingdombetween 1922and 1938,of the Phillipscurve "level effect" infavorofaneffect workingexclusivelythrough therate of growthof unemployment or output. This phenomenonis documentedin RobertJ. Gordonand James S. Wilcox, "MonetaristInterpretations of the Great Depression:An Evaluationand Critique,"in Karl Brunner,ed., TheGreat Depression Revisited (Martinus Nijhoff, 1981),pp. 49-107; andRobert J. Gordon,"A Centuryof Evidenceon Wageand Price Stickiness in the United States, the United Kingdomand Japan,"in JamesTobin, ed., Macroeconomics,Piices, and Quantities: Essays in Memory of Arthur M. Okun (Brookings, 1983), pp. 85-121. Similaritiesbetween Europe today and the United States in the late 1930s discussed subsequentlyin thispaper are examined in OlivierJ. Blanchardand Lawrence H. Summers, "Hysteresisand the EuropeanUnemployment Problem," in StanleyFischer, ed., NBER Macroeconomics Annual, 1986 (MIT Press, 1986),pp. 65-71. A discussion of high real wages and reduced profitmargins in the 1928-32 contraction,and their reversal in the Robert J. Gor-don 273 the inflation-outputrelationship in 1939 reveals a critical difference as well. Inflationwas not nearly as persistent in interwarAmerica as in postwar Europe, and as a result the United States in 1939faced a more favorableinflation-output trade-off than does Europetoday, in the sense thathigher inflation coming from a rapidexpansion would eventuallydie out. A Few Essential Facts Figure 1 chartsU. S. and Europeanunemployment since 1961.Here, as in subsequenttables, "Europe" refers to the six originalmembers of the EuropeanCommunity, plus the United Kingdom,Austria, Norway, Sweden, and Switzerland. By late 1987 unemploymentin the United States hadfallen to the level reachedin 1963,while Europeanunemploy- ment in late 1987exceeded that in 1963by a factor of five. The upsurge in Europeanunemployment took place in two phases, firstin 1974-76at the time of the first oil shock, and then in 1980-83 at the time of the second oil shock and the worldwide contractionin aggregatedemand. There was no furtherincrease in Europeanunemployment after 1984, but no decrease either, leadingto the widespreadreferences to Europe's situationas a low-employmentequilibrium trap. The second aspect of this low-level trap is displayed in figure2, set directly below figure 1. Since 1971, Europe's inflation rate has been about 2 percentage points higher on average than that of the United States, with the differenceranging to as much as 3 percent.3In 1987the difference almost vanished. After declining rapidly between 1980 and 1984, the rate of Europeaninflation slowed only slightly more through 1987,while unemploymentremained steady, indicatingthat Europewas operatingrelatively close to its NAIRU. Table 1 displays unemploymentrates in the United States, Canada, Japan,and 11 Europeancountries for selected years spanning1961-87. 1932-37expansion, is containedin Sheila Bonnell, "Real Wages and Employmentin the GreatDepiession," Economic Record, vol. 57 (September1981), pp. 277-81. The Bonnell dataand discussionwere linkedto Europein the 1980sin JeffreyD. Sachs, "Real Wages and Unemploymentin the OECDCountries," BPEA, 1:1983,pp. 271-74. 3. The averageannual 1971-87inflation rate (measuredby the GDP deflator)for the United Statesis 5.94 percentand for Europeis 7.71 percent. 274 Brookings Papers on Economic Activity, 1:1988 Figure 1. Unemployment Rate, United States and Europe, 1961-87 Percent 12 10 8 6- 4- 2 Eur~uope 1965 1970 1975 1980 1985 Source: OECD Econotnic Outlook, various issues. The unemployment rate for Europe is the total unemployment rate for I I countries: Austria, Belgium, Denmark, France, West Germany, Italy, Netherlands, Norway, Sweden, Switzerland, and United Kingdom. For Denmark and for 1961-74 for Switzerland the data were provided by Andrew Newell of the Centre for Labour Economics at the London School of Economics. Data for 1987 are forecast data from OECD EconomizicOutlook, no. 42 (December 1987), table 12. Figure 2. Inflation Rate, United States and Europe, 1961-87 a Percent 14 - 12 Europe 10 8 6 United States 4 - 2 1965 1970 1975 1980 1985 Source: OECD, National Accounts, various issues. a. Inflation rates are the annual percentage change in the GDP deflator. Robert J. Gordon 275 Table 1. Standardized Unemployment Rates, Selected Countries, Selected Years, 1961-87 Percent Coluntry 1961 1972 1979 1987 United States 6.7 5.5 5.8 6.2 Canada 7.1 6.2 7.4 8.9 Japan 1.4 1.4 2.1 3.0 Eleven European countries 1.9 3.0 5.0 9.6 France 1.2 2.7 5.9 10.6 Germany 0.8 0.8 3.2 8.0 Italy 5.1 6.3 7.6 12.1 United Kingdom 1.5 4.0 5.0 11.0 Austria 1.9 1.2 2.1 3.8 Belgium 2.1 2.7 8.2 12.7 Denmark 1.4 0.9 5.4 7.9 Netherlands 0.7 3.1 5.4 11.0 Norway 1.5 1.7 2.0 2.3 Sweden 1.4 2.7 2.1 2.5 Switzerland 0.0 0.0 0.3 0.8 Sources: Switzerland and Denmark, 1972 and 1979 fronmOECD, Labor Force Statistics 1963-83 (Paris: OECD, 1984). Other countries for 1972, 1979, and 1987: OECD Economic Oitlook, no. 42 (December 1987), tables 12 and R17. All 1987 data are OECD projections. All breaks indicated in table R17 are linked using table R18, basing on 1979 levels of unemployment. All unemployment rates for 1961 are taken from International Labor Office, Yeatbook of Labor Statistics, 1971 (Geneva: ILO, 1971), table 10, linked to OECD Series in 1964. Datacorrespond to the standardizedOECD definitions, with adjustments for data breaksand discontinuities.The Europeancountries are divided into two groups: the four large countries, followed by the seven small countries. In 1961 and in 1972 unemploymentwas uniformlylower in Europe than in the United States, except for Italy in the latter year, but by 1987unemployment was higherin Europe than in the United States in every country but the four small wunderkinder-Austria, Norway, Sweden, and Switzerland.4
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