Labor Economics

Are Protective Labor Market Institutions at the Root of Unemployment?

Most studies have found a strong correlation between a country’s unemployment benefit generosity–in terms of either duration, wage replacement rate, or eligibility–and the unemployment rate. Many economists contend that one reason why Europeans have higher unemployment rates is due to their more generous unemployment benefit package.

Yet a paper in Capitalism and Society by Howell, Baker, Glyn and Schmitt (2007) calls into question whether more generous unemployment benefits are really causing increased unemployment. Here are some of their more convincing points from the article.

  • Take up. The authors claim that take-up rates of unemployment benefits is generally low. According to Hernanz et al. (2004), in the OECD countries, only 60-80 percent of eligible unemployed actually take-up their benefits. Thus not all people who are eligible for unemployment benefits actually take them up. However, this argument is not very convincing if the overwhelming majority of those eligible, take up benefits.
  • Eligibility. Most countries have rules which require a certain amount of prior work experience to be eligible for unemployment. This means that the youth are less likely to be eligible for unemployment and thus will not respond to changes in unemployment benefit generosity changes. In most countries the employment rate for youths is much higher than those of working age. For instance, in the U.S. the unemployment rate among males aged 15-24 is 12.9%, but only 4.6% for males aged 25-54. Similarly in France, the UK and Spain the unemployment rate is much higher for youths (20.8%, 11.8% and 18.7% respectively) than for prime aged males (7.4%, 3.8% and 6.9% respectively). Since a large group of the employed are not eligible for unemployment benefits, unemployment benefit generosity may not have as big an impact on the unemployment rate as once thought.
  • Policy lag. Changes in unemployment benefit generosity may take years to affect the unemployment rate. With an indeterminate lag between policy inaction and the policy result, spurious relationships may be found in the data.
  • Policy Endogeneity. The most convincing argument is found with a Granger causality test. The authors find that high unemployment Granger causes an increase in unemployment benefits, but an increase in unemployment benefits does not Granger cause higher unemployment rates. This make sense if we are operating in the (likely) world of policy endogeneity. When politicians see a rise in unemployment, they may propose more generous benefits. Thus, economists will see a contemporaneous relationship between benefits and unemployment and may incorrectly attribute causation to the benefit rather than the unemployment rate.

While this paper makes some good points that unemployment benefits are likely not the only cause of high unemployment rates in Europe, it does not find evidence against the hypothesis that more generous unemployment benefits increase unemployment–only that this relationship has not yet been conclusively proven. In my mind, it is only sensible that being paid more not to work will increase an individual’s incentives not to work.

Policy makers must balance the work disincentive resulting from unemployment benefits with the social insurance efficiency gains from providing the insurance.