A New Explanation for European Unemployment based on Rational Institutions

We show that European-style hysteresis can arise in a normative model where labor market institutions are determined optimally. We focus on the government's decision to set unemployment benefits in response to an unemployment shock. The government balances insurance considerations with the tax burden of benefits and the possibility that they introduce adverse “incentive effects” whereby benefits increase the unemployment rate. It is found that when the shock occurs, benefits should be increased in those economies where the adverse incentive effects of benefits are largest. Adjustment costs of changing benefits can introduce hysteresis in benefit setting and unemployment. A good temporary shock can permanently reduce unemployment by making it optimal to have a cut in unemployment benefits. Desirable features of the model are that we obtain an asymmetry out of a symmetric environment and that the mechanism yielding hysteresis is both simple (requires the third derivative of the utility function to be non-negative) and self-correcting.

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