Must-Read: Olivier J. Blanchard and Lawrence H. Summers (1986): Hysteresis and the European Unemployment Problem

Must-Read: Olivier J. Blanchard and Lawrence H. Summers (1986): Hysteresis and the European Unemployment Problem:

European unemployment has been steadily increasing for the last 15 years and is expected to remain very high for many years to come….

We argue that this fact implies that shocks have much more persistent effects on unemployment than standard theories can possibly explain. We develop a theory which can explain such persistence, and which is based on the distinction between insiders and outsiders in wage bargaining. We argue that if wages are largely set by bargaining between insiders and firms, shocks which affect actual unemployment tend also to affect equilibrium unemployment. We then confront the theory to both the detailed facts of the European situation as well as to earlier periods of high persistent unemployment such as the Great Depression in the US.