External Constraints on European Unemployment

The persistently high rate of unemployment has probably been Western Europe's most important economic problem of the 1970s and 1980s. Average unemployment rose relentlessly between the early seventies and the mid-eighties, in contrast to the United States, where unemployment has displayed a normal cycle, around a slightly higher mean. This has led to a number of supply-side explanations centred on the structure of Europe's labour markets.In this paper we re-examine the aggregate demand explanation of Europe's unemployment experience, using a succession of models of interdependent open economies. We find that a small North-South macro model which allows for price sluggishness in manufactures and flexible commodity prices can explain the most important stylized facts about OECD unemployment and Europe's relative performance, as well as the behaviour of relative commodity prices. The explanation is based on the timing and the mix of monetary and fiscal policies. We argue that Europe's more restrictive stance in the 1970s and 1980s can be attributed to external constraints related to the greater openness of individual European economies, asymmetries in the international monetary system, and the quest for intra-European exchange rate stability.