Trends in Earnings Inequality and Unemployment Across the OECD: Labor Market Institutions and Simple Supply and Demand Stories

Grounded in the standard supply and demand model, the conventional wisdom assumes a tradeoff between earnings inequality and unemployment, blames low skills for high earnings inequality in the U.S. and U.K., and attributes high European unemployment to institutional constraints. This paper finds little evidence of a tradeoff between earnings inequality and unemployment across OECD countries, and while welfare state institutions aimed at employment, unemployment, and wage protection matter a great deal for differences and changes in earnings inequality, they do not appear to be the main source of OECD employment problems. This evidence suggests a need to move beyond the policy implications of the simple textbook model. Specifically, returning to a more compressed wage distribution is not likely to create "European" levels of unemployment in the U.S., and greater earnings inequality is not likely to fix employment problems in Europe. Policy makers should give more credence to the view that the right kind of labor market institutions can further both egalitarian and efficiency goals.