An Estimation of Unemployment Hysteresis

This paper explores the degree of hysteresis in EU unemployment rates. The hysteresis hypothesis holds that actual (demand-determined) unemployment can turn into structural unemployment. The European Commission estimates and reports NAIRUs as part of the AMECO dataset, which also inform the EU fiscal policy rules. These exclude the possibility of hysteresis by assumption. We present a simple model to estimate hysteresis effects. We demonstrate that there is significant evidence for the existence of unemployment hysteresis in the majority of the EU15 countries. In the EU15 as a whole, we find the average degree of hysteresis to be 80%. Our findings suggest that the European Commission could profitably consider alternative NAIRU estimation strategies that allow for unemployment hysteresis. These results have two important consequences for policy makers. First, they indicate that a lack of government intervention in response to negative shocks has immediate effects in the form of increasing unemployment as well as long-lasting effects on the NAIRU. This is consistent with the OECD Employment Outlook 2017. Second, as the NAIRU estimates enter the calculation of the output gap and the structural deficit, the EU Fiscal Compact should be reconsidered.