Unemployment in an Interdependent World



1 Introduction

“In the flat world, one person’s economic liberation could be
another’s unemployment.” (Thomas Friedman, The World is Flat,
2005, p. 205)

“Globalization” is one of the key words in the current economic debate. It vaguely
refers to the fact that countries and their actions are no longer independent from each
other. Rather, the economic, political, and social performance of one country also depends
on the policies taken by other countries. The study of these interdependencies is the epit-
ome of international economics, whether countries are linked via trade in final goods or
inputs or through international mobility of capital or labor. These interdependencies
also seem to be at the core of widespread popular fears related to the globalization phe-
nomenon. Those worries are typically strongly related to labor market issues and feature
prominently in discussions of the current global economic crisis.

This paper offers a theoretical and empirical perspective on how changes in labor mar-
ket institutions in one country affect labor market outcomes in the countries with which
it trades. The theoretical framework combines the model of trade in differentiated goods
(Krugman, 1979, 1980; Melitz, 2003) with the canonical search and matching approach
(Pissarides, 2000). To capture interdependencies, countries may differ with respect to
labor endowments, geographical position, and labor market institutions. We account for
firms’ monopoly power on the goods markets by modeling strategic wage bargaining.
Besides these generalizations of the standard frameworks, we do not add any other struc-
tural elements, shortcuts or simplifications and focus on structural (long-run) equilibrium
unemployment.

This no-frills model of the trade-unemployment relation predicts that bad institutions
in one country worsen labor market outcomes not only in that country but also in those
that are related through trade in goods. This spill-over effect depends on trade costs and
country size: smaller and/or more centrally located nations suffer less from inefficient
policies at home and are more heavily affected from spill-overs abroad than larger and/or
peripheral ones. We confirm this spill-over effect of bad labor market institutions in
our econometric analysis. However, we also find that the spill-over effects present in
the data are substantially bigger than the ones predicted by our theoretical exercise.
To remedy this shortcoming, the model requires more real wage rigidity than the one
implied by wage-setting a` la Mortensen and Pissarides (1994). We interpret this finding
as another indication that the standard matching model has difficulties reproducing the
variability of unemployment rates found in the data. Whereas Shimer (2004, 2005) refers
to unemployment fluctuations over time, we find a similar phenomenon across countries..

There is an emerging consensus in the macroeconomic labor literature that institutions
matter for structural unemployment; in particular, pervasive product market regulation
increases unemployment.
1 One may therefore conjecture that trade barriers also foster

1 See for example Layard, Nickell, and Jackman (1991); Nickell (1997); Ljungquist and Sargent (1998);



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