European unemployment. This is a puzzle because unemployment rates increased massively
in Europe relative to the U.S. only after the early 1980s although many of the underlying
institutions were already in place before that time. The authors show that the puzzle can
be resolved by consideration of turbulence, i.e. human capital degradation (d). In their model
increased turbulence (as observed in the 1980’s) has a strong effect on unemployment in countries
with a large welfare state compared to a laisser-faire economy.
Our investigation partly replicates their results but finds also new and different effects. First,
while Ljungqvist and Sargent identify unemployment insurance benefits as the main culprit,
our analysis suggest that high welfare assistance (s), high expected labor market tightness (λτ)
and high labor income taxes or, more generally, a large welfare state may induce large-scale skill
degradation among the LTU. Second, Ljungqvist and Sargent’s study suggests that in particular
workers with high initial skill level (high pre-unemployment wage) choose to stay unemployed
for a while (i.e. search with low intensity for a new job) in times of turbulence. In contrast, our
analysis suggests that employment increases in the high-skill segment when d increases because
the opportunity costs of skill-loss are too high in turbulent times. The unemployment pool is
filled with workers from the lower end of the skill distribution who find a permanent life on the
dole attractive when times are turbulent.
Finally, we can derive a result with respect to working-age. The derivative of hC is increasing
in δT in absolute terms. Thus, the positive effect on employment operates among the youth
(with a long remaining work life T - t) who exit unemployment earlier under the threat of rapid
skill degradation. On the other end of the education spectrum we find that hA is decreasing in
δT implying that the LTU pool is in particular filled by older workers close to retirement age
who face a lower threat of skill degradation. Our result is supported by the observation that
LTU in Europe increased in particular within the group of older workers (OECD, 2002).
3.6. Retraining Costs. An increase in retraining costs discourages retraining among the STU
and therefore increases LTU. In Figure 1, higher retraining costs c shift hA to the right and hC
to the left.
∂hA e ∂hC e
∂c δτ(1 — θ)(1 — d) ^^ , ∂c (1 — θ) [δτ(1 — b)+ δτd] ~ .
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