Are Protective Labor Market Institutions at the Root of Unemployment? A Critical Review of the Evidence

Abstract

A rapidly expanding empirical literature has addressed the widely accepted claim that employment-unfriendly labor market institutions explain the pattern of unemployment across countries. The main culprits are held to be protective institutions, namely unemployment benefit entitlements, employment protection laws, and trade unions. Our assessment of the evidence offers little support for this orthodox view. The most compelling finding of the cross-country regression literature is the generally significant and robust effect of the standard measure of unemployment benefit generosity, but there are reasons to doubt both the economic importance of this relationship and the direction of causation. The micro evidence on the effects of major changes in benefit generosity on the exit rate out of unemployment has been frequently cited as supportive evidence, but these individual level effects vary widely across studies and, in any case, have no direct implication for changes in the aggregate unemployment rate (due to ``composition" and ``entitlement" effects). Finally, we find little evidence to suggest that 1990s reforms of core protective labor market institutions can explain much of either the success of the ``success stories" or the continued high unemployment of the large continental European countries. We conclude that the evidence is consistent with a more complex reality in which a variety of labor market models can be consistent with good employment performance.