When U2 and the Pogues headlined a benefit concert in Dublin in 1986, their goal wasn’t to feed starving children in Africa. They aimed to help the hundreds of thousands of Irish unemployed, more than 16% of the workforce.
Ireland wasn’t alone. In France, Italy and the U.K. at the time, unemployment was 9% or higher; in Spain it was 16% and rising.
But in the U.S., it was “Morning in America”: Joblessness was at 7% and falling fast.
Today, the divide has again emerged, after U.S. and European unemployment rates converged during the nadir of the global financial crisis. Economists have been left scratching their heads about why the trans-Atlantic difference is so persistent.
But a few practitioners of the dismal science argue the answer has been staring policy makers in the face: Tight monetary policies aimed at controlling inflation and setting the region on a path to a single currency have damaged Europe’s labor markets.
The explanation violates orthodoxies that have taken root in economics due to the revolution against Keynesian thought that began in the 1960s. Monetary policy is supposed to have no effect on the variables of the real economy such as growth and employment; or if it does, the effects are relatively short-lived. That orthodoxy is why central bankers in Europe set the fight against inflation as their guiding star, with little consideration of employment.
The U.S. Federal Reserve has a dual mandate to limit unemployment and control inflation. After Fed Chairman Paul Volcker raised interest rates sharply in the early 1980s to stem inflation caused by the oil price shock of 1979, the Fed eased policy aggressively soon after to reduce unemployment.
But European central banks kept policy tight, even as inflation was falling, says Laurence Ball, a macroeconomist at Johns Hopkins University who has written several well-known papers on the subject.
“Let’s say nobody’s willing to accept double-digit inflation, so you’re going to have to tighten policy and have a period of high unemployment,” Mr. Ball says. “That’s painful medicine, but these European countries prescribed an overdose.”
Economists have typically looked at other culprits for the divergence, such as labor markets. The U.S. has weaker unions and less-generous unemployment insurance than most European countries. The argument is that U.S. labor markets can therefore adjust more easily to economic shocks. But various studies have turned up little correlation between changes in labor markets, both across advanced countries and within countries over time, and variations in unemployment.
The demands of the European Monetary System, the precursor of the euro, played an important role. Started in 1979, the EMS required its eight founding members to keep their currencies trading within fixed ranges of each other. For countries that saw pressure mount on their currencies, the EMS required them to keep interest rates high to prevent devaluation.
EMS countries such as France, Italy and Ireland frequently had to defend their currencies from falling against the deutsche mark of West Germany, which boasted one of the world’s lowest inflation rates. Sometimes those efforts failed and limited devaluations were allowed. But high real interest rates were the rule.
The U.K. provides more evidence. It ran tight money policies in the 1980s. Since it abandoned its effort to keep the pound tied to the deutsche mark in the early 1990s, monetary policy has usually been looser than in continental Europe. Unemployment is now 5.4%.
Also, take the difference between Portugal and Spain. For years during the 1980s and 1990s, Portugal consistently boasted one of the lowest unemployment rates in Europe. Its larger neighbor next door had one of Europe’s highest. This despite both countries having similar labor-market institutions and a recent history of having emerged from dictatorships.
Teresa Ter-Minassian, who was chief of the International Monetary Fund’s Southern European division in the 1980s, said Portugal accepted a large initial currency devaluation as part of a bailout negotiated with the fund in 1983; then it adopted a policy of allowing further weakening of the escudo to maintain its competitiveness. Spain “did not use the exchange rate as aggressively as Portugal,” Ms. Ter-Minassian said. “For them, keeping low inflation was an important policy objective.”
Mr. Ball says Europe’s monetary-policy conservatism is very much part of the ECB’s current DNA. He recalls presenting some of his results at a conference hosted by the European Central Bank in 2000, just as the euro was kicking off. Speaking on a panel with future ECB President Jean-Claude Trichet, Mr. Ball argued that European monetary officials had made some serious mistakes over the last two decades.
“I was a little worried that someone would call the security guards and they would drag me out of the building,” he says. “What actually happened was, in a sense, worse. If you see a guy on the street corner with a sign saying the world is going to end on Thursday, you just kind of chuckle. He’s harmless. And you move on. That was more or less the reaction.”