Hysteresis and the European Unemployment Problem

European unemployment has been steadily increasing for the last fifteen years and is expected to remain very high for many years to come. In this paper, we argue that this fact implies that shocks have much more persistent effects on unemployment than standard theories can possibly explain. We develop a theory that can explain such persistence, and that is based on the distinction between insiders and outsiders in wage bargaining. We argue that if wages are largely set by bargaining between insiders and firms, shocks which affect actual unemployment tend also to affect equilibrium unemployment. We then confront the theory with both the detailed facts of the European situation as well as those of earlier periods of high persistent unemployment, such as the Great Depression in the United States.