European versus US Unemployment: Different Responses to Increased Demand for skill?

Abstract

According to Paul Krugman, "the European unemployment problem and the US inequality problem are two sides of the same coin". In other words, both continents have had the same shift in demand towards skill; in the US relative wages have adjusted and in Europe not. The implication of this hypothesis is that in Europe the unemployment rate for the unskilled will have risen but the unemployment rate for the skilled will have fallen. In fact it has risen. To investigate the hypothesis more systematically we develop an internally consistent model which allocates the change in a country's unemployment between that resulting from (a) shifts in relative demand for skill minus shifts in relative supply, (b) shifts in the relative intercepts of skilled and unskilled wage functions, (c) shifts in aggregate wage pressure. We show that the rise in British unemployment relative to the US since the 1970s is almost certainly due to shifts in aggregate wage pressure. Similarly for 5 other European countries the combination of (a) and (b) accounts for none of the increase in unemployment since the 1970s.