Countries with very flexible institutions and labor market policies, like the U.S., experienced substantial increases in unemployment over the course of the Great Recession, while countries with relatively rigid institutions and strict labor market policies, like France, fared better. However, this better short-term performance comes with a tradeoff; evidence suggests that flexible labor markets keep unemployment lower in the long run.Labor market ; Unemployment ; Recessions

Mary Zenker

Murat Tasci

English

Research Papers in Economics

ECONOMIC COMMENTARY
Number 2011-11
June 29, 2011
Labor Market Rigidity, Unemployment, 
and the Great Recession
Murat Tasci and Mary Zenker
Countries with very ﬂ  exible institutions and labor market polices, like the U.S., experienced substantial increases in 
unemployment over the course of the Great Recession, while countries with relatively rigid institutions and strict labor 
market policies, like France, fared better. However, this better short-term performance comes with a tradeoff: Evidence 
suggests that ﬂ  exible labor markets keep unemployment lower in the long run.
  ISSN 0428-1276
The recent recession that hit the global economy resulted 
in substantial contractions in GDP among major industri-
alized countries, but their labor market outcomes varied 
signiﬁ  cantly. For example, the U.S. and France experienced 
similar declines in GDP during the recession. While un-
employment in the U.S. shot up about 5 percentage points 
over that period, France saw an increase of only about 
1.5 percentage points. Looking over the last 25 years, how-
ever, the average unemployment rate is much lower in the 
U.S. than in France (5.9 percent versus 9.6 percent). What 
explains these differences in labor market outcomes?
We argue that some of this divergence is due to differences 
in labor market institutions and the policies that regulate 
labor market interactions. Labor markets with very ﬂ  exible 
institutions and policies, like the U.S., experienced substan-
tial increases in unemployment over the course of the reces-
sion. Meanwhile, countries with relatively rigid institutions 
and strict labor market policies, such as large continental 
European countries, fared better. However, this smoother 
short-term performance comes with a tradeoff; evidence 
suggests that ﬂ  exible labor markets manage to keep unem-
ployment lower in the long run. 
Labor Market Rigidity and Unemployment: Theory
The unemployment rate is the main indicator of the labor 
market’s health, and economic theory provides an intuitive 
framework for understanding the forces that determine its 
level: At any time, there are ﬂ  ows into and out of unem-
ployment, which we call job-ﬁ  nding and -separation rates, 
respectively (for more evidence on how these ﬂ  ow rates 
map into long-run unemployment rates, see Tasci and 
Zaman 2010). By affecting these ﬂ  ow rates, labor-market 
institutions and policies inﬂ  uence both short- and long-term 
unemployment rates. In every labor market, workers and 
ﬁ  rms are regulated by institutions and policies that affect 
these ﬂ  ow rates, such as minimum wages, unemployment 
insurance, severance pay, advance notice, labor taxes, and so 
on. The observed unemployment rate is affected by all the 
incentives and disincentives implied by these arrangements. 
Consider unemployment insurance, which cushions work-
ers against unemployment risk by providing some income if 
they lose their job. On the one hand, this is much-needed ﬁ  -
nancial assistance during a jobless spell. On the other, it may 
also give unemployed workers an incentive to turn down 
job offers that they would otherwise ﬁ  nd acceptable, thereby 
reducing the job-ﬁ  nding rate. As a result, all else equal a 
higher level of unemployment compensation will increase an 
economy’s long-run unemployment rate. 
Similarly, employment-protection measures might provide a 
disincentive to create jobs. For instance, continental Euro-
pean countries have very strict laws against ﬁ  ring employees 
and hiring temporary workers. Conceivably, employers in 
those countries would have less ﬂ  exibility to adjust their 
workforces in the face of a recession. A direct effect might 
be a muted increase in the separation rate. Although this 
might mitigate an increase in the unemployment rate during 
bad times, ﬁ  rms that anticipate the ﬁ  ring restriction might 
hesitate to hire in the ﬁ  rst place, even in good times; this 
behavior would increase unemployment by lowering hiring 
(job-ﬁ  nding) rates. 
Another example—one that gets a lot of attention—is taxation 
of labor income. Some researchers think that by effectively 
reducing the return from market work, labor-income taxes 
distort workers’ behavior. Most continental European coun-
tries also have high labor-income taxes. 
To simplify the discussion going forward, we divide countries, 
somewhat arbitrarily, into two groups according to how rigid 
their labor markets are. We call labor markets that have strict-ployment responses. Although Italy and Greece experi-
enced similar-sized GDP shocks, Italy’s unemployment 
rate ticked up only slightly, whereas Greece’s rose more 
than 5 percentage points. Germany is unusual in that its 
7 percent decline in GDP was accompanied by a decrease 
in its unemployment rate!
It’s impossible to tell from the unemployment rate alone, 
however, what else might be happening in the labor market 
to explain such data. For example, Germany’s unemploy-
ment rate declined, but those who are employed might be 
working less. That response would not be captured explicitly 
in the unemployment rate. In fact, when we look at the rel-
evant data, we see that the length of the average work week 
in Germany actually plummeted throughout the recession.
So far, we have assumed that labor markets respond to ag-
gregate economic activity, with higher unemployment rates 
following contractions in real output. But all economies 
might not respond to aggregate conditions in the same way. 
Since rigid labor markets might have responded differently 
to the contraction in output than more ﬂ  exible labor mar-
kets during the Great Recession, we ﬁ  rst plot the change 
in countries’ unemployment rates and their level of overall 
strictness (using the OECD’s indicator) and see how the 
relationship plays out (ﬁ  gure 2). 
Our sample countries vary widely in the strictness of their 
employment protection, taking values between 0.2 and 
3.4 (the OECD average is 1.9). The United States has the 
lowest employment protection score of the countries in the 
sample. Correspondingly, its unemployment rate response is 
one of the strongest on the chart. The trend line suggests a 
somewhat negative relationship: As employment protection 
increases, the unemployment rate response becomes more 
muted. This relationship is even stronger if we exclude 
Spain, Ireland, Greece, and Portugal, which all had deep ﬁ  s-
cal crises on top of the recession. Nevertheless, this relation-
Figure 1.  Changes in GDP and Unemployment Figure 2.  Employment Protection and 
Unemployment
Notes: GDP is measured from country-speciﬁ  c peak to country-speciﬁ  c trough. 
Unemployment is measured over the same period as GDP.
Sources: International Monetary Fund;Organization for Economic Cooperation 
and Development (OECD).
Note: Unemployment is measured over country-speciﬁ  c GDP peak and trough. 
Employment protection is averaged from 2005 to 2008.
Source: Organization for Economic Cooperation and Development (OECD).
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Percentage point change in unemployment rate
Overall strictness of employment protection
Greece
U.S.
Canada
U.K.
Ireland
Japan
Italy
Spain
All sample countries
Iceland
New Zealand
Excluding Spain, Greece, Portugal, Ireland
Slovenia
Denmark
Germany
France
Portugal
Sweden
Norway
Netherlands
Czech Republic
Hungary
Mexico Belgium
Austria
Finland
er requirements governing employment relationships rigid, 
and labor markets with more lenient requirements ﬂ  exible. 
The Organization for Economic Cooperation and Develop-
ment (OECD) publishes an “Overall Strictness of Employ-
ment Protection” index that allows us to categorize countries 
as rigid or ﬂ  exible. The index provides a measure of the 
general strictness of the labor market in a country with re-
spect to the processes and costs involved when ﬁ  ring workers 
or hiring temporary employees. The U.S. has maintained the 
same index value, 0.21, for the entire period over which the 
index is available. European countries tend to have a much 
higher index value, with 2.5 being the average value over that 
period for the EU-15 countries (15 countries that made up 
the European Union before May 2004). 
Economic theory suggests that rigid labor markets, all else 
equal, will have higher unemployment rates and lower rates 
of churning. However, labor market rigidities might dampen 
the ﬂ  uctuations in the unemployment rate in the short run, 
since workers and ﬁ  rms in rigid markets will have a harder 
time adjusting to rapidly changing economic conditions, es-
pecially around the turning points of the business cycle. We 
will provide some evidence in support of these arguments 
by looking at data from some OECD countries during the 
last recession and over a longer period. 
Labor-Market Rigidity and Unemployment 
during the Great Recession
As we noted above, the recent recession translated into 
exceptionally bad performance in world output. According 
to the International Monetary Fund, after growing at a rate 
of 4.2 percent every year between 2000 and 2007, world 
output rose only 2.8 percent in 2008 and contracted by 
0.5 percent in 2009. This might have been the ﬁ  rst time 
since World War II that the world economy actually shrank. 
Looking at the sample of countries in ﬁ  gure 1, we see that 
similar-sized GDP shocks yielded a wide range of unem-ship ignores the variance in the severity of the recession 
across countries. 
To understand how the severity of the recession inter-
acted with the degree of employment protection, we 
plot the change in the unemployment rate against the 
decline in GDP and calculate a trend line for each of the 
two types of countries, rigid and ﬂ  exible (ﬁ  gure 3). The 
ﬂ  exible countries exhibit labor markets whose responses 
vary with the depth of the GDP decline: The more severe 
contractions are associated with larger increases in the ob-
served unemployment rate. In the rigid countries, when 
GDP reductions increase in severity, the labor market 
does not recalibrate accordingly. 
One should interpret these results cautiously because a 
small sample for a particular episode does not necessar-
ily generalize to other episodes. Nevertheless, this casual 
correlation suggests that, in countries with relatively strict 
employment protection, increasingly large declines in GDP 
fail to yield additional increases in the unemployment rate. 
Labor Market Rigidity and Unemployment: 
Long-Term Evidence
Do we see higher unemployment rates in countries with 
more rigid labor markets over the long run? Coming into 
the 1980 recession, the EU-15 countries actually main-
tained an unemployment rate lower than that of the U.S. 
However, coming out of the recession, unemployment 
in those countries remained elevated, whereas the U.S. 
experienced a cyclical decline and return to trend. 
Since then, EU-15 unemployment has been trending 
around 3 percentage points higher than the U.S. (see 
ﬁ  gure 4). Economists attribute some of this divergence to 
the so-called “skill-biased technical changes” that occurred 
throughout the 1980s, along with labor-market rigidities 
(Blanchard, 2006; Ljungqvist and Sargent, 2008). Skill-
biased technical change is a shift in production technolo-
gy that favors skilled over unskilled labor by increasing its 
relative productivity and, therefore, its relative demand. 
In the face of skill-biased technical change, recently dis-
placed workers face the prospect of large human capital 
losses. Because generous unemployment beneﬁ  ts tend to 
increase the duration of unemployment spells, they may 
exacerbate human capital losses. 
One artifact of a rigid labor market is the prevalence 
of long-term unemployment, which contributes to an 
elevated trend unemployment rate in the long run. The 
U.S. and EU-15 labor markets have drastically different 
shares of long-term unemployed workers (ﬁ  gure 5). The 
share rose steadily throughout the 1970s and 1980s in the 
EU and has remained elevated. While the share has been 
trending up slightly in the U.S., the majority of the unem-
ployed are short term.
For workers, skill-biased technical change might mean 
that the rate of skills depreciation accelerates during 
periods of unemployment, so long-term unemployment is 
particularly damaging. Increasingly, rapid technological 
change is difﬁ  cult for unemployed workers in any type of 
Figure 4.  Unemployment Rate
Figure 5.  Unemployed One Year or More
Figure 3.  Changes in GDP and Unemployment
Note: Shaded bars indicate recessions.
Source: Organization for Economic Cooperation and Development (OECD).
Note: Shaded bars indicate recessions. 
Source: Organization for Economic Cooperation and Development (OECD).
Notes: GDP is measured from country-speciﬁ  c peak to country-speciﬁ  c trough. 
Unemployment is measured over the same period as GDP.
Sources: International Monetary Fund;Organization for Economic Cooperation 
and Development (OECD).
–2
0
2
4
6
8
10
12
0 5 10 15
Percentage point change in unemployment rate
Percent decline in GDP
Rigid countries
Flexible countries
Flexible countries
Spain
Japan
Rigid countries
Ireland
U.S.
Canada
Germany
Italy France
Portugal
Denmark
Hungary New 
Zealand
Austria
Greece
Mexico Finland
Slovenia Belgium
Netherlands
Norway
Czech Republic
Sweden
U.K.
Iceland
0
2
4
6
8
10
12
1970 1976 1982 1988 1994 2000 2006
U.S.
EU-15
Percent of total unemployed
0
10
20
30
40
50
60
1975 1981 1987 1993 1999 2005
EU-15
U.S.Murat Tasci is a research economist at the Federal Reserve Bank of Cleveland, and Mary Zenker is a research analyst at the Bank.The views 
they express here are theirs and not necessarily those of the Federal Reserve Bank of Cleveland, the Board of Governors of the Federal 
Reserve System, or Board staff.
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labor market. Skill-based technical change, combined with a rigid 
labor market, creates a particularly precarious situation for the 
long-term unemployed. For instance, generous unemployment 
beneﬁ  ts might inadvertently enable workers to stay unemployed 
longer than they would otherwise have done. But as these dis-
placed workers stay unemployed longer, they lose more human 
capital and valuable skills because of technical change. This loss 
in turn makes them less desirable to potential employers. 
In the past decade, some EU countries have instituted labor-
market reforms (partly reﬂ  ected in their declining values in the 
employment protection index), which may help to account for 
some of the decline in their unemployment rates. For example, 
Portugal’s initial employment protection rating was 4.15, but it has 
gradually decreased to 3.15. Italy had an initial reading in 1985 of 
3.57, but currently it is 1.89. Finland and Greece also have lower 
employment protection rankings now than they did in the mid-
1980s. At the same time, some countries, like the UK, Ireland, and 
France, increased their protection as measured by the index. 
Conclusion
Movements of workers in and out of jobs, which we call job-
ﬁ  nding and separation ﬂ  ows, determine to some extent the path 
of the unemployment rate in any given economy. By affecting 
these ﬂ  ows over short and long time horizons, institutions play a 
nontrivial role in the labor market. In the short term, rigid labor 
markets may help prevent spikes in the unemployment rate, but 
they tend to keep trend unemployment higher than ﬂ  exible labor 
markets in the long term. Therefore, when examining labor-
market performance, the effect of these institutions on both 
long- and short-term dynamics should be taken into account.
References
“European Unemployment: The Evolution of Facts and Ideas,” 
by Olivier Blanchard. Center for Economic Policy Research, 
Economic Policy, vol. 21, no. 45 (January 2006).
“Two Questions about European Unemployment,” by Lars 
Ljungqvist and Thomas J. Sargent. Econometrica, vol. 76, no. 1 
(January 2008).
“Long-Term Changes in Labor Supply and Taxes: Evidence 
from OECD Countries, 1956–2004,” by Lee E. Ohanian, 
Richard Rogerson, and Andrea Raffo. 2008. Journal of Monetary 
Economics, vol. 55 (2008).
“Unemployment after the Recession: A New Natural Rate?” by 
Murat Tasci and Saeed Zaman. Federal Reserve Bank of Cleve-
land, Economic Commentary, no. 2010-11 (September 2010).

Long-Term Changes in Labor Supply and Taxes: Evidence from OECD Countries, 1956–2004,” by

The Evolution of Facts and Ideas,” by Olivier Blanchard.

Two Questions about European Unemployment,” by Lars Ljungqvist and

Unemployment after the Recession: A New Natural Rate?” by Murat Tasci and Saeed Zaman. Federal Reserve Bank of Cleveland,

Labor market rigidity, unemployment, and the Great Recession

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Labor market rigidity, unemployment, and the Great Recession

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