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Federal Reserve Bank of Philadelphia
MARCH • APRIL 1990
Why Are So Many
New Stock Issues
Underpriced?
Saunders
Is There
\
a Natural Rate
of Unemployment?,
William W. Lang
MARCH/APRIL 1990
WHY ARE SO MANY
NEW STOCK ISSUES UNDERPRICED?
Anthony Saunders
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2
According to studies, the prices of new
stock issues are, on average, set below the
prices investors appear willing to pay
when the stocks start trading in the secon
dary market. Financial economists offer
various explanations for this underpricing,
including the “monopoly power" of under
writers, legal penalties for misinforming
in a prospectus, and the costliness of col
lecting information about the issuing firms.
What do these explanations—and the em
pirical evidence— imply for regulation of
commercial and investment banks?
IS THERE A NATURAL RATE
OF UNEMPLOYMENT?
William W. Lang
In the early 1980s, unemployment rates
in Europe and the U.S. reached their high
est levels since the Great Depression. Since
then, U.S. rates have dropped to more
normal levels, but European rates are still
relatively high. Citing the European
experience, some economists are aban
doning the idea that unemployment gravi
tates toward some natural rate. They
advocate a theory of "hysteresis," which
argues that aggregate-demand policies can
raise the unemployment rate permanently.
Will theories of hysteresis replace the
natural rate theory?
FEDERAL RESERVE BANK OF PHILADELPHIA
Why Are So Many
New Stock Issues Underpriced?
Anthony Saunders*
Each year hundreds of small firms approach
the capital market to issue equity for the first
time. These firms are usually growing so fast,
or have so many profitable investment projects
available to them, that traditional sources of
funds (bank loans, retained earnings, and the
owners' own equity) are often insufficient to
finance their expansion.
Because of this need for finance at a crucial
stage in their growth, it is important for these
firms that the prices of their shares reflect the
*Anthony Saunders is a Professor of Finance at New
York University's Stern School of Business. He wrote this
article while he was a Research Adviser to the Federal
Reserve Bank of Philadelphia.
true value of company assets or growth oppor
tunities. In particular, if their shares are sold
too cheaply, these firms will have raised less
capital than was warranted by the intrinsic
values of their assets. In other words, their
shares will have been "underpriced."
Considerable evidence shows that new or
initial public equity offerings (IPOs) are underpriced on average. That is, the prices of firms'
shares offered to the public for the first time
are, on average, set below the prices investors
appear willing to pay when the stocks start
trading in the secondary market. That is, in the
parlance of investment bankers, small firms
appear to leave behind considerable "money
on the table" at the time of a new issue.
3
BUSINESS REVIEW
Why small firms raise fewer funds in the
new-issue process than the market indicates
they should is a crucial public policy issue.
Clearly, some degree of market imperfection
or lack of competition could cause such an
outcome. For example, if, by restricting com
mercial banks' participation in the market, the
Glass-Steagall Act of 1933 has allowed invest
ment bankers to enjoy a type of monopoly
(market) power over new equity-issuing firms,
then this would suffice to explain underpricing.
Alternatively, underpricing may be the pre
mium the issuing firm must pay for having
little information about itself to offer potential
investors. In that case, underpricing would
have little to do with the regulatory structure
of the investment banking industry.
Let's examine the reasons for IPO underpricing and evaluate the degree to which un
derpricing is due to Glass-Steagall restrictions.
What is the evidence on the degree of underpricing of U.S. IPOs? What are the various
explanations for underpricing? And what are
the implications of these explanations, and of
the associated empirical evidence, for com
mercial and investment bank regulation?
EVIDENCE ON UNDERPRICING
In "firm commitment" underwriting ("firm"
in that the investment banker guarantees the
price), an investment banker (and his syndi
cate) will undertake to buy the whole new issue
of a firm at one price (the bid price, or BP) and
seek to resell the issue to outside investors at
another price (the offer price, or OP). In doing
so, the investment banker offers a valuable
risk-management service to the issuing firm by
guaranteeing to purchase 100 percent of the
new issue at the bid price (BP). The return for
the investment banker in bearing underwriting
risk— that is, the risk that investors will de
mand less than 100 percent of the issue when it
is reoffered for sale to the market— is the spread
between the public offer price and the bid price
(OP - BP) plus fees and commissions. (Here,
4
MARCH/APRIL 1990
and throughout this article, the term "inves
tor" refers to those who buy shares through the
investment banker at the offer price.) Thus, the
investment banker's spread plus fees and
commissions may be viewed as the direct cost
of going public.
However, there is also potentially an indirect
cost of going public, measured by the degree to
which the issue is underpriced. For example, if
the BP is $5 per share and the OP is $5.25 per
share, then the underwriter's spread is 25 cents
per share. However, suppose that on the first
day of trading in the secondary market the
share price (P) closes at $7 per share. This
indicates that the share has been underpriced
in the new-issue process and that, potentially,
the firm might have raised as much as $7 per
share had it been priced "correctly." This
implies that the issuing firm has borne an
additional indirect new-issue cost of $1.75 per
share ($7.00 - $5.25), because the investment
banker has set the offer price below the price
the market was willing to pay on the first day of
trading.
Thus, more formally, the "raw" percentage
degree of underpricing (UP) of an IPO can be
defined as:
(1)
UP = [(P - OP) / OP] x 100
where:
OP = offer price of the IPO
P = price observed at the end of
either the first trading day, week,
or month
If UP is positive, the issue has been underpriced; if UP is zero, the issue is accurately
priced; and if UP is negative, it has been over
priced. The expression for UP is also the ex
pression for a percentage rate of return. Thus,
equation (1) can be viewed as the one-day (or
one-week or one-month) initial return on buy
ing an IPO (that is, UP = R, the initial return on
the stock).
FEDERAL RESERVE BANK OF PHILADELPHIA
Why Are So Many New Stock Issues Underpriced?
Returns calculated by equation (1) are deemed
raw returns. However, researchers also com
pute excess (market-adjusted) returns, as well.
The reasons for this are easy to see. Given a lag
between the setting of the offer price and the
beginning of trading on an exchange (any
where from one day to two weeks or more), the
price observed in the market on the first day of
trading may be high (low) relative to the offer
price simply because the stock market as a
whole has risen (fallen) over this period. Thus,
in analyzing underpricing, reseachers need to
control for the performance of the stock market
in general. More specifically:
(2)
Rm = [(^ - 10) / I0] x 100
where:
Rm = return on the market
portfolio
^ = level of the general market
share index at the time of listing
(first day, first week, or first
month)
I0 = level of the market share index
at the time offer is announced
If Rmis positive, the market has been going
up in the time between the setting of the offer
price and the listing of the stock on the stock
exchange. If Rm is negative, the market has
been falling. Excess market or risk-adjusted
initial returns (EX) can therefore be defined as:1
1 For a detailed discussion of excess returns, see Robert
Schweitzer, "How Do Stock Returns React to Special
Events?" this Business Review (July/August 1989) pp. 17-29.
For IPOs, researchers adjust the initial return on the stock by
deducting the return on the market. This is equivalent to
assuming that a new IPO's returns move exactly with the
market's. That is, they have a unit degree of systematic risk
(or their (3 is 1). The reason for this assumption is that since
IPOs have no past history of returns, one cannot estimate
directly the IPO's (3 at the time of issue. The only researcher
Anthony Saunders
(3)
EX = R - Rm
According to equation (3), underpricing oc
curs only when R is greater than Rm.
The findings of 22 studies that examine the
degree of underpricing are summarized in the
table on p. 10. Although the time periods,
sample sizes, and ways of calculating initial
returns (especially raw versus market-adjusted)
differ widely across these studies, each finds
underpricing on average. For example, studies
that use a one-week period to calculate the
difference between the offer price and the market
price of an IPO find underpricing ranging from
5.9 percent to as much as 48.4 percent.2*
Thus, an important empirical fact is that
U.S. IPOs are underpriced on average, result
ing in small firms raising less capital than is
justified by the markets' ex post valuation of
their shares.
WHY ARE NEW ISSUES UNDERPRICED?
Several reasons have been proposed in the
institutional, finance, and economics literature
as to why underpricing occurs. Although this
article will not discuss all the proposed rea
sons, it concentrates on four views that have
received much publicity. The first view attrib
utes underpricing to "monopoly power" en
joyed by investment bankers. The second re
gards Securities and Exchange Commission
regulations as the primary cause. And the
third and fourth see underpricing as a problem
of imperfect information among contracting
parties—especially between investors and is
suers.
who has tried to address this problem was Ibbotson (1975),
who developed an ingenious method of constructing syn
thetic P’s for IPOs.
2 It should be noted that these are one week's returns
and are thus very large. These underpricing "costs" swamp
the direct costs of a new issue, which are, on average, in the
range of 2 to 5 percent of the issue's dollar size.
5
BUSINESS REVIEW
The Monopoly Power of Underwriters. One
possible explanation for pervasive underpricing
is the monopoly power the investment banker
enjoys over the issuer.3 Given that commercial
banks are barred from entering into corporate
equity underwriting (a result of the GlassSteagall Act, which effectively separated com
mercial banking from investment banking),
investment bankers may have a degree of
monopoly power that they use to earn "rents"
by underpricing new issues. Of course, com
petition among investment banks would limit
the extent of this monopoly power.
But how real is this monopoly power?
Compared to U.S. commercial banks, U.S.
noncommercial banking firms and foreign banks
have always faced fewer restrictions on entry
into investment banking. Moreover, thrifts
also can enter investment banking. In recent
years, for example, nonbank firms such as
General Electric and Prudential have entered
the investment banking industry via acquisi
tions, as has Franklin Savings Bank, a thrift.
This potential competition presumably places
a limit on the degree of monopoly power en
joyed by investment bankers.
In addition, foreign banks were not subject
to Glass-Steagall regulations until passage of
the International Banking Act of 1978. Even
then, those already possessing investment
banking powers had them grandfathered. The
emphasis on investment banks is due to their
traditional dominance of the underwriting
market and to their potential economies of
scope (cost savings from offering a combina
tion of services) in extending to their under
writing customers a broader range of financial
services.
If investment bankers have monopoly power
3For a discussion of the reasons for and effects of invest
ment bankers' potential monopoly power, see Ibbotson
(1975) and Pugel and White (1984).
6 FRASER
Digitized for
MARCH/APRIL 1990
over the new issuer, they might use it to in
crease both the spread between the offer price
and bid price (the underwriters' spread) as
well as the degree to which the offer price is set
below the markets' true valuation (P). A
monopolist investment banker might have the
incentive to underprice, since by doing so he
can increase the probability of being able to sell
the whole issue to outside investors (thereby
minimizing his underwriting risk) while earn
ing a high investment banking spread (OP - BP)
on the issue.4
Clearly, if this was the prime reason for
underpricing, it would tend to make a case for
allowing commercial banks into the under
writing business. This argument would be
based on the expectation that pro-competitive
effects would reduce the average degree of
underpricing.5 But this argument would, of
implicitly, this argument presumes that investment
bankers are risk-averse. This is reasonable, given the pri
vate nature of many companies, their limited capital bases,
and the potential for a large loss if they take a "big hit" (loss)
on an underwriting. For example, many U.S. investment
bankers suffered significant losses in underwriting an issue
of British Petroleum shares at the time of the October 1987
stock market crash.
5A different monopoly-based argument, advanced in
Baron (1982), is that investment bankers possess monopoly
power through their private access to information about the
likely size of the demand for a new issue. Since issuers are
viewed as being relatively uninformed about the nature of
this demand, they can easily be exploited by the investment
banker. Indeed, since the issuer has no way of knowing ex
ante the size of investor demand, the underwriter has an
incentive to save resources on distribution and search
("shirking") by simply underpricing enough to ensure that
the whole issue is sold. In this context, the presence of
potential competitors, such as commercial banks, and the
importance of maintaining a reputation might be viewed as
potential controls on the investment bankers' temptation to
shirk. This presumes, however, that commercial banks, if
they entered into underwriting, have the same abilities to
"place" (sell to investors) a new issue as investment bankers
do. In reality, it might take commercial bankers a number of
years to build up the same placement powers.
FEDERAL RESERVE BANK OF PHILADELPHIA
Why Are So Many New Stock Issues Underpriced?
course, be tempered by the need to maintain
safety and soundness of the banking system,
which could be lessened if the spread (P - OP)
is small enough to risk inability to sell the entire
issue.6
Due-Diligence Insurance. A second reason
given for why underwriters underprice IPOs is
the fear of potential legal problems stemming
from overpriced issues. Underwriters, along
with company directors, are required to exer
cise "due diligence" in ensuring the accuracy
of the information contained in the prospectus
they offer to investors.7 Since passage of the
Securities Acts of 1933 and 1934, both under
writers and directors may be held legally re
sponsible under SEC regulations for the accu
racy of this information.
Investors who end up holding heavily over
priced issues may well have an incentive to sue
the underwriter and/or the company directors
for publishing misleading or incomplete infor
mation in the prospectus. The investors could
contend they were misled into believing this
was a "good" issue rather than a "bad" one. To
avoid any negative legal effects, as well as
adverse publicity and damage to reputation, a
risk-averse underwriter may try to keep inves
tors happy by persistently underpricing IPOs.
Hence, some researchers believe that the legal
penalties for due-diligence failures are what
have created incentives for investment bankers
to underprice.
The Problem of the "Winner's Curse." The
academic literature has paid a great deal of
attention to a theory first advanced by Rock
(1986) and extended by Beatty and Ritter (1986)
and McStay (1987), among others. This theory
considers underpricing as a competitive out
6 Since P is not known with certainty, a small spread
(P - OP) risks occasional negative spreads, in which case the
underwriting firm suffers a loss.
7 See, for example, Tinic (1988).
Anthony Saunders
come in an IPO market in which some investors
are viewed as informed while a larger group is
viewed as uninformed. As a result, underpricing is directly related to the degree of infor
mation imperfection—or, more specifically,
information asymmetry—in the capital market
and to the costs of collecting information. Both
this theory and the one that follows view un
derpricing as a way of resolving the problem of
costly information collection.
In Rock's model, there are two types of
IPOs: good issues and bad issues. Informed
investors, defined as those who expend re
sources collecting information on IPOs, will
bid only for those issues that are good. (This
search effort is assumed to allow the informed
investor to assess exactly the true value of the
IPO.) Those investors who are uninformed,
however, will not engage in expensive search,
but rather will bid randomly across all issues,
good and bad. It is further assumed that
informed investors are never sufficiently large
as a group to be able to purchase a whole issue.
First, consider a good issue. In this case,
both informed and uninformed investors will
bid for the issue (the uninformed in a random
manner). Because both groups bid for the
issue, it is likely to be oversubscribed, so that
any single individual bidder (informed or unin
formed) will get fewer shares than he bid for.
Thus, for good issues, uninformed investors
get only partial allotments.
Next, consider bad issues. In this case,
informed investors will not bid at all. The only
bidders will be the uninformed. Moreover,
owing to the absence of competing informed
bidders, any individual bidder will more likely
achieve his full allotment (or a higher probabil
ity of an allotment). That is, the uninformed
bidder suffers from the problem of the "win
ner's curse": he achieves a large allotment for
bad IPOs and a small allotment for good IPOs.
Rock's argument is that, because of the win
ner's curse, IPOs have to be underpriced on
average so as to produce an expected return for
7
BUSINESS REVIEW
the uninformed investor that is high enough to
attract investment in IPOs regardless of whether
the issue is good or bad.8 That is, underpricing
is a phenomenon perfectly consistent with
competitive market conditions in a world of
imperfect information flows. Thus, monopoly
power is rejected as an argument explaining
underpricing.
Underpricing as a Dynamic Strategy. In
the most recent literature, underpricing is seen
as a dynamic strategy employed by issuing
firms to overcome the asymmetry of informa
tion between issuing firms and outside inves
tors.9 Implicitly, underpricing is viewed as a
cost to be borne by the issuing firm's insiders to
persuade investors to collect (or aggregate) in
formation about the firm and in that way estab
lish its true value in the secondary market.
Moreover, the better the firm (a "good" issue),
the more it will be underpriced relative to the
bad issue.
Specifically, a good firm will underprice its
issue to attract outside investors.10 Investors
(such as analysts) collect information about the
firm and, in the secondary market, establish its
true value above its offer price. The owners of
the firm benefit from this strategy because once
the true (higher) market value is established,
the owners have an incentive to "cash in" by
coming out with new (further) secondary of
ferings at the higher market price. Thus, the
cost or losses of underpricing the IPO are offset
MARCH/APRIL 1990
by the benefits from cashing in on the secon
dary offering.11
By comparison, a bad firm—one that knows
it is a bad firm—will have the opposite incen
tives. In particular, the firm may seek to price
the IPO as high as possible, since it knows that
once investors collect information and discover
that it is a "bad" firm, its stock's price will fall
on the secondary market.12*
As in the Rock model, these types of dy
namic-strategy models view underpricing as a
phenomenon that is consistent with competi
tion in a world of imperfect information among
issuing firms and investors. The difference is
that, here, IPO underpricing is viewed as a cost
to be borne by good firms, which is offset by the
revenue benefits from making a secondary
("seasoned") offering later on at a higher price.
IMPLICATIONS FOR BANK REGULATION
What do these models imply for bank regu
lation and, in particular, the Glass-Steagall Act?
If underpricing is indeed due to information
imperfections in the capital market—especially
between firms and investors—it is difficult to
see how commercial banks' entry into under
writing will have much effect, unless these
banks somehow collect more information and
alleviate the degree of information imperfec
tion in the market. Since the modern theory of
banking views banks as major collectors and
users of information, increased production of
information about small firms may indeed be a
benefit from repealing Glass-Steagall.
However, a better test of whether Glass-
8 Technically, the conditional expected return for the un
informed investor, across both good and bad issues, must be
at least as great as the risk-free rate.
9 See, for example, Chemmanur (1989) and Welch (1988).
10 In these models, the investment banker plays a largely
passive function, operating as an agent on behalf of the
principal (the firm). The failure of the investment banker to
take a more active role may be seen as a weakness of these
information-based models.
8
11 Welch (1988) offers preliminary evidence that these
issues that are more underpriced tend to follow up more
quickly with a secondary (seasoned) offering.
12 This is not to imply that the bad firms necessarily over
price. However, the theory has the aggregate implication
that the greater the porportion of good to bad issues in the
market, the greater the degree of underpricing on average.
FEDERAL RESERVE BANK OF PHILADELPHIA
Why Are So Many New Stock Issues Underpriced?
Steagall has undesirable costs is whether it
confers monopoly power on existing invest
ment banks that is reflected in the degree of
underpricing. That is, what, if any, is the
empirical evidence linking underpricing to the
monopoly power of investment banks?
One implication of the monopoly-power hy
pothesis13is that an underwriter, because of his
expertise and more precise knowledge of the
issuing firm's true value, can save effort (shirk)
by ensuring maximum sales through underpricing while still earning a high underwriting
spread (OP - BP). However, even in a world of
asymmetric information, presumably firms
would learn that they are being exploited and,
if competition exists, would switch to other
underwriters. In contrast, monopoly power
would imply that issuing firms would fare as
well with one investment bank as with another
and that underwriters could ignore all prob
lems or considerations related to maintaining a
reputation.
Beatty and Ritter (1986) have sought to test
this reputation-monopoly power effect. That
is, do investment bankers who heavily under
price in one period lose business from issuing
firms in the next? Beatty and Ritter's results
tended to confirm that the more an investment
banker underpriced in one period, the greater
his loss of business in the next—a result sug
gesting that monopoly power is temporary at
best.
A second implication of the monopoly-power
hypothesis is that the investment banker—to
avoid risk—will have a greater incentive to
underprice relatively risky issues so as to en
sure maximum sales. For example, it can be
argued that the more uncertain are firms' uses
of the proceeds of the issue (for example, to pay
Anthony Saunders
off existing debt, to develop new projects, and
so on), the riskier the issue. Or, alternatively,
the more variable the after-market returns on
an issue— measured by the standard deviation
of returns over a period subsequent to listing
on the stock exchange— the riskier the issue.
Thus, we would expect underpricing to in
crease as the number of potential uses of pro
ceeds, and the volatility of its (expected) price
in the after-market, grows.
Beatty and Ritter (1986) found a positive
relationship between number of uses of pro
ceeds and underpricing; Ritter (1984) and Miller
and Reilly (1987) found a positive relationship
between the standard deviation of after-mar
ket returns and the degree of underpricing.
Both these results are consistent with the
monopoly-power hypothesis; however, it must
be noted that both findings are also consistent
with the competitive-market, informationimperfection "winner's curse" theory of Rock
(1986).14
A third potential implication of the monop
oly-power model is that the degree of underpricing should have been less prior to passage
of Glass-Steagall— that is, the pre-1933 average
degree of underpricing should have been less
than the post-1933 average degree. In a recent
study, Tinic (1988) tested the degree of underpricing in the period 1923-30 and compared it
with the period 1966-71. He found that underpricing was higher in the 1966-71 period. While
Tinic interpreted these results as consistent
with the due-diligence-insurance hypothesis—
that is, the passage of the Securities Act of 1934,
which forced investment banks to underprice
to avoid potential lawsuits— they are also con
sistent with the monopoly-power hypothesis.
That is, in a period preceding Glass-Steagall
(when commercial banks had greater power to
13
See Baron (1982), who developed a theory of invest
14
That is, the greater the risk or uncertainty about the
ment banker monopoly power based on the inability of
issue, the greater the cost of becoming informed and thus the
issuers to accurately monitor the investment bankers' effort
greater the degree of underpricing required in equilibrium.
in placing new shares with investors.
9
BUSINESS REVIEW
MARCH/APRIL 1990
underwrite corporate securities),15 the degree than the median or mean underpricing found
of underpricing was less than in a period fol in the majority of studies listed in the table
lowing the Glass-Steagall separation of pow below and that monopoly power may offer a
partial explanation for underpricing.
ers.
A fourth implication of the monopoly-power
Nevertheless, the results favoring monop
hypothesis is that IPOs of investment banks oly power as the major determinant of new(for example, Morgan Stanley going public) issues underpricing appear somewhat weak.
should not be underpriced, since the invest Indeed, the evidence is largely consistent with
ment bank brings its "own firm" public. Look the existence of competitive markets in which
ing at 37 IPOs of investment banks that went investors have incomplete or imperfect inforpublic in the 1970-84
period and partici
pated in the distri
Initial Returns, According to Various Studies
bution of their own
issues, Muscarella
Sample
Sample
Initial Returns
and V etsuypens
Period
Size
1 Week
1 Mo.
Study
(1987) find an aver
age degree of underReilly/Hatfield (1969)
53
9.9%
8.7%
1963-65
pricing of 8 percent
McDonald/Fisher (1972)
1969-70
142
28.5%
34.6%
on the first day of
—
1965-69
41.7%
Logue (1973)
250
trading. At first sight
—
62
9.9%
Reilly
(1973)
1966
this tends to contra
17.1%
19.1%
Neuberger/Hammond (1974)
1965-69
816
dict the monopoly
power hypothesis as
—
1960-71
Ibbotson (1975)
128
11.4%
the sole reason for
Ibbotson/Jaffe (1975)
1960-70
2650
16.8%
—
underpricing; how
10.9%
1972-75
486
11.6%
Reilly (1978)
ever, it could be
102
5.9%
Block/Stanley (1980)
1974-78
3.3%
argued that 8 percent
Neuberger/LaChapelle
(1983)
1975-80
118
27.7%
33.6%
underpricing is less
15This was particu
larly true in 1927-33,
when commercial banks
had the same powers as
investment banks. Since
technology and the struc
ture of the financial serv
ices industry are continu
ously changing, a more
valid test might have
been to compare underpricing in the period im
mediately following pas
sage of the Glass-Steagall
Act.
10
Ibbotson (1982)
1971-81
N /A
Ritter (1984)
1960-82
5162
—
18.8%
2.9%
—
1977-82
1028
26.5%
—
1980-81
325
48.4%
—
Giddy (1985)
1976-83
604
10.2%
John/Saunders (1986)
1976-82
78
—
—
8.5%
Beatty/Ritter (1986)
1981-82
545
14.1%
—
Chalk/Peavy (1986)
1974-82
440
13.8%
—
Ritter (1987)
1977-82
Firm commitment
664
14.8%
—
Best efforts
364
47.8%
—
9.9%
—
—
7.6%
Miller/Reilly (1987)
1982-83
510
Muscarella/Vetsuypens (1987)
1983-87
1184
FEDERAL RESERVE BANK OF PHILADELPHIA
Why Are So Many New Stock Issues Underpriced?
Anthony Saunders
mation about new firms. While new issues did
appear to be less underpriced before GlassSteagall (consistent with the monopoly-power
hypothesis), evidence suggests that those in
vestment banks that excessively underprice
today lose future business from prospective
issuing firms and that investment banks' own
IPOs are also underpriced on average (although
less so than those of other firms).
The gains
from allowing commercial banks to compete
directly with investment banks for corporate
equity underwritings may come less from cre
ating more potential competition than from
collecting, producing, and disseminating more
information about small firms in the new-issue
process. This conclusion suggests that allow
ing banks into investment banking activities
may indeed bring about price changes that
benefit the public; however, those changes may
be smaller and occur for different reasons than
once thought.
REFERENCES
Baron, D.P. "A Model of the Demand for Investment Banking and Advising and Distribution Serv
ices for New Issues," Journal of Finance (1982) pp. 955-77.
Beatty, R., and J. Ritter. "Investment Banking, Reputation, and the Underpricing of Initial Public
Offerings," Journal of Financial Economics (1986) pp. 213-32.
Block, S., and M. Stanley. "The Financial Characteristics and Price Movement Patterns of Companies
Approaching the Unseasoned Securities Market in the Late 1970s," Financial Management (1980)
pp. 30-36.
Chalk, A.J., and J.W. Peavy. "Understanding the Pricing of Initial Public Offerings," Southern
Methodist University Working Paper 86-72 (1986).
Chemmanur, T.J. "The Pricing of Initial Public Offerings: A Dynamic Model With Information
Production," mimeo, New York University (1989).
Giddy, I. "Is Equity Underwriting Risky for Commercial Bank Affiliates?" in I. Walter, ed., Deregulat
ing Wall Street (New York: John Wiley, 1985).
Ibbotson, R.G. "Price Performance of Common Stock New Issues," Journal of Financial Economics 3
(1975) pp. 235-72.
Ibbotson, R.G. "Common Stock New Issues Revisited," Graduate School of Business, University of
Chicago, Working Paper 84 (1982), unpublished.
Ibbotson, R.G., and J.J. Jaffe. " ’Hot Issue' Markets," Journal of Finance 30 (1975) pp. 1027-42.
John, K., and A. Saunders. "The Efficiency of the Market for Initial Public Offerings: U.S. Experience
1976-1983," unpublished (1986).
Logue, D.E. "On the Pricing of Unseasoned New Issues, 1965-1969," Journal of Financial and Quanti
tative Analysis (1973) pp. 91-103.
ll
BUSINESS REVIEW
MARCH/APRIL 1990
McDonald, J.G., and A.K. Fisher. "New-Issue Stock Price Behavior," Journal of Finance (1972)
pp. 97-102.
McStay, K.P. The Efficiency of New Issue Markets, Ph.D. thesis, Department of Economics, U.C.L.A.
(1987).
Miller, R.E., and F.K. Reilly. "An Examination of Mispricing, Returns, and Uncertainty for Initial
Public Offerings," Financial Management (1987) pp. 33-38.
Muscarella, C.J., and M.R. Vetsuypens. "A Simple Test of Baron's Model of IPO Underpricing,"
Southern Methodist University Working Paper 87-14 (1987a).
Muscarella, C.J., and M.R. Vetsuypens. "Initial Public Offerings and Information Asymmetry,"
Edwin L. Cox School of Business, Southern Methodist University, unpublished (1987b).
Neuberger, B.M., and C.T. Hammond. "A Study of Underwriters' Experience With Unseasoned
New Issues," Journal of Financial and Quantitative Analysis (1974) pp. 165-77.
Neuberger, B.M., and C.A. LaChapelle. "Unseasoned New Issue Price Performance on Three Tiers:
1975-1980," Financial Management (1983) pp. 23-28.
Pugel, T.A., and L.J. White. "An Empirical Analysis of Underwriting Spreads on IPO's," Working
Paper 331, Salomon Brothers Center for the Study of Financial Institutions, Graduate School of
Business Administration, New York University (September 1984).
Reilly, R.K., and K. Hatfield. "Investor Experience With New Stock Issues," Financial Analysts Journal
(September/October 1969) pp. 73-80.
Reilly, R.K. "Further Evidence on Short-Run Results for New Issue Investors," Journal of Financial and
Quantitative Analysis (1973) pp. 83-90.
Reilly, R.K. "New Issues Revisited," Financial Management (1978) pp. 28-42.
Ritter, J. "The 'Hot Issue' Market of 1980," Journal of Business 57 (1984) pp. 215-40.
Ritter, J. "The Costs of Going Public," University of Michigan Working Paper 487 (1987a).
Ritter, J. "A Theory of Investment Banking Contract Choice," University of Michigan Working
Paper 488 (1987b).
Rock, K. "Why New Issues Are Underpriced," Journal of Financial Economics 15 (1986) pp. 187-212.
Tinic, S. M. "Anatomy of Initial Public Offers of Common Stock," Journal of Finance 43 (1988)
pp. 789-822.
Welch, I. "Seasoned Offering, Imitation Costs and the Underpricing of Initial Public Offerings,"
University of Chicago Working Paper (1988).
12 FRASER
Digitized for
FEDERAL RESERVE BANK OF PHILADELPHIA
Is There a Natural Rate
of Unemployment?
William W. Lang *
The idea that a nation's unemployment rate
gravitates toward some "natural" rate has been
a mainstream theory in macroeconomics for
the past 20 years. According to this theory, the
natural rate of unemployment is determined
by factors related to the economy's supply
side, such as labor force demographics. Ac
tions that influence aggregate demand, such as
monetary and fiscal policies, can affect how
"■William W. Lang is an Assistant Professor of Economics
at Rutgers University, New Brunswick, NJ. He wrote this
article while he was a Visiting Scholar in the Research
Department of the Federal Reserve Bank of Philadelphia.
much unemployment varies over the business
cycle, but they cannot affect its average level.
The unemployment situation in Europe has
forced economists to reevaluate the natural rate
theory. During the early 1980s, recessions in
Europe and the United States boosted unem
ployment rates to their highest levels since the
Great Depression. Since then, unemployment
has returned to more normal levels in the United
States. But in Europe, unemployment remains
high even now.
Citing the European experience, some econo
mists are advocating that the natural rate the
ory be replaced with a theory of "hysteresis," a
theory that explains how aggregate-demand
13
BUSINESS REVIEW
policies can permanently raise the unemploy
ment rate. Although the debate is still in its
early stages, at issue is the long-run impact of
demand-management policies on unemploy
ment.
MARCH/APRIL 1990
rienced workers find themselves unemployed
when their skills are no longer in demand
because of declining demand for the goods
they once produced or because of changes in
technology. For example, in the United States
the demand for steel workers has been de
pressed since the mid-1970s. Now these struc
turally unemployed workers must either relo
cate or develop new skills in order to find jobs.
According to the natural rate theory, the
average level of both structural and frictional
unemployment is relatively unaffected by
monetary or fiscal policies. Over the long run,
THE NATURAL RATE THEORY
Regardless of how healthy the economy is,
some unemployment is inevitable. Some people
quit their jobs, some workers are fired, and
some industries reduce employment levels while
others increase them. The unemployment that
these shifts create constitutes the nation's natu
ral rate of unemployment.1
Frictional and Structural Un
employment. One component
Unemployment Rates
of the natural rate is "frictional"
in Europe and the U.S.
unemployment, represented by
unemployed workers who are
over the Past Two Decades
temporarily between jobs or
who have just come into the la
After peaking in 1982, U.S. unemployment has returned to
bor force. A worker who quits
more normal levels of between 5 percent and 6 percent— levels
thought to represent the "natural" rate of unemployment. But
his job to find work in another
unemployment in Europe kept rising after 1982 and has re
trade or another industry would
mained high. It's easy to see why many economists have ques
be considered frictionally un
tioned
the natural rate theory, at least for the European econo
employed.
mies.
The other component of the
natural rate is "structural" un
employment. This occurs when
workers do not have the neces
sary skills to meet the current
demands of employers. Often,
young workers lack sufficient
education or training to find
work. Sometimes, even expe
1Edmund Phelps, "Phillips Curves,
Expectations of Inflation and Optimal
Unemployment Over Time," Journal of
Political Economy (August 1967), and
Milton Friedman, "The Role of Mone
tary Policy," American Economic Review
(March 1968), are generally credited
with developing the natural rate theory
of unemployment.
14
FEDERAL RESERVE BANK OF PHILADELPHIA
Is There a Natural Rate of Unemployment?
frictional and structural unemployment is de
termined by supply-side factors: the demo
graphic composition of the labor force, shifts in
employment between industries and regions,
minimum-wage laws, and government bene
fits to the unemployed.
The demographic composition of the labor
force can affect the natural rate of unemploy
ment significantly. For example, workers under
the age of 25 have higher average rates of
unemployment than older workers. This is
because young workers change jobs relatively
frequently in their search for appropriate ca
reer employment. In other words, young
workers have higher rates of frictional unem
ployment because they either quit or are fired
more frequently than older workers.
Rapid shifts in employment across indus
tries also tend to increase the levels of struc
tural and frictional unemployment. When
workers must shift from one industry to an
other, they usually experience a period of
unemployment while searching for new jobs.
Moreover, workers in declining industries may
not have the appropriate skills for the indus
tries that do have job openings. All of this
would lead to higher levels of structural unem
ployment.
Increases in minimum-wage benefits and
in government benefits to the unemployed tend
to increase the level of structural and frictional
unemployment. A higher minimum wage will
increase structural unemployment, since em
ployers are less inclined to hire poorly edu
cated workers with little work experience if
they must be paid a higher wage. Similarly, an
increase in government benefits to the unem
ployed will increase frictional unemployment,
as these higher benefits tend to make unem
ployed workers less willing to accept lowerpaying jobs.
Cyclical Unemployment. According to the
natural rate theory, normal rates of structural
and frictional unemployment are invariant to
demand-management policies, but the cyclical
William W. Lang
component of unemployment is not.2
For example, a contractionary monetary
policy lowers the demand for goods and serv
ices, which tends to reduce inflation. But wage
increases do not slow commensurately. Work
ers' wages are often set a year or so in advance,
many by contract. And rarely are wages in
dexed completely to the inflation rate.3 So
firms, faced with declining demand for their
product and inflexible labor costs, lay off work
ers and cut back on output. Thus, the tighter
monetary policy reduces inflation but raises
unemployment.
According to the natural rate theory, this
trade-off between inflation and unemployment
is short-lived. The economy eventually adjusts
to the lower inflation rate. Workers and firms
write new wage contracts based on the lower
inflation rate, and real wages once again reflect
the fundamental supply and demand condi
tions. Producers find it profitable to rehire
workers and raise output. In the end, the con
tractionary monetary policy permanently low
ers the inflation rate, but unemployment re
turns to its natural rate.
THE NATURAL RATE THEORY
EXPLAINS THE U.S. EXPERIENCE—
BUT NOT EUROPE'S
The natural rate theory associates an eco
nomic downturn with declining inflation and
2A s already discussed, a government's social welfare
policy may have an impact on the levels of structural and
frictional unemployment.
3There are, of course, different versions of the natural
rate theory. Modern Keynesians emphasize the role of rigid
wages and prices in explaining the short-run effects of
monetary policy. The New Classical economists argue that
only the unexpected components of monetary policy affect
unemployment. However, the crucial issue for our discus
sion is that both versions of the natural rate theory have
argued that monetary policy, over the long run, has no effect
on the average unemployment rate.
15
BUSINESS REVIEW
MARCH/APRIL 1990
How Different Are the Inflation-Unemployment Experiences
for the U.S. and Europe?
These graphs show the unemployment rate (horizontal axis) and the inflation rate (vertical axis)
for the United States, France, West Germany, and the United Kingdom over the 1979-88 period. Note
the U.S. economy's proclivity to return to a "natural rate" of unemployment: U.S. unemployment
increased from 1979 to 1982 while inflation had begun to decline in 1980; after inflation had stabilized
by 1983, unemployment reversed direction to settle in 1988 at a rate even lower than 10 years before.
Inflation also plummeted in the three European economies; however, unemployment there has
actually increased in the past decade.
0 _____ I______ I______ I______ I______ I_____ I
4
5
6
7
8
9
10
Unemployment Rate (Percent)
FEDERAL RESERVE BANK OF PHILADELPHIA
William W. Lang
Is There a Natural Rate of Unemployment?
high unemployment in the short run. Over the
longer run, unemployment returns to the natu
ral rate while inflation remains low.
The recent paths of inflation and unemploy
ment in the U.S. fit the natural rate theory.
Between 1979 and 1982, the United States
adopted disinflationary money and credit poli
cies that drove the unemployment rate to nearly
10 percent. But since 1983, inflation has leveled
off and unemployment has fallen even below
its 1979 level. While its precise level is debat
able, the natural rate of U.S. unemployment
seems to be somewhere between 5 percent and
6 percent.
The inflation and unemployment levels for
several European countries tell a dramatically
different story. For example, between 1979
and 1985 the inflation rate in France fell and
unemployment rose. But after 1985, when the
inflation rate stabilized at about 3 percent, the
unemployment rate remained in double digits.
While the French example is the most dra
matic, the unemployment rates for West Ger
many and the United Kingdom seem to have
stabilized at significantly higher levels as well.
HAS EUROPE'S
NATURAL RATE RISEN?
In principle, changes in nor
mal rates of structural or fric
tional unemployment could have
boosted Europe's natural rate
above the U.S. rate. However,
the factors most commonly cited
fail to support this view.
Demographic Changes. One
explanation commonly given for
the notion of a higher natural rate
in Europe is the increase in the
relative shares of women and
youth in the labor force.4 The
4The argument for higher average
rates of unemployment among women
may be losing some of its force, as women
structural and frictional unemployment rates
for both groups are higher than those for male
workers. However, demographic changes alone
do not justify a relative rise in many European
countries' average unemployment rates.
Let's look at the change in the share of young
workers in the U.S., French, German, Italian,
Dutch, and Swedish labor markets between the
1960s and the 1980s (see Figure 1). Of all these
countries, only the U.S. has seen an increase in
that share. The European countries have expe
rienced declining shares.*5
Women's labor force shares increased for all
the countries (see Figure 2). However, there is
no strong correlation between those countries
showing large gains in this share and those
workers are becoming more firmly attached to the labor
force. In fact, in the U.S., the female unemployment rate is
now roughly equivalent to the male unemployment rate.
5This may seem surprising, since European countries
also experienced a baby boom. However, young people in
Europe stay in school longer and thus remain out of the
labor force longer than their U.S. counterparts.
FIGURE 1
Changes in Youths’ Share of Total
Labor Market from the 1960s to the 1980s
Percent
12-,
- 8-1
US
France
Germany
Italy
Netherlands
Sweden
17
BUSINESS REVIEW
MARCH/APRIL 1990
to another increases unemploy
ment, because workers in the
Changes in Women’s Labor Market
declining industries must learn
Share from the 1960s to the 1980s
new skills and search for jobs in
healthier industries.6
Percent
On the surface, this explana
tion seems to fit with the devel
oped nations' rapid shifts in
employment from the manufac
turing sector to the service sec
tor. But several studies have
found that sectoral shifts have
little impact on overall unem
ployment rates.7*
To identify national shifts in
employment, economists often
develop a "mismatch index" for
the country. The index captures
US
France
Germany
Italy
Netherlands
Sweden
the divergences in employment
growth among the industries in
countries with large increases in unemploy the economy. When the index number is low,
ment. Sweden, which has not experienced employment rates in all industries are growing
sustained high unemployment, shows the larg at about the same pace. When the index num
est expansion in the percentage of working ber is high, the industries' employment growth
women. The U.S. is in the middle in terms of rates are diverging significantly—some may
growth in the share of women in the labor force be growing rapidly, some more slowly, and
when compared to France, Germany, Italy, and some not at all.
Having calculated mismatch indexes for
the Netherlands; yet all of those European
countries have experienced greater increases several OECD countries, researcher Robert
Flanagan found that the indexes for France and
in unemployment rates.
West
Germany were lower in the late 1970s
In short, the European countries with large
than
they
had been in the previous 15 years and
increases in average unemployment have not
seen relatively big increases in the shares of
women and young people in their labor forces.
This suggests that demographic shifts are not
inducing a higher natural rate of unemploy
6Probably the most influential paper on this subject is by
ment for these countries.
David Lilien, "Sectoral Shifts and Cyclical Unemploy
Job Shifts Across Industries. Another popu ment," Journal of Political Economy 90 (August 1982) pp. 777lar explanation for why Europe's natural rate 93.
may have risen is that the secular movement of
7See, for example, Richard Jackman, Richard Layard,
employment away from manufacturing and and Christopher Pissarides, "On Vacancies," Discussion
toward services has increased both structural Paper 165, London School of Economics, Centre for Labour
and cyclical unemployment. Even if the aver Economics, 1985; Orley Ashenfelter and David Card," Why
Have Unemployment Rates in Canada and the United
age number of jobs to be filled remains un States Diverged?" Economica 53 (Supplement 1986) pp. 171changed, shifting employment from one sector 96.
Digitized for 18
FRASER
FIGURE 2
FEDERAL RESERVE BANK OF PHILADELPHIA
Is There a Natural Rate of Unemployment?
that they remained low in the 1980s. And
while the index value for the United Kingdom
rose in the early 1980s, the rate of increase only
matched that of the U.S., where unemploy
ment has fallen back to its earlier levels.8 (See
Mismatch Indexes.) So, at least by this measure,
a shifting industrial mix does not seem to have
raised natural rates of unemployment for France,
West Germany, and the United Kingdom re
cently.
Flanagan examined other types of mismatch
indexes, including measures of shifts in labor
market conditions across regions. He con
cluded that any mismatch effect on the relative
rise in European unemployment has been small.
Minimum-Wage Laws and Government Pro
grams. Government programs and minimumwage laws, the last factors cited as possibly
having an effect on the natural rate of unem
ployment, could in principle have generated
increases in Europe's natural rate. There is
little evidence, however, that Europe's minimum-wage laws and government benefits to
the unemployed have been more generous over
the last decade than before. If anything, gov
ernment programs have tended to be more
stringent than in the past.
Government programs may be contributing
to the increase in European unemployment
indirectly. When there are employment de
clines in high-wage industries, workers may be
unwilling to accept low-wage jobs if they are
receiving substantial unemployment benefits
from the government. But it would be difficult
to argue that government benefit programs are
the sole explanation for high European unem
ployment.
8Robert J. Flanagan, “Labor Market Behavior and Euro
pean Economic Growth," in Barriers to European Growth,
Robert Z. Lawrence and Charles L. Schultze, eds. (Washing
ton, D.C.: Brookings Institution, 1987) pp. 175-211.
William W. Lang
Mismatch Indexes
Divergences in Employment Growth
Among Industries,
1960 -1983
Years
1960-64
1965-69
1970-74
1976-79
1980-83
France
2.3
2.8
2.8
2.0
1.7
West
Germany
U.K.
U.S.
2.6
3.2
3.2
1.9
1.8
1.9
2.2
2.5
1.4
3.4
2.4
2.1
2.3
1.5
2.9
Based on data in Robert J. Flanagan, "Labor
Market Behavior and European Growth," in
Barriers to European Growth, Robert Z. Law
rence and Charles L. Schultze, eds. (Brookings
Institution: Washington, D.C., 1987) p. 181.
Data for 1975 were not available.
THEORIES OF HYSTERESIS: THE IMPACT
OF AGGREGATE-DEMAND POLICIES
The prolonged slump in Europe has helped
revive the notion that aggregate-demand pol
icy can have long-run impacts on the level of
unemployment.9 The term "hysteresis" has
been used to describe theories in which tempo
rary shifts in aggregate demand cause perma
nent or long-term changes in unemployment.
If there is a natural rate of unemployment,
9Unemployment, Hysteresis and the Natural Rate Hypothe
sis, Rod Cross, ed. (Basil Blackwell Ltd., 1988), presents
various papers on this subject by European and American
authors. In "On the History of Hysteresis," Rod Cross and
Andrew Allan note that the term "hysteresis" comes from
the Greek word meaning "to come after" or "to be behind."
It was originally used by physical scientists to describe the
tendency for a previous state or condition to persist. Econo
mists apply the term to theories that attempt to explain why
high unemployment in one period tends to produce high
unemployment in subsequent periods.
19
BUSINESS REVIEW
then a recession causes only temporary changes
in unemployment. The unemployment rate
returns to the natural rate during the subse
quent economic expansion. If there is hyster
esis in the unemployment rate, the unemploy
ment rate remains permanently higher. That
is, there is no inherent tendency for the unem
ployment rate to fall back to its pre-recession
level.10
Wage Rigidities. Almost all theories of
hysteresis in unemployment have in common
the notion that real wages are not fully flexible,
even in the long term. For one reason or
another, real wages remain high even when
there are large numbers of unemployed work
ers willing to work for less.
Recent discussions of hysteresis have fo
cused on microeconomic rationales for wage
rigidity. In particular, theorists are exploring
the idea that employed workers have the power
to prevent wage cuts and thus introduce the
rigidities that cause hysteresis in unemploy
ment.
Insider/Outsider Models. In insider/out
sider models, employed workers, called "in
siders," are able to maintain wages at high
levels even though unemployed workers, or
"outsiders," are willing to work for lower wages.
Insiders can prevent firms from hiring the lowwage workers by making it more costly for
firms to fire employees and hire others in their
place.
To some extent, every firm that hires new
workers incurs some cost in training them.
Insiders can raise the costs by refusing to par
ticipate fully in the training process. And they
can punish firms that hire outsiders at low
wages in other ways. They can take some overt
action to disrupt production, such as staging a
strike or a slowdown. Or they may simply put
10Of course, an expansionary economic policy or other
positive economic events may push the unemployment rate
below its pre-recession level.
MARCH/APRIL 1990
less effort into their jobs.11 Forming a labor
union can enhance insiders' power to act col
lectively, but insiders can punish the firm even
without a union.
The key insight of the insider/outsider models
is that once workers become unemployed, they
lose their status as insiders. The now-smaller
group of insiders is unwilling to reduce wages
in order to get the unemployed rehired, be
cause these former employees no longer exer
cise any influence in the group. In other words,
the more exclusive the group, the less willing
the group will be to make wage concessions to
increase employment.
The Permanent Impact of Aggregate De
mand. To explain permanent shifts in the
unemployment rate, theories of hysteresis add
to the insider/outsider model the notion that
aggregate-demand swings can cause persis
tent productivity shifts.
Suppose a monetary contraction slows the
economy and induces firms to lay off workers.
According to the insider/outsider model, the
remaining insiders will keep real wages from
falling, despite the slack in the labor market.
But if the economic contraction somehow re
duces labor's productivity, then firms will not
rehire laid-off workers unless real wages de
cline. So the combination of rigid wages and
lower productivity keeps unemployment from
returning to its old level. Now the question is,
how does the economic contraction perma
nently lower productivity?
n For a fuller treatment of the insider/outsider model,
see Assar Lindback and Dennis Snower, "Wage Setting, Un
employment and Insider-Outsider Relations," American
Economic Review 72 (1986). Note that the ability of insiders
to punish firms for hiring low-wage workers would not
affect new entrants into an industry. Such insider power
will play a significant role only when there are fixed costs or
other barriers to start-up firms in an industry. It is worth
noting that much of the increase in U.S. employment over
the past decade is due to small firms, many of them start-up
firms. This may help explain why insiders in the U.S. have
been less effective in exerting pressure to maintain high real
wages.
FEDERAL RESERVE BANK OF PHILADELPHIA
Is There a Natural Rate of Unemployment?
Theorists offer two explanations. First, a
contractionary monetary policy raises interest
rates and lowers spending on capital goods.
The reduction in capital formation, in turn,
lowers workers' productivity.
Without a
commensurate fall in real wages, firms have
less incentive to hire workers—and so unem
ployment is permanently higher.
What is the evidence for this source of hys
teresis? While member nations of the Euro
pean Economic Community have seen sub
stantial increases in their unemployment rates,
the ratio of capital to employed worker has
remained roughly constant. This has led some
to argue that the existing capital stock is inade
quate to employ the current available labor
force in the EEC countries.
The second possible explanation for hyster
esis focuses on the long-term impact of unem
ployment itself. When an economic contrac
tion throws people out of work, long layoffs
may erode their job skills. Without a decline in
real wages, these less skilled workers will find
firms unwilling to rehire them. Thus, what
could have been a temporary increase in unem
ployment is perpetuated by the wage rigidity.
The argument that prolonged unemploy
ment will erode job skills is difficult to quan
tify. Direct measures of labor productivity
reflect the productivity of workers who are
employed, not those who are unemployed.
One piece of supporting evidence for this
hypothesis is that a large part of the increase in
unemployment is due to an increase in the
number of long-term unemployed.
In short, theories of hysteresis propose that
Europe's high unemployment is due to wage
rigidity, insufficient capital formation, and
deteriorating job skills.
HYSTERESIS LEAVES
SOME QUESTIONS UNANSWERED
While theories of hysteresis seem consistent
with some aspects of the European experience,
some difficult issues must still be addressed
William W. Lang
before these theories gain wide acceptance.
First, the data indicate that the persistence of
unemployment has increased over the past 20
years both in Europe and in the United States.
Since the current theories of hysteresis rely on
various forms of wage rigidity, we would expect
those rigidities to have increased as well. But
there is little evidence that union or insider
power has increased over this period. In fact,
labor union power has generally waned over
the past two decades in Europe and the United
States.
Perhaps the more important question is why
the natural rate theory seems to fit the United
States but not Europe. The microeconomics of
labor markets in the U.S. show some important
differences compared to European labor mar
kets. For example, the U.S. has fewer union
members as a percentage of the labor force. In
addition, social welfare programs in the United
States are, on the whole, less generous than in
Europe. Both of these factors tend to reduce
real wage rigidity in the United States. So
perhaps the labor market in the U.S. more
closely approximates the type of labor market
envisioned by the natural rate theory.
Alternatively, hysteresis may characterize
labor markets in both the U.S. and Europe, and
their experiences may differ only because of
different macroeconomic policies. According
to this interpretation, after the 1982 recession
the United States decided to reduce unemploy
ment at the risk of higher inflation by engaging
in a more stimulative macroeconomic policy
than Europe.
The U.S. has yet to experience a sharp accel
eration in inflation. Perhaps this is because the
recessions of 1980 and 1982 have given the
Federal Reserve credibility as an inflationfighter—and this is keeping the lid on inflation
expectations. Oil prices have helped as well.
Their sharp increases of the 1970s were largely
reversed in the 1980s.
Separating the contributions of macroeco
nomic demand-side policy from microeconomic
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supply-side conditions is crucial to U.S. poli
cymakers. If it is the microeconomics of the
labor market that differentiate the U.S. from
Europe— that is, if the U.S. has a natural rate of
unemployment but Europe does not—then U.S.
policymakers face no trade-off between infla
tion and unemployment in the long run. If it is
macroeconomics that separate the two—in other
words, if both the U.S. and Europe are subject
to hysteresis— then U.S. inflation policies have
a lasting impact on unemployment.
CONCLUSION
Stubbornly high unemployment rates in
Europe are beginning to undermine econo
mists' confidence in the natural rate theory.
The theory says that only supply-side factors,
such as demographics and technology, have
MARCH/APRIL 1990
any persistent impact on a nation's unemploy
ment rate.
There is little evidence, however, that ad
verse supply-side shifts have hit Europe in
recent years. Now some economists are break
ing away from the natural rate idea and are
exploring the possibility that aggregate de
mand shifts—including changes in monetary
and fiscal policy—can have persistent effects
on the level of unemployment.
According to these theories of hysteresis,
Europe's high unemployment is the legacy of
policymakers' anti-inflation programs of the
early 1980s. If these theories are correct, then
policymakers' decisions have much more of a
long-run impact on the unemployment rate
than economists had realized up until now.
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