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FRBSF

WEEKLY LETTER

May 31,1985

Real Wages and Unemployment
Economic activity in the United States has been on
the upswi ng for well over two years. The economics of nearly all other industrialized countries
are also advancing, although generally not quite
as quickly as the American economy. In the
decade prior to the current recovery, which began
in 1982, the economies of the United States and
Europe grew atsimilar rates. Despite this similarity
in output growth, employment growth has been
strong here but nonexistent in Europe.
Output and unemployment
The current expansion in the United States is leading the world recovery. Total output of goods and
services in this country was about ten percent
higher last year than in 1982, while the annual
unemployment rate dropped from its postwar high
of 9.7 percentto 7.5 percent over the same period.
In the ten years since 1974, the U.S. economy
generated 18 million new jobs. In the last two
years alone, five and a half million people were
added to payrolls.

Europe has fared less well. Since 1982, production
in France, West Germany, Italy, and the United
Kingdom together (hereafter referred to as
"Europe") has so far advanced at less than halfthe
rate of the American economy. Moreover, European employment remains virtually unchanged
from what it was ten years ago despite the mi II ions
of new entrants into its labor force. Even the
current recovery has not prevented European
employment from declining. These European
countries as a group now have an unemployment
rate ofeleven percent and double-digit unemployment for at least the next year seems likely.
Chart 1 plots the annual unemployment rates, for
the U.S. and for Europe (including Belgium and
the Netherlands). Measuring rates on a standardized basis makes across-country comparisons
more useful. These rates have been adjusted to
allow for differences in the way unemployment
rates are calculated in different countries. The
unemployment rate in the United States fell as we
recovered from the 1973-1975 recession, rose as
the economy contracted sharply in the early
1980s, and again retreated appreciably as the current recovery continued. The European experi-

ence has been markedly different. There, the
unemployment rate rose in the wake ofthe fi rst oil
price shock in the mid-1970s, much as itdid in the
United States. But then, unlike in the United
States, it continued to rise through the rest of the
1970s even though overall European economic
activity grew at only a slightly slower pace than
economic activity grew here. As a result, when
Europe's rate of unemployment rose after the
second oil price shock, it was starting from an
already high plateau by historical standards offive
and one half percent. By 1982, the European (i:lte
had risen to nine percent and the modest recovery
of output since has not been enough to keep the
rate from continuing to climb.
The burden of this unemployment is not spread
evenly across countries or across groups within
countries. In the United Kingdom and the Low
Countries, the rate is 13 percent or more. In the
Scandinavian countries, it is less than half that.
France, Germany, and Italy currently have rates in
the 8-10 percent range. As is typical in industrial~
ized countries, unemployment is particularly high
among young people. In 1984, the youth unemployment rate in the U.S. was about 13 percent. By
contrast, the youth unemployment rate in the
United Kingdom, France, and Italy ranged from 20
to 35 percent.
Different equilibrium unemployment rates
These levels of unemployment in Europe are even
more startling when we consider Europe's past
unemployment experience. A country's unemployment rate at any time consists of the sum of its
equilibrium unemployment rate and the deviation
from that rate. The equilibrium rate is that observed when an economy is subject to neither
excess aggregate supply nor excess aggregate
demand. That equilibrium rate will be influenced
by demographic shifts, government policies toward unemployment, the fluidity of labor markets,
and other developments. Differences in these
factors account for the variation in equilibrium
unemployment rates across countries.

Historically, Europe has had much lower unemployment rates than the
because of its lower
equilibrium unemployment rate. Among Euro-

u.s.

FRBSF
pean countries, there are significant differences as
well. Suppose we take the average unemployment
rate from 1968 to 1973 in each country as a rough
measure of its equilibrium unemployment rate.
For the United States, this rate was 4.6 percent. In
Italy, it was 5.7 percent. France and the U.K. had
rates of 2.5 and 3.5 percent, while West Germany
had an average unemployment rate of 1 percent.
The weighted average rate for these countries
(plus Belgium and the Netherlands) was 3 percent.
Thus, at least until the early 1970s, we would
expect (and did observe) European unemployment rates to be significantly lower than American
rates on average. This means that the current
unemployment rate abroad is about 8 percentage
points above the normal rate.
Estimates of the current equilibrium unemployment rate for the United States hover around 6
percent. Thus the actual unemployment rate in the
U.S. has been moving closer to its equilibrium
level. If the U.S. unemployment rate were as much
above its equilibrium level as Europe's rate is now,
we would have a total unemployment rate of
about 14 percent -h igher than any other rate
recorded since World War II.
Wages and unemployment
What accounts for this continual rise in European
unemployment rates relative to American rates?
Growth rates of total output here and abroad have
been too similar to be the cause. One argument is
that the increasing share of output devoted to
(labor intensive) services is responsible for the
relatively rapid growth in American employment.
In the decade prior to 1982, the output of the
private service sector (e.g., wholesale and retail
trade, finance, transportation) grew rapidly-at
approximately three times the rate of manufacturing. As a result, the ratio of private service employment to manufacturing employment grew by
about one-quarter. Virtually the same sectoral
shift happened in Europe. However, the shift in
Europe occurred in a dramatically different way.
In the U.s., the number of service jobs increased
sharply while manufacturing employment held
steady. In Europe, by contrast, service employment rose about 10 percent while manufacturing
employment decl ined by about the same
percentage.
One notable area where the American and European econom ies do differ is in the behavior ofthei r

real, or inflation-adjusted wages. European real
wages have risen relatively since World War II.
The recovery of the European economies after
World War II presumably accounts for faster real
wage growth for much of this period. However,
with much of the adjustment completed by the
early 1970s and with similar growth rates of the
capital stock and similar demographic developments in later years, real wages would be expected to grow at similar rates here and abroad. In fact,
as Chart 2 shows, European real wages have continued to rise more rapidly than real wages in the
United States. This differential existed in both
manufacturing and in services. Over the most
recent decade, the effect of the differential shown
in Chart 2 was to raise European real wages by
one-third relative to U.S. real wages.
This sizable advance in real wages may have been
a powerful restraining force on European employment growth. Even though at first glance Europe
has achieved impressive labor productivity
growth, it has not been great enough to keep up
with real wage growth. Presumably much of this
productivity increase reflects the response of European business to rising real wage costs. Since they
apparently have had little success in reducing real
wages through wage bargaining, it would be
natu ral for them to try to raise the average productivity of their workers in other ways. Two routes
have been taken. The first has been to eliminate
the least productive plants, jobs, and employees,
thereby raising the average productivity of those
remaining. The second has been to direct new
investment in plant and equipment toward laborsaving processes.
Though both strategies lead to lower employment
in the short run, they may have very different
longer run implications. If real wages were to
decline in the future, many of the plants and employees id led by the fi rst strategy cou Id be recalled
into service. By contrast, once labor-saving capital
is installed,even rather large real wage declines
are unlikely to appreciably raise the number of
workers employed in plants constructed or remodeled underthesecond strategy. This long-run,
"capital deepening" effect is likely to become
more serious the longer real wages remain too
high, for as time passes firms can continue to
invest in labor saving machinery both to add to
their existing capital and to replace worn-out
capital.

Causes and cures
One explanation for high real wages in Europe is
that nominal wages there have tended to rise commensurately with prices, regardless of the source
of the rise in prices. In contrast, wages in the
United States tend to respond relatively slowly to
increases in prices. This relative sluggishness of
American wages, which is so often cited as an
impediment to disinflationary demand policies,
proved to be beneficial in the wake of the aggregate supply shocks of the 1970s. The fact that
wages here rose little in response to the surge of
the general price level. after the dramatic oi I price
increases in the middle and late 1970s generated
exactly the type of real wage reduction needed to
moderate unemployment. The effective indexing
inflation of European wages, by contrast, precludes precisely the type of real wage ad justment
that "supply shocks," such as sudden energy price
or productivity changes, call for.
We might still expect that after a decade of everrising unemployment, the European real wage
would have begun dropping, thereby resuscitating

Percent

12

Chart 1
Unemployment Here and Abroad
1970 - 1984, Annually

employment. It hasn't. And unemployment conti nues to rise. Th is suggests that neither employees
nor employers regard the large pool of unemployed labor as an effective alternative source of
labor. Public policies toward labor markets may
have contributed to such a perception. Increased
restrictions on employee dismissal, for example,
may have discouraged employment of labor and
encouraged more capital-intensive production
processes.
To date, there is not a consensus as to how much
labor market policies and other factors have contributed to the increase in European unemployment. Two things seem clear however. First, ten
years of very high European unemployment have
neither eliminated nor illuminated the cause of
that unemployment. And second, and perhaps
more importantly, business, labor, and government policies pursued over the past decade also
seem unlikely to cure Europe's unemployment
problem.

James A. Wilcox

Percent

8

10

6

8

Chart 2
Real Wage Growth Here and Abroad
1974 - 1984, Annually

4

6

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1970

1972

1974

1976

1978

1980

1982

1984

1972

1974

1976

1978

1980

1982

1984

1986

Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of San
Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Gregory Tong) or to the author .... Free copies of Federal Reserve publications
can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702, San Francisco
94120. Phone (415) 974-2246.

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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar amounts in millions)

Selected Assets and liabilities
Large Commercial Banks
Loans, Leases and Investments1 2
Loans and Leases1 6
Commercial and Industrial
Real estate
Loans to Individuals
Leases
U.S. Treasury and Agency Securities 2
Other Securities 2
Total Deposits
Demand Deposits
Demand Deposits Adjusted 3
Other Transaction Balances 4
Total Non-Transaction Balances 6
Money Market Deposit
Accounts-Total
Time Deposits in Amounts of
$100,000 or more
Other Liabilities for Borrowed MoneyS

Two Week Averages
of Daily Figures

Amount
Outstanding

05/15/85
191,397
172,887
52,186
62,963
33,967
5,377
11,562
6,948
195,920
47,370
29,895
13,228
135,323

Change from 05/16/84
Dollar
Percent?

Change
from

05/08/85
1,132
753
117
100
43
2
376
3
2,460
2,551
366
- 147
58
243

43,280
38,230
23,165

11,263
12,049
2,862
2,815
6,128
374
447
338
7,967
1,963
567
1,093
4,911

-

-

229
1,779

Period ended

780
4,454

Period ended

05/06/85

04/22/85

1

2

3
4

S
6

?

6
49
42

-

3,943

Reserve Position, All Reporting Banks
Excess Reserves (+ )/Deficiency (-)
Borrowings
Net free reserves (+ )/Net borrowed (-)

-

88
24
64

Includes loss reserves, unearned income, excludes interbank loans
Excludes trading account securities
Excludes U.s. government and depository institution deposits and cash items
ATS, NOW, Super NOW and savings accounts with telephone transfers
Includes borrowing via FRB, TI&L notes, Fed Funds, RPs and other sources
Includes items not shown separately
Annualized percent change

6.2
7.4
5.8
4.6
22.0
7.4
3.7
4.6
4.2
4.3
1.9
9.0
3.7
10.0

-

1.9
23.8