Labor Market Rigidity and Business Cycle Volatility

Comparing labor markets of the United States and Germany over the period 1980 − 2004 uncovers three stylized differences: (1) transition rates from unemployment to employment (UE) were lower by a factor of 5 and inflow rates from employment to unemployment (EU) were lower by a factor of 4 in Germany. (2) The volatility of the UE rate was equal but the EU rate was 2.3 times more volatile in Germany. (3) In Germany EU flows contributed 60 − 70% to the unemployment volatility while in the U.S. they contributed only 30−40%. We show that these differences can be largely explained by a single factor, namely a lower efficiency in matching unemployed workers to open positions in Germany. Alternative explanations like employment protection, the benefit system, union power, or rigid earnings are likely not the main driving force for the cross-country difference. The lower matching efficiency leads to a substantial propagation of shocks. After an adverse shock peak unemployment is reached after 3 quarters in the United States but only after 9 quarters in Germany.