Unemployment and External and Internal Labor Market Flexibility: A Comparative View of Europe, Japan, and the United States

This paper examines the relationship between unemployment and labor market flexibility. The latter is considered in the broadest sense - as it relates to labor markets at large (external flexibility) and to practices within firms (internal flexibility). The first part of the paper addresses the argument that differences in employment performance among the advanced economies result largely from differences in labor market flexibility. Empirical evidence is considered on nominal and real wage flexibility, labor market institutions, the trade-off between unemployment and inequality (the so-called unified theory), social policy, and Beveridge curves. With the exception of ambiguous evidence on the duration of unemployment insurance benefits, there is little solid evidence that high unemployment results from labor market rigidities. The second part of this paper addresses the argument that Japan's low rate of unemployment results from high internal labor market flexibility. This assertion is suspect, or at least overstated, for several reasons. Japanese firms' reliance on internal flexibility is not an alternative to but rather is complemented by external flexibility. This external flexibility is provided disproportionately by women workers, who serve as a buffer workforce. Rather than being counted as unemployed, Japanese women who lose their jobs tend to leave the labor force altogether. This is manifested in the remarkably high proportions of discouraged workers in Japan, the vast majority of them women. Thus the Japanese unemployment rate as well as unemployment volatility are deceptively low, much more so than for the other advanced economies. Most studies examining wage flexibility in relation to unemployment conclude that wage flexibility is comparatively high in Japan. But studies that examine the relationship between changes in nominal or real wages and output conclude that Japan does not have comparatively high wage flexibility. The point is of relevance not only for the literature on comparative wage flexibility but also for that on labor market institutions and unemployment, in which is is assumed that Japan has comparatively high wage flexibility.