The perennial challenge - bring down unemployment and stabilise inflation

This book reproduces a series of articles by Richard Layard and colleagues to give an account of the contribution of one of Britain's leading labour-market economists to one of the key economic policy debates of the 1980s and 1990s.

Few people have made such a consistent and influential contribution over the years as Layard. He helped found the respected Employment Policy Institute and has ensured the Centre for Economic Performance at the London School of Economics remains a major source of innovative academic work on the economy and the labour market. He can claim to be one of the intellectual godfathers of the "welfare to work" strategy that the government is now putting into practice.

The book is divided into two sections. The first looks at why European unemployment failed to fall back after the mid-1970s oil shock, in contrast to the US. The second section sets out proposals for tackling the problem.

The question of why European unemployment today is still high while the US is close to full employment is still at the heart of the economic policy debate. Layard identified as a key factor the long duration of unconditional unemployment benefits in Europe: these reduced the incentive for the unemployed actively to seek work. And there was a failure to give the long-term unemployed a positive alternative.

The policy prescriptions that flow from that analysis rest on a view about the relationship between inflation and unemployment. For many years governments accepted high unemployment as the cost of keeping inflation under control. But for Layard, long-term unemployment serves no economic purpose. If the long term unemployed could not compete for jobs they could have no impact on wage inflation.

In the 1980s, labour-market "rigidities" such as employment protection and social security taxes on employers were also blamed for high unemployment. Layard rejects these views: the effects of employment protection are described as negligible. But he points out, when the 1984 OECD Jobs Study spoke of labour-market rigidities, this for some became synonymous with employment protection legislation. And although the latest OECD thinking confirms his findings, we still find numerous examples of the wrong-headed assertion that better employment rights for UK workers will cause higher unemployment.

The second half of the book turns to what to do about unemployment. Although the analysis of the unemployment problem described above has been seized on by those from the right to justify attacks both on the welfare state and on the unemployed themselves, it is clear this is far from Layard's own position.

His consistent view has been that policies that effectively leave the long-term unemployed excluded from the active labour market should be replaced by more positive policies. This approach owes much more to the interventionist "Swedish" model than the agenda pursued by the British government in the 1980s.

The emphasis on the role of unemployment benefits as the explanation for the divergence in European and US unemployment can be challenged. Moreover,the book could be criticised for giving too little attention to the role of monetary and fiscal policies, particularly after 1990.

It has become part of the conventional wisdom that unemployment cannot be brought down below the so-called Non-Accelerating Inflation Rate of Unemployment (Nairu) by demand expansion alone, otherwise inflation will take off and the fall in unemployment will be reversed. This concept has proved less useful as a guide to practical policy-making. The Nairu cannot be accurately estimated and has shown a tendency to wander around behind the actual unemployment rate, but in a self-fulfilling prophecy governments and financial markets have acted as if the Nairu were precise and fixed in both the short and long run.

This is a key distinction, which Layard himself would probably accept. In the short run - which could be a considerable period of time - it is clear that macro-economic policy can play an important role. The stark contrast between unemployment in the US and Europe since 1992 must in large part reflect the Fed's policy of "giving growth a chance" while many European governments, struggling with the shock of German reunification and the preparation for Economic and Monetary Union (Emu), ran fiscal and monetary policies which kept unemployment high.

But sooner or later the limits of demand expansion must be reached, and further efforts to bring down unemployment through expansion alone will cause inflation to take off. Supply-side policies to reduce the long-run Nairu are a vital part of any government's armoury to sustain low levels of unemployment.

The efficacy of active labour-market programmes in reducing aggregate unemployment has also been criticised. The traditional Swedish labour-market model itself seemed less attractive after the sharp rise in Swedish unemployment in the mid-1990s, both to those who dislike the high degree of government intervention such an approach symbolises and to those who, more pragmatically, think that the programmes do not deliver.

Whatever the misgivings, active labour-market policies, for which Layard has been one of the most consistent advocates, have now become an accepted part of every EU member state's employment action plans. In countries such as the Netherlands and Denmark such policies have been credited with a significant role in reducing unemployment. France has introduced major new programmes, with several shared features with the UK New Deal. And for all the criticisms of the Swedish model, high unemployment in Sweden in the 1990s has shown less persistence than in many other European countries.

One of the most interesting and perceptive articles, however, is one that appeared in 1990 on the issue of economic policy and pay. This argued that the "going rate" generated in Britain's highly uncoordinated labour markets might well be incompatible with price stability. Layard suggested a better result could come from institutional reforms that would provide both an authoritative demonstration of the economic consequences of excessive going rates and bargaining structures that delivered sensible outcomes. These included an independent Council of Economic Advisers, and a lead from the CBI and the TUC (initiated by the government if necessary).

Layard also predicted that under the ERM the choice would be between wage-bargaining reform and high unemployment. Within two years unemployment had doubled to nearly three million.

This debate is still with us. In 1999 an independent Bank of England has an inflation target of 2.5 per cent set by the chancellor. The bank's rule of thumb is that earnings growth cannot exceed 4.5 per cent if the target is to be met. Ministers have persistently called for wage moderation.

Wage bargainers are supposed to take these signals into account in individual negotiations over pay, even though in an uncoordinated labour market there is no rational reason for them to do so.

In the short term the labour market is showing few signs of wage inflation despite significant falls in unemployment. The key question is now whether the existing institutional structure can sustain low unemployment over the medium term, particularly if the UK should decide to enter the Emu. This was one reason why in 1997 the TUC proposed national social partner discussions around these issues.

So far, it has to be said, neither employer organisations nor government have shown much enthusiasm. This is a pity. The best time to pursue institutional reform of this sort is when the economy is doing well and attention can be focused on longer-term structural issues rather than an immediate economic crisis.

The choice that Layard saw in 1990 immediately before ERM entry may not be so stark today, but the underlying challenge to reconcile full employment and stable prices is still there.

John Monks is general secretary, Trades Union Congress.