Increasing Earnings Inequality and Unemployment in Developed Countries: Markets,Institutions,and the “Unified Theory”

It is widely accepted that global forces of technology and trade have caused a profound shift in labor demand toward the most highly skilled, generating sharply rising earnings inequality in flexible labor markets (United States) and persistently high unemployment in rigid labor markets (Europe). This article critically assesses the evidence for this “Unified Theory.” It finds little compelling empirical support for either the skill-biased demand-shift explanation for high U.S. earnings inequality or the rigid labor markets explanation for high unemployment in Europe. This assessment challenges the policy orthodoxy of the 1990s that developed economies feature a strict inequality-unemployment trade-off and that policy options are therefore limited to skills enhancement in the United States and labor market deregulation in Europe. It is suggested that the theoretical dominance of the textbook supply/demand model has contributed to the neglect of labor market institutions for U.S. wage outcomes and tight macroeconomic policy for European unemployment.