Similar durations but lower flows into unemployment gave Europe lower unemployment rates than the United States until the 1970's. But since 1980, higher durations have kept unemployment rates in Europe persistently higher than in the U.S. A general equilibrium search model with human capital explains how these outcomes arise from the way Europe's higher firing costs and more generous unemployment compensation make its unemployment rate respond to a parameter that measures a worker's loss of human capital after an involuntary job loss. An increase in that parameter between the 70s and the 80s made workers face more turbulence in labor market outcomes and allows our model to match features of a number of empirical studies showing that workers experienced more earnings volatility after 1980. Our model also explains why, especially among older workers, hazard rates of gaining employment in Europe fall off sharply with the duration of unemployment, and why displaced workers in Europe experience smaller earnings losses and lower re-employment rates than those in the United States. The effects of layoff costs on unemployment rates depend on the proportions of frictional and structural unemployment and therefore on the generosity of unemployment benefits and the amount of microeconomic turbulence facing workers.
