This paper examines the impact of structural reforms on labor-market outcomes. However, whether structural reforms take place or not and their timing depend on economic and political factors and interactions between such factors. Macroeconomic conditions themselves might determine structural reforms. For example, poor macroeconomic performance and conditions (that would include high unemployment rates or alternatively high inflation rates) might lead governments to seek technical help from multilateral institutions, including the International Monetary Fund (IMF). Such technical assistance often comes with the conditionality of deep economic reforms, especially structural reforms.

A set of instruments to tackle this endogeneity is identified using economic intuition based on existing models. A valid instrument is one that is correlated with the endogenous explanatory variable but orthogonal to the error term. While no instrument can be perfect, and finding valid instruments is arguably made more difficult by the country-level analysis, we make use of the best available, namely the external debt-to-GDP ratio, lagged reforms, terms of trade, and democratization. For example, micro-level studies that regress individual wages on industry-level variables to measure the impact of outsourcing argue that the empirical specification is less prone to endogeneity bias, since the industry’s outsourcing intensity may be largely considered exogenous to the individual worker (Geishecker and Görg 2005, Munch and Skaksen 2009). We now present the economic arguments behind the use of these instrumental variables, and why we expect that they satisfy each of their two requirements. Econometric tests of the validity of these instruments are discussed below in the results section. While there is the possibility that the instruments are still invalid even if we fail to reject the null hypothesis of these tests, these tests inform that any endogeneity problem is not severe enough to distort our estimates.

**External debt-to-GDP ratio:** The external debt-to-GDP ratio can be a good instrument for reforms in our regressions because, while it triggers reforms, it does not, by itself, affect unemployment. It is government spending (and the budget deficit) that is related to unemployment and other labormarket outcomes. In certain cases, high levels of government spending lead to high aggregate economic activity and economic growth and a low unemployment rate. However, this high level of spending is possible through big budget deficits. Over time, national debt keeps building and at a certain point in time the size of the debt can become risky, making an economy susceptible to a debt crisis when capital markets stop providing roll-over financing. Such a debt crisis can lead the government to seek financial assistance from the IMF, which comes attached with the strong conditionality of reforms. Reforms that were not politically viable earlier become politically viable in times of crises. Below we present different models showing that the country’s debt can be an important variable determining the likelihood and timing of reforms. Note that while the budget deficit and government spending are flow variables, a country’s overall and external debt are stock variables. In other words, the deficit can be high but the debt need not be high unless the high deficit is run for many years. The current deficit is a small part of the debt and due to the volatile nature of the deficit its correlation with the debt is likely to be small. Measuring this relationship using a sample of over 90 countries over all available years suggests that the correlation between a country’s external debt-to-GDP ratio and deficit-to-GDP ratio is low, measuring only 0.35. If we recognize that it is the flow variable (deficit) that determines unemployment and not the stock variable (debt), then we can understand why a variable like the debt-to-GDP ratio can be a good instrument for reforms as it would be orthogonal to the error in our labor-market regression models.

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