an unemployed individual may lose more general skills such as the ability to effectively work in a team. Unemployment also usually implies that an individual is not gaining or developing any new productive skills. Depreciation of human capital however, is not the only mechanism that has been hypothesized. There are alternative possible mechanisms to suggest a link between present and future unemployment. In particular, issues regarding imperfect information about labor productivity (signalling, see Fernández‐Blanco and Preugschat (2011)) and also, reliance by employers on social networks to overcome such imperfections (see Armegnol and Jackson (2004)).

Lastly, as argued by Heckman and Borjas (1980), it is possible that persistent unemployment may be observed even if there is no “true state dependence” or “scarring”. They suggest, for example, that it is possible that there are some individuals that have poor job search skills and that this is constant over time. As a result of these poor job search skills, finding a job takes longer and hence unemployment duration is extended compared to otherwise identical individuals. Hence what appears to be unemployment scarring (unemployment in the present _determining_ future unemployment) is simply the consequence of unobserved heterogeneity. The empirical identification of a relationship between present and future unemployment is necessary but not sufficient to establish the existence of a causal “scarring” effect. Since Heckman and Borjas (1980), the literature has attempted to separate the effects of individual heterogeneity from true state dependence.

As Arulampalam, Booth and Taylor (2000) comment, research on scarring has great policy relevance as government “...policies rest on very different assumptions about the extent to which government intervention can alter the equilibrium or so called natural rate of unemployment. If there is no state dependence in unemployment incidence at the micro level, then short run policies to reduce unemployment (such as job creation schemes and wage subsidies) will have no effect on the equilibrium aggregate unemployment rate.” Conversely, if scarring does indeed exist, this may justify government action to prevent frequent or long spells of unemployment among the earliest entrants to the labor force, in order to bring down the long term structural rate of unemployment. Finally, if scarring relates specifically to human capital depreciation, governments may want to consider policies that may mitigate this, such as through special training or education provision to those searching for work.

Greatest support for the scarring hypothesis is found in the UK. Arulampalam, Booth and Taylor (2000) used data from the British Household Panel Survey BHPS 1991‐1995 to find strong evidence of state dependence. They estimated that roughly 40% of the observed persistence in unemployment probability could be accounted for by state dependence for men over 25 and about 25% for men under 25. In addition to recognizing and addressing the problem of individual heterogeneity (by using panel data and random effects estimation), Arulampalam, Booth and Taylor also highlight the need to deal with the “initial conditions problem” whereby ignoring what happens to individuals upon entry into the labor market 5