European Monetary Union: A Trojan Horse to Liberalize Labour Markets

Many commentators conclude that real rigidities in European labour markets threaten the success of EMU. Yet forecasts of the future success of European monetary union based solely on the past characteristics of the countries of Euroland are misplaced: the Lucas Critique demonstrates that major shifts in policy regime can fundamentally alter the structure of economic relationships. So how will the introduction of the euro affect European labour markets? This was the question posed by Michael Burda at a lunchtime meeting held in London on 26 January 2000.

The conventional wisdom used to be that the US is characterized by nominal price rigidities but flexible real wages, whereas the nations of Europe have real wage rigidities but flexible prices. The standard assumption being that the large role of centralized collective bargaining, the use of indexation and a high degree of openness all make Europe more likely than the US to translate aggregate demand disturbances into inflation. But according to Burda, this situation is about to change. He believed that the introduction of the single currency would result in a decrease in real rigidities in the labour market and an increase in nominal rigidities in the goods market. In effect, Euroland will begin to look more like the US and Japan and less like France and Germany.

Burda began by noting that many commentators argue that inflexibility in the labour market will spell the death of EMU. Yet these arguments become less relevant if labour market rigidities are endogenous. So could the lack of labour market flexibility in continental Europe be affected by the introduction of a common currency? According to Burda, the major assault on real wage rigidities will be the weakening of union power in wage determination. Although unions are already in retreat in much of the OECD, in Europe this decline is largely restricted to the UK; membership losses in France and Italy belie an ever-stronger influence on central wage setting institutions, while membership in Germany has declined primarily only in the East.

The Marshall-Hicks rule of labour demand suggests that market integration will tend to increase the elasticity of the demand for labour at any given level (local, regional or national). In the context of EMU, three of the four elements of the Marshall-Hicks rule will be operative. First, product market competition among companies operating with quasi-rents will increase dramatically; this translates into an increase in the elasticity of product demand and subsequently into an increase in the elasticity of labour demand. Second, the acceleration of intra-European corporate mergers and takeovers opens up the possibility of easy substitution of capital and cheaper labour for more expensive labour within the Euroland area, which in turn weakens the bargaining strength of national unions. Third, for any given national labour market, the rest of Euroland is large (and possibly getting larger) and subsequently the supply elasticities of competing factors are likely to be high. Hence, the integration of product and factor markets, driven by EMU, means that unions' ability to monopolize the supply of labour will be severely weakened by the increase in the demand elasticity that they face.

Of course, unions could significantly mitigate the effects of this process if they were able to 'pan-Europeanize' their collective bargaining structures. However, Burda believed that the potential for coordinated bargaining strategies is presently incompatible with union structures across countries: already fragmented along industrial, political or religious lines, union structures represent decades of gradual evolution and, at present, there is little evidence of an effective pan-European labour movement. National unions that insist on aggressive wage settlements will be faced with higher unemployment. Only if the social safety net accommodates higher unemployment will unions be able to ignore these factors, and given the hard budget constraint of monetary union, they may well find this increasingly difficult to achieve. So increasing capital mobility, trade integration and competition will force wages for a given quality of labour to converge (i.e. the factor price equalization theorem) as well as to react more flexibly to changing local real conditions. This suggests that EMU will affect labour market flexibility in the direction of more efficiency, but without more detailed information on preferences it is impossible to say whether this increase in efficiency will lead to overall welfare gains.

Burda believed that EMU would not only affect the functioning of labour markets but that it would also have a profound impact on the monetary transmission mechanism. He highlighted three reasons why nominal price rigidities would increase in Euroland. First, the introduction of a common currency will effectively convert a Europe of many small, open economies into one large economy, roughly as closed as Japan and the US. As a consequence, a large share of industry will be moved into the 'home goods' sector and will therefore no longer be exposed to nominal exchange rate and international demand fluctuations. In a small, open economy, exchange rate changes are rapidly reflected in both input and output prices; monetary union removes this aspect as inputs become increasingly non-traded goods invoiced in euros. Thus, cost pressure will increasingly be restricted to domestic (Euroland) labour markets, marginalizing the importance of exchange rate changes for pricing decisions.

The second reason is more subtle (and possibly less relevant). For producers, EMU implies both a decrease in the relevance of the external market and an increase in the relevance of the domestic market, with subsequently more pricing power on balance – i.e. the market using euros increases relative to that using foreign currencies. Increased exposure to the sheltered domestic market will mean greater incentives to set nominal prices in advance for longer periods, as customer relations become more important and the net benefits of charging stable nominal prices increases. In addition, local market power will increase further as the pace of mergers and acquisitions within Euroland accelerates, again raising monopolistic power in price setting.

The third and potentially most important effect derives from the perceived ability of the ECB to base its decisions on the euro zone as a whole, not on economic conditions in individual countries. If the ECB really is the most independent central bank in the world then agents will expect low inflation and will not attribute short-term fluctuations in inflation to policy changes. This important source of inertia should be distinguished from the usual wage-price mechanism; it is derived from the anchoring of inflationary expectations and the effect this has in raising the willingness of agents to negotiate contracts in nominal terms.

Hence, Burda concluded, future aggregate demand shocks, both internal and external, will have less of an impact on prices and show up more strongly in output variations: the European short-run aggregate supply curve will be flatter post-EMU. This will fundamentally change the macroeconomics of Europe as monetary policy gains a new potency. But the effectiveness of monetary policy is largely dependent on it not being used in a predictable way to inflate the economy. Therefore, these arguments should not be construed as endorsing a domestic demand strategy, but rather as a warning that the temptation to employ such a strategy will increase in future years.