Since the first debates on the European Economic and Monetary Union decades ago, the major challenge for the countries involved has been to adjust to asymmetric shocks without a flexible nominal exchange rate (Gros 2010). In the early debate it was stressed that the Eurozone scores less well compared with other monetary unions, notably the US, in terms of wage and price flexibility. This matters. The Optimal Currency Area theory teaches us that in the presence of asymmetric shocks, the slow reaction of wages and prices would not permit the necessary adjustment in competitiveness necessary to bring back actual output to potential.
In the first decade of the euro, intra-area adjustment did not pose dramatic challenges as depicted by euro-pessimists at the onset of the common currency. This was to a large extent because in the past the biggest idiosyncratic shocks that hit Eurozone countries were the positive start-up shocks. Risk premia fell and drove absorption booms and current-account imbalances in peripheral countries like Spain and Greece. The boom in these countries implied rising wages and prices and progressive competitiveness losses, and the operation of the Eurozone adjustment mechanisms took place together with rising incomes.
Looking forward, the situation looks quite the opposite for the Eurozone periphery. As a result of the global recession of 2008, the economies of the Eurozone are largely out of synch because the financial market crisis had very different effects from one country to the other. Risk premia has risen especially in the countries where the banking sector has been most damaged (e.g. Ireland) and in the countries that had been borrowing most in the past decade (e.g. Spain and Greece). Hence, the countries that received a boost by Eurozone entry are now suffering major recessions. The operation of the competitiveness channel in these countries will imply subdued inflation and stagnating or falling wages – a bitter medicine to recover price competitiveness and kick start growth again. In the absence of substantial productivity gains, the alternative to nominal flexibility is depressed economic activity and widespread and protracted unemployment, an even costlier route.
Further tests for the Eurozone
The Eurozone adjustment channel will receive a major test in the years to come. Resilient labour and product markets will be key to ensure that the adjustment is efficient and sustainable socially and politically. The necessity to put in place policies to correct harmful imbalances and favour adjustment in Eurozone countries is underscored in a legislative package recently proposed by the European Commission and the work carried out by the EU Council Task Force on economic governance, chaired by Herman Van Rompuy. Promoting adjustment-friendly structural reforms is also among the objectives contained in the Europe 2020 strategy launched last March by the European Commission, and EU Member States will submit their National Reform Programmes by April 2011, which will be assessed by the Commission, the EU Council, and the European Council (draft programmes will be submitted in the course of November 2010).
Labour market reforms will feature strongly, together with reforms ensuring the flexibility of product prices and the mobility of production factors, among those that can contribute to making the Eurozone adjustment channel more effective. But, how to indentify and prioritise the concrete reform measures that may help in this respect? Recent research of ours (Biroli et al. 2010), along the lines of previous attempts to measure the behaviour of inflation differences in the Eurozone (Honohan and Lane, 2003; Arpaia and Pichelmann, 2007), may provide some indications.
Measuring the effectiveness of the adjustment mechanism
How to measure whether Eurozone countries adjust as expected following idiosyncratic shocks? As a rule, inflation is expected to fall with respect to the rest of the area in countries hit by asymmetric shocks that reduce economic activity with respect to potential, while those facing shocks raising output above potential are expected to exhibit higher inflation. These dynamics in relative inflation coincide with movements in price competitiveness that help absorbing asymmetric shocks. Countries hit by negative shocks will see their competitiveness improving and will benefit from a stabilising boost in net exports, while the opposite will happen for countries hit by a positive shock.
To test whether the above mechanism is at work in Eurozone countries we regress inflation differentials on cyclical divergence (i.e. relative output gaps) in a panel data set for Eurozone countries. As additional controls, we include the lagged inflation differential as an inertia component (inflation is a persistent variable) and the lagged relative price level (capturing the fact that higher inflation is expected if the price level is below that in partner countries). Moreover, for the years before the monetary union, the percentage change in the nominal exchange rate is also used as an explanatory variable, as exchange rate depreciations tend to raise inflation above that in partner countries.
We find that price competitiveness reacts in a significant way to relative output gaps, with each additional percentage point of output gap being associated with between 0.2 and 0.4 percentage points of additional inflation compared with the other countries in the Eurozone (see our underlying paper Biroli et al 2010 for more details). This reaction has somehow strengthened over time, as revealed by the regressions only considering years after 1998. Moreover, price competitiveness became not only more reactive to asymmetric shocks but also less persistent, as indicated by the fall in the coefficient of lagged relative inflation.
The main message is that, while the process of monetary unification implied the loss of the nominal exchange rate as an adjustment tool, inflation differentials have adjusted faster after the creation of the euro and displayed somehow stronger instantaneous reaction to shocks. Reforms reducing nominal rigidities carried out in the past decades in several Eurozone countries can be among the possible explanations for this evidence.
Can reforms play a role?
With a view to assessing the role of the functioning of product and labour markets on the reaction of price competitiveness, we measure the impact of various types of labour market regulations and institutions on the response of inflation differences to cyclical divergences and on the competitiveness inertia. Our results suggest that there are product and labour market institutions that may actually matter. Product market regulations, employment protection legislation and minimum wages appear to play a role, unlike unemployment benefits.
Our result is in line with expectations. It has been shown empirically that firms tend to reset more frequently their prices in markets more open to competition (see e.g. Fabiani et al. 2006) so that less rigid regulations are expected to be associated with lower nominal rigidity.
Stringent employment protection legislation appears to reduce the responsiveness of relative inflation to cyclical divergence and raise its persistence. This result is consistent with existing theoretical and empirical work showing that strict legislation, by raising the bargaining power of protected workers ("the insiders"), may hamper the adjustment of wages (e.g. Holden 2004; Holden and Wulfsberg 2005).
High minimum wages also appear to reduce the reaction of competitiveness to cyclical divergences and increase its persistence of inflation differentials, which is what can be expected when high minimum wages are coupled with indexation clauses that produce a link between minimum wages and past inflation.
Although assessing empirically the effects of regulations and institutions involves considerable difficulties and results need to be interpreted carefully, strengthened analytical efforts in this area could help identify reform priorities to improve the adjustment capacity of Eurozone economies.
Arpaia, A, and L Pichelmann (2007), “Nominal and real wage flexibility in EMU”, European Economy Economic Papers, No. 281.
Bassanini, A, and R Duval (2006), "Employment Patterns in OECD Countries: Reassessing the Role of Policies and Institutions", OECD Economics Department Working Papers 486, OECD Economics Department.
Biroli, P, G Mourre and A Turrini (2010), "Adjustment in the Euro Area and Regulation of Product and Labour Markets: An Empirical Assessment", CEPR Discussion Papers 8010
Conway, P, and G Nicoletti (2006), "Product Market Regulation in the Non-Manufacturing Sectors of OECD Countries: Measurement and Highlights", OECD Economics Department Working Papers 530, OECD Economics Department.
Fabiani, S, M Druant, I Hernando, C Kwapil, B Landau, C Loupias, F Martins, T Matha, R Sabbatini, H Stahl, and A Stockman (2006), "The Pricing Behaviour of Firms in the Euro Area: New Survey Evidence", International Journal of Central Banking, vol. 2(3).
Gros, Daniel (2010), “The long shadow of the fall of the wall”, in Richard Baldwin and Daniel Gros (eds.), Completing the Eurozone rescue: What more needs to be done?, A VoxEU.org Publication, 17 June.
Holden, S (2004), "The Costs of Price Stability: Downward Nominal Rigidity in Europe", Economica, 71.
Holden, S, and F Wulfsberg (2005), "Downward Nominal Rigidity in the OECD", Department of Oslo Working Paper No. 10/2005.
Honohan, P, and P Lane (2003), "Inflation Divergence", Economic Policy, October, 357-394