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Eurozone : From austerity to structural reforms
Structural Reforms and the Euro
Why Should the Euro Matter?
The adoption of the euro and the implementation of structural reforms in the labor and product markets seem at first glance to be two largely unrelated events.
However, the euro has always been portrayed as the final stage of a process of economic integration among the country members of the European Union that involved more trade, more labor, and capital mobility: in a word, fewer restrictions on the mobility of goods, services, and people.
To achieve this goal, the introduction of the ESM in 1992 established a legal framework to increase trade and competition in the European Union and allowed the European Commission to rule against state aid or against monopolistic practices to all EU members. Thus, it seems quite plausible that the ESM would have had an effect on product and labor market reform.
But the subsequent adoption of the euro did not have direct legal effects on competition policies. Did it have economic implications on them?
Several commentators have discussed various reasons why the adoption of the euro may facilitate, or on the contrary, create obstacles to the adoption of structural reforms.
On the pro-reform side, one may argue that entrance into the EMU acts as an external constraint that pushes countries to reform. By relinquishing the control of the monetary policy to an external authority (the ECB), member countries become unable to use their monetary policy to accommodate negative shocks. This might have created incentives to liberalize the labor and product market in order to rely more heavily on market- based adjustments that take place through changes in prices and wages (Bean 1998; Duval and Elmeskov 2005).
A single currency may also increase price transparency and therefore facilitate trade. A larger European market increases competition and makes it more difficult for domestic monopolists to protect their rents. It is certainly true that Europe does not have a truly common market in every sector, especially in the service sector, where domestic protection, direct or indirect, is still widespread. Yet, the degree of competition and integration in the European product market has largely increased in the last two decades.
To the extent that a larger common market makes it more difficult for local monopolists to dominate local markets, this might have created pressures to deregulate product markets. Yet, is this the result of the euro increasing the trading opportunities across member countries, or is it simply the impact of the ESM? In the empirical analysis, we try to disentangle these two effects.
The question of whether a monetary union is necessary for a common market and whether it reduces trade barriers across countries and facilitates commerce in goods, services, and financial assets has received much attention following a provocative paper by Rose (2000). This paper found that monetary unions have an extremely large effect on trade amongst members.
Critics argued (amongst other things) that most monetary unions in Rose’s sample involved very small countries and that the effects would have been much smaller in the euro area.6 According to them, the adoption of the euro appears to have facilitated trade among member countries, even though the order of magnitude of this effect is on a different scale relative to Rose (2000) and seems more realistic. Research applied to Canada and the United States showed that trade between Canadian provinces, even ones that were thousands of miles apart, was easier than trade between United States and bordering Canadian provinces, suggesting that a single currency matters for trade.7
Note that these pro-reform arguments based on the role of trade imply that most action should take place in the tradable sector, where competition becomes stronger, rather than in the non-tradable service sector. But firms in the tradable sector may react to an increase in competition by translating this pressure upstream onto the intermediate goods producers-and hence only on the service sector-and onto the labor market (Nicoletti and Scarpetta 2005). The economic literature also provides some arguments suggesting that the euro may hinder structural reforms. Saint- Paul and Bentolila (2000) argue that under the EMS, the up-front cost of structural reforms may increase.
Some labor market reforms may have positive long-term effects but entail a negative short-term impact in terms of higher unemployment. For this reason, several commentators have favored a two- handed approach: structural reform on the supply side, accompanied by expansionary aggregate demand policies. Under the euro, this two- handed policy may be more difficult, because aggregate demand is more constrained at the national level, and monetary policy is in the hands of the ECB. A similar argument may apply to pension reforms. They may provide long-term savings for the social security funds but may also imply short-term budget deficits, which may violate the limits imposed by the Stability and Growth Pact.
Obstfeld (1997), in his early and wide- ranging review of the pros and cons of the euro, emphasized that the euro would eliminate a major channel of adjustment to macroeconomic shocks-namely, a nominal devaluation of the exchange rate-to regain competitiveness by reducing real wages for given (rigid) nominal wages. He suggested that this might put pressure on the unions to be more flexible about allowing adjustments to nominal and real wages and argued that this was a necessary condition for the euro to
survive. The pessimists argued that unions would not be so flexible in Europe and that on the contrary, they would fuel political momentum against the euro project, leading to its collapse.
Reality turned out to be more creative than economists’ predictions. There have certainly been complaints and political rumblings against the euro, mainly in countries that felt they were especially in need of devaluation, but the euro has not collapsed and does not seem even close to doing so. Sure enough, the political battle with the unions for labor market reforms in many countries is still in place, and the next few years may be critical.
Because in many European countries the labor unions have effectively become unions of old workers, public employees, and pensioners (in Italy, for instance, the majority of union members are retired), it should not come as a surprise that they tolerated or even endorsed the introduction of temporary job contracts, in which young, entry- level workers would be hired without much or any protection at low wages and could be fired at will by the employers. In exchange, they kept a very high degree of protection for older workers in the traditional labor markets. Spain, Italy, and France are prime examples.8 In Italy, around a third of the newly created jobs are temporary contracts, and in Spain, the percentage reaches 50 percent. In theshort run, this has worked in terms of increasing employment. In the last ten years in Europe, about 18 million jobs have been created-just as many as in the United States. But in the medium run, lacking further reforms, this situation may become explosive, because such a two- tier market might be unsustainable.
One may argue that as these temporary workers became a large minority of the workforce, they will put pressure on the workers in the traditional sector to abandon some of their privileges, creating a momentum in favor of deregulation of the entire labor market.9 However, there is another possibility. These temporary workers may demand to enter the traditional labor market, with all its implied protection and rules against firing. If all these workers are simply shifted into the traditionally rigid labor market of union-protected elderly workers, Europe will move back ten years. In summary, labor markets in several European countries are then in a precarious position: half- baked reforms have created a two-tier labor market that is economically inefficient and politically unsustainable.
Finally, this discussion relates to issues of sequencing of reform; that is, is it more politically feasible to move first with product market deregulation or with labor market deregulation? Blanchard and Giavazzi (2003) argued that European countries should first deregulate the product market, claiming that this would make labor market reforms easier. The reasoning is that product market regulation creates rents, which are enjoyed both by incumbent firms and by labor unions. Unions would strenuously oppose labor market reforms that reduce their rents. Product market reforms would curtail rents, reducing the benefits for the unions from the status quo in the labor market and thus reducing their opposition to labor market reforms.
The argument is compelling European countries have indeed moved faster on product market liberalizations than on labor market ones. There is, however, one important caveat. Deregulation of product markets sometimes implies closures or reductions in size of incumbent firms in favor of new entrants, and more generally, reallocation of labor force from firm to firm and sector to sector. This process of “creative destruction” generates temporary unemployment. In countries in which firing is costly, if not virtually impossible, this process is difficult. In this respect, the elimination or reduction of firing costs is then a prerequisite in order for product market liberalization to work. The elimination of firing costs requires some well-designed system of unemployment compensation, but not all European countries have this-a case in point being Italy. Inefficiencies in the system of unemployment compensation give the unions ammunition to defend existing jobs and oppose restructuring. So in this respect, a labor market reform that reduces firing costs and introduces unemployment compensation systems seems like a prerequisite for a well-functioning product market deregulation. Denmark is an example of a country in which labor market reforms have moved exactly in this direction.10
5. For instance, Austria is classifi ed under a de facto fixed-exchange regime with the deutschemark, even before the EMU.
6. Alesina and Barro (2002); Alesina, Barro, and Tenreyro (2002); Persson (2001); Thom and Walsh (2002); and Tenreyro (2007) address theoretically and empirically a host of issues relating the effect of monetary unions on trade.
7. See, for instance, McCallum (1995).
8. See Saint- Paul (1996, 2000) for an early discussion of reforms that avoid touching the interests on incumbent workers and focus only on new entrants and also for a comparison of French and Spanish early reform attempts.
9. See Saint- Paul (1999) for a formalization of this argument.
10. See, for instance, Alesina and Giavazzi (2006) for some discussion of the Danish case and the applicability to other European countries.
