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The labor market as an adjustment mechanism in

the European Economic and Monetary Union

Faculty of Economics and Business (FEB), University of Amsterdam (UvA)

Student: Patrick Dongelmans Supervisor: Ieva Rozentale BSc in Economics and Finance Student Number: 10216049

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Contents

1.1 Background ... 3

1.2 Aim and objectives of the thesis ... 3

1.3 Outline ... 4

2.1 Choice of method ... 5

2.2 Quality assessment ... 5

3.1 Symmetric and asymmetric shocks ... 7

3.2 Adjustment mechanisms ... 8

3.2.1 Price and wage flexibility ... 8

3.2.2 Labor mobility ... 8

3.2.3 Financial integration ... 9

3.2.4 Fiscal transfers ... 9

3.3 Other OCA properties ... 9

3.5 Criticism on the OCA... 10

3.6 Endogeneity ... 10

4.1 Price and wage flexibility ... 12

4.2 Labor mobility ... 12

4.3 Financial integration ... 13

4.4 Fiscal transfers ... 13

4.5 Economic openness ... 14

4.6 Endogeneity of the OCA ... 14

4.6.1 Wage and labor market flexibility ... 14

4.6.2 Economic similarity ... 18

4.7 Concluding remarks ... 19

5.1 Why is the labor market so important? ... 20

5.2 The labor market ... 20

5.2.1 Wage flexibility ... 21

5.2.2 Labor mobility ... 22

6.1 Labor mobility ... 25

6.2 Wage flexibility ... 25

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1. Introduction

1.1 Background

The European Economic and Monetary Union (further in the text as EMU) has faced major challenges in the last years. After the burden of the financial crisis, a second major shock occurred in the Euro zone from late 2009. The European sovereign debt crisis made it difficult for some countries to repay their government debt and several bailouts were necessary. In 1992 the members of the EMU signed the Maastricht Treaty in which they implemented convergence criteria, which required EU countries to satisfy several requirements before they are able to join the EMU. They agreed that the budget deficit may not be higher than 3 percent of GDP and the country must have a public debt that is below 60 percent of GDP. In 1997 the Stability and Growth Pact (SGP) was added to maintain the stability of the EMU and put penalties on countries that fail to keep their public deficit and debt at the required level. At the end of 2009, some EU members were not able to stay into the boundaries of the SGP and the Maastricht Treaty. In early 2010 the leading European nations implemented the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) to give financial support to countries in trouble. The crisis had severe economic effects with extremely high

unemployment rates. After these events, speculation has risen concerning the potential break-up of the EMU, but also about the deepening of integration to avoid such a crisis in the future. For instance, the President of the Deutsche Bundesbank proposed a fiscal and political union, but there are many opponents to this solution. All in all, after the recent crisis skepticism about the functioning of the EMU has increased. The question is asked if the benefits of the euro exceed the costs, and the debate is ongoing.

After the establishment of the EMU, a lot of research is done about the functioning of the currency area, and there is no unambiguous answer if it will ever function as an Optimum Currency Area (further in the text as OCA). In 1961 the Canadian professor Robert Mundell proposed his theory about OCA and tried to find a solution under what circumstances currency areas can survive.

According to the theory there can be different adjustment mechanisms to restore equilibrium in a currency area after a shock occurred. I will give a detailed explanation of the OCA theory in the next section, but in short there are two mechanisms to restore equilibrium: insurance schemes and the labor market.

1.2 Aim and objectives of the thesis

With this thesis I examine whether the labor market of the EMU can function as an automatic stabilizer in the theory of the OCA. I derive my general conclusion by answering the following questions: to what extend is the EMU an OCA now and what changes does the labor market of the EMU has to go through to come closer to optimality. The focus of this paper is limited to the

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economic characteristics of the Euro zone, I do not delve into political factors that are of influence to the EMU. The objective of the thesis is to study the theory of the OCA and apply the properties of this theory to the EMU, with special focus on the labor market. This way you get a greater understanding about the functioning of the EMU, and what the costs are of forming a currency union. I chose the labor market because it is very important in the OCA theory. For instance, in the U.S. the labor market is one principal element, which sustains economic balance within the U.S. currency area. Moreover, two-third of the European Union’s (EU) GDP is labor income (Sylvia, 2004), which means it is a very important adjustment mechanism. Greater understanding of the structure of the European labor market is important to understand the connection between the labor market and the functioning of the EMU as an OCA.

1.3 Outline

Chapter two consists of a description of my research method and methodology. In chapter three I give a detailed description about the theory of the OCA and the contributions done to extend this theory. The fourth chapter consists of an analysis to what extend the EMU currently is an OCA and how the labor market developed after the establishment of the EMU. In chapter five there is an extensive analysis of the European labor market. The previous two chapters lay the foundation to chapter six, where I investigate to what extend the labor market can change to satisfy the requirements of the OCA, which changes the EMU has to go through to make the labor market a good automatic stabilizer and if this is feasible in the future. In the last chapter I provide a brief summary, answer my research question and give a suggestion for further research.

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2. Methodology

2.1 Choice of method

To draw a conclusion and answer my research question I will use a literature based study using descriptive analyses of secondary data within the framework of the OCA theory about what determines an optimal currency area. The case I will investigate is the EMU. The literature used comes from different sources, reports from the European Commission, but also articles from independent academic studies.

I base my theoretical framework on the original OCA theory of Mundell, alongside the most important contributions made by other economists. Due to the extensiveness of the theory, the many contributions and the different views, it will be too much to review all of the OCA theory in my thesis. For this reason only the most general and most widely accepted contributions and properties to the OCA theory will be discussed, with special focus on the labor market and any contribution, which I think is relevant for my research.

To answer the question whether the EMU is an OCA at this point in time, the properties of the OCA theory are applied to the EMU based on an analysis of the different reports and academic articles.

For the evaluation of the labor market in the EMU an analysis is made between the U.S. and Europe. This comparison is derived from the similarities between the two areas: they are both developed monetary unions and the two largest currency areas in the world. Empirical studies and reports of the European Commission on the EMU are analyzed to evaluate the labor market. Special focus of this analysis lays on the wage flexibility and labor mobility as these are important properties according to the OCA theory and a good understanding of the problems with the labor market in the EMU is needed to derive a conclusion about what has to change to come closer to an OCA.

To analyze what kind of changes the labor market of the EMU needs to come closer to an OCA, I use the evaluation of the labor market and different academic articles that that have suggested solutions for the EMU.

2.2 Quality assessment

The theoretical framework of the OCA does not require exact figures so any time sensitive figures and sources I use do not risk being out of date and still contribute to my general research. However, most of the used reports, which evaluate the EMU, are from the period before the sovereign debt crisis that hit Europe hard. The crisis was such a big economic shock that might change my conclusions. The effects of the crisis are not clear, but they might have changed the degree of optimality in the EMU. This is not taken into complete consideration in my research. Further, not every article includes all the current EMU members, I do not consider this a big problem because the

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latest members (Slovenia in 2007, Cyprus and Malta in 2008, Slovakia in 2009, Estonia in 2011 and Latvia in 2014), account for a small percentage of total GDP in the EMU, so their influence is limited on the total area even though they are even less similar than the earlier EMU members.

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3. The theory of OCA

In 1961 Robert Mundell proposed his theory about the OCA. At that time parts of the world were undergoing processes of economic integration, like Europe, or disintegration, new experiments were being made with flexible and pegged currencies. Mundell wanted to give a conception of what constitutes an optimum currency area and clarify the reasons and meaning of these experiments. He concluded that each nation should have labor and capital mobility to perform the stabilization function necessary to restore equilibrium after a shock. After that many contributions to the original OCA theory were done, for example by McKinnon (1963) who stated that the degree of economic openness is also an important feature for an OCA. Kenen (1969) emphasized the importance of a diversified economy, which reduces the stabilization costs because a country is less vulnerable to sector specific shocks. These contributions highlight a wide range of properties for areas to become an OCA.

Mongelli (2002) defines an optimal currency area as the optimal geographic domain of a single currency, or of several currencies, whose exchange rates are irrevocably pegged against each other and these currencies may be unified. The OCA properties define the optimality of the area, these include labor mobility and mobility of other factors of production, price and wage flexibility,

economic openness, diversification in production and consumption, similarity in inflation rates and fiscal and political integration. If the countries share all these properties they have a higher degree of economic similarity and it would be optimal to peg exchange rate and create a currency area

(Mongelli, 2002).

3.1 Symmetric and asymmetric shocks

Forming an OCA has benefits like the loss of exchange rate risk and the loss of currency conversion costs. These two factors tend to interrupt trade and investment as exchange rate risk is a cost-equivalent for a risk-averse investor; an investor will carry an explicit cost to avoid this risk. Eliminating this risk lowers the costs of trade and investment, and tends to stimulate import and export, but also removes speculative capital flows within the area. Moreover, a common currency enhances the role of money as a unit of account because transaction costs, which include costs of information, calculation and uncertainty, decline (Tavlas, 1993).

Forming a monetary union also comes at a cost, the loss of independent monetary policy, which means that countries cannot choose its desired mix of inflation and unemployment itself, but also the exchange rate tool. Union members are no longer able to influence the exchange rate of their currency or set their own short-term interest rate to influence the money supply in their country. How costly the loss of these instruments is depends on the domestic circumstances.

Mundell (1961) first stated that a currency area is an OCA if there are no asymmetric shocks. Sylvia (2004) defines an asymmetric shock as follows: ‘’An asymmetric shock occurs when one region

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in a currency area experiences a significantly different economic development than the others.’’ Such a country-specific shock probably has a small effect on the union as a whole so the common central bank cannot do anything to mitigate the effect the shock has on that single country. The fact that the central bank cannot use monetary policy to reverse the negative effect of the shock means the problem has to be mitigated by the country itself. This could cause a problem as a country cannot adjust its exchange rate anymore, and the cost of losing monetary anatomy could be very high if asymmetric shocks occur frequently and are large. If there are no asymmetric shocks but only common or symmetric shocks in a currency area, monetary policy is similar for each country to reverse the negative effects of the shock, which means that the central bank can use their monetary instruments. If this is the case countries should leave their national currencies and create a monetary union (Mundell, 1961). The probability that asymmetric shocks occur is lower when countries are homogenous, so the benefits from forming a monetary union are higher when countries are economically similar. If there are asymmetric shocks, the countries must have different adjustment mechanisms than the exchange rate tool to bring economy back to equilibrium. The main adjustment mechanisms are wage and price flexibility, labor mobility, automatic transfers and fiscal transfers. These mechanisms are related to the properties of the OCA mentioned earlier.

3.2 Adjustment mechanisms

3.2.1 Price and wage flexibility

When nominal prices are flexible between countries in a monetary union, an asymmetric shock is less likely to cause unemployment in one country and/or inflation in the other because prices can easily adapt to the new level of equilibrium (Mongelli 2002). Prices must adjust quickly in that case; the wage normally reacts slowly to changes in demand. This causes a problem in monetary unions; this form of wage rigidity can lead to unemployment. When prices and wages are flexible there is no need for exchange rate adjustment, but if they are downwardly rigid, losing the exchange rate mechanism increases the costs of forming a monetary union.

3.2.2 Labor mobility

Labor mobility is another adjustment mechanisms that can function as a cushion to the negative impact of asymmetric shocks. According to Mundell (1961), labor is the most important factor of production. If a country in the monetary union suffers from a recession and there is high unemployment, workers can easily move from a high unemployment country to a country where the demand for labor is higher. This means that the countries and workers do not need to suffer from high unemployment rates. Labor mobility can be an alternative for the wage and price flexibility, but as with wage flexibility, labor mobility tends to be rigid in the short run due to costs of migration. Low labor mobility increases the costs of forming a monetary union.

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3.2.3 Financial integration

Also automatic transfers due to financial market integration can reduce the costs of losing the exchange rate adjustment mechanism. The higher the level of integration, the lower the costs of losing the exchange rate mechanism. For example, with highly integrated financial markets, a deficit country can borrow from a surplus country to bring the economy back equilibrium. The drawback of highly integrated markets is that the slightest change in interest rates can cause a large capital outflow or inflow, which makes markets more instable. Mongelli (2008) argues that automatic transfers are not a substitute for a permanent adjustment when necessary. The capital flows are just temporary until the permanent adjustment mechanisms bring back the economy to equilibrium. Financial market

integration can form a bridge to close the time gap of the wage rigidity and the labor mobility, which are for permanent adjustment.

3.2.4 Fiscal transfers

The last automatic stabilizer we will discuss more extensively are fiscal transfers. When there is high fiscal integration between countries from a monetary union, like a centralized fiscal authority (for instance in the US), taxes from one country could be distributed to the country who has high unemployment due to a shock, for instance unemployment benefits could be increased. Such transfers could also bring the economy to a state of equilibrium. However, fiscal transfers to depressed

countries leads to moral hazard problems (Persson and Tabellini, 1996). When countries in a monetary union know they will get fiscal support when they face a depression, there is a smaller incentive to decrease national risk or help the economy adapt to national shocks because when things go wrong part of the burden is transferred to the other members. Janiek and Wasmer (2008) further state that these transfers to depressed countries are disincentives to perform radical structural changes when this is actually necessary. With a permanent shock the fiscal adjustment mechanism postponed the

measures necessary to bring the economy back to long-term equilibrium, it is only a temporary solution.

3.3 Other OCA properties

These are the four main adjustment mechanisms, and they include a large part of the OCA properties mentioned earlier. The other properties, which have not been evaluated but are of importance to the OCA theory and stimulate economic similarity are:

• High diversification in production and consumption is important because it dilutes the impact of a shock in a specific sector on the economy as a whole. This contribution was made by Kenen (1969). Diversification makes countries less vulnerable to asymmetric shocks ex ante, but it also minimize the damage caused by a shock ex post.

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• Fleming (1971) states the if inflation rate are stable and similar between countries, the terms of trade of these countries is stable as well, this will reduce the need for exchange rate adjustments.

• Political integration is highly correlated with high fiscal integration. If the countries have the same political vision it will be easier to formulate a policy in favor of the monetary union, and fiscal transfers are more likely to stabilize the economy. Mintz (1970) argues it is one of the most important criteria for a monetary union to function properly.

• McKinnon (1963) added the degree of economic openness, the higher the degree of openness the more a change in international prices directly impacts the prices in the domestic country and the higher the rate of trade between the countries in the monetary union. When economic openness is high the benefits of losing the exchange rate risk is high as exchange rate

fluctuation have a big effect on the domestic price level, so forming a monetary union would be preferable as it reduces the volatility of the exchange rate.

3.5 Criticism on the OCA

The OCA theory and the different criteria have been criticized as well. One problem with these criteria is that they can be contradictory. A small country usually has a very open economy, so a fixed exchange rate would be preferable, but small economies usually do not have a highly diversified production sector, so in this case a floating exchange rate would be best. The different criteria might contradict with the characteristics of a country, when a country satisfies one factor, doesn’t mean it satisfies another. Tavlas (1994) calls this the inconsistency of the OCA criteria. A second problem Tavlas explains is the inconclusiveness of the OCA theory. By inconclusiveness he means that the different criteria to judge the optimality of a currency area do not need to point in the same direction. For example, a country might have a relatively open economy or a high degree of trade with a number of countries, suggesting desirability of fixed exchange rates or a currency area, but might struggle with high factor immobility between these same countries, in which case a flexible exchange rate would be optimal. This raises the question which factor is more important than another. He further argued that this question is hard to answer because the OCA criteria are difficult to measure unambiguously and therefore cannot be weighed against each other. In addition to this, Ishiyama (1975) criticized the OCA criteria because of the fact that most criteria are interdependent, which makes an evaluation of them very difficult.

3.6 Endogeneity

I mentioned in the introduction that the Maastricht convergence criteria required EU countries to satisfy several requirements before they are able to join the EMU. These convergence criteria intended to increase the homogeneity of the EU countries and make them economically stable and similar. As argued by Mundell (1961), countries that are homogenous should form a monetary union

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as they both would have the same monetary policy responding to a shock, so the converge criteria are in line with the functioning of an OCA. Mongelli (2008) calls this the exogeneity of OCA and states that countries should undertake structural reforms to increase the homogeneity before they form a monetary union. Such reforms are stimulated by the convergence criteria.

As an extension on the earlier theory of OCA, Frankel and Rose (1997) proposed their theory of ‘’endogeneity of OCA’’. This theory states that economic similarity comes after the forming of a monetary union. Once a union is created trade integration and income correlation will increase (Mongelli, 2002). Frankel and Rose (1997) studied the effects of several monetary unions in the past to search for the endogeneity of OCA. They found that entry in a monetary union increases trade, which increases the benefits of joining. Further, this increase in trade affects the business cycles of the countries and it could increase or decrease the correlation of business cycles between countries. A decrease in correlation occurs if the business cycle becomes more idiosyncratic due to increased specialization in the production of goods in which countries have a competitive advantage. If this happens, countries become more vulnerable to industry specific shocks as mentioned in the properties of OCA earlier, in the form of low diversification of production. But if common demand shocks dominate, or most of the trade is intra-industry between the countries, then the correlation of business cycles may increase when a monetary union is formed. After their analysis of 20 countries, Frankel and Rose (1997) came to the conclusion that an increase in trade intensity between countries resulted in a higher correlation of business cycles, this means that greater integration leads to common business cycles and economic similarity. So even if some countries are not ideal candidates to join the EMU ex ante, they are likely to satisfy the criteria ex post. A more recent research on the endogeneity of the OCA is done by Jürgen Matthes (2009), he studied whether the countries in the EMU have converged or diverged after the forming of the monetary union in 1999. His results will be evaluated in Chapter 4.

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4. Is the EMU an OCA?

In this chapter I examine to what extend the EMU is an optimal currency. Mundell (1961) mentioned that a currency area is an OCA if there are no asymmetric shocks, but if there are, adjustment mechanisms are necessary to mitigate the effects of the shock. Matthes (2009) states that asymmetric shocks are still present and important in the EMU so we need to look at the adjustment mechanisms and the OCA criteria discussed in the previous chapter.

4.1 Price and wage flexibility

There has been an increase in price integration in the European Union after the establishment of the EMU, but still deviation from the law of one price is present (Sylvia, 2004). Verhelst and Van der Poel (2010) did a comparative study between the U.S. and the EMU and found that prices where more sticky in the EMU than in the U.S. In some European sectors price flexibility is hampered due to the slow implementation of the Single Markets Program (SMP) or the presence of subsidies, especially in sectors with a high concentration of state owned companies or sectors where the government had a monopoly, but are now privatized (such as the energy sector). The differences in the labor market between countries could also explain part of the price discrepancies in the EMU. As diversity in labor market institutions could lead to variation in wages, this effect could be transferred to prices of goods as well, even in the presence of common shocks (Mongelli, 2008).

Wages are inflexible in the EMU. Due to the presence of strong labor unions, a downward wage rigidity exists. This means that the wage cannot function as an adjustment mechanism. In the next chapter there is a more extensive evaluation of this problem.

4.2 Labor mobility

As mentioned earlier, high factor mobility and especially labor mobility is a crucial adjustment mechanism in the OCA. According to Sylvia (2004), labor mobility is particularly important in the EMU because wage flexibility is low, and labor income is equivalent to

approximately two-third of GDP. But even after the signing of the Treaty of Rome in 1957 and the Schengen agreement of 1985, which intends to increase the labor mobility in the EU, labor mobility remains extremely limited. The first explanations for this are the cultural and linguistic differences across the different nations in the EMU (Bertola, 1999). But also other factors contributed to the immobility of the labor market, which are discussed in the next chapter.

This low labor mobility imposes a large restriction on the optimal functioning of the EMU. If you compare the European situation with the US situation you see that the regional migration in the U.S. almost complete eliminates the short-term variation in employment, whereas in Europe migration responds very weakly to regional employment differences (Blanchard and Katz, 1992). This

conclusion is still valid now. Pasimeni (2013) says that labor mobility in the U.S. rebalances 12

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differences in unemployment between states but in the EMU the differences in unemployment are more persistent, which indicates that labor mobility is a weaker adjustment mechanism in the EMU than in the U.S. One additional remark is that labor mobility increased over time, especially in the period 2009-2012, probably due to the high unemployment rates as a consequence of the financial crisis (Pasimeni, 2013).

Further, in the U.S. almost one-third to one-half of the initial decline in employment is offset by inflows of capital in the region three to four years after the shock, whereas in the EMU the adjustment mechanism of labor is ineffective after the shock and eventually equilibrium was reached through higher unemployment and a lower participation rate, which is not optimal (Janiek and Wasmer, 2008).

4.3 Financial integration

With the forming of the EMU, free capital movement was introduced between all the countries that joined the monetary union, which increased financial integration and the mobility of capital. This does not mean that foreign direct investment (FDI), which is direct investment in a business or production in a foreign country, and financial markets have become completely flexible. There are barriers, which hinder fuller integration. One of these barriers is the liberalization of mergers and acquisitions, which is not implemented in the European Union. This really restricts intra-European FDI, especially in traditionally sensitive sector such as the banking sector, but intra-European FDI has accelerated after the establishment of the EMU (Sylvia, 2004).

For financial markets the same applies, even though great progress is made, financial markets still have some way to go before there is full integration between all countries. Sylvia (2004) argues that national policy often act as impediments in the flexibility of the financial markets. This is due to differences in laws, tax-systems and information differences between countries, but also the presence of home bias when investing in equity instruments and a low level of cross-border ownership of assets are indicators that financial integration is not optimal. Yet, a decline in interest rates gaps between countries and a decrease in arbitrage opportunities indicate progress in financial integration.

4.4 Fiscal transfers

At this moment the EU does not have a centralized fiscal authority, and the EU centralized budget accounts 1.24% of the whole EU GNI, whereas in the U.S. this is 24%. So no redistribution through centralized fiscal transfers is present at this moment (Barbosa and Alves, 2011). For

comparison, in the U.S., one third too one half of the effects of asymmetric shocks are compensated by fiscal transfers (Pasimeni, 2013). Another factor that contributes to the fact that fiscal policy fails to mitigate the effect of shocks is the presence of the Stability and Growth Pact (SGP), which constraints the countries to use fiscal policy as a stabilizing tool (Sylvia, 2004). In 2005 the rules of the SGP were relaxed under pressure of France and Germany to give countries greater flexibility, but even after this reform the SGP imposes large restrictions on fiscal policy.

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4.5 Economic openness

One way of measuring the economic openness of the countries in the EMU is the rate of reciprocal trade. After the establishment of the EMU, intra-European trade increased by approximately 50 percent, also price differences that cannot be explained by geographical or other natural factors began to fall by some estimate, this is consistent with an increase of reciprocal trade (Sylvia, 2004). This conclusion is uniform with the endogeneity of the OCA theory discussed earlier, and indicates that economic openness increases when a monetary union is formed. Barbosa and Alves (2011) support this conclusion by stating that the EMU increased their openness ratio until the start of the crisis in 2008. Even though economic openness increased significantly, the fraction of intra-European trade still falls short notably from the fraction interregional trade in the U.S., which means that full integration is lacking.

4.6 Endogeneity of the OCA

As already mentioned, economic openness and intra-European trade have increased after the establishment of the EMU. This endogeneity of the OCA properties state that the EMU might converse to a level where it is an OCA. Several studies are done if this theory is applicable to the EMU and I will evaluate two studies. If this endogeneity effect also is of influence on the wage flexibility is researched by Sylvia (2004). Barbosa and Alves studied the endogeneity of wage flexibility as well as labor market flexibility. Research if the business cycles converged or diverged after 10 year of EMU is done by Matthes (2009).

4.6.1 Wage and labor market flexibility

According to Calmfors (2001) the establishment of the EMU should yield an endogenous increase in wage flexibility. As the forming of a monetary union should lead to more integrated product markets, competition should increase as well. Countries who face the highest costs for a given sector lose their shield of transaction costs when a common currency is introduced and should have pressure to restructure. One area where they could do this is through their price of labor. This way the labor costs should converge. This effect should go in two phases. First there is the one-time wage adjustment due to the elimination of transaction costs and other barriers that disappear when the EMU was formed. This should bring the economy to a new state of equilibrium with a convergence of the wage at sector level and aggregate up to the national level because of the increase in price competition, this short run effect does not alter the production levels so no wage converging at European level yet. The second phase is that in the long run production is adjusted due to the increase in competition in Europe and should lead to a convergence in labor costs (Calmfors, 2001).

Sylvia (2004) did research on this statement by analyzing the nominal hourly labor costs and the unit labor costs (ULC) of the countries in the EMU and looked if the standard deviations differed from the period 1995 until the fourth quarter of 1998 and from 1999 until the fourth quarter of 2002 for the nominal unit labor costs. For the ULC he used the periods 1991-1993 and 1994-2000, to see if

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the stage two of the forming of the EMU had any significant difference, and the period from before and after 1999 (the actual introduction of the euro) as with the nominal labor costs. He argued that the ULC is an excellent measure of convergence because it reflects the full trade-off between producing in one area or the other. The data used came from the OECD (see Figure 1). A t-test was performed to see if the standard deviations differed between the periods to determine if the forming of the EMU had any significant impact on the wage determination in the Euro area. In all periods there was no

significant statistical difference in the standard deviations implying that the forming of the EMU had no impact on labor costs, which means no converging of wage is present. An explanation for the fact that labor costs are not converging in the Euro area is that time span used by Sylvia (2004) is too short for the EMU to have an effect on the labor market.

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Figure 1: Nominal hourly labor costs developments and unit labor costs developments. Source: Sylvia (2004), Is the Euro Working? The Euro and European Labor Markets, pp. 160 &162

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In a more recent study by Barbosa and Alves (2011) the converging of wages was studied based on ULC as well. In Table 1 they presented the initial wage and the accumulated growth in wages, productivity and ULC with data from the OECD with a time span from 1999 until 2009. The data indicates that there is a tendency for stronger nominal wage growth in countries where nominal wages were lower when they joined the EMU. This result illustrates converging wages. However, as you can see in the data, only Germany kept nominal wage growth in line with productivity growth, indicated by the small increase in ULC. Countries like Greece and Ireland experienced a high

productivity growth but this growth was largely outpaced by increases in nominal wages. In countries like Italy, Spain and Portugal wages increases significantly but productivity growth was falling behind as well, this implies a loss in competitiveness and no converging of labor costs and thus wages is taking place.

Table 1. Accumulated growth in wages, productivity and ULC in EMU (1999-2009). Source: Barbosa and Alves (2011), The Euro Area Ten Years After Its Creation: (Divergent)

Competitiveness and the Optimum Currency Area Theory. p.613

Barbosa and Alves (2011) also did research on labor market flexibility and whether this has increased after the forming of the EMU. With data from the OECD they did this analysis by measuring the dispersion of unemployment rates and they concluded that the standard deviation of the

unemployment rate consistently decreased until 2007, this interruption is probably due to the financial crises (see Figure 2). The fact that the standard deviation consistently decreased is an indicator of labor market integration. To study the inter-sectorial mobility in the EMU they used long term

unemployment rates to assess whether works have difficulties finding another job in a different sector after an asymmetric shock. The data showed a decrease in long term unemployment rates and a decrease in the standard deviation, except for the time period that the financial crisis began (see Figure 3). This indicates that inter-sectorial mobility has increased inside countries or between the member countries of the EMU.

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Figure 2: EMU countries unemployment rates (%). Source: Barbosa and Alves (2004), The Euro Area Ten Years After Its Creation: (Divergent) Competitiveness and the Optimum Currency Area Theory, p. 612

Figure 3: EMU countries long term unemployment rates (%). Source: Barbosa and Alves (2004), The Euro Area Ten Years After Its Creation: (Divergent) Competitiveness and the Optimum Currency Area Theory, p. 613

4.6.2 Economic similarity

Matthes (2009) investigated whether the business cycles in the EMU converged or diverged with 10 year of hindsight. As mentioned before, forming a monetary union leads to an increase in trade and financial integration. In the end this could lead to higher correlation of the business cycles when most of the trade is intra-industry between the countries, or lower correlation due to increased specialization in the production of goods in which countries have a competitive advantage (Frankel and Rose, 1997). Evidence of a strong EMU effect on business cycle synchronization is lacking. Since the run-up to the EMU similarity in business cycle and inflation have increased, but after the forming of the EMU in 1999 there has been little evidence of an additional increase. In the short run there was no increase in the divergences of business cycle or inflation rate since the forming of the EMU, but in

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the medium run there were growth and inflation differences. This diverging developments have led to competitive problems and strong imbalances in the EMU. Matthes distinguishes two reasons for the economic divergences in the EMU: reasons to which the EMU has contributed and general reasons.

- General reasons: country-specific shocks contributed to the divergence. He points out that in Southern Europe nominal wage increases exceeded the productivity growth, a result consistent with the results of Barbosa and Alves (2011) discussed earlier, which contributed to a higher inflation rate. Normally such a shock has a temporary nature, but due to the price and wage rigidities they are more persistent in the EMU. He further states that in the Euro area prices change every four to five quarters on average, whereas in the U.S. they change every two quarters.

- EMU related reasons: the most important reason for the divergence in the EMU was the positive interest rate shock in southern Europe. While in these countries inflation rates had decreased in the early 1990s and the devaluation risk disappeared as well, the risk premium on their interest rate fell dramatically. This increased domestic demand and stimulated the economy. Countries like Germany did not benefit from this shock. Further, in southern Europe prices rose faster than in Germany, so real interest rates were noticeably lower in the southern countries and this stimulated the economy as well, which contributed to the diverging of business cycles and made economies less similar.

4.7 Concluding remarks

After evaluating all of the OCA criteria, you can state that the EMU is not an optimal currency union at this moment. Price flexibility is not optimal yet, even though progress is made. Progress is also made in financial integration, which makes adjustment to shocks with capital easier, and in the degree of economic openness. Problems arise in the labor market, even though inter-sectorial labor mobility and labor market integration increased until the financial crisis (Barbosa and Alves, 2011), the EMU still lacks wage flexibility and labor mobility, which are important adjustment mechanisms. This imposes large restrictions on the functioning of the EMU as an OCA and makes economic adjustment to shock very painful, as we saw in the recent crisis. In the next chapter an analysis of the labor market is done to understand the problems in the labor market. The fact that there is no fiscal authority in the EMU makes fiscal transfers a problem as well. Another development that is important is the divergence of the business cycles, which leads to the presence of more asymmetric shocks (Matthes, 2009) and the fact that after the forming of the EMU no converging of wages is present, concluded by Sylvia (2004) and Barbosa and Alves (2011).

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5. The European labor market

In this section I analyze the European labor market. To evaluate the functioning of the European labor market I use the U.S. market as a benchmark, which is also considered a monetary union and the labor market adjustment mechanism functions relatively well in the U.S. According to Blanchard and Katz (1992) most of the adjustment to shocks in the U.S. takes place through labor mobility. Further, most of the existing literature compares the Euro-area with the U.S. because these are the two largest currency unions in the world. I give special attention to the wage flexibility and the labor mobility as these are the most important factors of the labor market in the OCA theory.

5.1 Why is the labor market so important?

According to the European Commission report by Janiek and Wasmer (2008) labor mobility can play an important role as an adjustment mechanism in the EMU, especially when shocks are permanent, for example a decline in the working-age population due to ageing or regional differences in unemployment. Permanent shocks usually require a reallocation of production factors, for these kind of permanent shocks it is important that the labor market properly functions as an adjustment mechanism to bring back equilibrium.

Further, Janiek and Wasmer (2008) argue that other adjustment mechanism cannot function at their full potential if the labor market adjustment mechanism does not function well. For example, due to downward wage rigidity, capital inflows to depressed countries cannot benefit from lower wages or these inflows would have to deal with an ageing or low-skilled workforce due to the lack of labor mobility.

Lastly, fiscal transfers to depressed countries leads to moral hazard problems and work as a disincentive to perform radical structural changes when this is necessary. To permanent shocks, fiscal policy is not the optimal adjustment mechanism, it is just a temporary solution (Persson and Tabellini, 1996). With these arguments it is clear that the labor market is one of the most important mechanism to adjust for shocks.

5.2 The labor market

The European labor market historically has a higher unemployment rate than in the U.S. This is due to the rigidities and immobility of the European labor market. Not only are the wages

downwardly rigid and not flexible, the social benefits, generous holiday allowments, etc. make labor expensive and increase unemployment. Krueger (2000) states that people might choose for a higher unemployment rate in exchange for generous social benefits and holiday allowments. After the forming of the EMU, the power of this argument might even be stronger because countries lost their monetary autonomy and as volatility increases they are more sensitive to asymmetric shock. This

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means that workers want to have greater security and more generous social benefits. This might bring back the pressure for labor markets to deregulate, which means that wage will stay inflexible.

Figure 4: Unemployment in the Euro area and the U.S. Source: Eurostat

5.2.1 Wage flexibility

Typical markets adjust to changes in demand through prices. As with product markets, you would think this also counts for the labor market. But the price in the labor market is the worker his wage and can be more difficult to adjust if the market conditions change; the wage is not set in the spot market. Most wages change annually by a complex process, which involve contracts, standards of living, minimum wage policy and most important labor unions that bargain for a good position for their member workers. European countries historically have a high unionization rate and the most important reason for the nominal wage rigidity in the European labor market is the bargaining power of these labor unions (Campbell and Kamlani, 1997). Labor unions do not want a decrease of wages when this is actually necessary to restore equilibrium and decrease the wage flexibility, which makes it harder to mitigate imbalances between demand and supply in the labor market. This wage rigidity is a problem in the EMU and is downwardly bias because a decrease in the wage is of course less wanted by workers than an increase in wage. It is also important to make the distinction between nominal and real wage rigidity. High nominal wage rigidity infers that workers (or the labor unions) are reluctant to accept a wage cut or freeze, whereas with high real wage rigidity inflation is taken into account and the downward movement of the real wage is rigid (Babecký et al., 2009).

Dickens, Goette, Groshen, Holden, Messina, Schweitzer, Turunen and Ward (2007) did research for the International Wage Flexibility Project (IWFP) on the nominal and real wage rigidity in 15 European countries and the United States and found a statistically significant correlation between real wage rigidity and union density, but not a significant correlation between nominal wage rigidity and

0,0% 2,0% 4,0% 6,0% 8,0% 10,0% 12,0% 14,0%

Unemployment in the Euro area and the U.S.

Euro area United States

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union density (see Figure 5). Their result indicates that wage indexation is more prevalent in Europe than wage freezes and that increasing union density or collective bargaining power is associated with increasing real wage rigidity.

Further, Dickens et al. (2007) found that, at all times, the distribution of wage changes is non-normal, which indicates wage rigidity. The level of downward wage rigidity changes from country to country, some have high nominal wage rigidity, but almost no real wage rigidity or vice versa, other have both high or low real and nominal wage rigidity. The results are summarized in Figure 6, which shows the fraction of workers potentially affected by real and nominal wage rigidity.

Figure 5: Correlation between real wage rigidity and union density by country. Source: Dickens et al. (2007), How Wages Change, p. 211

Figure 6: Fraction of workers potentially affected by real and nominal wage rigidity. Source: Dickens et al.(2007), How Wages Change, p. 209

5.2.2 Labor mobility

Labor mobility can be divided into two groups: geographical mobility and occupational mobility. Occupational mobility is simply a change in job and does not necessarily imply moving to a different country or region. Geographical mobility is the physical change from regions for work or to find work.

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The geographical mobility in Europe as a whole is lower than in the U.S. Of course there are differences in Europe as well. Geographical mobility is approximately 7% for the EU and 16% in the U.S. The differences between the European countries are very large. In Italy only 3% of the population moves whereas in Finland it is almost 16%, but not a single country has a higher mobility rate than the U.S. Further, the northern countries have a higher overall mobility rate than the southern countries, which you can see in Figure 7 (Janiek and Wasmer, 2008).

Figure 7: Share of movers in the population. Source: Janiek and Wasmer (2008), Mobility in Europe - Why it is low, the bottlenecks and the policy solution, p. 18

Janiek and Wasmer (2008) argue that the low mobility could be due to differences in the individual underlying shocks which drive mobility. They compared the motivation for people to move in the U.S. and the EMU. Their result indicated that the proportions for the reason to move were almost the same in the EMU and the U.S. So even though the U.S. and European households face the same type of shock, people from the U.S. are three times likelier to move geographically. So there must be different obstacles in Europe, which cause the lower mobility.

Bonin et al (2008) did research on the mobility of the EU labor market and the migration between EU countries and found that the following factors were important for low labor mobility:

• First of all, the rise in female participation in the workforce reduces the mobility. With the women having a job as well there are a lot of double income household and makes moving to a different country even more complex.

• The ageing of the European workforce. Older people are less likely to migrate than younger people. With the ageing population on Europe, migration becomes less likely.

• Limited transferability of social security systems. If pensions, health care or other sort of social security systems are not transferable to another EMU, the costs of migrating are much higher. With the recent rise in unemployment in the whole EMU people attach to their current social security systems even more.

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• Increase in homeownership. People who buy housing have less incentive to sell their investment and move to a different country where job opportunities may be more present. • Too little recognition of formal qualities in other countries. If workers have problems getting

their educational and professional skills recognized, they have problems getting a job which fits their expertise even if they are available in a foreign country. This might hold them back from migrating.

• Absence of transparency of European online employment exchanges. When unemployed workers are unaware of the availability of jobs which fit their profile, they are not stimulated to work in a different country. In Europe the employment exchanges tend to be vague and not very transparent.

• Language and cultural differences. In contrast with the U.S. there are a lot of different

languages and cultures in Europe. Working in a foreign countries means you will have to learn a new language and adapt to the different culture. This imposes another restriction on the mobility of the labor market in the EMU.

Bonin et al. (2008) found that the cultural and language differences and the prospect of finding a job for oneself and for the partner where the only factors which are statistically of influence on the impact of future migration. They conclude that the primary barriers which arise in European labor mobility are not of institutional or market-related nature, but lie in the individual domain. Although the prospect of finding a job could be because of market imperfection like imperfect information about opportunities in a foreign country, or because of problems with the transferability of formal qualities or professional skills. They further argue that the immobility due to language and cultural differences is likely to decline. In the more globalized world, young adults speak multiple languages and have fewer problems adapting to a different culture than the older workforce, so fewer problems when migrating to a foreign country.

Other literature highlights a different topic that might cause immobility and mention the inverse causality between unemployment and mobility. As mentioned earlier a mobile labor market reduces unemployment as people can easily move from a high unemployment area to an area where the demand for labor is higher. Fidrmuc (2004) states that high level of inter-regional unemployment, for instance the whole Euro area, may cause a lower mobility of labor as people do not want to pay the cost of migration if it is likely that they will stay unemployed, even in a different place.

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6. Changes EMU labor market should go

through

Let’s look at the changes the labor market has to go through to function as an adjustment mechanism in the EMU. First I want to stress that no other currency area depends solely on the labor market and the wage as adjustment mechanisms to asymmetric shocks. It is also important to develop the other mechanisms mentioned earlier to respond to shocks.

6.1 Labor mobility

For geographical mobility to function as an adjustment mechanisms to permanent shocks mostly structural reforms are necessary. The inefficient housing market should be reformed and become more transparent to close the gap, which stops people from moving to low unemployment countries. Janiek and Wasmer (2008) found that countries with a high product market regulation and a high housing market regulation faced an inflexible labor market. So these regulations must be relaxed first. This confirms the theory of Calmfors (2001) who mentioned that unregulated product markets increase the flexibility of the labor market. Social and pension funds should be transferable through whole Europe, which also stimulates the incentives to migrate to low unemployment countries (Bonin et al., 2008), also better corporation between countries is a way to increase the labor mobility and put downward pressure on the high unemployment rates and to stimulate the people who are unemployed to look for a job. Bringing back the cultural and linguistic differences, which are the primarily barriers that hinder mobility, will be difficult. In the more globalized world Bonin et al. (2008) state that the younger generation will have fewer problems with these differences, so time might tackle these barriers.

6.2 Wage flexibility

Also the wage flexibility should be increased by lower the influence of the strong European labor unions. A new wage bargaining system should be set up to make the downward wage rigidity disappear. European and national legalization should be adjusted to allow for the possibility of more flexible contracts, and not the long-term contracts with an indefinite period of time. Further the employment protection legalization should be less severe and the costs of unemployment should be increased by lower the social and unemployment benefits, thereby increasing the net gains of migration. Unfortunately, national policies like the minimum wage and the generous social benefits, but also the strong labor unions are deeply anchored that reform will be difficult.

Because reform will be difficult, Krueger (2000) puts forward the relaxation of product markets restrictions. His statement follows the same argumentation as the product market relaxation to increase the labor mobility mentioned before. He found a tight connection between product and labor

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markets. So product market deregulation would put pressure on labor market flexibility and wages but product market deregulation is politically more popular than labor market reforms. As trade increases and product markets integrate more, the earlier mentioned increase in competition and price pressure might force the policymakers and labor unions to liberalize the labor market and make wage setting more flexible.

The effect of the crisis and the EMU is also something that must be taken into account. The crisis had a larger impact on the EMU and contributed to the extremely high unemployment rate. But this crisis might work as an eye-opener and stimulate the structural reforms necessary in the Euro area and it also puts downward pressure on wages, as people are willingly to work for a lower wage. Pasimeni (2013) already argued that labor mobility increased after the start to the financial crisis, but if this increase is temporary or permanent is not certain. Which part of the increase can be considered as a natural development of the EMU and which part is just due to the severe financial crisis is hard to say. He still puts forward that the increase in labor mobility did not offset the huge rise in

unemployment, due to the structural problems of the EMU, and emphasizes that reforms are necessary.

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7. Conclusion

At first I outlined the theory of the OCA extensively. I mentioned which properties a currency area needs to satisfy to become an OCA. Many contributions of different economists where discussed to get a broad understanding of the debate what defines an OCA. After that I examined if the EMU satisfied these requirements to become an OCA. To get a clearer understanding of the functioning of the labor market I have analyzed the labor market by evaluating several articles and reports to discover the flaws and weaknesses of the European labor market. These flaws and weaknesses were used to determine what sort of changes the labor market has to go through to function as a proper adjustment mechanism.

All in all, you can conclude that the EMU is not an OCA at this moment in time. Progress is made on the integration of financial market, price flexibility and the increasing degree of trade, but many of the criteria to satisfy for an OCA are not present in the EMU. Especially the poor functioning of the labor market imposes a large restriction on the adjustment to asymmetric shocks. It makes adjustment economically painful as new equilibrium is reached through unemployment instead of reallocation of production factors or wage changes, also the diverging of business cycles, which increases the probability of asymmetric shocks, is a serious threat to the functioning of the EMU (as Europe experienced with the recent financial crisis). Before I can state that the labor market can function as an automatic stabilizer, structural changes are necessary to increase labor mobility and wage flexibility. To increase the labor mobility the costs of migrating to another EMU countries should be reduced considerably. To increase the wage flexibility, the power of the labor union should be reduced, European legalization should stimulate the flexibility of wages and also product markets should be unregulated as this increases competition and makes wages more flexible. After structural reforms, time might close the gap between different cultures and languages as younger people will have less problems with these differences. This means that, after the structural reforms, the labor market can function as a proper automatic stabilizer in the future.

There are some limitations to my conclusion. A large part of the articles and reports used are published before the financial crisis and carry the risk of being outdated, also they may not include all the EMU members who are members now. This also means that the full effects of the crisis are not taking into account even though some literature on the effect of the crisis on labor mobility is

discussed. It would be interesting to investigate what the effect of the crisis is on the EMU as an OCA, if the crisis contributed to increase the endogeneity of the EMU and if these effects are temporary or permanent, and if they stimulated structural reforms.

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- Barbosa, João Rebelo and Alves, Rui Henrique (2011), The Euro Area Ten Years After Its Creation: (Divergent) Competitiveness and the Optimum Currency Area Theory.

Panoeconomics, No. 5, Special Issue, pp. 605-629

- Bertola, Giuseppe (2008), Labor Markets in EMU: What has changed and what needs to change. European Commission, Economic Papers 302, February 2008.

- Blanchard, O. and Katz, L. (1992) “Regional Evolutions’’, Brookings Papers on Economic Activity, No. 1.

- Bonin, H., W. Eichhorst, C. Florman, M. O. Hansen, L. Skiöld, J. Stuhler, K. Tatsiramos, H. Thomasen, K. F. Zimmermann. (2008). Geographic Mobility in the European Union: Optimizing its Economic and Social Benefits, IZA Research Report No. 19.

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- Campbell, C. M. and Kamlani, K. S. (1997): “The Reasons for Wage Rigidity: Evidence from a Survey of Firms.” Quarterly Journal of Economics, Vol. 112, No. 3, pp. 759–89.

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- Fidrmuc, Jan (2004), Migration and Regional Adjustment to Asymmetric Shocks in Transition Economies, Journal of Comparative Economics, Vol. 32, No. 2, pp. 230-247.

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