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«1 The stage is already set Convincing economic arguments in favor of EMU are rare. The merits of a currency union in the absence of an „optimum ...»

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Michael Bolle∗ / Michael Neugart

Free University Berlin

1 The stage is already set

Convincing economic arguments in favor of EMU are rare. The merits of a currency union in

the absence of an „optimum currency area“ (Mundell 1961) are by no means obvious. Among

economists it is still widely disputed what constitutes an optimum currency area and how

much economic homogeneity has to be achieved for it. There is not doubt, however, that the European Union does not constitute an optimum currency area at all. Remarkable differences in productivity, the absence of a common economic policy, and low labor mobility point to severe economic and political risks. Economic risks are linked to asymmetric shocks (c.f.

Dohse and Krieger-Boden 1998) which may not be absorbed efficiently by mal-functioning markets. Political risks are easily be observed by the strong pursue of national interests and the lack of financial European solidarity between poorer and richer nations.

This notion of risks has lead quite some economists to argue in favor of building a political union and achieving a greater degree of economic homogeneity before experimenting with a

currency union. Otherwise Europe may find itself unable to deal with problems peacefully:

“If EMU does come into existence... it will change the political character of Europe in ways that could lead to conflicts in Europe and confrontations with the United States.”(Feldstein 1997) This perception is far from correct. It underestimates the laws of economic adjustments within an institutional framework with high exit costs and political learning procedures in competitive democracies. The introduction of the Euro was never intended to build on an existing optimal currency area. The idea was to help to establish an ever closer economic and political union by laying the firm grounds for a process of self-organization of European economies. The optimal currency area was supposed to stand at the end of the process introduced by a sound institutional framework -the EMU- with high exit costs and a trustworthy monetary authority.

It certainly is true, however, that the success of this self-binding political process depends on some prerequisites. Most scholars seem to agree that the success of the EMU depends on, (a) how quickly the EU develops an EU wide system of federalism, and (b) how nations will handle the implications of surrendering the exchange rate and an independent national monetary policy as instruments of adjustments (c.f. Eichengreen 1994). The focus here is on labor markets and on the extent to which wage flexibility and labor mobility can substitute for the forgone instruments. It is closely linked also to the conduct of national fiscal policy under the Maastricht criteria and the Stability Pact.

The removal of theexchange rate instrument, the fiscal constraints of Maastricht and the Stability Pact - as well as the no-bail-out clause- puts considerable weight on the flexibility of markets. Contrary to the regime of the EMS, the EMU will only work if product, labor and capital markets are flexible enough to absorb asymmetric shocks to which European ∗ Corresponding author.

monetary policies cannot respond properly. The EMS always did provide for exits without unbearable costs for national economies and national as well as European politics. As it seems, national governments in Europe were tempted indeed by the sweet poison of excessive deficits and currency depreciation to overcome economic problems. Often, necessary and harsh structural reforms were postponed, sometimes to doomsday. But there never was a rigid framework which prevented nations to opt for the easier way out of stable exchange rates and to finance too expensive welfare state approaches by excessive public deficits.

With the EMS things have changed. There is no easy divorce in Euroland. To deal with adverse economic shocks, Euroland has to rely on the flexibility of markets. And critics of the EMU are right: Neither capital markets nor labor markets are in a good shape in most European countries. Indeed: if markets do not become flexible and will not work more efficiently there may be a war of roses in Europe.

2 Flexibility - is it a matter of life and death?

2.1 Labor market More transparency coming from the single European market and a single currency will make the dependency of national or regional unemployment rates on wage and productivity growth more obvious. Punished by comparably high unemployment rates and the inability to devalue its own currency, or finance unemployment by state transfers countries within the European union will rather choose to deregulate their labor markets - although they can stick to their labor market institutions as long as they are willing the bear the costs (Krueger 2000). But these costs are likely to increase given two assumptions: first, that the variability of output rises with the EMU. This may happen as there is no national monetary authority that accommodates country specific shocks by devaluating the currency. Nor can the monetary policy of the European central bank take into account regional disparities. And second, that the additional disutility of unemployment is larger for higher unemployment rates. As a consequence one would expect that labor market reforms are more likely within the EMU (Calmfors 1998), because a comparably high component of structural unemployment combined with larger swings in output causes costs in excess of those before the EMU and which are perceived as unbearable by policy makers now. However, labor market reforms following from the introduction of the Euro are not a one-way street, should reforms be more likely if they are accommodated by monetary policies (Bean 1998). One can run easily in to a situation where a single country would choose reforms but does not in the end as other countries would not follow, thus preventing an accommodating monetary policy.

To become more specific on what might change on European labor markets and what not, shaping them towards an optimum currency area, let us briefly discuss possible impacts on nominal wage and price flexibility, and labor market mobility coming from the single currency.

A major impact on nominal wage flexibility may come from a change of the wage contract lengths in the EMU. If they would become shorter there would clearly be less inertia through fixed wage settlements. Addressing the question what determines the optimal length of a wage contract, Ball (1987) proposes that one should take into account the costs that arise from changing the wage contract, opposed to the losses that accrue from not adjusting the going wage to unanticipated events, thus loosing profits. With the EMU there could be an incentive to reduce contract lengths if the common currency area comes with more uncertainty about future states of the economy. That could happen, because there is no possibility to dampen the business cycle by devaluating the national currency anymore, and because a common monetary policy may affect regions differently. Thus, contract lengths may shorten and increase money wage flexibility in Europe.

It was put forward that an increase in nominal wage flexibility on the grounds of more uncertainty and therefore shorter contract lengths might be compensated by a coordination failure (Calmfors 1998). The mechanism behind the coordination failure would be that an individual firm does only have an incentive to reduce the length of their wage contracts if this increases the variability of the product demand it faces. If, however, all firms would shorten their contract lengths, nominal wages would become so flexible that any product demand variability was erased. Hence, no individual firm would have an incentive to change wage contracts. In the end, there would be no impetus on nominal wage flexibility from the EMU.

In addition, one would also conjecture that money wages become more rigid in an EMU that succeeds in bringing down inflation rates. If inflation rates are low and anchor inflation expectations, longer term wage contracts become more profitable.

The whole question of more or less nominal wage flexibility seems to burn down to become an empirical one. Here, as with the other alternative adjustment channels to a devaluation of the currency, the already existing evidence does hardly take into account the Lucas critique.

Data is at best from the early nineties and before. Any nominal wage elasticity or correlation index does not deal with the fact that people in Europe already adjusted their behavior to the new rules that were partly implemented with the completion of the single European market in

1993. If the European Monetary Union changed expectations, evidence on past behavior does not tell anything about the future. To address the question of whether the EMU will shape an optimal currency area, it would suit well to have the latest data on nominal wage flexibility and compare that to estimates from the pre-single market era.

A rough estimate of that is presented in Table 1. We took changes in nominal hourly earnings for the European countries and averaged out the bilateral correlation coefficients for different sets of countries. Comparing the period before the completion of the single European market with the period from 1993 to 1998 we find that the correlation of nominal wage changes declined, no matter what group of country we consider. Although, Table 1 does not tell anything about the reasons of the increased nominal wage flexibility, it implies that wages in Europe do not coincide anymore to that extent they used to do in the eighties and the beginning of the nineties.

–  –  –

Contrary to the Feldstein (2000) scenario there are quite a few reasons to believe that inflation rates stay low in the EMU: First of all, his assessment that inflation rates were declining in Europe during the last decades because it meant a major embarrassment to devalue against the German mark in the past, occurs wrong. Italy, i.e. welcomed the opportunity to circumvent the detrimental effects of rising inflation rates on the terms of trade by devaluating its currency from time to time to reestablish competitiveness. Generally, such behavior is corroborated by empirical evidences for the U.S. and the U.K. presented by Alogoskoufis and Smith (1991). They can show that the persistence of price inflation is significantly higher under managed exchange rate systems as compared to fixed-exchange rate regimes. Thus, if it should be right, that the main incentive for beating inflation in Europe origins in the anticipation that the policy to devalue the currency has to be dismissed, then inflationary pressure should not resurrect in the EMU. In fact, with a single European money the costs of such a policy have risen tremendously.

Second, the ECB is probably the most independent central bank in the world.

Third, there will be less pressure on nominal wages. This has simple got to do with the fact that the bargaining power of unions erodes in the EMU. The following chapter puts forward some reasons to believe that capital becomes more mobile and that firms are not bound to one place of production. As the costs of shifting the production of goods and services declined, any firm that faces excessive wage claims can successively threat unions to close the plant and move somewhere else. This will keep nominal wage claims moderate.

Finally, with the EMU small open economies convert to lower import-export exposure, so that firms will have the opportunity of pricing-to-the-market Burda (1999). Customer relationships (Bils 1989) will become more important. Hence, firms will be more reluctant to make short run profits by adjusting prices to changing economic conditions. In addition to low inflation rates, prices will be more rigid.

Should those scenarios become true, Europe would be characterized by more flexible nominal wages, more rigid prices and governments that successfully deregulate national labor markets. All this would result in more flexible real wages.

The evidence on labor mobility in Europe, surveyed by Puhani (1999), can be summarized as follows: Compared with the U.S., total migration as a share of total population was generally lower in European countries in the past. Migration in Australia, Canada or Japan was higher than in Europe. Immigration contributed to labor mobility by as much as migration within Europe1. Finally, migration in Europe was largely migration within the European countries, rather than between the states, whereas people in the northern states of Europe are more inclined to move than in the southern countries like Italy or Spain.

Puhani (1999) claims that these results are questionable as what would be decisive are not total migration flows between European regions but how workers’ decision to move corresponds to economic conditions such as wages or unemployment rates. Based on the elasticities that he estimates it would take years until migration flows would have absorbed an economic shock.

But there is another, probably more important point to be made about these estimates as, again, the Lucas critique applies. The past may not accurately tell what happens in the future if agents’ believes about how the system works change. People may become more mobile if they are convinced that policy makers will not bail them out from unemployment by devaluating the currency or establishing generous unemployment benefit systems in the future as the costs of doing this have increased significantly. However, as far as we know there is only little evidence on labor mobility that relates to the period after the completion of the single European market (c.f. Krueger 2000). If we look at figure 1 we can see that migration measured as inflows in and out of the country in relation to the population, at least for Germany, has not risen at all but declined since 1993.

The evidence for Germany differs from that statement. In 1997, 840.633 people moved to Germany. 553.772 came from European countries, 180.432 from countries that belong to the European Union. Thus, migration within the European Union contributed to immigration by far less than a half of total immigration to Germany in 1997.

–  –  –

Source: Statistisches Jahrbuch 1999, p.77 and Statistisches Jahrbuch für das Ausland 1999, p. 39.

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