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Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Towards completing EMU: The case for wagecoordination among member states
Martin Gachter1, Alexander Gruber2 and Aleksandra Riedl1
1Oesterreichische Nationalbank
2University of St. Gallen / Stanford University
Empirical Economics and Econometrics SeminarUniversity of Innsbruck, March 2014
The views expressed are strictly those of the authors and do in no way commit the
Oesterreichische Nationalbank (OeNB) or the Eurosystem.
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Motivation
European debt crisis brought optimum currency area (OCA) theoryback to the center of economic policy debates
• What policy measures are needed to stabilize the euro area?
• Reform of EMU governance structures
→ European Semester→ Macroeconomic Imbalances Procedure (MIP)→ European Systemic Risk Board (ESRB)→ Reform of the Stability & Growth Pact, Fiscal Compact→ Banking Union→ EFSF, ESM→ Europe 2020 etc.
Martin Gachter (OeNB) The case for wage coordination among EMU member states 1 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Macroeconomic Scoreboard - MIP
Source: Alert Mechanism Report 2014, European Commissionhttp: // ec. europa. eu/ europe2020/ pdf/ 2014/ amr2014_ en. pdf
Martin Gachter (OeNB) The case for wage coordination among EMU member states 2 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Macroeconomic Scoreboard - MIP (ctd.)
Source: Alert Mechanism Report 2014, European Commissionhttp: // ec. europa. eu/ europe2020/ pdf/ 2014/ amr2014_ en. pdf
Martin Gachter (OeNB) The case for wage coordination among EMU member states 3 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Motivation (ctd.)
Empirical literature on OCAs
• Business cycle (BC) synchronization as a ’meta-criterion’ for enteringa currency union (see e.g. de Haan, 2008)
Are EMU governance reforms in line with OCA theory?
• Determinants of business cycle synchronization
→ Bilateral trade relations (Frankel & Rose, 1998)→ Fiscal policy (Darvas et al., 2005)→ Financial integration (Imbs, 2004)→ Industrial specialization (Krugman, 1991)→ EMU membership (Gachter & Riedl, 2013)→ etc.
Martin Gachter (OeNB) The case for wage coordination among EMU member states 4 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Motivation (ctd.)
Empirical literature on OCAs
• Labor market developments and competitiveness - while at the centerof policy discussions - have not been examined so far as a majordeterminant of BC synchronization.
Research question: The impact of diverging labor costs on (bilateral) BCsynchronization
• First empirical study that examines this empirical relationship both forEMU and non-EMU countries
• New BC synchronization measures allow panel estimation methods
• Empirical results show that labor cost developments are crucial forEMU member countries, while being insignificant for other countries
Martin Gachter (OeNB) The case for wage coordination among EMU member states 5 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Theoretical Background I: OCA
Early contributions: Several prerequisites for successful monetaryintegration
• price and wage flexibility (Friedman, 1953)
• mobility of factors of production including labor (Mundell, 1961)
• financial market integration (Ingram, 1962)
• similarities of inflation rates (Fleming, 1971)
• fiscal integration (Kenen, 1969)
• high degree of economic openness (McKinnon, 1963)
• criteria are endogenous (Frankel & Rose, 1998)
• etc.
→ All criteria intended towards facilitating cyclical adjustment→ High level of BC synchronization lowers costs of common currency
Martin Gachter (OeNB) The case for wage coordination among EMU member states 6 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Theoretical Background II: OCA and Labor Markets
Early OCA theory emphasized crucial role of labor markets
• Crucial role of labor mobility (Mundell, 1961)
• “The principal danger ... in participating in a fixed exchange rate area arises fromthe certainty, in the absence of perfect competition in product and factor markets,that developments would occur from time to time that pushed the relative costlevels of the participating countries out of line.” (Fleming, 1971)
• Similar inflation rates more likely with increasing similarity of
- national employment goals,- rates of productivity growth, and- the degree of trade union aggressiveness.
→ Divergencies in relative nominal unit labor costs (NULC) more likely if trade unionsand employers’ organizations are organized on a national basis. (Fleming, 1971)
Martin Gachter (OeNB) The case for wage coordination among EMU member states 7 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
The Role of Divergent Labor Cost Dynamics in EMU
• Labor cost divergence would require corresponding exchangerate adjustments
• Members of a currency union lose their control over monetary policyand the possibility of exchange rate movements to adjust to internal(inflation) and external (trade deficits) imbalances.
• Recent studies show that BC correlation increases with increasingexchange rate volatility (de Haan et al, 2002; Bergman, 2006)
→ Crucial role of labor market institutions and wage setting mechanisms
Martin Gachter (OeNB) The case for wage coordination among EMU member states 8 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Labor Cost Developments in EMU
Martin Gachter (OeNB) The case for wage coordination among EMU member states 9 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
NULC and BC Synchronization I
• Pre-crisis boom phase: The internal perspective
- Peripheral countries recorded above-average increases in NULC- Persistent inflation differentials led to differences in real interest rates- Stimulation of domestic demand, credit growth and housing markets- Increasing demand further drives up NULC and causes wage-driven
inflation→ Self-reinforcing vicious circle→ Further facilitated by capital market failure of converging nominal
interest rates across countries (Keuschnigg, 2012)
→ NULC divergence decreases BC sychronization
• Inflation differential within EMU were commonly explained by theBalassa-Samuelson effect
- But: Inflation differentials originated from the non-tradeable sector,indicating domestic demand booms (reversed sequence)
Martin Gachter (OeNB) The case for wage coordination among EMU member states 10 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
NULC and BC Synchronization II
• Post-crisis bust phase: The external perspective
- Inflation differentials in a CU stemming from wage developmentsdirectly translate into changes in real exchange rates
- Decrease of export market shares, deterioration of trade and currentaccount balances
- Once again, the adjustment mechanism of nominal exchange rates isnot available
- Over time, decrease in competitiveness dampens domestic booms, thefollowing bust is considerably larger
→ Effect further accelerated by global financial crisis, diverging nominalinterest rates and sharp decline in external demand
→ Rigid labor market policies and nominal wage stickiness furtherimpeded necessary adjustments
→ NULC divergence decreases BC sychronization
Martin Gachter (OeNB) The case for wage coordination among EMU member states 11 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Labor Cost Developments and BC Synchronization
→ How do NULC developments affect (bilateral) BC co-movement?
Martin Gachter (OeNB) The case for wage coordination among EMU member states 12 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Measuring BC Synchronization on an Annual Basis
Adapted version of a synchronization index developed by Cerqueira &Martins (2009):
Correlij ,t =1
2log
(1 +
ρij,t2T−3
1− ρij ,t
)
ρij,t = 1− 1
2
cj,t − c j√1T
∑Tt=1(cj,t − c j)2
− ci,t − c i√1T
∑Tt=1(ci,t − c i )2
2
cj,t ... cyclical component of real GDP (using HP- & BK-filter) / real GDP growth rates
It can be shown that 1T
∑t ρij,t = ρij with ρij =
Cov(ci ,cj )
σ(ci )σ(cj )
Martin Gachter (OeNB) The case for wage coordination among EMU member states 13 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Measuring BC Synchronization on an Annual Basis
(a) AT&DE: 1T
∑t ρ
Cycleij,t = 0.93 (b) PT&SK: 1
T
∑t ρ
Cycleij,t = 0.34
Martin Gachter (OeNB) The case for wage coordination among EMU member states 14 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Panel Data Sample
• 27 EU countries (excl. Croatia), i.e. 27×(27−1)2 = 351 country pairs
• Annual observations, period 1993− 2011
• Overall observations: 6669
Martin Gachter (OeNB) The case for wage coordination among EMU member states 15 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Main Explanatory Variables
• Nominal Unit Labor Costs
Labor costsij,t = | ˙nulc i,t − ˙nulc j,t |
where ˙nulc i(j),t =nulci(j),t−nulci(j),t−1
nulci(j),t−1∗ 100
• EMU membership
EMUij,t =
{1, if i and j are EMU members in year t,
0, otherwise.
• Interaction term
Labor costsij,t × EMUij,t
Martin Gachter (OeNB) The case for wage coordination among EMU member states 16 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Main Explanatory Variables (ctd.)
Sample averages for country pairs by EMU membership, 1993-2011
Variable Full sample Non-EMU EMU
Correlij,t 1.26 1.21 1.50Labor costsij,t 7.70 8.84 2.13
Compensation per employeeij,t 10.58 12.41 2.00
No. of observations 6,048 4,983 1,065
Partial Correlation Coefficients for Business Cycle Synchronization
nominal unit labor costs compensation per employee
Labor costsij,t -0.04*** -0.10***Labor costsij,t × EMUij,t -0.05*** -0.07***
EMUij,t 0.09*** 0.10***
Martin Gachter (OeNB) The case for wage coordination among EMU member states 17 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Control Variables
• Bilateral trade
Bilateral tradeij,t =Exportsij,t + Exportsji,t
GDPi,t + GDPj,t
• Fiscal policy differences
Fiscal policyij,t = |fbcai,t − fbca
j,t |where fbca
i(j),trepresents the cyclically adjusted fiscal balance (net lending/net borrowing in
percent of GDP) of country i(j) at time t
• Financial integration
Financial integrationij,t =Ai,t + Li,t + Aj,t + Lj,t
GDPi,t + GDPj,t
where Ai(j),t and Li(j),t represent a country i(j)’s total external assets and liabilities(portfolio equity, foreign direct investment, debt and financial derivatives) in year t (seeLane & Milesi-Ferretti, 2007)
Martin Gachter (OeNB) The case for wage coordination among EMU member states 18 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Empirical Model
Correlij ,t = α + β1Correlij ,t−1 + β2Labor costsij ,t + β3EMUij ,t
+β4(Labor costs× EMU)ij ,t + β5Zij ,t + µij + λt + νij ,t
Zij,t ... ijtth observation on three control variablesµij ... country-pair specific effectsλt ... time effectsνij,t ... error term
Feasible system GMM estimator (Blundell & Bond, 1998)
• endogenous variables: EMU, labor costs, interaction term, bilateral trade
• arbitrary pattern of heteroskedasticity
• external instruments for trade (distance, common border, population size)
• number of instruments is restricted (up to five time lags)
Martin Gachter (OeNB) The case for wage coordination among EMU member states 19 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Empirical Results
No Baseline Altern. ULC Altern. ULC BK-filter Unfiltered Excluding RE-modelcontrols measure 1 measure 2 GDP growth crisis
(1) (2) (3) (4) (5) (6) (7) (8)
Labor costs -0.002 -0.007* -0.001 -0.001 -0.001 0.007 -0.005 -0.004*(-1.08) (-1.81) (-0.28) (-0.46) (-0.13) (1.58) (-1.39) (-1.74)
EMU member 0.499*** 0.289*** 0.340*** 0.378*** 0.663*** 0.303*** 0.644*** 0.212***(6.83) (3.41) (3.66) (4.59) (6.11) (3.22) (6.78) (3.36)
Labor costs × EMU -0.133*** -0.108*** -0.092*** -0.145*** -0.212*** -0.143*** -0.236*** -0.052***(-4.90) (-3.55) (-2.96) (-4.50) (-6.02) (-4.09) (-7.41) (-2.63)
Bilateral Trade 0.074*** 0.069*** 0.072*** 0.053*** 0.051*** 0.058*** 0.064***(5.12) (4.47) (5.03) (3.45) (3.96) (3.60) (5.94)
Fiscal Policy -0.014** -0.022*** -0.022*** 0.007 -0.003 -0.006 -0.042***(-2.35) (-3.92) (-3.87) (0.88) (-0.53) (-0.90) (-8.20)
Financial integration 0.189*** 0.065 0.161*** 0.083* 0.106*** 0.081* 0.056***(4.69) (1.63) (3.88) (1.73) (2.62) (1.94) (2.66)
Correlt−1 0.158*** 0.073*** 0.083*** 0.063*** 0.039** 0.138*** 0.093***(4.64) (4.62) (4.89) (3.96) (2.06) (4.51) (5.51)
Obs 6196 5701 4974 5537 4606 5703 4299 5446Hansen 337.3212 341.9314 344.3582 348.3925 343.5011 343.6728 340.7910
Hansen p 0.1053 0.8119 0.9812 0.7379 0.7952 0.7107 0.4625AR(1) p 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000 0.0000AR(2) p 0.8056 0.2333 0.0930 0.2370 0.8300 0.0999 0.1147
Martin Gachter (OeNB) The case for wage coordination among EMU member states 20 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Robustness Check: Country Exclusion
Country Labor costs Labor costs×EMU Country Labor costs Labor costs×EMU
Austria -0.007* -0.110*** Ireland -0.007* -0.130***(0.004) (0.035) (0.004) (0.035)
Belgium -0.009** -0.105*** Italy -0.006* -0.092***(0.004) (0.032) (0.004) (0.034)
Bulgaria -0.006 -0.109*** Lithuania -0.011*** -0.107***(0.004) (0.031) (0.004) (0.031)
Cyprus -0.006 -0.123*** Latvia -0.010*** -0.112***(0.004) (0.031) (0.004) (0.031)
Czech Rep. -0.007* -0.109*** Luxembourg -0.008** -0.102***(0.004) (0.030) (0.004) (0.030) )
Germany -0.006 -0.083** Malta -0.008** -0.098***(0.004) (0.034) (0.004) (0.033)
Denmark -0.006* -0.106*** Netherlands -0.007* -0.089***(0.004) (0.031) (0.004) (0.032)
Estonia -0.009** -0.113*** Poland -0.004 -0.114***(0.004) (0.031) (0.004) (0.032)
Spain -0.007* -0.110*** Portugal -0.007* -0.119***(0.004) (0.035) (0.004) (0.031)
Finland -0.006 -0.095*** Romania -0.002 -0.103***(0.004) (0.034) (0.005) (0.032)
France -0.006* -0.107*** Sweden -0.007* -0.101***(0.004) (0.033) (0.004) (0.031)
UK -0.005* -0.101*** Slovakia -0.005 -0.122***(0.004) (0.031) (0.004) (0.031)
Greece -0.007* -0.089** Slovenia -0.006 -0.125***(0.039) (0.040) (0.004) (0.029)
Hungary -0.004 -0.114***(0.004) (0.032)
Sensitivity of Labor Cost Coefficients to Country Exclusion
Martin Gachter (OeNB) The case for wage coordination among EMU member states 21 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Discussion & Conclusion
• Early literature highlighted several prerequisites for a country group toconstitute an OCA
- BC synchronization as a “meta-criterion” to assess the appropriatenessof a CU
- Remaining prerequisites are still important to facilitate economicadjustment in case of asymmetric shocks
• Some countries experienced unsustainable pre-crisis booms
- Policy-makers partly reckoned those developments as being part of awelcomed catching-up process
- Policy institutions in the EA were also powerless to correct imbalances
Martin Gachter (OeNB) The case for wage coordination among EMU member states 22 / 23
Motivation Theoretical Background Data & Empirical Approach Discussion & Conclusion
Discussion & Conclusion (ctd.)
• Impact of ULC dynamics on BC synchronization has so far beenneglected by empirical literature
- Empirical results show a strong effect of ULC dynamics within EMU- ULC developments hardly matter for countries outside a CU where
exchange rates can adjust accordingly
• Results add to current debate on structural reforms in EMU
- Crucial role of (national) wage-setting mechanisms and institutions- Alert Mechanism Report (AMR) / Macroeconomic Imbalances
Procedure as an important step in the right direction- Nominal thresholds for each variable are however insufficient to monitor
relative wage developments- Further efforts needed to establish effective monitoring systems
Martin Gachter (OeNB) The case for wage coordination among EMU member states 23 / 23
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