European Labor Markets and EMU Challenges Ahead

• Author: Rüdiger Soltwedel, Dirk Dohse, and Christiane Krieger-Boden
• Position: Regional Economics research department at the Kiel Institute of World Economics, Kiel, Germany/Regional Growth and Spatial Structure research group at the Kiel Institute of World Economics, Kiel, Germany/Staff member at the Kiel Institute of World Economics, Kiel, Germany

The debate about European Economic and Monetary Union (EMU) has so far been dominated by questions of fiscal convergence and macroeconomic stability. Far less attention has been given to EMU's effects on labor markets, although labor market performance will be crucial in determining the long-term success or failure of EMU.

Currency unions like EMU have certain undisputed benefits. They reduce the costs for foreign exchange and hedging transactions and heat up competition in goods and factor markets, which stimulates trade, investment, growth, and employment. However, the members of currency unions must also relinquish two important policy instruments for responding to economic shocks: an independent monetary policy and currency devaluation. When these tools are unavailable, asymmetric shocks-shocks that affect some countries or regions in a currency union but not others-put pressure on national labor markets and may boost unemployment rates in affected areas.

The exchange rates between the currencies of European Union (EU) member states played an important role as shock absorbers before the establishment of EMU on January 1, 1999. EU members hit by asymmetric shocks responded by adjusting prices (particularly the nominal exchange rate) rather than by adjusting output. The incidence of asymmetric shocks has been higher for Finland, Greece, Ireland, Italy, Portugal, Spain, Sweden, and the United Kingdom than for Austria, Denmark, France, Germany, and the Benelux countries.

Among the EU members prone to asymmetric shocks, Finland, Italy, and Spain also have inflexible labor markets and are therefore the countries most likely to experience rising unemployment as they adjust to shocks (see table). From a labor market point of view, Austria and the Netherlands appear to be the EU members best prepared for EMU. Although Ireland, Portugal, and the United Kingdom have high exposure to asymmetric shocks, their labor markets are flexible enough to absorb shocks without huge increases in unemployment. In contrast, Belgium, Denmark, France, and Germany would probably see greater structural unemployment in response to shocks, however rare such shocks might be.

[ SEE THE GRAPHIC AT THE ATTACHED RTF ]

Historic patterns of susceptibility to shocks may not persist in the euro area, one reason being that EMU has eliminated some of the major sources of asymmetric shocks-namely, inconsistent national monetary policies and speculative attacks on national currencies; moreover, EMU members have less scope for implementing destabilizing national fiscal policies. However, even a common monetary policy can be a source of asymmetric shocks. U.S. monetary policy, for example, has generated asymmetric shocks to regions in the United States because of structural differences in regional economies.

Hence, the probability of asymmetric shocks depends upon the economic structures-and their development over time-of countries participating in a currency union. The...