To reduce the negative effects of a bank-lending crunch on economic activity, adequate credit provision should be ensured. Further bank recapitalization, restructuring and consolidation of the banking sector, and regulatory reform decisions will reduce uncertainty. A long-lasting configuration of the euro-area’s fiscal architecture can be achieved by tightly coordinated reforms of national fiscal frameworks. Substantial benefits will emanate from deepening further structural reforms. Financial sector reform in the EU is proceeding at a rapid pace, and poses challenges and opportunities for the EU.

Abstract

To reduce the negative effects of a bank-lending crunch on economic activity, adequate credit provision should be ensured. Further bank recapitalization, restructuring and consolidation of the banking sector, and regulatory reform decisions will reduce uncertainty. A long-lasting configuration of the euro-area’s fiscal architecture can be achieved by tightly coordinated reforms of national fiscal frameworks. Substantial benefits will emanate from deepening further structural reforms. Financial sector reform in the EU is proceeding at a rapid pace, and poses challenges and opportunities for the EU.

III. Narrowing The Gap Between An Optimal Curreny Area And Emu: Integrating The Labor Market1

Europe stands at the crossroads. We either go ahead-with resolution and determination or we drop back into mediocrity. We can now either resolve to complete the integration of the economies of Europe; or, through lack of political will to face the immense problems involved, we can simply allow Europe to develop into no more than a free trade area.”

Commission White Paper to June 1985 European Council on Completing the Internal Market

1. This conclusion is even more valid today than it was twenty five years ago. The Single Market is now well advanced, and completing it remains key to revitalizing prosperity in Europe. But to ensure the continuity of EMU and make the most of European integration, enhanced adjustment capacity through the labor market will be needed.

2. Theory suggests four main channels through which equilibrium can be restored in presence of asymmetric shocks or asymmetric reactions to common shocks: market-driven price and wage adjustment, policy induced fiscal adjustment, risk-sharing against country-specific shocks through fiscal transfers and labor mobility. It is broadly agreed that, during its ten years of its existence, EMU has lacked the capacity to cope with such shocks due to inadequate price and wage adaptability, insufficient fiscal retrenchment in good times, ill-targeted EU budget transfers and poor labor mobility between Member States. This note argues that further harmonization of labor and social models is essential to enhance the adjustment capacity of markets and labor mobility within the area, while clarifying the role of EMU-wide fiscal transfers in the face of asymmetric shocks.

uA03fig01

Former EU 15 Member States: Structural indicators

(Stricter towards the periphery)

Citation: IMF Staff Country Reports 2010, 222; 10.5089/9781455205806.002.A003

Source: the indicators are the OECD summary measure of benefit replacement rates; an average of OECD tax wedge across two family ituations (a single worker and a couple with a dependent spouse and two children, at average earnings levels in both cases); the OECD summary index of employment protection legislation; the OECD summary index of product market regulation in non-manufacturing industries; an average of the OECD measures of implicit tax rates on continued work in old-age pension systems and early retirement schemes. All indexes were standardized to have zero mean and unit standard deviation across the whole available sample.

A. Structural Reform During The Lisbon Decade: Where Does Emu Stand?

3. The launch of EMU and the Lisbon Strategy did not mark a breakthrough in structural reform. The Lisbon Strategy was set up in 2000 to ensure that euro area members strengthen market forces to underpin their adjustment capacity. High expectations that the absence of exchange rate flexibility would generate an impetus to structural reform did not materialize during the early Lisbon years (van Poeck and Borghijs, 2001, Duval and Elmeskov, 2006, European Commission, 2008). Neither did implementation in EMU clearly outperform reform progress in non-EMU OECD countries following the 2005 mid-term review of the Lisbon strategy.

4. There were notable advances in deregulating product markets but less visible progress in core labor market areas. Euro-area members took important steps towards opening product market access. Labor market reform also progressed in activating female and older workers, but stalled in the areas of labor taxation, employment protection legislation, collective bargaining and unemployment benefits, all considered key to the adjustment capacity of EMU economies.

Compliance with Going for Growth recommendations of structural reforms: 2005–2008

article image
Sources: OECD Going for Growth 2010 and IMF Staff calculations. For each country group, scores are computed as the cross-country arithmetic mean of the degree of follow-up with annual OECD recommendations, as coded In the following manner: 3=action taken leading to removal of recommendation, 2=action taken, 1 = no significant measure, and 0=policy relapse.

5. Labor market efficiency is still much lower than in the 1960s. Labor market institutions became less employment friendly in Europe between the 1960s and the mid-1980s. Thereafter, higher employment rates and more rapid productivity growth in the US directed the attention towards the role of institutions in explaining differences in performance and created some political momentum for labor market reform in Europe in the run up to EMU, continuing during the Lisbon years. Even so, efficiency of European labor markets—as measured by the position of Beveridge curves—stays far way from its starting position in the 1960s (Nickell et al., 2001).

uA03fig02

The unemployment-vacancy relationship in 4 Euro Area countries Annual data, 1960–2007 1/

Citation: IMF Staff Country Reports 2010, 222; 10.5089/9781455205806.002.A003

Source: Unemploymentrates are Eurostat data. Vacancy rates until 1983 are taken from the Nickell and Nunziata (2001) databank, and extended there after using OECD data. Data are also available for France, Luxembourg, the Netherlands, Portugal, Spain, Sweden and the UK, but are omitted for the sake of brevity. In virtually all cases countries are far from reversing the outward movement in the Beveridge curves starting in the 1960s–70s. A notable example is the Netherlands, which in recent years seems to gravitate around the same curve as in the 1960s.1/ Latest data for Belgium 2003, and for Germany 2008.Note: Unemployment rates as a percentage of active population, vacancy rates as a percentage of total employment.

B. The Political Economy of Structural Reform

6. EU driven reforms have succeeded when accompanied with clear powers, but failed when reliant on peer pressure. Since the beginning, the Lisbon Strategy adopted a two-handed approach combining product market reform at the EU level with labor market and social policy reform at the national level. A top-down approach towards product markets seemed appropriate, as reform in these areas was generally perceived as essential and uncontroversial. By contrast, preferences over labor market and social models were considered country-specific and their case for reform less compelling. Still it was hoped that resolute actions by the center to implement reforms in products markets would enhance national incentives to carry out labor market improvements as they tend to be mutually reinforcing (Berger and Danninger, 2007); that countries would learn from best practices; and that intra-zone competitiveness spillovers would force non-reforming countries to follow active reformers. And soft coordination would eventually suffice to overcome the political resistance to labor market reform at the national level. However, these expectations were not met:

  • The absence of immediate pressure on exchange rates and the illusion of unlimited external financing under EMU made reforms to sustain competitiveness less compelling.

  • Advances in product market reform did not increase incentives to reform core labor market institutions enough to overcome the fierce resistance by large groups of insiders.

  • Learning spillovers across Member States were not fully exploited as governments were first and foremost constrained by political economy considerations. Reform episodes during the Lisbon years were characterized by piecemeal rather than comprehensive packages, often involving direct compensation to losers or complex trade-offs between institutions to overcome resistance in particular areas by compensating losers in other areas (Tompson and Price, 2009). This very much limited the scope for importing best practices or avoiding mistakes committed abroad. For instance, in the area of employment protection legislation, while some countries suffering the worst from labor market dualism in terms of efficiency and equity struggled to ease regulations of incumbents (Spanish 1994 and 1997 labor market reforms), others embarked on “two-tier reforms” (Hartz 2002–05 reforms of Germany, Treu 1997 and Biagi 2002 reforms in Italy) as a means to increase flexibility at the margin. As regards collective bargaining, whereas some countries quickly internalized the consequences of EMU to wage setting, wage increases in some others worsened the competitiveness impact of their relatively weaker productivity.

  • The reluctance to reform partly reflected the perception that voters punish reformist governments. However, the evidence suggests that reformist governments have the same likelihood of being re-elected as those that favor the status quo and that governments receiving a clear mandate to reform go on to be re-elected (Williamson and Haggard, 1994 and Buti et al., 2008).

C. Revisiting the Case For Structural Reform in Emu

7. Substantial benefits will emanate from deepening further structural reforms in EMU. Reform agendas differ across countries, but must focus on establishing a common set of regulations on labor contracts for all workers without constraining job turnover, further activating tax and benefit systems, seeking employment-friendly wage bargaining and liberalizing fully liberalizing services sectors. Such a reform package will yield substantial returns:

  • Ensuring the sustainability of social models: Social models that do not deliver high employment rates are not sustainable in the face of growing strains on public finances coming from population ageing and crisis-support measures. Key measures to lift employment growth include:

    • Improved labor market dynamism. Countries where employment rules are strict display lower turnover and are likely to experience a marked increase in structural unemployment following downturns (Mourougane and Furceri, 2009, OECD 2009). In good times employment rates are the highest in labor markets characterized by intense labor flows (Garibaldi and Mauro, 2002, Sapir, 2006). Boosting labor flows will require a relaxation of regulation on labor contracts.

    • Generous but limited-in-time unemployment benefits contingent on tightened activation and combined with effective training will protect workers during transitions, improve the quality of job matches, shorten unemployment spells and prevent job seekers from loosing skills and drifting into inactivity. Past reforms of this kind (best represented by Denmark during the 90s and the Hartz reforms in Germany 2002–05), were subsequently followed by sustained employment creation.

    • Further activating female and older workers: The labor supply of women and older workers has been found highly elastic to tax treatment and out-of-work benefits (OECD, 2005). Hence their participation could be raised substantially by making pension systems actuarially neutral and providing tax incentives for second earners.

    • Renewed impulse to the Single Market Program, especially in services sectors, will amplify the employment returns of labor market reform. Evidence shows that liberal product markets tend to reinforce the employment gains of labor market reform (Annet, 2007) and to reduce the persistence of unemployment following downturns (Guichard and Rusticelli, 2010).

  • Improved equity: Equity tends to be stronger in Continental and Nordic countries, characterized by higher taxes and redistribution. Adequate unemployment support conditional on strict job acceptance requirements, a tax mix biased towards indirect taxation and a tradition of responsible wage formation preserve work incentives and healthy employment in Scandinavian countries but tend to generate an efficiency-equity trade off in Continental economies, where these features are less present. Mediterranean countries, ranking the lowest in terms of equity, would benefit from better education policies and a reduction in labor market dualism. The latter should improve social inclusion by reducing the wage premium of incumbents over outsiders and mitigating employment volatility.

  • Enhanced productivity: Boosting competition in product markets through the completion of the Single Market Program will induce resource reallocation towards vibrant sectors and force companies to be more efficient either by fully exploiting economies of scale or encouraging innovation. Competition-restraining regulation is found to reduce innovation (e.g., Bassanini and Ernst, 2002, Jaumotte and Pain, 2005b) with the burden of regulation being greater the further a given country is away from best practice technology (Conway et al., 2006). A productivity-enhancing environment is especially needed in Southern countries.

  • A reduced impact of asymmetric shocks: With more harmonized labor market institutions, common shocks would not have as large asymmetric consequences as observed in the current crisis and better institutions would facilitate the adjustment to asymmetric shocks. Monetary policy would thus be more effective and less strain would be put on national budgets.

  • Higher labor mobility: Strict employment protection, limited portability of pensions, long-lasting and passive unemployment benefits and weak active labor market policies have been identified in the literature as deterring labor mobility and impairing the adjustment capacity of EMU to asymmetric shocks (Wasmer and Janiak, 2008).

  • Facilitating a rebalancing of regional growth: Stringent product market regulations and labor market institutions—i.e. relatively tighter employment legislation, generous unemployment benefits, higher tax wedges and wage floors—tend to cause persistent deviations of wages from productivity improvements, especially in countries where collective bargaining is dominated by sheltered sectors (Berger and Nitsch, 2010 and European Commission, 2008). Regaining cost competitiveness through labor market reform will be important for countries with current account deficits larger than justified by fundamentals, specialized in low technology goods. Surplus countries can also contribute through a different set of labor and services market reforms that could reinvigorate domestic investment and demand.

uA03fig03
Sources: Euro stat and staff calculations
uA03fig05
Sources: Eurostat and staff calculations
uA03fig06
Sources: Eurostat and staff calculations

D. Delivering Structural Reforms

8. Against this background, there are not just substantial benefits from reforms in euro area countries, but also from taking a simultaneous, comprehensive approach to make monetary union more effective and sustainable. Moreover, a coordinated move can be expected to help overcome political resistance to reform while generating substantial synergies across reform areas and across borders. Key actions to give more traction to the structural reform agenda at the supranational level should include:

  • Pursuit of a more integrated labor market: Properly functioning labor markets should be seen as an EMU public good and their harmonization-consistent with arts. 151 and 156 of the TFEU2—considered as a desirable outcome. Recent proposals by the Commission and the ECB and early deliberations by the Van Rompuy Task Force signal awareness of these issues, but progress will need to go much further. Ideally, features affecting most directly price and wage formation, namely labor taxation, unemployment benefits, employment protection legislation and some aspects of collective bargaining should be subject to heightened coordination and surveillance.

  • Strong commitment by the Eurogroup to structural reform: The peer review of fundamental structural reforms needs to be upgraded within the Eurogroup, which based on art. 136 of the TFEU should act as a collective body rather than engaging into political bargaining. Notably, it should provide systematic assessments and communicate in a transparent manner the benefits of reforms and the costs of the status quo from a euro-area perspective. This political dialogue should help individual countries to take the consequences for other Member States into account when designing their national policies, thereby creating an EMU-compatible framework.

  • Integrated surveillance with the Stability and Growth Pact: The Commission’s proposal to align in time the surveillance over structural reforms with fiscal policies and external imbalances is a welcome development. This should facilitate the analysis of policy interactions such as the effects of structural reforms on budgetary positions, the implications for fiscal consolidation of inadequate reform progress, and the role of the composition of budgets to support growth potential.

  • Surveillance over targets and policies: As reforms usually take time to materialize or their positive effects may be blurred by changes in the economic environment outside the control of governments, surveillance should look both at performance indicators (e.g., employment growth) and policy indicators (e.g., labor market institutions).

  • More power to issue warnings: Enforcement requires the Commission reaffirm its independence vis-à-vis the Council by issuing policy warnings (art. 121.2) with determination whenever it is judged that economic developments risk jeopardizing the proper functioning of EMU.

  • Sanctions and incentives to foster reform: Financial incentives could be channeled through a reformed EU budget where disbursements would be closely linked to reform implementation. Currently, the Common Agricultural Policy and Structural Funds, whose disbursement is contingent on very weak conditionality, absorb more than 70 percent of the budget. A larger proportion of resources should be allocated to strengthen market adaptability, possibly through higher provision of funds for the regional competitiveness and employment objective and the European Global Adjustment Fund. Alternatively, access to financing through a common EU bond could be modulated on the basis of compliance with reform implementation.

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Notes

1

Prepared by Esther Perez Ruiz.

2

TFEU stands for Treaty of Functioning of the European Union.

Euro Area Policies: Selected Issues
Author: International Monetary Fund