Europe has been struggling to raise trend-growth as a result of the lack of flexibility in its product and labor markets. The remedy to brighten the prospects for higher growth—structural reforms—has been well established. Diminishing regulations and barriers to competition in product markets would force firms to reduce the markup they charge customers and lead to lower prices for consumers, raising real wages and lowering resistance to labor market reforms (Blanchard and Giavazzi, 2003).
The focus of this study, setting it apart from previous applications of the IMF’s Global Economy Model (GEM), is on the transition dynamics and the potential gains from synchronizing structural reforms across markets and across countries within a monetary union, the euro area. Traded good market reforms alone have immediate positive effects on output, wages, and welfare, while stand-alone labor market reforms lead to output gains and reduce real wages. Stand-alone reforms in the nontraded sector, where rigidities are the highest, would push consumption and output significantly below baseline in the near term. Synchronizing the timing of product and labor market reforms mitigates downward pressures on real wages, but may not suffice to avoid a transitory decline of output, and especially of consumption below baseline. Coordinating reforms among euro area economies brings into play monetary policy, which will ease as reforms reduce inflation in the entire euro area. Monetary accommodation is sufficient to prevent a temporary fall in consumption. Long-run (steady-state) effects are consistent with earlier studies (Bayoumi, Laxton, and Pesenti, 2004).
In the version of GEM used here, the world is confined to the 2005-European Union (EU) and split into four blocs: a reforming economy (France or Belgium, respectively); the rest of the euro area (RE); a group of three non-euro-area EU members (Denmark, Sweden, and the United Kingdom); and a group of 10 new member states (NMS). Trade (in percent of GDP) covers intra-EU flows only. Therefore, the four blocs appear less open than they are in reality, and the spillover effects are limited to those that benefit EU members.
Behavioral parameters were taken from the relevant literature, some of which are invariant across countries, but others were modified using country-specific information. Differences across blocs and countries, which are geographically and culturally very close, were kept to the minimum necessary. Hence, all key elasticities of substitution, the discount factor, and habit persistence have been set at the same value. Based on a recent metaregression (Evers, de Mooij, and van Vuuren, 2005), the elasticity of labor supply with respect to wages is set at 0.33. This elasticity is key for the response of the model to labor market reforms. All agents have perfect foresight. EU economies are characterized by relatively strong real rigidities, relatively high adjustment costs in the investment equations, and strong habit persistence in consumption and labor supply, combined with a high intertemporal elasticity of substitution. Real rigidities and adjustment costs in price and wage equations are calibrated to reproduce realistic sacrifice ratios. Together, nominal and real rigidities generate typical VAR-type responses to shocks.
Monetary policy authorities are assumed to target 2 percent inflation three quarters ahead, while smoothing fluctuations in the interest rate, which is used as a policy instrument. The European Central Bank (ECB) sets monetary policy on the basis of area-wide indicators. Nominal interest rates in France and Belgium are determined by the ECB, which takes into account these countries’ inflation rates, weighted by their respective shares in area-wide GDP. With the euro as its currency, changes in relative prices between traded and nontraded goods, or the real effective exchange rate, take the form of inflation differentials and result in important cross-country variations in the real interest rate after shocks.
Fiscal policy is essentially passive; a fiscal rule ensures debt sustainability in the long run, with labor tax rates adjusting such that, after a shock, public debt returns to a target level. However, fiscal policy is not neutral; if structural reforms improve the tax base, the tax rate on labor declines with positive feedback effects on labor supply.
Bayoumi, T., D. Laxton, and P. Pesenti, 2004, “Benefits and Spillovers of Greater Competition in Europe: A Macroeconomic Assessment,” ECB Working Paper 341 (Frankfurt, European Central Bank).
Blanchard, O., and F. Giavazzi, 2003, “Macroeconomic Effects of Regulation and Deregulation in Goods and Labor Markets,” Quarterly Journal of Economics, Vol. 118, No. 3 (August), pp. 879–907.
Conway, P., V. Janod, and G. Nicoletti, 2005, “Product Market Regulation in OECD Countries: 1998 to 2003,” OECD Economics Department Working Paper 419 (Paris, Organization for Economic Cooperation and Development).
Crépon, B., R. Desplatz, and J. Mairesse, 2002, “Price-Cost Margins and Rent Sharing: Evidence from a Panel of French Manufacturing Firms” (unpublished; CREST-ENSAE, France).
Dobbelaere, S., 2004, “Estimation of Price-Cost Margins and Union Bargaining Power for Belgian Manufacturing,” International Journal of Industrial Organization, Vol. 22, No. 10 (December), pp. 1381–98.
Dumont, M., G. Rayp, and P. Willemé, 2006, “Does Internationalization Affect Union Bargaining Power? An Empirical Study for 5 European Countries,” Oxford Economic Papers, Vol. 58, No. 1, pp. 77–102.
Everaert, L., and W. Schule, 2006, “Structural Reforms in the Euro Area: Economic Impact and Role of Synchronization Across Markets and Countries,” IMF Working Paper 06/137 (Washington, International Monetary Fund).
Evers, M., R.A. de Mooij, and D.J. van Vuuren, 2005, “What Explains the Variation in Estimates of Labor Supply Elasticities?” CESifo Working Paper 1633 (Munich, CESifo Group Munich).
Jean, S., and G. Nicoletti, 2002, “Product Market Regulation and Wage Premia In Europe and North America: An Empirical Investigation,” OECD Economics Department Working Paper 419 (Paris, Organization for Economic Cooperation and Development).
Konings, J., J.P. Van Cayseele, and F. Warzynski, 2001, “The Dynamics of Industrial Markups in Two Small Open Economies: Does National Competition Policy Matter?” International Journal of Industrial Organization, Vol. 19, No. 5 (April), pp. 841–59.
Oliveira Martins, J., and S. Scarpetta, 1999, “The Levels and Cyclical Behaviour of Markups Across Countries and Market Structures,” OECD Economics Department Working Paper 213 (Paris, Organization for Economic Cooperation and Development).
Saint-Paul, G., 2004, “Did European Labour Markets Become More Competitive in the 1990s? Evidence From Estimated Worker Rents,” CEPR Discussion Paper 4327 (London, Centre for Economic Policy Research).
Luc Everaert is a division chief and Werner Schule a senior economist with the IMF’s European Department.
See Oliveira Martins and Scarpetta (1999); and Jean and Nicoletti (2002) for product markets; Saint-Paul (2004); Crépon, Desplatz, and Mairesse (2002); Dobbelaere (2004); and Konings, Van Cayseele, and Warzynski (2001) for joint labor-product market estimates; and Dumont, Rayp, and Willemé (2006) for estimates of union bargaining power.
Welfare gains are measured in present-value consumption units that would be needed to achieve the post-reform utility level, holding hours worked at baseline (compensating variation). Transitory declines in consumption matter for the present value (3 percent annual discount rate). However, with the focus on the long run, welfare effects of volatility in consumption as such are ignored (see Leigh, 2008).
Alternatively, more competition in the tradables sector lowers tradables prices vis-à-vis nontradables prices and therefore represents a real appreciation of the home currency.