The Achilles heel of the EMU: the labour markets
The common factor that holds a currency union together is definitely risk sharing. The risk of being exerted towards external shocks (energy and agricultural prices, financial shocks, productivity and aggregate demand shocks) needs to be equally distributed among the members of a currency union; then, this currency union is an optimal currency area (OCA). If this were not ensured it were not very important that the Euro is currently strong compared with the dollar and seems to become a World reserve currency. It is a well-known fact that the EU fulfils less of the conditions of an OCA than the U.S. due to some institutional restrictions of the EMU. There is no central fiscal transfer system as a buffer against regionally unevenly distributed shocks like in the U.S. Such a system seems to be necessary when the labour market of the single currency area is not sufficiently integrated, hence, does not allow for an even distribution of the adjustment costs of shocks. Indeed, this might be one of the crucial properties that defend the strength of the Dollar in the long run and undermines the rise of the Euro.
One of the conditions of risk sharing in an OCA is the similarity of output cycles, or the synchronization of business cycles. While business cycles of EMU countries show some synchronization since the Euro introduction in1999, it is well known that national labour markets are still separated with the consequence that the adjustment costs of external shocks are unevenly distributed. But, there is an ongoing debate whether a currency area needs to fulfil the conditions of an OCA ex ante or not. Frankel and Rose argued in their seminal paper from 1998 that a single currency and monetary policy cause the EMU to become an OCA ex-post, and many research papers tested this hypothesis in the field of output synchronization. But does that also apply to the field of labour markets? If yes, wage developments should become more similar, induced by more trade intensity or migration or FDI. Similar to studies on output synchronization one would have to look at de-trended data, for their movement includes the reaction of wage formation on shocks. A correlation analysis of de-trended real and nominal wage developments illustrates what is happening in the EMU behind the official success story. In fact, the synchronization of real and nominal wage developments weakened significantly since the introduction of the single currency, and since exchange rates as coordination and adjustment mechanisms were abandoned! Figure 1 depicts how strongly real and nominal wage developments deviated since the introduction of the Euro. The discrepancy between them underlines that national wage policies have a strong influence on wage setting and are able to outperform, at least, partly the correcting impact of different inflation rates or purchasing power parities. Indeed, those policies remain the only important national tool for the creation of competitive national monetary conditions under a single monetary policy: real interest rates deviate and with them the conditions for economic activity.
What Figure 2 illustrates are the different developments with respect to regional groups. Wage formation of the ‘Northern group’ with Germany, Austria, Belgium, and the Netherlands was more linked with other countries (mainly in the same group) than of the French-Mediterranean group until 2000. While synchronization of the latter remained stable after 2000, that of the first group weakened significantly. Macro-economic wage coordination, formerly ensured through the exchange rates of national currencies, actually broke down in German relations with other countries, accompanied by similar trends for Austria and Belgium Table 1).
One could argue that de-synchronization of wage developments would create national monetary conditions. However, this would be a second-best solution only in lifting the rigors of a single monetary policy (‘one jacket for all?’), and one has to ask why they need to be in a monetary union. Here, we find the basis of official and semi-official criticisms regarding the existing EU institutions, for example, Mr. Sarkozy’s proposal for a EU central budget, or his criticism of German value added tax increases as a method to export unemployment. The problem might worsen with the addition of new members with different labor market institutions and economic structures into the EMU. Clearly, a single currency and monetary policy cannot per se replace the exchange rate mechanism as core coordination institution among countries. Then, further reforms of EU institutions become necessary. The old accord, mainly supported by Germany, not to install central authorities which are too strong, will be challenged. Above all, a central EU budget with transfer functions as in the US would make EU institutions complete.