Further tests for the Eurozone
The Eurozone adjustment channel will get a major test in the a long time. Resilient labour and product markets will be key to make sure that the adjustment is efficient and sustainable socially and politically. The need to set up place policies to improve harmful imbalances and favour adjustment in Eurozone countries is underscored in a legislative package recently proposed by the European Commission and the task completed by the EU Council Task Force on economic governance, chaired by Herman Van Rompuy. Promoting adjustment-friendly structural reforms can be among the objectives within the Europe 2020 strategy launched last March by the European Commission, and EU Member States will submit their National Reform Programmes by April 2011, which is assessed by the Commission, the EU Council, and the European Council (draft programmes will be submitted throughout November 2010).
Labour market reforms will feature strongly, as well as reforms ensuring the flexibleness of product prices and the mobility of production factors, among the ones that can donate to making the Eurozone adjustment channel far better. But, how exactly to indentify and prioritise the concrete reform measures that might help in this respect? Recent research of ours (Biroli et al. 2010), such as previous attempts to gauge the behaviour of inflation differences in the Eurozone (Honohan and Lane, 2003; Arpaia and Pichelmann, 2007), might provide some indications.
Measuring the potency of the adjustment mechanism
How exactly to measure whether Eurozone countries adjust needlessly to say following idiosyncratic shocks? Generally, inflation is likely to fall with regards to the remaining area in countries hit by asymmetric shocks that reduce economic activity regarding potential, while those facing shocks raising output above potential are anticipated to demonstrate higher inflation. These dynamics in relative inflation coincide with movements in cost competitiveness that help absorbing asymmetric shocks. Countries hit by negative shocks will dsicover their competitiveness improving and can reap the benefits of a stabilising boost in net exports, as the opposite may happen for countries hit by a positive shock.
To test if the above mechanism reaches work in Eurozone countries we regress inflation differentials on cyclical divergence (i.e. relative output gaps) in a panel data set for Eurozone countries. As additional controls, we are the lagged inflation differential as an inertia component (inflation is a persistent variable) and the lagged relative price level (capturing the actual fact that higher inflation is expected if the purchase price level is below that in partner countries). Moreover, for the years prior to the monetary union, the percentage change in the nominal exchange rate can be used as an explanatory variable, as exchange rate depreciations have a tendency to raise inflation above that in partner countries.
We find that price competitiveness reacts in a substantial way to relative output gaps, with each additional percentage point of output gap being connected with between 0.2 and 0.4 percentage points of additional inflation weighed against the other countries in the Eurozone (see our underlying paper Biroli et al 2010 for additional information). This reaction has somehow strengthened as time passes, as revealed by the regressions only considering years after 1998. Moreover, price competitiveness became not merely more reactive to asymmetric shocks but also less persistent, as indicated by the fall in the coefficient of lagged relative inflation.
The primary message is that, as the procedure for monetary unification implied the increased loss of the nominal exchange rate as an adjustment tool, inflation differentials have adjusted faster following the creation of the euro and displayed somehow stronger instantaneous a reaction to shocks. Reforms reducing nominal rigidities completed during the past decades in a number of Eurozone countries could be among the possible explanations because of this evidence.
Can reforms are likely involved?
With a view to assessing the role of the functioning of product and labour markets on the result of price competitiveness, we gauge the impact of varied types of labour market regulations and institutions on the response of inflation differences to cyclical divergences and on the competitiveness inertia. Our results claim that there are product and labour market institutions that could possibly matter. Product market regulations, employment protection legislation and minimum wages may actually are likely involved, unlike unemployment benefits.
Our result is consistent with expectations. It’s been shown empirically that firms have a tendency to reset more often their prices in markets more available to competition (see e.g. Fabiani et al. 2006) in order that less rigid regulations are anticipated to be connected with lower nominal rigidity.
Stringent employment protection legislation seems to decrease the responsiveness of relative inflation to cyclical divergence and raise its persistence. This result is in keeping with existing theoretical and empirical work showing that strict legislation, by raising the bargaining power of protected workers ("the insiders"), may hamper the adjustment of wages (e.g. Holden 2004; Holden and Wulfsberg 2005).
High minimum wages also may actually reduce the result of competitiveness to cyclical divergences and increase its persistence of inflation differentials, which is what should be expected when high minimum wages are in conjunction with indexation clauses that create a link between minimum wages and past inflation.
Although assessing empirically the consequences of regulations and institutions involves considerable difficulties and results should be interpreted carefully, strengthened analytical efforts in this area may help identify reform priorities to boost the adjustment capacity of Eurozone economies.
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