How Much Flexibility in European Labour Markets?

Increasing political pressure for greater flexibility in European labour markets ‘may be the economic equivalent of whipping a dead horse, and could provoke counter-productive reactions’. This conclusion appears in a paper published by the Centre for Economic Policy Research. A leading economist, Michael Burda, of Humboldt University in Berlin, says that the advent of the euro should make labour markets more flexible. As many others have pointed out, trade unions have national boundaries and will be unable to impose their rigidities on Euroland. Therefore at least one source of labour inflexibility will disappear. ‘My prediction is that unless an improbable miracle occurs in pan-European collective bargaining, labour markets will become more and not less flexible in the future.’

However, the euro will tend to increase some other rigidities. Prices could well be less responsive to changing economic conditions. This is because Euroland is an economic giant with only 10% of GDP flowing from foreign trade. This means that price competition from outside will be less effective in influencing pricing behaviour. And increasing cross-border mergers within Euroland will result in greater powers for large corporations to set prices. This ‘inwardisation’, as the author calls it, will mean that internal and external shocks ‘will have less impact on nominal wage and price setting, and will show up more strongly in output variation’. Economies where once prices changed rapidly in response to exchange rate movements will now behave differently with the result that rate movements will affect the real economy. Burda also points out that the expectations of low inflation in all countries, thanks to the nature of the European Central Bank, will mean contracts will inaviariably be negotiated in nominal terms, thus increasing the degree of nominal rigidity in the European economy.

Burda also argues that the euro will change the macroeconomics of Euroland fundamentally over the next decade. If the European Central Bank is as independent as is alleged, monetary policy will not be used to reflate the economy so there should be a new regime for both monetary and fiscal policy. There is the problem that fiscal policy is hobbled by the Maastricht Treaty and the Stability Pact. The author says that there could, therefore, be a growing temptation to adopt the approach of the recent German finance minister, Oskar Lafontaine, and employ a ‘domestic demand strategy’ for reflationary purposes. There is another pessimistic view which predicts grave consequences as a result of the rigidities induced by monetary union: countries may well be forced to regain competitiveness by painful means, as Britain did in the 1920s as a result of rejoining the gold standard. The author takes the view that not all rigidities in Europe are set in stone.

Burda says his analysis is based on a new Keynesian viewpoint: the evolution of the monetary union will provide much information for policy makers to see if its tenets are correct.

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The Author:

Michael Burda is a Professor of Economics at Humboldt University, Berlin and a Research Fellow in CEPR’s International Macroeconomics, Labour Economics and Transition Economics research programmes.