Europe's labour markets, dogged by persistently high unemployment and slow employment growth, have been the continent's central economic weakness over the past two decades. But if monetary union is to go ahead by 1999, it will be the operation of these markets that determines its success or failure. The speed with which the labour market responds is one of the two conditions proposed by Robert Mundell in 1961 for a successful monetary union or optimal currency area.

A single currency means that governments can no longer use changes in the exchange rate to cut real wages in the face of a fall in labour demand. According to Mundell, monetary union only makes sense under two conditions: first, when asymmetric regional supply or demand shocks are rare; and second, if and when a negative shock does occur, either out-migration or a fall in nominal wages prevents unemployment staying persistently high.

How does Europe measure up to these Mundell tests? And how does it compare with the successful US experience with a single currency? These are the questions addressed by Jörg Decressin and Antonio Fatás in work which compares labour market performance over the past twenty-five years across fifty-one European regions and fifty US states.

Their starting point is the pattern of regional disturbances across US states and Europe's regions. By comparing changes in regional employment rates with changes in total US and European employment, they identify the degree to which regional employment shifts reflect region-specific shocks rather than general European developments.

For Europe, the authors find that 80 per cent of shocks since the late 1960s have been idiosyncratic, compared with only 40 per cent for US states. This may, in part, be explained by differences in national macroeconomic policies. But even controlling for national effects, Decressin and Fatás find that more than 50 per cent of regional employment shocks are region-specific.

So Europe does not fare too well on the first Mundell test: asymmetric regional shocks are more common in Europe than in the US. Furthermore, the greater regional specialization that European economic integration is likely to encourage, may mean that asymmetric regional shocks become more rather than less common over the next few decades.

So how do Europe's regional labour markets respond to these asymmetric shocks? To make the comparison with the US, Decressin and Fatás replicate the seminal paper by Olivier Blanchard and Lawrence Katz which studies how US states respond to regional employment shocks. Surprisingly, given the fabled flexibility of US labour markets, Blanchard and Katz discover that state employment shocks tend to persist over time, even though state unemployment rates invariably return to their starting points.

The mechanism that drives this response at the state level is out-migration by displaced workers in search of new job opportunities. Blanchard and Katz also find evidence that real wages tend to fall following negative employment shocks. But the out-migration of unemployed workers swamps any in-migration of firms offering new jobs at lower wages.

Decressin and Fatás similarly find that, within Europe, regional employment shocks tend to persist over time, though this persistence is not as marked as in US states. And while the pattern of regional unemployment differentials across Europe is more stable than in the US, regional unemployment rates tend to return to their starting points relatively quickly after a general employment shock, just as in the US. This may appear surprising given the secular rise in overall European unemployment rates over the past two decades. But the authors find that, while common European unemployment shocks do tend to be persistent, the opposite is true for regional shocks.

It is here that the similarities between US and European labour markets end. While out-migration tends to return US state unemployment rates to their starting points following permanent employment shocks, such migratory phenomena do not occur between European regions on anything like the same scale. Instead, it is shifts in participation rates which reconcile the asymmetric pattern of employment and unemployment rates in the first years following the shock.

Unemployment rates tend to fall back not because employment increases or workers leave the region, but because they drop out of the labour force entirely. Decressin and Fatás suggest reasons why participation rates respond in this way: because unemployed workers drop out of the labour force, into early retirement or onto disability benefits, or because women and part-time workers tend to bear the brunt of employment shocks but are excluded from the unemployment count.

At first sight, the conclusions of the analysis are not encouraging for EMU enthusiasts. On both Mundell tests, Europe falls well short as a candidate for an optimum currency area. Compared with the US, employment shocks are distributed less symmetrically across regions, and labour markets are less able to absorb them. People are much less inclined to migrate, and unemployment rates return to their starting points only because unemployment becomes hidden as inactivity.

But this conclusion demands a substantial caveat. For, as the authors point out, when they repeat their analysis at the individual country level, they find that this pattern of differential regional shocks and sluggish labour market responses is as much a problem within existing national boundaries as across Europe as a whole. In short, moving to a monetary union may be no more risky than the status quo. Whether or not Europe has a single currency, it looks to be stuck with its poor performing labour markets into the next century.

This article reviews research reported in Regional Labour Market Dynamics in Europe, Discussion Paper No. 1085, by Jörg Decressin and Antonio Fatás, available from CEPR. Decressin is an economist at the International Monetary Fund. Fatás is an Assistant Professor of Economics at INSEAD, and a Research Affiliate in CEPR’s International Macroeconomics programme. (check details). The paper is produced as part of CEPR's research programme on Market Integration, Regionalism and the Global Economy, supported by the Ford Foundation.