Labour market reforms and current account imbalances

Member countries of the European Monetary Union (EMU) initiated wide-ranging labor market reforms in the last decade. These reforms tend to have stabilized output and employment during the economic and financial crises. For this reason, countries that are faced with serious labor market imbalances, perceive reforms as the fastest way to restore competitiveness. Observers, nevertheless, fear a beggar-thy-neighbor policy that leaves non-reforming countries with a loss in competitiveness and an increase in foreign debt. In this paper, we follow an indirect approach that treats structural reforms as a change in institutional settings rather than a shock. This adds to an already growing literature analyzing the impact of labor markets reforms on macroeconomic stability using similar methods.

The contribution of this paper is to provide a two-county two-sector DSGE model with search and matching frictions that enables us to identify the contribution of different labor market reform measures on a transitory current account deficit of non-reforming countries. In addition to previous models, we include trade, international borrowing and preferences for the consumption of home tradables. In such a setting, households adjust consumption according to differences in the terms of trade so that international borrowing gives rise to a current account deficit or surplus. As the labor market stance has an influence on prices and productivity, reforms can have an impact on net exports and the current account.

Our model implies that in the case of a positive technology shock, fears about a beggar-thy-neighbor policy cannot be confirmed. We find a positive effect of a reduction in the replacement rate that more than compensates negative spillovers from an increases in matching efficiency and a decrease in vacancy posting costs. This does, however, not hold for a negative productivity shock in a non-reforming country. The reason for this phenomenon is that the third reform measure, a reduction in vacancy posting costs in the tradable sectors, is clearly dominating the overall impact of labor market reforms. This enables the reforming country to take over some of the production of the non-reformer which increases the current account deficit. The impact of labor market reforms in the latter case, however, is small in size compared to the impact of labour market reforms in the first case. That's why, having all scenarios in mind, we consider labour market reforms of EMU members as a benefit for the union as a whole.