Labor market reforms and current account imbalances - beggar-thy-neighbor policies in a currency union?

Member countries of the European Monetary Union (EMU) have 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. This process is ongoing, as countries that are faced with serious labor market imbalances perceive reforms as the fastest way to restore competitiveness within a currency union. This fosters fears among observers about a beggar-thy-neighbor policy that leaves non-reforming countries with a loss in competitiveness and an increase in foreign debt. These fears cannot be corroborated by us for the specific bundle of reforms applied in the early and mid-2000s. Using a two-country, two-sector search-and-matching DSGE model, we analyze the impact of labor market reforms on the transmission of macroeconomic shocks in both non-reforming and reforming countries. We examine the effects of three types of labor market reform measures applied in Eurozone member countries in the early 2000s on the foreign debt, reflecting current account positions of previous periods, of a non-reforming country. We implement reforms as a change in the institutional setting affecting macroeconomic stability rather than as a shock.  By analyzing  the impact of these reforms on foreign debt, we contribute to the debate on whether labor market reforms increase or reduce current account imbalances. We find that the impact of labor market reforms on current account imbalances relies on the specific bundle of reforms. Future labor market reforms, however, might have an impact on current account imbalances if they concentrate on single measures or countries apply reforms unevenly.