Wage Inflation and the Distribution of Output Gaps in Europe: Insiders vs. Outsiders

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1 Economtric Rsarch and Spcial Studis Dpartmnt Wag Inflation and th Distribution of Output Gaps in Europ: Insidrs vs. Outsidrs M. Dmrtzis and A. Hughs Halltt Rsarch Mmorandum WO&E no. 631 Sptmbr 2000 D Ndrlandsch Bank

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3 WAGE INFLATION AND THE DISTRIBUTION OF OUTPUT GAPS IN EUROPE: insidrs vs. outsidrs M. Dmrtzis and A. Hughs Halltt * * Univrsity of Strathclyd, Glasgow and CEPR. W would lik to thank Francsco Zantti for hlping collct th data. With th usual disclaimr, w would also lik to thank Kirstin Hubrich and Ptr Vlaar for commnts and suggstions. Rsarch Mmorandum WO&E no. 631/0026 Sptmbr 2000 D Ndrlandsch Bank NV Economtric Rsarch and Spcial Studis Dpartmnt P.O. Box AB AMSTERDAM Th Nthrlands

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5 ABSTRACT Wag Inflation and th Distribution of Output Gaps in Europ: Insidrs vs. Outsidrs M. Dmrtzis n A. Hughs Halltt This papr xamins whthr Europ's montary union framwork of "ins" and "outs" rflcts diffrncs in markt structurs undrpinnd by rlativly immobil labour. Such a situation could giv ris to sufficint nominal convrgnc to satisfy th ntry rquirmnts to EMU, but littl ral convrgnc and hnc a significant incntiv for som to stay outsid. Using modls of wag ladrship vs. locational comptition, w xamin th xtnt and strngth of intgration in labour markt costs using a sampl of data covring th 1980s and 1990s - i.. for th run up to EMU. This xposs a conflict btwn ral and nominal convrgnc which is ultimatly incompatibl with furthr intgration. Th mpirical vidnc suggsts that wag bargainrs now appar to focus mor on thir own domstic markt conditions. That may dlivr a bttr conomic prformanc, but littl xtra intgration. Ky words: EMU, Unmploymnt, ral vs nominal convrgnc, locational comptition JEL cods: F15, F42, J60 SAMENVATTING Looninflati n d vrdling van output gaps : ins vs outs M. Dmrtzis and A. Hughs Halltt In dz studi wordt ondrzocht of ht EMU-raamwrk van ins n outs kan wordn vrklaard uit vrschilln in marktstructurn tussn landn, uitgaand van n gbrkkig arbidsmobilitit. En drglijk situati kan nrzijds lidn tot voldond nominal convrgnti (in ht licht van d totrdingsisn tot d EMU), maar andrzijds tot n gring rël convrgnti, htgn n prikkl kan zijn om buitn d montair uni t blijvn. Op basis van wag ladrship vrsus locational comptition modlln wordn d significanti n kracht van d convrgnti in arbidskostn ondrzocht voor d jarn 80 n 90, dat wil zggn voor d aanloopppriod naar d EMU. D uitkomstn wijzn op n conflict tussn nominal n rël convrgnti dat in bginsl onvrnigbaar is mt vrdr intgrati. Bovndin lijkn d loonondrhandlingn zich mr door national marktconditis t latn lidn. Dit kan rsultrn in n btr conomisch prformanc op nationaal nivau, maar bvordrt nit d intgrati. Trfwoordn: EMU, wrklooshid, nominal vrsus rël convrgnti, locational comptition JEL cods: F15, F42, J60

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7 - 1-1 INTRODUCTION Economic and Montary Union (EMU) in Europ startd with 11 participants on 1 January At that stag four countris dcidd not to participat, rsrving th right to join latr if thir conomis had convrgd mor closly on th avrag prformanc of th xisting EMU mmbrs. Howvr it was not spcifid if this convrgnc should b in ral or in nominal trms. On might xpct ral factors to play a prominnt rol in this dcision sinc thr of ths four "outsidrs" (Swdn, Dnmark and th UK) had bn abl, but unwilling, to join EMU at th start. Thy had satisfid all th nominal Maastricht convrgnc critria for ntry into EMU, but had chosn not to join. It is thrfor likly that a mor robust convrgnc in ral trms would b ndd to prsuad thm to join. Th fourth outsidr (Grc) was dmd not to hav satisfid th convrgnc critria in 1998, but announcd hr intntion to join as soon as sh had convrgd sufficintly - now in so th sam point applis to hr. Sinc thn, a rang of cntral Europan countris hav bn accptd as candidat mmbrs of th EU, and onc again th issu will b whthr thr has bn sufficint convrgnc in ral as wll as nominal trms.1 This papr xamins wag cost bhaviour among th currnt st of ins and outs in ordr to dtrmin th xtnt of thir conomic intgration and convrgnc in th run up to EMU. W ask whthr thr has bn incrasing divrgnc or convrgnc in labour costs bcaus, in a world of highly mobil capital and wll intgratd and mobil goods markts, th traditional rigiditis and lack of mobility in Europ's labour markts could wll mak th structural diffrncs btwn th Europan conomis a prmannt stat of affairs and th convrgnc thn mor difficult to achiv. 1 Although th candidat countris' cas for ntry will not b judgd solly on thir fulfilmnt of th Maastricht critria.

8 - 2 - Our analysis looks at th dgr of comptition or intgration btwn th wag bargains in th national labour markts, both mpirically and analytically, and finds that whr convrgnc has bn taking plac, it has bn painfully slow. Part of th rason for this is that thr is a sharp conflict btwn ral and nominal convrgnc, with th formr having bn nglctd in favour of th lattr. Howvr th "wag ladrship" forcs which producd that ffct appar to hav subsidd, and countris hav, if anything, convrgd on a modl of bhaviour in which wags bcom mor snsitiv to xcss supply or dmands in thir own conomis. It is not clar if that will incras convrgnc, but it should at last - if combind with suitabl structural rforms - provid for bttr prformancs on avrag. 2 THEORY: WAGE TRANSFERS VERSUS LOCATIONAL COMPETITION 2.1 Wag Transfr Mchanism In th rgional conomics litratur, an important factor in trad union bargaining for highr wags, is th xistnc of wag incrass for comparabl mploys in diffrnt labour markts. Originally this was said to b th rsult of comparisons with wag sttlmnts in a lading sctor or lading industry in th conomy. Th rsult would b an upward drift in th avrag lvl of wags towards thos in th lading sctor vn whn th cost or productivity lvls in th lss prosprous sctors do not justify such wag incrass (Thomas and Stony, 1971). Indd, according to Bhaskar (1990), "...Workrs car for fairnss, and rsnt bing paid lss than idntical workrs in othr sctors". This implis som qualising forcs in wag bargaining, with wags dtrmind in part by conditions prvailing in a lading sctor which xrts upward prssur on national wag lvls. Of cours in th absnc of prfct labour mobility this could just as asily happn btwn rgions, with wags in a

9 - 3 - lading rgion stting th pac instad.2 Indd Thirlwall ( ) justifis this proposition on at last thr grounds: "...1) if xcssiv arnings drift taks plac in a givn industry in on rgion, this may add to prssur lswhr on th union to ngotiat an upward rvision of th basic rat for all workrs, irrspctiv of th prssur of dmand for labour in th industry in othr rgions. 2) That in turn may produc upward prssurs on wag bargaining in th country as a whol. 3) Within a rgion xprincing an incrasd prssur of dmand for labour, th customary arning diffrntials may gt out of lin, and if th rgion is an important mployr of workrs in crtain "ky" industris this may provok unions lswhr to start national bargaining for a highr basic wag...". Thus th rol of th "ladr" whos wag ngotiations ar closly obsrvd, could b playd by an industry, or a sctor or a rgion. In a divrs Europ, howvr, it is unlikly that any on rgion or industry within on country will manag to influnc th ngotiations in anothr rgion or industry in anothr country - or that it would mattr much if it did. But if a country (or vn a st of countris) did so, thr would b a vry considrabl scop for influncing th lvl of wags dmandd in othr countris byond that justifid by thir own labour markt conditions. Morovr th ky fatur of Europ's montary union is th commitmnt to pric stability,3 low inflation rats bing achivd by strict montary controls. Undr such a rgim, if a country wants to avoid running unsustainabl trad dficits, or unsustainabl fiscal dficits, or a growth rat prmanntly lowr than hr partnrs, thn that country will b obligd to st wags to follow thos in th cntr just to kp costs and comptitivnss in lin. Thus mmbrship of th systm is achivd and maintaind through control of th ral xchang rat. And, in that cas, who bttr to provid th ncssary anti-inflationary 2 Th convrgnc problms causd by wag ladrship btwn Wst and East Grmany ar a prim xampl of this; Hughs Halltt, Ma and Mlitz (1996). 3 And if wags rspond to changs in prics, thn som of ths anti-inflationary tndncis should fd through to wags.

10 - 4 - disciplin and ladrship than a country that has th rputation of having achivd it domstically, and th gratst incntiv to safguard thos achivmnts? Thus, in th stablishmnt of montary union, th concntration on strong inflation disciplin has invitably introducd an asymmtry in th form of Grman Ladrship. On th othr hand such an asymmtry also risks imposing a lack of disciplin for prsrving comptitivnss - or at last a gratr lack of rsponsivnss to changing conditions in local markts - on thos who can last afford it.4 That in turn crats a distinction btwn th "cor" countris whos conomic structurs ar similar to Grmany, and th "priphry" whos structural diffrncs undr a common st of policis consign thm to diffrnt (and prhaps infrior) lvls of conomic prformanc Th Cas at Hand: Grman Ladrship Empirically, th possibility of Grman ladrship has bn tstd in diffrnt ways. Som tsts ar simpl causality tsts (D Grauw, 1989), which yild only wak vidnc outsid th financial markts. Thr may hav bn a brak in this ladrship during th r-unification priod, but Gardnr and Prraudin (1993) suggst Grman financial dominanc has strngthnd sinc thn. Mor stringnt tsts ar basd on th xtnt to which Grman inflation lads pric stting lswhr - and th rsults ar largly positiv (Artis and Ormrod 1990; Artis and Nachin 1991). Somtims ths arrangmnts ar vn codifid into law; Blgian wag sttlmnts for xampl ar rquird to follow Grman wags, in an attmpt to "ti Blgian hands" furthr. As a rsult of ths pricing arrangmnts and comptitivnss concrns, Fratianni and von Hagn (1992) show that Grman montary 4 i.. in th low wag-low pric and mor dprssd rgions and conomis. This can b sn, for xampl, in th Grman r-unification pisod and in its ffcts on othr rgions in Europ (Hughs Halltt and Ma, 1993, Hughs Halltt t al, 1996). 5 Th distinction btwn cor and priphry, in th 2-spd rgim of th mid 90's, is no longr rlvant. W limit ourslvs thrfor to th distinction btwn th "ins" and th "outs".

11 - 5 - dvlopmnts tnd to lad montary policy lswhr. What all ths studis dmonstrat is that an unchallngd montary ladrship will affct th stting of wag costs lswhr. But thy don t say how. 2.3 Th Opposit Cas: Locational Comptition Both th Grman Ladrship hypothsis, and th wag transfr mchanism suggst a positiv association btwn th lading country's wag inflation and th rats of wag inflation lswhr. That mans it's a sllrs' markt. But th distinguishing fatur of th Europan labour markts has bn rigidity; that is low labour mobility and wag flxibility, but high capital mobility. Hnc it is th mployrs, not th mploys, who arbitrag wags. That givs ris to an altrnativ mchanism basd on th ida of "locational comptition". Burda and Mrtns (1995) dfin locational comptition as "...th fficint conomic rspons of locals to th immobility of labour and th rgional variation of conomic outcoms". In th absnc of sufficint labour mobility, wags hav to mov continuously in ordr to attract and rtain th mobil factors of production (physical and human capital). Hnc countris that ar unabl to compt ithr in trms of attracting capital or in trms of productivity lvls, find thmslvs compting with Grmany in trms of labour costs in ordr to rtain factors of production. Burda and Mrtns go on to point out that locational comptition, in th fac of capital mobility and labour immobility, will invitably rsult in incoms bcoming mor variabl. To prvnt xcssiv losss in wlfar arising from locational comptition, agnts will sk insuranc. Howvr, protcting incoms can only b wlfar improving if non-systmatic risk prdominats sinc, if thr ar systmatic shocks or policy biass, locational comptition will appar and ral wags will mov in ordr to rtain

12 - 6 - th mobil factors of production.6 But, as Burda and Mrtns argu, in othr cass including som Europan countris, whr bargaining and labour mobility ar not flxibl nough to rspond to changs in xcss dmand) insuranc against vry low ral wags will b wlfar-improving.7 That is th purpos of th social scurity nt and labour markt rgulation. But if thos programms ar rolld back thn somthing ls (locational comptition) will invitably mrg to limit wag fluctuations. 2.4 Locational Comptition: An Exampl Suppos a productivity shock in a mmbr country causs an incras in th lvl of ral wags. If that country is Grmany, thn th combination of th two hypothss prsntd abov will induc all othr countris to sk gratr wag incrass to match th dvlopmnts in Grmany. This will push th avrag lvl of Europan wags up. Howvr, in th absnc of any capital controls, it is th industris in thos countris that now hav to fac gratr wag costs - but without th xtra productivity gains. Aftr a tim thy will b tmptd to mov to th aras whr labour costs match productivity lvls. This has an advrs ffct on th lvl of aggrgat dmand and will caus gratr volatility of short-trm intrst rats. In anticipation, thrfor, of capital moving from th lss "fficint" aras to th mor productiv ons, not only will th trad unions in th lss fficint aras avoid dmanding highr wags; thy will actually try to maintain comptitiv wags in ordr to countract th incras in th ladr's fficincy. Th sam rasoning can b usd to justify why "followr" countris will not initiat wag incrass whil Grman trad unions rmain inactiv. 6 Th rduction in wlfar in this modl ariss ntirly from th risk involvd, and not from th lowr wags ncssary to stimulat locational comptition. But it obviously applis in th lattr cas too. W find th sam thing in this papr: a widr union rstricts locational comptition and lowrs th incom risks for crtain participants (s Sction 5 blow). Extnding th union may thrfor act as a kind of incom insuranc, although not for all participants. 7 This may account for th gratr dmand for social insuranc in Europ; and also for th fact that, whr drgulation has bn introducd, cuts in th wlfar nt hav bn accptd.

13 - 7 - Rcnt thortical work dmonstrats mor formally how this locational comptition ffct ariss. Puga (1999), for xampl, has a modl of how intgration affcts diffrncs in structurs and incom lvls. If th cost of doing businss across rgional bordrs is high, industry will sprad ovr th rgions to mt dmand. But if thos costs fall (trad barrirs fall, transport is asir), incrasing rturns, comparativ advantag and pattrns of spcialisation will crat cntrs of agglomration. Whn workrs and/or capital migrats to rgions with highr rturns, th agglomration procss is intnsifid and wags will follow th lading rgion. But if workrs do not (or cannot) migrat, thn th falling barrirs and transactions/transport costs will mak firms mor snsitiv to wag diffrntials and thy will sprad out again. In ssnc, that is xactly th kind of comptitiv procss w ar dscribing hr. Th implication of this xampl is that locational comptition will mak wag lvls in th followr countris lowr than thy would othrwis b; and that Grman wag ladrship would mak wags highr than othrwis whnvr Grman wag prssurs ris. 3 MODELLING THE EFFECT OF WAGE TRANSFERS Thr ar a numbr of possibl formulations of th way th transfr mchanism works. Th gnral charactristics ar th following [s Thomas and Stony (1971)]:8 a) A normal Phillips-typ trad-off dtrmins th lading sctor's rlationship btwn wag changs and unmploymnt: w& = f( u ) f < 0, f 0 G: lading sctor (1) G G b) For all non-lading sctors howvr, w hav: w& = f ( u ) + h[& w f ( u )] i = 1...m (2) i i G i 8 Th modl prsntd hr is basd on th Layard, Nickll and Jackman (1992) wag bargain, xtndd to allow for th ladrship trm. Th spcification that follows is drivd in mor dtail in Appndix 1.

14 - 8 - Changs in th non-lading sctor wags may thus b sparatd into thos rsulting from local labour markt conditions, plus an additional trm which is proportional (by a factor of h) to th diffrnc btwn th "lading" rat of wag chang (&w G ) and th wag changs which would hav occurrd in th absnc of any transfrs. Rwriting (2) w gt w& = ( 1 h) f( u ) + hw& i i G (3) whr, in th most gnral vrsion of our modl, th paramtr h may b allowd to vary for ach conomy considrd (h i, i=1...n).9 From (3), wag ladrship, h>0, will downgrad th influnc of markt forcs on wag sttlmnts. But locational comptition, i.. h<0 will upgrad th impact of ths markt forcs. That is th implication of th distinction btwn th Grman ladrship and th locational comptition hypothss. W now procd by xtnding quation (1) and (2). Lt ach markt's inflation-unmploymnt tradoff hav th following form: 10 w & = a + kp & + β f( u ) i i (4) whr th sign of β guarants an invrs rlationship. Allowing for a ladrship ffct, wag inflation in ach country is formd as: w& = a+ kp& + βf ( u ) i i w& = a + kp& + βf ( u ) + h [& w a kp& βf ( u )] i i G i for i = G for i G (5) 9 Th &w G trm can b wag inflation in a singl country, or it can rprsnt th avrag for a group of countris (& w = Σ w& / m, for j = 1...m, if "m" is th numbr of countris in that lading group). In addition th idntity of th G j ladr or lading group of countris could vary ovr tim. For th purposs of this papr, howvr, w will assum that th lading sctor compriss of a singl country (Grmany) whos idntity dos not chang. 10 Alogoskoufis t al (1995) justify th us of Phillips curvs for th short to mdium trm analysis of labour markt prformanc in Europ, and w follow thir xampl.

15 - 9 - In forming (5) w hav mad two assumptions: first, that all countris within a group ar influncd by th aggrgat group pric inflation rat through a common cofficint k and a singl markt in goods;11 and scond, that th wag transfr mchanism itslf oprats with qual strngth (h) in all non-lading markts. Th first assumption is not unralistic. If w ar concrnd with diffrnt rgions in on country, w would not xpct ach rgion's trad-off btwn inflation and unmploymnt to b affctd by diffrnt rats of pric inflation. But th scond assumption is almost crtainly not tru, and a numbr of factors would suggst a diffrntiatd impact across countris. Howvr, w ar intrstd in discovring first whthr Grmany's labour markt conditions ar of any significanc in forming wags in othr parts of Europ; and scond whthr thr is a diffrnc in rspons btwn th ins and th outs. That mans w should, to a first approximation, first look for uniformity in wag ladrship or locational comptition within ach group. W can now dfin aggrgat wag inflation in ach group as:12 W& q = n Σ α i= 1 w& i, q i, q q = c: ins = p: out (6) whr α i rprsnts ach country's shar of labour forc in th rspctiv group's total labour forc. Givn (5) and (6) w can driv an xprssion for th aggrgat wag inflation of ach of th two groups as follows:13 11 For a country spcific paramtr k i, th proportion of pric inflation rflctd on wag inflation varis from country to country. In this cas, anticipatd pric changs in ach country cannot b rprsntd by changs in th aggrgat pric lvl and kp & must b substitutd by Σk γ& p whr γ i is th appropriat wight. i i i 12 From now on, capital lttrs rprsnt aggrgat masurs for ach of th groups. 13 Upward sloping aggrgat Phillips curvs will gnrally xist in this form whrvr thr is htrognity but immobility btwn rgional or sctoral labour supplis: Hughs Halltt (2000).

16 W& = q nq Σ α w& i= 1 i i n q q = a + kp& + β Σ α f ( u ) + Σ α h [ βf ( u ) βf ( u )] i q i i= 1 i= 1 n i q q G q i (7) Sinc w hav assumd h to b constant within ach group, and dropping q to simplify xposition, w hav n W& = a+ kp& + β Σ α f( u ) + βh Σ α [ f( u ) f( u )] Howvr, n i i i= 1 i= 1 n i G i βh Σ α [ f( u ) f( u )] = βh Σ α f( u ) Σ α f( u ) i G i i G i= 1 i= 1 i= 1 sinc Σα i =1. Thus, n L NM L NM n = βh f( u ) Σ α f( u ) G n i= 1 W& = a+ kp& + β Σ α f( u ) + βh f( u ) Σ α f( u ) L NM i i G i= 1 i= 1 n i n i i i O QP i O QP i O QP (8) (9) (10) for ach group. Equation (10) rprsnts a Phillips typ trad-off in which aggrgat wag inflation is a function of aggrgat pric inflation, xcss dmand as capturd by th aggrgat of domstic unmploymnt rats,14 and a Grman ladrship ffct in th last trm. W writ A=[f(u G )-Σα i f(u i )]. In addition, Σα i f(u i ) can b xpandd in a Taylor sris approximation around U=Σα i u i to yild: Σα f( u ) = f( U) + i i n α Σ Σ j= 2 i= 1 i ( u i U) j! ( ) j du j j d f U f U s d 2 f U ( ) 1 d f( u) 1 d f( U) = ( ) + + µ + µ du 6 du 24 du (11) whr µ j is th j th sampl momnt of th unmploymnt distribution about its man, and µ 2 =s 2. Substituting (11) into (10) shows that both th ovrall lvl of wag inflation (i.. W & on th lft of (10)) as wll as th dgr of Grman ladrship or locational comptition (th last trm in (10)), will both dpnd on th distribution of unmploymnt rat (i.. th sum of all th momnts in (11)) and on 14 S Dmrtzis, Hughs Halltt (1995) for a distinction btwn avrag and aggrgat unmploymnt rats.

17 th markts' snsitivity to xcss dmand β). In fact, th gratr th inqualitis in unmploymnt (s 2 ), th highr is avrag wag inflation, th lowr th wag ladrship ffcts, and th strongr is locational comptition (h>0, h<0 rspctivly). Finally it is important to not that both Thirlwall (1970) and Mtcalf (1971) discovrd that th impact of a ladr's wag on th followrs taks som tim to matrialis. This suggsts that th wag transfr trm should not b includd contmporanously, but should allow tim for th ffcts to fd through. Indd, Bhaskar (1990) maintains that this trm should b in xpctations format bcaus "a trad union will match, within limits, th mony wag it xpcts othr unions to st". In th cas of Europ w argu that th cas for th xpctations form will b vn strongr bcaus th information on th outcoms of ngotiations in othr countris will tak som tim to b transmittd and may b lss wll undrstood. Hnc bargaining will ncssarily b conditiond on what is xpctd to mrg from th bargaining round currntly undrway in Grmany. W thrfor rplac A by its rational xpctation. 4 ECONOMETRIC MODELLING W adapt (10) to giv a standard short-run spcification of th Fridman-Phlps typ: W & f ( u ) P & ( W & k P & ) A = β + β Σα + β + β + β + t 0 1 i it 3 t 4 t 0 t 5 t t (12) whr actual and xpctd wag changs ar now masurd as dviations from actual and xpctd pric changs. This is th spcification rcommndd by Brchling (1973). Th trm A t =f(u G )- Σα i f(u i ) rprsnts th wag transfr mchanism, whr β 5 =β 1 h. Thr ar two furthr paramtr rstrictions. Intrnal consistncy rquirs k 0 =β 3, sinc othrwis th aggrgat Phillips curv would nvr tnd to any stady stat. This w impos. Scond β 4 =1 would mak our trad-off vrtical. W do not impos that rstriction, but allow it to b dtrmind by th data. Finally, sinc k 0 =β 3, it maks

18 no diffrnc whthr w intrprt th rsults in trms of ral or nominal wag inflation. W prfr th lattr. To complt this modl w must spcify f(u it ) xplicitly. For maximum flxibility, w adopt a Box- Cox transformation and allow th data to pick th bst fitting spcification: i.. f(u it ) = a+β log u it with β<0, if λ=0 (13) or f(u it ) = a+βu it -λ with β>0, if λ>0 Th signs of β in (13) and (14) ar such as to nsur wak convxity. and β<0, if λ<0. (14) Nxt w impos rational xpctations on all th xpctd valus which go into th wag formation procss. For quartrly data that implis:15 & W & t+ 4 = Wt + 4 ξt+ 4 P& = P& ζ whr ξ, ζ and ψ, ar whit nois (15) A t+ 4 t+ 4 t+ 4 = A ψ t+ 4 t+ 4 t+ 4 U V W t+ 4 t+ 4 t+ 4 W hav allowd th data to dtrmin th bst valus for λ, and concludd that th two most suitabl spcifications for f(u i ) ar th logarithmic and rciprocal formats. Appndix 2B prsnts th rsults of th Ramsy misspcification tsts, in which thr is a clar prfrnc for th logarithmic spcification, for both "ins" and "outs". Morovr th logarithmic form gav rsults which ar uniformly robust in trms of quation diagnostics, corrct paramtr signs, and th significanc, plausibility and stability of th paramtr stimats. Th sam cannot b said of th rciprocal spcification. Hnc w rtain th logarithmic form and insrt xpctations as dscribd in (15) to yild th final stimating form: 15 Expctations ar drivd today about tomorrow's variabls, but xprssd on an annual basis. Implicitly, annual wag bargaining rounds li bhind this spcification thrfor.

19 W & = β + β Σα log( u ) + β P & + β ( W & k P & ) + β A + v t 0 1 i it 3 t 4 t+ 4 0 t+ 4 5 t+ 4 t (16) whr v = β ξ + β β ζ β ψ, and k = β and β = β h. t t 4 t t+ 4 5 t To stimat (16) w us th Gnralisd Mthod of Momnts (Hansn 1982) in ordr to account for both th implicit simultanity btwn P & and W & and th moving avrag rror trm. 16 t t Th choic 2 of stimating instrumnts is mad so as to satisfy th tst for ovridntifying rstrictions cχ k h in which th appropriatnss of both th instrumnt st and th spcification of th modl ar simultanously xamind. Th stimats producd ar htroscdasticity and MA(4) consistnt and fr of srial corrlation. W hav applid standard tim sris analysis (Appndix 2C) to nsur that th quations stimatd ar not spurious. Th data is of quartrly frquncy and spans from 1975 to 1997 (Appndix 2A). W prsnt th rsults for th whol sampl and thn for two sub-sampls, , and Th sparation of th sampl into two parts in 1986 rflcts both th mpirical fact that th paramtr valus showd a structural brak at that point, and th thortical obsrvation that th charactr of th xchang rat mchanism changd from an adjustabl pg systm to a mor crdibl fixd xchang rat rgim at that point. W in fact xprimntd with th division point bing btwn , on th basis that, this priod saw th start of th nw EMS, charactrisd by gratr pric stability and gratr crdibility in national montary policis, but 1986 gav th bst rsults. 16 Instrumnting th pric trm in this way allows us to avoid spcifying an xtra pric quation for ach group, and hnc any furthr spcification rrors which this might imply. Our argumnt is that th distinction btwn ins and outs in a singl goods markt will aris in wag bhaviour, not pric stting bhaviour - so w don't want uncrtaintis in th lattr contaminating our modlling of th formr.

20 EMPIRICAL RESULTS 5.1 Gnral Faturs Tabl 1 summariss th stimatd paramtrs of (16), dtrmind for th "ins" ("EU11") and for th whol EU-ara including outsidrs ("EU15") sparatly. From th diffrncs btwn th two, it will b apparnt that th bhaviour of th outsidrs has bn significantly diffrnt to that of th insidrs. W focus hr on th following diffrncs in bhaviour: wag ladrship vs. locational comptition; snsitivity to changs in supply and dmand ("markt snsitivity") and prics; th dsir for incom insuranc in th labour markts; th dgr of convrgnc in wags and unmploymnt lvls. This has bn don to dmonstrat th natur of th conflict btwn nominal convrgnc, in wags, and ral convrgnc in activity or unmploymnt lvls. Givn such a conflict, convrgnc in wag lvls (or wag inflation rats) will lad to gratr unmploymnt diffrntials, and hnc a wors trad-off btwn wag inflation and unmploymnt. That maks it mor difficult to rais activity lvls in th dprssd aras, or to improv comptitivnss (lowr labour costs), or to allow wags and mploymnt to bnfit from productivity growth. As a consqunc, any convrgnc in wags will tnd to produc divrgnc on th ral sid.

21 Tabl 1: th Euro-Zon (EU11) and Euro-ara (EU15) rsults for quation (16) Tabl 1a. Whol Sampl: β 0 β 1 β 3 β 4 h χ 2 (k) EU (6.10) (6.04) 0.67 (31.68) (4.22) -.64 (3.62) 7.42 obs = 70 k = 8 EU (1.79) 6.55 (1.71) 0.42 (4.36) 1.42 (7.53) -.69 (1.35) obs = 70 k = 8 Tabl 1b. 1st sub-sampl: β 0 β 1 β 3 β 4 h χ 2 (k) EU (6.8) (6.99) 0.47 (10.16) (5.50) -.77 (10.18) 6.07 obs = 38 k = 8 EU (3.11) (2.93) 0.67 (11.87) (2.34) -.71 (2.27) 6.43 obs = 38 k = 8 Tabl 1c. 2nd sub-sampl: β 0 β 1 β 3 β 4 h χ 2 (k) EU obs = 32 (22.85) (20.80) (3.12) (9.80) (2.66) k = 8 EU obs = 32 (12.98) (12.56) (7.36) (8.51) (1.62) k = 8 Nots: t-ratios k numbrs in brackts dgrs of frdom numbr of ovridntifying rstrictions = (numbr of instrumnts lss th numbr of stimatd paramtrs)

22 Tabl 2: Th Individual Country Rsults for (16): Th "Pr-Ins" Tabl 2a. UK UK β 0 β 1 β 3 β 4 h 2 χ ( k) 1st Sub obs = 38 (5.87) (2.75) (15.60) (2.89) (.95) k = 7 2nd Sub obs = 32 (.45) (.16) (3.92) (5.72) (.16) k = 7 Tabl 2b. Grc β 0 β 1 β 3 β 4 h 2 χ ( k) 1st Sub obs = 38 (.51) (1.30) (.80) (2.34) (1.54) k = 5 2nd Sub obs = 32 (4.48) (4.15) (6.25) (2.25) (1.26) k = 7 Tabl 2c. Swdn β 0 β 1 β 3 β 4 h 2 χ ( k) 1st Sub obs = 38 (3.01) (.63) (2.27) (1.49) (.23) k = 7 2nd Sub obs = 32 (12.3) (7.92) (2.18) (2.18) (.58) k = 9 Tabl 2d. Dnmark β 0 β 1 β 3 β 4 h 2 χ ( k) 1st Sub obs = 38 (6.51) (4.72) (4.79) (2.06) (2.32) k = 7 2nd Sub obs = 32 (5.17) (4.74) (.14) (4.53) (1.47) k = 6 Nots: as in Tabl 1.

23 Wag Ladrship vs. Locational Comptition Bhaviour among th EU11 and th EU1517 is rally quit similar in th first subsampl (to 1986). That suggsts that th labour markt bhaviour in th priod of stting up and adjusting th Europan xchang rat mchanism (ERM) was not much diffrnt btwn th vntual insidrs and outsidrs. Only in th snsitivity to domstic markt conditions (th paramtr β 1 ), and prhaps xpctd futur losss in comptitivnss (β 4 ), is thr much diffrnc. In th sam way, th rsults for th scond subsampl ar also similar; thy diffr only in th markt intgration paramtr h, and possibly in th raction to xpctd losss in comptitivnss. Morovr, th stimats in both subsampls ar all statistically significant. Consquntly, th diffrncs, whn thy com, ar btwn th subsampls rathr than btwn th two groupings. Th nxt point is that h is ngativ, implying locational comptition (of about th sam strngth) across all countris in th EU, in th first subsampl. This locational comptition is vry significant, although somwhat lss so in th EU15. That suggsts thr may b diffrncs in th dgr of comptition offrd by th outsidrs. Howvr that is a small point compard to th chang in th h paramtrs whn w com to th scond subsampl. Hr th valu of h mor than halvs for th EU11, although it rmains significant and ngativ. For th EU15, h turns positiv but bcoms insignificant. Hnc, as w mov into th 1990s, th dgr of locational comptition is drastically rducd and wags may vn b following Grmany's lad in som of th "out" conomis. At th sam tim, th markt snsitivity paramtr β 1 also changs btwn th two subsampls. It rmains ngativ and significant throughout, in both th EU11 and EU15 quations, so wags rspond convxly and as xpctd to th xcss supply of labour. But whras wags ar much mor 17 In as much as thr ar diffrncs btwn EU11 and EU15, thy ar drivn by th bhaviour of th rmaining four countris, th outs, not diffrncs among th original 11.

24 rsponsiv to shifts in dmand and supply in th EU11 bfor 1986, thy ar about qually rsponsiv in th EU11 and EU15 aftr That must imply a slight fall in markt snsitivity among th "ins" sinc 1986, but a sharp ris in that snsitivity for th "outs". At th sam tim, th significanc of both markt snsitivity trms has risn dramatically. All of this suggsts that, in th priod lading up to montary union, thr has bn lss prssur for convrgnc or intgration, than thr had bn in arlir tims. Indd, if thr has bn convrgnc, it has bn in trms of convrgnc onto a diffrnt paradigm of bhaviour. It appars that th Europan conomis hav progrssivly switchd to basing thir wags on local markt conditions (th incidnc of pric indxation, β 3, has also falln). Thus, in plac of intgration w hav convrgnc on a mor indpndnt form of wag dtrmination in which variations in domstic conditions play a largr rol. 5.3 Th Bhaviour of th "Pr-Ins" That is th simpl xplanation of our rsults. Howvr things ar actually mor complx in that th snsitivity to local markt conditions (β 1 ) falls among th "ins", whil it riss for th "outs", in th scond sampl. At th sam tim, th dgr of locational comptition is falling vrywhr. That implis th influnc of EU-wid markt forcs on wag sttlmnts has bn downgradd sharply - whatvr may hav bn happning to th influnc of domstic markt conditions. Thus, in th EU11, w hav th rsult that th prssur of markt forcs on wags has bn waknd all round. But among th "outs", w hav th conflicting rsult that th influnc of markt forcs drivn by EUwid vnts has bn wakning whil th influnc of domstic markt conditions has bn rising. Thus th "ins" appar to hav bcom mor intgratd among thmslvs, in that thir wags ar lss dtrmind by local conditions or comptition with othrs in th EU11. But th "outs" hav bcom lss wll intgratd - prfrring an indpndnt path. But, that said, th bhaviour of th outsidrs

25 varis significantly - s Tabl 2. Th thr smallr outsidrs (Grc, Swdn, Dnmark) had bn subjct to significant wag ladrship ffcts (h>0) in th 1980s, which fadd to vry small wag ladrship ffcts (h 0) in th 1990s. At th sam tim, thir β 1 paramtrs turnd sharply ngativ and significant in th scond sampl. Thy thrfor form a rlativly cohrnt subgroup. Th UK, by contrast, dos xactly th opposit. Th UK's h paramtr bcoms sharply mor ngativ (but insignificant) aftr 1986, whil hr markt snsitivity paramtr (β 1 ) tnds to zro in both siz and significanc. Thus th UK's bhaviour is quit unlik that of th othr "outs", or indd that of th insidrs (whos bhaviour had bn vry similar to hrs in th first sampl priod). Thus th UK appars to b bcoming lss wll intgratd with vrybody - "outs" as wll as "ins"- prhaps through th influnc of conditions lswhr and outsid th EU ara. Thus w nd to distinguish two subcass hr: a) whr h riss and β 1 bcoms mor ngativ. This is th cas whr wags bcom mor snsitiv to markt conditions in th domstic conomy, instad of thos lswhr in th EU. Grc, Swdn and Dnmark appar to b convrging on this "modl" of wag bhaviour. It says littl about ral or nominal convrgnc with th insidrs. b) whr h riss or gos insignificant, and β 1 tnds to zro. This is th cas whr wags bcom lss wll intgratd with th EU markts, and potntially mor snsitiv to changs in xtrnal conditions. This would b consistnt with th fact that th shar of UK forign rvnus drivd from th EU markts is now lss than 45% and falling. In fact, howvr, th UK has a falling h paramtr and β 1 0 which suggsts British wags may hav bcom snsitiv to both EU and non-eu conditions - although th statistical significanc of that is vry small. A third subcas is, of cours, th on whr h is rising and β 1 falling. This is th EU11 cas, whr th influnc of markt conditions has bn wakning across th board - which provids th vidnc that structural rform will b ndd in thos conomis.

26 Prics, Ral Wags and Indxation Bhaviour As for th rmaining rsults: convxity is confirmd in both groups with th xpctd ngativ and highly significant β 1 paramtrs. Similarly th influnc of pric inflation (β 3 ) on wag stting is positiv, highly significant and broadly similar among "ins" and "outs". About half currnt pric inflation was compnsatd by wag incrass in th 1980s, and a quartr in th 1990s. Th ffct of any xpctd changs in ral wags (β 4 ) ngativ and significant vrywhr implying that, in ordr to had off any anticipatd losss in comptitivnss in th futur, wag sttrs would modrat thir claims now.18 This provids an lmnt of ngativ "indxation", born of th gratr dsir for stabl prics and mploymnt. Th scond sampl shows that this lattr ffct bcoms strongr and mor significant if w rstrict our attntion to th arly 90s, whn th forcs of convrgnc undr th Maastricht traty wr at thir pak. W hypothsis that this is du to non-grman wag bargainrs anticipating th xtra dflation which will b ndd to mt th lowr inflation lswhr in th union (or which is ndd to maintain th "tying of on's hands"). As a rsult thy rduc wags in ordr to prsrv mploymnt whn inflation is xpctd to fall. This ffct is particularly markd among th "outs", but it is prsnt among EU11 as wll. 18 Vry much as has happnd in Italy, for xampl.

27 Should th "Outs" Join, or th "Ins" lt thm Join?19 On rason that "ins" might prfr th "outs" not to join is that, to do so would incras th comptitiv prssurs oprating in th Europan labour markts. In fact (16) implis that th avrag wag inflation in a full union may xcd what th "ins" would njoy on thir own: W& + W& / 2 > W&. This can b sn by xpanding (16) around th avrag lvl of unmploymnt, c p c U, whn xpctations and ladrship ffcts rmain constant: F HG 2 & s µ 3 µ 4 W log U... P& W& kp& t = β + t + + t + t t + ha 0 β 1 β β β t + v 2 U U U KJ I d i t (17) and β 1 <0. Sinc, on currnt data, th "outs" hav both lowr unmploymnt on avrag and a lowr disprsion of unmploymnt, it is not clar if th "ins" would wlcom thm, sinc W & for th combind union would fall with s 2, but ris with a lowr U (whil β 1 bcoms slightly lss ngativ). And vic vrsa for th outsidrs. To s ths incntivs in mor dtail, notic that (3) implis dw& = ( 1 h) f '( u ) du dh[ f ( u ) w& ] (18) i i i G whr, by hypothsis, &w G is unaffctd by changs in wag prssurs lswhr; and f'(u)=1/u. Hnc, m r (19) if dw& i = 0, thn du i = w& G f( u i ) u i /( 1 h) dh But if du i = 0, thn dw& = w& f( u ) dh (20) i G i 19 W do not wish to imply that thr is a cas for th "outs" opting out from joining or for th "ins" to actually rfus thm ntry. Th Maastricht critria will tak car of that. Th point w wish to mak is simply that thr may b diffrnt incntivs for joining if th bhaviour of th "ins" and "outs" has diffrd; and that, consquntly, thr may b costs involvd in allowing th uro-zon to xpand.

28 whr i rprsnts any on country.20 Evidntly thr is a trad-off if h<1, in that if wag inflation is hld constant in country i whn an outsidr joins, thn unmploymnt will fall or ris dpnding on th sign of w& f( u ) and th sign of th chang in h which th act of joining inducs. But if G i policis ar adjustd to kp country i's unmploymnt constant, thn wag riss will ris or fall (i.. go th othr way). Hnc you cannot hav both improving at onc, unlss h>1. In particular, according to our stimats, an "out" country joining would find dh<0, in ithr sampl priod - th UK xcptd of cours, whr dh>0 [h<1 holds in all cass]. Hnc in th arly 1990s whn Grman inflation and unmploymnt wr rlativly low i.. E w& > w&, so that w& f( u ) < 0, an d i p G G i outsidr joining would hav found unmploymnt falling if wag inflation was fixd. But th insidr, as an xisting mmbr, would find th opposit if (for thm) th sign of w& f ( u ) wr rvrsd. G i j 20 Ths ar vidntly country i quations. Howvr that country may b in "c" or in "p", sinc th sam algbra applis in ach cas (thy would only b distinguishd by diffrnt paramtr valus, in practic). Hnc subscript i = 1..n c or 1..n p.

29 TABLE 3: QUANTIFYING THE RIGHTWARD DISPLACEMENT (EU11) Contribution of s 2, µ 3 to &w Contribution of %contribution annualisd Unmpl. Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Q 1/ Column 2: (β 1 σ 2 f )/2+(β 1 µ 3 f )/6 Column 3: β 0 +β 1 log(u) Column 4: [Col2/(Col2+Col3) ]*100

30 MEASURING THE CONVERGENCE INDUCED BY MARKET INTEGRATION 6.1 Nominal Convrgnc: Convrgnc in Wags Givn th rsults so far, on might xpct that markt intgration would lad to som convrgnc in wag inflation and wag costs sinc h<0 among th insidrs; but h 0, among th outsidrs. In fact from quation (3) w can writ b g b g (21) w& = 1 h E w& + h w& c c c c G d i b g (22) and w& = 1 h E w& + hp w& whr E w& c p p c G b g and Edw& p ladrship and no locational comptition; i.. E w& c i dnot th xpctd rats of wag inflation whn thr is no wag b g and Edw& p i ar givn by th right hand sids of th stimatd quations. Hr w writ c = th "ins" as a group, but p for any on of th outsidrs UK, GR, SW or DK.21 This formulation now allows us to idntify how much wag convrgnc has occurrd, compard to what could hav bn xpctd to happn in th absnc of any ladrship or locational comptition ffcts. W hav b g d i d i b g d i (23) w& w& = E w& E w& + h E w& h E w& + h h w& c p c p p p c c c p G That mans wag costs will nd up closr togthr than would hav bn xpctd in th absnc of intgration, if th last two trms of (23) ar nt positiv: i.. dh h iw& > h Ebw& g h Edw& i c p G c c p p (24) for p = UK, GR, SW or DK. Sinc h c <0, this boils down to rquiring b g d i d ij (25) w& E w& < h / h w& E w& G c p c G p 21 &w G rmains th rat of wag inflation in th rfrnc ladr, Grmany.

31 That says that th (xpctd) wag inflation gap among th insidrs must b smallr, by a crtain proportion, than th corrsponding wag inflation gap btwn th outsidr in qustion and th "avrag" insidr.22 If that is not tru, wags and wag inflation will divrg. Has Europ actually xprincd convrgnc in wag costs? Tabl 4 rports th valus of h p /h c in (25) for ach of th outsidrs ovr our sampl priod. On can immdiatly s th diffrnc btwn th UK's bhaviour and th othr outsidrs, in that th UK has a positiv and incrasing ratio for h p /h c. Th othrs hav a ngativ but dcrasing ratio. That mans th UK's wag inflation would hav to go th opposit way, rlativ to Grmany, than that in Grc, Dnmark or Swdn, in ordr for th UK to scur convrgnc with th insidrs. Tabl 4 b g b g b g 64 3 b g b g 3 64 b g b g 0 93 b g b g 1 39 b g b g 0 44 b g b g 0 99 b g b g 0 19 b g UK: 1st sampl w& E w& < w& E w& G c G UK 2nd sampl w& E w& <. w& E w& G c G UK GR: 1st sampl w& E w& <. w& E w& G c G GR 2nd sampl w& E w& <. w& E w& G c G GR SW: 1st sampl w& E w& <. w& E w& G c G SW 2nd sampl w& E w& <. w& E w& G c G SW DK: 1st sampl w& E w& <. w& E w& G c G DK 2nd sampl w& E w& <. w& E w& G c G DK 22 (25) may b rformattd as b g d i d i, sinc h c -h p <0 for all four outsidrs. This shows th sam w& E w& < hp / h h Ew& Ew& G c c p p c inquality as (25) but gnuinly in trms of th avrag insidr, as opposd to th rprsntativ insidr, as claimd in th txt.

32 In practic th xtnt to which (25) actually implis nominal convrgnc can vary significantly yar by yar. In 1995, for xampl, th UK and Grc wr convrging on th "ins", but th two Scandinavians wr divrging. But in 1996, vrybody was convrging xcpt th UK. And th sam is tru in both 1997 and 1998, th yars in which th Maastricht convrgnc critria for joining montary union itslf wr actually applid. 6.2 Convrgnc in Ral Trms: th Wag Convrgnc-Unmploymnt Trad-Off Svral rcnt paprs,23 hav idntifid a trad-off btwn a convrgnc in wags and convrgnc in mploymnt, unmploymnt or activity lvls. Ths two options ar frquntly rfrrd to as th "Europan" and "Amrican" modls of labour markt bhaviour rspctivly, in which th Europan modl allows unmploymnt to absorb th shocks and kps nominal or ral wag growth, and rlativ wags, fairly constant. Th Amrican modl, by contrast, attmpts to kp mploymnt growth and activity lvls fairly constant, and uss wags (and rlativ wags in particular) to absorb th shocks. Our rsults imply that this kind of trad-off may b on of th mor important faturs sparating th "ins" from th "outs". For xampl, taking th stimatd wag dtrmination quations (16), for th UK, and for th "ins" as a group, w gt (in th first sampl), w& w& = log U log U +. 65P&. 47P& UK c UK c UK c log U 1. 55w& w& g, t+ 4 UK, t+ 4 c, t log U log U UK, t+ 4 c, t+ 4 (26) 2 2 But w can writ log U log U s / 2U +... using (17). Consquntly (26) bcoms c c c 23 S, for xampl, Burda and Mrtns (1994), Hughs Halltt t al (1996), Dmrtzis and Hughs Halltt (1998), or Agll t al (1999).

33 b g c h w& w& log U / U log U s / 2U 2 2 UK c UK c c c +. 65dP& P&. P& UK ci + 18 c + forward xpctations (27) and th short run wag convrgnc - unmploymnt convrgnc trad-off bcoms bw& & = = UK wcg bwuk / Wcg 2. 91bWUK / Wcg, or < 0 (28) U / U U / U U / U U / U b g UK c UK C b UK 2 whn th structur of Europan unmploymnt ci.. Uc, s tc. h is not matrially affctd by small changs in th UK labour markt. That shows th wag convrgnc-unmploymnt convrgnc trad-off dos xist, and will bcom mor rstrictiv (on th ral sid) th mor ngativ is th cofficint in th numrator (β 1 ) and th lowr is UK unmploymnt rlativ to th Euro-11 avrag. So, in th short trm, wag convrgnc has to b bought by allowing gratr unmploymnt disparitis - although lss so th highr is your unmploymnt, and th mor comptitiv ar your wags. c g UK c Procding in th sam way for th rmaining outsidr countris, w gt Tabl 5. Onc again w s how diffrnt th UK is. Sh movs from a highly significant ngativ trad off to an insignificant (positiv) on in th 1990s. Th thr othr outsidrs mov from an insignificant positiv trad-off, to a highly significant ngativ on which is vn strongr than th UK's trad-off in th arlir priod. That mans th UK's conflict btwn ral and nominal convrgnc has bcom lss of a rstriction. Th rmaining outsidrs, by contrast, now fac a major trad-off btwn nominal and ral convrgnc - particularly Grc and Dnmark whr unmploymnt rats hav bn coming down. Thy nd to prsrv a rgim of locational comptition if thy ar not to los thir gains in mploymnt and growth whn thy ntr EMU.

34 Tabl 5: Th Short-Run Wag Inflation-Unmploymnt Convrgnc Trad-Offs 1st Sampl Priod 2nd Sampl Priod UK -2.91/(U UK /U c ) 0.13/(U UK /U c ) GR 6.31/(U GR /U c ) /(U GR /U c ) SW 0.46/(U SW /U c ) -3.05/(U SW /U c ) DK -4.35/(U DK /U c ) /(U DK /U c ) 6.3 Rationalising th Rsults: Endognising Locational Comptition Thr is anothr way to xplain th diffrncs in bhaviour btwn Europ's labour markts. Figurs 1 and 2 show th volution of th man unmploymnt, and th varianc or disparity btwn th national unmploymnt rats for th EU15 as a group, and for th four "outs" as a group, ovr th priod Dspit th diffrncs in scal, th four "outs" appar to hav had mor variability in thir (avrag) unmploymnt rats ovr tim. But th rising trnd in avrag unmploymnt has not bn so vry diffrnt. Hnc th rally striking diffrnc is that whras th disparity in unmploymnt rats in th EU15 has continud to ris sinc 1975, and again from 1991, that for th four "outs" has bn falling sinc 1986 and had, by 1993, virtually disappard altogthr. That maks th avrag disparity of th four "outs" about on third of that among th 15 ovr th full sampl, and lss than on tnth of that of th 15 sinc Now, if w rturn to th wag inflation quation (10), w can s th ffct of th collaps in th unmploymnt disparity trm among th four "outs", s 2 in (11), will hav bn to rduc wag inflation thr as thy joind th singl (product) markt - bcaus th third trm of (10) is rducd - whil th locational comptition or wag ladrship trms will hav bn incrasd in importanc bcaus f (u G ) - Σα i f(u i ) will hav bcom mor positiv. In th vnt h was ngativ, so it is th locational comptition ffcts which hav bcom strongr. This is anothr way of showing that, in a world of intgratd markts and a (quasi) singl currncy, you must allow/ncourag gratr unmploymnt disparitis if you want to modrat

35 th prssurs on wag inflation. Th rason is simply that such disparitis will triggr gratr locational comptition on th supply sid. 7 CONCLUSIONS a) Europ's labour markts, in th 1980s and in th run up to Montary Union, hav shown a significant dgr of locational comptition in thir wag bargaining - rathr than intgration and harmonisation. b) Th strngth of that locational comptition has howvr bn wakning in th 1990s as opposd to th 1980s, and may not now b vry important. c) Th outsidrs, who did not join EMU at th start, hav followd Grman wag ladrship in th past, although that has now fadd to th point of insignificanc. Th UK shows non of ths charactristics, having followd an indpndnt path in th 1990s and locational comptition bfor that. d) Thr appars to b som vidnc, albit rathr wak and intrmittnt, of nominal convrgnc by th insidrs on th outsidrs in th 1990s. But th UK again is not part of this. Thr is rathr strongr vidnc, howvr, of convrgnc on a wag bargaining bhaviour which shows lss intraction or mutual dpndnc, and mor dpndnc on th balanc of supply and dmand conditions in thir own domstic markts. This shows convrgnc on a modl of incrasd markt snsitivity rathr than closr intgration pr s, and points to structural rforms as th ky policy instrumnt. ) Th xcption to conclusion d) is th UK onc again, whos wag bargaining (unlik that in th rst of th Euro ara) appars to hav bcom snsitiv to costs and conditions in th rst of th world. f) According to ths rsults, thr is a clar trad-off btwn wag convrgnc and unmploymnt convrgnc, or ral vs. nominal convrgnc, in both th short and long run. Without structural rforms, that conflict will prsist within th Euro ara.

36 REFERENCES Agll, A. (1999) " On th Bnfits of Rigid Labour Markts: Norms, Markt Failurs and Social Insuranc", Economic Journal, 109, F Alogoskoufis, G., C. Ban, G. Brtola, D. Cohn, J. Dolado and G. Saint-Paul (1995) "Unmploymnt: Choics for Europ", Monitoring Europan Intgration No. 5, Cntr for Economic Policy Rsarch, London. Artis, M. and D. Nachan (1991) "Wags and Prics in Europ, a Tst of th Grman Ladrship Hypothsis", Wltwirtschaftlichs Archiv, 122, p Artis, M. and P. Ormrod (1990) "Is thr an 'EMS Effct' in Europan Labour Markts?", Mimo, Univrsity of Manchstr, England. Bhaskar, V. (1990) "Wag Rlativitis and th Natural Rang of Unmploymnt", Economic Journal, 100, Brchling, F. (1973) "Wag Inflation and th Structur of Rgional Unmploymnt", Journal of Mony Crdit and Banking, Vol. 5, p Burda, M. and A. Mrtns (1995) "Locational Comptition Vrsus Coopration in Labour Markts: An Implicit Contract Rintrprtation", in H. Sibrt d., Locational Comptition in th World Economy, J. C. B. Mohr, Tübingn, Kilr Woch Sris. d Grauw, P. (1989) "Is th Europan Montary Systm a DM-Zon?", Discussion Papr No. 297, Cntr for Economic Policy Rsarch, London. Dmrtzis, M. and A. Hughs Halltt (1998) "Asymmtric Transmission Mchanisms and th Ris in Europan Unmploymnt", Journal of Economic Dynamics and Control, 22, Dmrtzis, M. and A. Hughs Halltt (1995) "Is th Natural Rat of Unmploymnt a Usful Concpt for Europ?", in R. Cross d., Th Natural Rat of Unmploymnt, Cambridg Univrsity Prss. Fratianni, M. and J. von Hagn (1992) "Th Europan Montary Systm and Europan Montary Union", Wstviw Prss. Gardnr, E. and W. Prraudin (1993) "Asymmtry in th ERM: A Cas Study of Frnch and Grman Intrst Rats Bfor and Aftr Grman Unification", IMF Staff Paprs, 40, Hughs Halltt, A. (2000) "Aggrgat Phillips Curvs ar Not Always Vrtical: Htrognity and Mismatch in Multirgion or Multisctor Economis", Macroconomic Dynamics (forthcoming). Hughs Halltt, A. and Y. Ma (1993) "East Grmany, Wst Grmany and thir Mzzogiorno Problm", Economic Journal, 103, Hughs Halltt, A., Y. Ma and J. Mlitz (1996) "Unification and th Policy Prdicamnt in Grmany", Economic Modlling, 13 (forthcoming).

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