Structural Reform, EMU, and Macroeconomics Performance Background In a previous research programme on enlargement of the Economic and Monetary Union (EMU) in Europe, we focussed explicitly on two central themes: the incentives to join the EMU; and the incentives to reform within the EMU and within the candidate countries. Our research has yielded new insights into both questions, including some “orders of magnitude” evidence on the size and balance of the incentive effects for joining and being joined; and on the desirability of reform in an out of the existing union. Our modelling framework has so far been restricted by two important factors: - The incentive structures, particularly with respect to the possibility of market flexibility reforms, were limited to exogenously imposed structural reforms. We have assumed that the incentives to undertake reforms are unrelated to the development of the model’s endogenous variables. This may not be a very realistic assumption. Indeed, one would typically expect that structural reforms would strengthen trade relationships, create more flexible price and wage responses, lower the natural rate of unemployment, give rise to more stable growth prospects etc. The incentives to undertake further reform would therefore depend on the behaviour of those variables. - The analysis has been conducted within a comparative statics framework. As a result, we have been unable to capture the fact that the costs associated with structural reform would typically appear before the benefits. Among the costs we expect to see alterations (losses) in the ability to manage short-run stabilisation operations, losses in job security and a shake out in employment, a possible worsening in the distribution of incomes and the capacity to use public expenditures for social/redistribution purposes. There may also be increased pressure on public finances and debt, a greater need to use fiscal policy or interventions in labour markets, as a result of being “in” and reformed, versus being “out” and unreformed. But among the long run gains, we would expect to see an increase in output capacity, enhanced growth prospects, lower natural rates of unemployment, increase market flexibility, increased trade etc. New Research In future work we therefore propose to refine and extend our results in two different directions: - Structural reforms, in the existing union as well as in the candidate countries, will be defined in terms of the development of the model’s endogenous variables in the case that the candidate members do (or do not) join, and when the existing members do (or do not) undertake certain flexibility reforms. - The comparative statics approach will then be extended into a dynamic setting, which allows us to analyse the timing and size of the costs of reform or enlargement vs. their benefits. In particular, we would like to see if the apparent lack of progress on the reform agenda may be due to the short run costs which appear to be “large” compared to the longer run, but possibly uncertain, benefits of extensive structural reforms. Again, this means that our existing framework needs to be placed within a larger empirical or calibrated dynamic model so that we can estimate the timing and relative size of these costs and benefits. We propose splitting our programme into two parts: one focussed on the general issue of the incentives and implications of reform itself, and one focussed on the time profile and size of the costs and benefits when combined with enlargement. The former will mainly be addressed within a theoretical framework, whereas the latter will mainly be addresses within an empirical framework. This is convenient classification, since it fits right into the separation of our agenda into two smaller projects as described above. Dynamic Aspects of Structural Reform: A Theoretical Investigation This part of the project proposes to examine the consequences of, and incentives for, structural reform in two arbitrary economies. These might be either existing members of EMU, or the existing EMU and a candidate member. The analysis will be carried out in a theoretical (“stylised facts”) framework to get at the issues of what happens when the reform process is endogenised. Given the complexity of the problem, straightforward analytic results may not be possible even in a simplified theoretical framework. We may therefore have to resort to numerical simulations. But the philosophy will be the same whether the solutions are analytic or numerical. We will be using simplified models to teach us what the main conclusions and lessons are in a more realistic but more complicated set of empirical exercises. Our strategy here will be to merge our existing theoretical model, which allows different degrees of rigidity in wage bargaining or labour mobility, together with asymmetric supply shocks and asymmetric trade links, with the Obstfeld and Rogoff (1996, ch. 10) model. This latter model has a very similar structure, but focuses on consumption decisions, the income/leisure trade-off, and price flexibility. Dynamic Aspects of Structural Reform: An Empirical Investigation This part of the project similarly proposes to merge two models: In this case we intend to superimpose our existing framework, which determines the outcomes of wage bargaining with different degrees of wage flexibility or mobility, on the labour market equations of the individual country models in the IMF’s multicountry model MULTIMOD. This is a relatively easier part of the project as MULTIMOD already exists as a working empirical model, and one of us (Hugehes Haslett) already has extensive experience of using it for policy related purposes. We know it can therefore be adapted to our purposes, and supply the necessary dynamic and empirical evaluations of the time profile of the costs and benefits of reform. Moreover, it has two distinct advantages for this part of our programme: First, it is split, explicitly, into a dynamic model and a steady state model, so we can analyse directly the empirical counterparts to our comparative statics results already obtained. Second, there are versions of MULTIMOD Mark II which include country models of the European transition economies. We can therefore make our estimates of the costs and benefits of reform in the existing EMU members and the candidate members for the enlargement, directly and without resorting to stylised facts or stylised models. In that connection we will also be able to retain our distinction between the Ncountries (those like UK and Scandinavia that might be able but unwilling to join) and the E- counties (those in Central Europe that may be willing but possibly unable to join), which has proved so important in our earlier work. To implement this part of our research programme will involve some modelling work to adapt MULTIMOD to our labour market specifications. Then the model will need to be solved to create a new baseline for the new specification. Then we will need to conduct a sequence of simulations, to be compared to that baseline, each one reflecting a different type of structural reform or market flexibility – either with existing EU members, or with different types of candidate members joining (with or without reforms themselves). Hughes Hallett and Jensen (2002b) gives an outline of the range of numerical simulations that need to be attempted, bearing in mind that the focus will now be on different degrees of reform in different places, and on the timing and size of the costs and benefits in different economic performance variables. Time schedule The work will be carried out during October 2002 - June 2003 References Hughes Hallett, A., and S. E. H. Jensen (2001): “Currency Unions and the Incentive to Reform: Are Market Mechanisms Enough?” North American Journal of Economics and Finance, 12, 139-155. Hughes Hallett, A., and S. E. H. Jensen (2002a): “EMU, Enlargement, and Structural Reform”, mimeo, Centre for Economic and Business Research, Copenhagen. Hughes Hallett, A., and S. E. H. Jensen (2002b): “On the Enlargement of Currency Unions: Incentives to join and Incentives to Reform”, in European Macroeconomic Policies After Monetary Unification: Fiscal Policies, Monetary Policies and Labour Markets, ed. by R. Beetsma, C. Favero, A. Missale, V.A. Muscatelli, P. Natale and P. Tirelli. Cambridge University Press, Cambridge, UK. Hughes Hallett, A., and S. E. H. Jensen (2002c): “On the Role of labour Market Reform for the Enlargement of a Monetary Union” paper commissioned by CESifo Economic Studies.