Why so much wage restraint in EMU? The role of country size: Integrating trade theory with monetary policy regime accounts

Marzinotto, Benedicta. (2007) Why so much wage restraint in EMU? The role of country size: Integrating trade theory with monetary policy regime accounts. In: UNSPECIFIED, Montreal, Canada. (Unpublished)

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Abstract

Wage growth has remained under control after the formation of the European Monetary Union (EMU). The literature has advanced numerous explanations to account for this phenomenon. But, arguments about the need to preserve competitiveness in an enlarged market remain too generic. At the same time, analyses that focus on the alleged deterioration of labour market institutions (e.g. de-unionization, decentralization, etc.) find little empirical support. More promising are the results obtained by Posen and Gould (2006) indicating that behind the generalised shift towards wage restraint is enhanced monetary credibility in EMU. This paper builds on the school in comparative political economy that models the interaction between wage bargaining systems and the monetary policy regime but integrates it with more traditional trade theories. The argument developed here is that the degree in wage restraint varies according to country size. The relationship between wage growth and economy size is hump-shaped. Wage compression is especially present in large countries (e.g. Germany) that entertain intense trade relations with the rest of the eurozone. This is because wage-setters in large countries fear that they might affect average price conditions in the euroarea forcing a reaction by the ECB, which is highly undesirable as it would dampen not only domestic demand but also demand conditions in the rest of EMU with employment costs spread across the board from more protected to export-oriented sectors. Downwards pressures on wages are less pronounced in small countries. In spite of the fact that small open economies perceive cost competitiveness as a key driver of their economic growth, wage-setters in small countries can nonetheless act as free-riders in the new EMU monetary regime. Finally, countries of intermediate size display slightly faster wage growth than in the rest of EMU because neither do they believe capable of affecting eurozone inflation, nor do they look at the improvement in cost competitiveness as the one and only chance for their economic survival.

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