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Aggregate Wage Flexibility in Selected New EU Member States 3

1. Introduction

After the enlargement of the European Union (EU) in May 2004, joining the European Monetary
Union (EMU) is the next challenging step on the agenda of the ten new member states (NMS). Six
of them - Cyprus, Estonia, Latvia, Lithuania, Malta, and Slovenia - are already participating in
the Exchange Rate Mechanism (ERM) II and have ambitions to adopt the euro by 2007. The
remaining four new EU members - the Czech Republic, Hungary, Poland, and Slovakia
(henceforth the CE-4) - plan to be ready to join the euro area by 2010-2014.

Various studies suggest that there is a need for higher labor market flexibility in the context of the
EMU (e.g. Hallett, 2000, Obstfeld, 1997, Pissarides, 1997), of a currency board arrangement (e.g.
Gulde et al., 2000), or of a less rigid exchange rate peg such as the European Exchange Rate
Mechanism (e.g. Kopits, 1999). Indeed, it is commonly argued that a fixed exchange rate regime
eliminates one degree of freedom in absorbing macroeconomic shocks. Since independent
exchange rate policy is no longer available under fixed exchange rate arrangements, adjustment
through the labor market should be of higher magnitude in countries with fixed exchange rates
than with flexible ones. Membership in the monetary union imposes further requirements on
factor market flexibility, since neither the exchange rate nor monetary policies can be used to deal
with country-specific shocks. Therefore, there is a call for higher labor market flexibility in
countries which are members of the monetary union or those which intend to join the monetary
union.

This paper aims to verify econometrically whether steps towards the EMU indeed go hand in hand
with higher wage flexibility in reality. This is done in two main dimensions: across countries and
over time. First, we compare the adjustment of aggregate wages (nominal, real) across three
groups of countries: four central European member states (CE-4), four member states already
participating in the Exchange Rate Mechanism-II (ERM-II participants), and three peripheral
members of the euro area (EMU-3). The representatives of the latter group - Austria, Greece, and
Portugal - serve as a benchmark for judging the degree of wage flexibility in the new member
states. Second, we analyze whether wage adjustment in the new member states changes over time.
A comparable quarterly data-set of wages, prices, unemployment rates, and productivity is
constructed for 1995-2004.

The paper is organized as follows. After this introduction, Section 2 outlines the concept of labor
market flexibility and provides further motivation for our focus on wage flexibility. Section 3
proposes the research methodology and formulates the research hypothesis. Section 4 describes
our data-set and gives the stylized evolution of unemployment, wages, prices, and productivity in
eight selected new member states and three EMU members. The estimation results are presented
in Section 5. These macro-economic outcomes are compared with micro-based measures of labor
market flexibility. Section 6 discusses policy implications and concludes.

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