Quantifying the Germany shock: Structural labor-market reforms and spillovers in a currency union

Abstract

We examine the effects of unilateral structural reforms within a currency union. Focusing on the surge of German competitiveness following the introduction of the Euro, we first provide reduced-form causal evidence supporting the notion that German structural labor-market reforms in the early 2000s led to a crowding-out of manufacturing employment in other Eurozone economies. To assess the impact of this German competitiveness shock, we build a quantitative multi-sector trade model that features downward nominal wage rigidities, endogenous labor supply, unemployment-insurance benefits and international savings. The fixed nominal exchange rate can create binding nominal rigidities in response to a foreign real supply shock – like the one prompted by the German reforms – resulting in significant contraction of manufacturing sectors and increased involuntary unemployment across other Eurozone countries. We consider a number of counterfactual scenarios, such as the impact of German labor-market reforms in the absence of a fixed exchange-rate regime, the role of coordinated reforms within the Eurozone and a higher average inflation rate.