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UK membership of the single currency

2 Flexibility

THE IMPORTANCE OF FLEXIBILITY

The flexibility test 

2.1  Flexibility is the ability to respond to economic change efficiently and quickly while safeguarding fairness. Changes include the impact of innovation and changing technology, shifts in consumer preferences and external shocks to the UK economy, such as the recent global slowdown. A high degree of flexibility means that the UK will be resilient in the face of such shocks and will minimise costs in terms of lost output and jobs. The central question in this test is, were the UK to enter EMU:

If problems emerge is there sufficient flexibility to deal with them?

2.2  In practice, there are many different ways that workers and firms can adjust to economic change, as discussed in the Introduction. For the worker, adjustment may require having to accept a lower wage increase, moving into a different job in the same firm or even changing employer. For firms, adjustment may involve adjusting prices or changing a product line. Flexibility is about minimising the costs of adjustment.

2.3  Flexibility matters whether or not the UK joins EMU. It ensures that the UK is able to make the most of trade and investment opportunities and new technologies. It also means that, within the UK, regions have the ability to adjust to meet changing and differing needs at the local level. Flexibility is also important in ensuring the Government meets its objective of achieving high and stable levels of growth and employment.

2.4  But flexibility would be particularly important if the UK joined the single currency. As noted by the Chancellor in a recent speech:¹

"Indeed in a single currency area where the old flexibilities to adjust exchange rates and interest rates are no longer available at a national level, labour, product and capital market flexibilities are even more essential. Adjusting to shocks without putting at risk high and stable levels of growth and employment demands even greater market flexibility." 

2.5  The experience of EMU to date shows that, in order to make a success of the single currency, countries need even more resilience to unexpected events since the ability to vary national interest rates and the nominal exchange rate between euro area countries no longer exists. As the test highlights, it is crucial to the membership decision that the UK economy has sufficient flexibility to deal with problems that might emerge in EMU. Sufficient flexibility means a high level of flexibility, both for existing members of EMU but also for countries which wish to join.

2.6  A successful single currency within a successful single market is of benefit to Europe. A recent Treasury paper² makes clear that EMU membership puts a premium on ongoing reform of EU labour, product and capital markets, delivered through the Lisbon agenda. The Government will continue to argue that employability, flexibility and stronger competition policies must be a top priority, so that EMU can be a sustained success. This will be particularly important as EMU expands to take in the new Member States joining the EU in 2004.

The 1997 assessment

2.7  The 1997 assessment judged that the UK did not yet have sufficient flexibility to cope with the challenges of monetary union and to compensate for the lack of convergence. In particular, the 1997 assessment noted that the UK and EU labour markets needed greater flexibility. Entry in these circumstances - without sufficient flexibility - would have been extremely costly, as demonstrated in the 'what if' exercise described in the Introduction. A key lesson from this is that flexibility would also be important for the transition to EMU. The impact of entry would be less likely to feed through to the real economy if there were sufficient flexibility.

2.8  The assessment of the convergence test has concluded that a high degree of settled and sustainable convergence has still not been achieved. The key question for the flexibility test, therefore, is whether there is a sufficient degree of flexibility to compensate for this and minimise the risks of entering EMU on this basis. Flexibility is now recognised as being even more important than it was at the time of the 1997 assessment, reflecting the challenges of the global economy and the increased demands that EMU membership would make on the UK economy.

Convergence and flexibility...

2.9  Even if cycles and structures had been assessed in the convergence test to be compatible, there would still be times when the UK would be more likely to experience different shocks - or different transmission of common shocks - to the euro area.

2.10  As flexibility relates to the resilience of the economy and its ability to adjust rapidly while minimising disruption, it determines the durability of convergence. Consequently, the convergence and flexibility tests together determine whether there is sustainable and durable convergence between the UK and the euro area. As emphasised in the Introduction, sustainable and durable convergence is a precondition for realising the potential benefits of EMU membership for the UK.

...and the growth, stability and employment test

2.11  High levels of flexibility will mean that workers and firms are able to take advantage of the opportunities that EMU membership would offer. Flexibility complements and supports productivity, particularly in supporting the key drivers of productivity through skills, competition, enterprise and innovation, and is a key element in the assessment of the fifth test on growth, stability and employment. The assessment of the fifth test also considers the broader issue of the impact of the UK decision on EMU on employment levels. 

Structure of the test

2.12  The assessment of the flexibility test considers the following key issues and questions:

• Flexibility and adjustment mechanisms in EMU answers the questions: How would adjustment differ inside EMU? Which types of flexibility matter? How much flexibility is needed in principle? How might joining EMU affect overall stability?

  The section considers how joining EMU might change adjustment to shocks and what types of flexibility would be most important inside EMU. The implications of different degrees of flexibility and how EMU might impact on macroeconomic stability are also considered. It draws on the EMU study Modelling shocks and adjustment mechanisms in EMU and the analysis in the EMU study The exchange rate and macroeconomic adjustment.

• Market flexibility answers the question: How flexible are UK and euro area labour, product and capital markets?

  Flexibility in all three markets is assessed with a focus on the types of adjustment most important inside EMU: wages for labour markets; prices for product markets; and risk sharing for capital markets. The framework adopted ensures a structured assessment, not just of flexibility in individual markets and regions, but also of how markets can interact and evolve and what this implies for the priorities for making a success of EMU. The assessment draws on the EMU studies EMU and labour market flexibility, Prices and EMU and EMU and the cost of capital.

• How flexibility and adjustment works in practice answers the question: How much adjustment and flexibility is experienced in practice in monetary unions?

  This section considers how existing monetary unions such as the US and UK adjust in practice, and also examines the experience of euro area countries since 1999. Evidence on how the US adjusts in practice draws on the EMU study The United States as a monetary union.

• The potential for fiscal flexibility answers the question: What role does fiscal policy play in adjusting to shocks and might this be enhanced inside EMU?

  Fiscal policy is an important tool available to policymakers within a monetary union. The fiscal policy section is informed by the Treasury discussion paper Fiscal stabilisation and EMU.

• The Conclusions assess the evidence on different forms of flexibility to answer the question: Is the degree of flexibility sufficient for the flexibility test to be met?

  These conclusions go on to address the question of whether the assessment of the convergence and flexibility tests together show that the achievement of sustainable and durable convergence has been demonstrated.  

FLEXIBILITY AND ADJUSTMENT MECHANISMS IN EMU

2.13  This section develops important insights which frame the subsequent assessment of the flexibility test. It draws on the EMU study Modelling shocks and adjustment mechanisms in EMU and the analysis in the EMU study The exchange rate and macroeconomic adjustment. The section considers four questions:

• how would adjustment differ inside EMU?
• which types of flexibility matter?
• how much flexibility is needed in principle?
• how might joining EMU affect overall stability?

How would adjustment differ inside EMU?

2.14  The economy continually needs to adjust to changing circumstances, affecting the competitiveness and profitability of the goods and services that it produces. The UK has experienced a number of such disturbances or shocks in recent years. Some are specific to parts of the UK, such as the foot and mouth crisis in early 2001. Others affect the UK as a whole, for example the strong rise in consumer spending in the late 1980s caused by financial market liberalisation. And others are global in nature, such as the ICT boom in the late 1990s and the heightened uncertainty following the recent global slowdown.

Flexibility ensures prompt adjustment to shocks

2.15  In or out of EMU, economic flexibility determines how costly adjustment to such shocks is likely to be in terms of unnecessary disruption to the real economy. In a flexible economy, rapid market adjustment, supplemented if necessary by effective policy action, ensures that any adverse impact is minimised. In an inflexible economy, little or no adjustment will cause disruption to the real economy. For example, if the UK economy were to experience a fall in demand for its exports, the resulting fall in the demand for labour would lead to higher unemployment. If workers find it difficult to re-enter the workforce, unemployment might stay higher for some time. There could therefore be a more sustained impact on the economy which, in the worst case, could have permanent effects.

2.16  Determining which aspects of flexibility matter most for a monetary union requires an understanding of how an economy adjusts to shocks in general inside and outside EMU. Box 2.1 illustrates, in a simplified form, how the UK economy might respond to the case, already highlighted, of a fall in external demand for UK export products. Possible adjustment channels include market adjustment, such as wage movements or labour mobility, and policy adjustment including monetary and fiscal policy and movements in the exchange rate.

2.17  In comparing how the economy adjusts inside EMU compared to outside, the key difference is that interest rates can no longer be set for national circumstances and the nominal sterling-euro exchange rate can no longer move to facilitate adjustment. Removal of these adjustment mechanisms means that the remaining ones have to work harder. If there is little or no flexibility, and therefore little or no adjustment, unemployment will rise.

Box 2.1: Adjustment mechanisms inside and outside EMU
The diagram below steps through the possible responses to a shock that causes a fall in external demand for UK export products and leads to a fall in the demand for labour in the UK. The shaded boxes indicate adjustment mechanisms that would not be present inside EMU.
There are a number of potential adjustment routes:
	real wages (money wages adjusted for inflation) could fall to help restore labour demand;
	outside EMU, the nominal exchange rate with the euro area could fall, making UK exports more competitive and facilitating real wage adjustment;
	displaced labour could move to a different region or another country, or workers might re-skill to enable them to move to other industries; and
	fiscal policy and, outside EMU, independent monetary policy, could be eased to support domestic demand.
Inside EMU, the key difference is that interest rates can no longer be set for national circumstances and the nominal sterling-euro exchange rate can no longer move to facilitate adjustment. Inside or outside EMU, an inflexible economy will experience a rise in unemployment.

Adjustments to a common shock do not differ...

2.18  Loss of these adjustment mechanisms inside EMU would not be a matter of concern if a shock affected the UK and the euro area equally and if the UK and the euro area had broadly similar responses to interest rate changes. In this case, the ECB's interest rate response would be the same as that of the Bank of England if the UK were outside EMU, and the sterling-euro exchange rate would not need to adjust in response to the shock. So changes in inflation and output in the UK would be broadly similar whether inside or outside EMU.

...but they do to a UK specific shock

2.19  But in the face of a shock specific to the UK, the situation is different. Box 2.2 explains this in more detail, focusing on the case of a temporary positive shock to UK demand, based on analysis in the EMU study Modelling shocks and adjustment mechanisms in EMU.

2.20  The different way that the economy responds to this (or any country-specific) shock inside and outside EMU importantly depends on the role of the interest rate and the exchange rate in helping the economy to adjust.

Outside EMU...

2.21  Outside EMU with an independent monetary policy and nominal sterling-euro exchange rate:

• interest rates could be raised to moderate demand in the UK economy; and
• the nominal sterling-euro exchange rate could appreciate, increasing the price of UK exports and lowering the competitiveness of the UK economy vis-à-vis euro area countries, measured by the real exchange rate.

2.22  Together, these two key channels would help to ensure that inflation remained close to target and output returned to trend.

...and inside EMU

2.23  Inside EMU, the adjustment path to a country-specific demand shock (for example, of the sort that might originate in the UK housing market) is very different. The example in Box 2.2 reinforces many of the lessons from the decision not to join EMU in 1999, highlighted in the Introduction:

• interest rates no longer play a primary adjustment role. In fact, because inflation rises due to strong demand, real interest rates actually fall significantly, exacerbating inflationary pressures and destabilising the economy;
• the nominal sterling-euro exchange rate is fixed but the real exchange rate still adjusts through price and wage movements, although this now happens much more slowly. This becomes the primary market adjustment mechanism inside EMU;
• moreover, inside EMU the euro area price level, rather than the UK price level, now effectively acts as a nominal anchor for the UK price level, with only a small degree of slippage allowed. Any period of high inflation in the UK relative to the euro area must be followed by a period of lower inflation in the UK relative to the euro area. Unless prices are completely flexible, this requires a period of UK output falling below potential; and
• since the adjustment mechanisms inside EMU are less effective, and in the absence of anything less than complete price flexibility, the responses of inflation and output to shocks are more protracted and volatile with adverse consequences for growth and employment.

2.24  However, it is important not to exaggerate the role that an independent monetary policy can play in helping the economy to adjust. Permanent shocks to demand or supply reflecting a change in economic fundamentals require structural changes or permanent shifts in relative prices whether the UK is inside or outside EMU. An increase in interest rates or an appreciation of the nominal exchange rate can only support the adjustment process. Neither can shocks that require adjustment between regions or industries within the UK be helped by an independent monetary policy.

2.25  It is also important to emphasise that medium-term inflation in the UK would still be guaranteed by the price stability objective of the ECB. But the inflation paths are likely to be very different inside and outside EMU. Outside EMU, price levels between the UK and the euro area can diverge in principle for sustained periods. Inside EMU, UK prices would be anchored by the price level in the euro area, with little scope for slippage.³

2.26  These findings highlight the importance of wage and price flexibility in EMU, especially for shocks that require an adjustment in the relative price level between the UK and other countries. Wage and price flexibility are also important in facilitating adjustment within the UK.

2.27  The degree of wage and price adjustment needed to respond to a shock depends on how easy it is for workers to move between different types of employment and between different locations. For example, a worker with transferable skills will be able to move easily from one job to another. Price and wage adjustment could also be less if businesses were able to create jobs easily when there is excess labour supply. Equipping the workforce with appropriate skills and facilitating entrepreneurship allows for a flexible redeployment of labour and capital in response to changing market conditions, contributing to the overall flexibility of the economy.

2.28  The ability of an economy to respond to shocks depends not only on how readily wages, price and quantities can adjust, but also on the effectiveness of demand stabilisation mechanisms. Stabilisation may occur through private sector responses: for example, firms and households may either draw on their savings or borrow in order to maintain their spending when incomes fall. The role of capital markets in facilitating adjustment is discussed in detail in a later section. Macroeconomic policy can also assist stabilisation, through changes in monetary and fiscal policy. Inside EMU, monetary policy would no longer operate at the national level, so fiscal policy would have a potentially greater role to play in macroeconomic stabilisation. The potential role of fiscal policy is discussed in detail in the penultimate section of this chapter.

How much flexibility is needed in principle?

2.29  To help answer the central question posed by the flexibility test - is the degree of flexibility sufficient - it is important to address the issue of how much is needed in principle. The straightforward answer is that a high degree of flexibility for all economies implies faster adjustment in response to shocks and better outcomes in terms of output and employment. Inside EMU, a higher degree of flexibility will also allow all economies to successfully reap the benefits of currency union.

Different degrees of flexibility

2.30  In practice, some countries may be more flexible than others, so they may respond more quickly to shocks. This increases the likelihood that euro area-wide interest rates will not be appropriate for UK conditions even when faced with shocks that are common to the UK and the euro area. On the basis of the analytical work in the EMU study Modelling shocks and adjustment mechanisms in EMU, Box 2.3 discusses the implications of different degrees of flexibility, in absolute and relative terms, if the UK were to join EMU.

2.31  The key conclusions from this analysis are that:

• if price flexibility were low in both the UK and the euro area, output and inflation would tend to suffer from long drawn out responses in the face of shocks - with sustained periods of output and employment below potential;
• if prices in the UK were more flexible than prices in the euro area, output stability in the UK would be much improved. But this advantage would be offset by greater inflation volatility. This occurs because the ECB would need to take account of sluggish euro area price adjustment when setting euro area monetary policy. So interest rates would not be appropriate for the UK and UK inflation would be needlessly volatile, even when faced with similar shocks to the euro area. This price volatility might have adverse consequences for the real economy in the UK and therefore makes it even more important that the UK achieves high levels of flexibility; but
• if prices were highly flexible in both the UK and the euro area, this would represent the best outcome. Now, output volatility would be lower and inflation would be well controlled at target levels. Inflation differentials between the UK and the rest of the euro area would only emerge when relative price changes were warranted, and they would take place promptly.

2.32  In his contribution to the EMU study Submissions on EMU from leading academics, Professor Andrew Hughes Hallett notes similarly: "Put simply, rigidities in one place spill over to constrain the performance of others. Hence asymmetries in the capacity of labour markets to adjust, asymmetric shocks, or asymmetric transmissions, all cause spill over which damage others (unless price flexibility is perfect)."

2.33  The assessment of the degree of flexibility needed in principle must be closely linked to the assessment in the convergence test of compatibility, because even if the UK is highly flexible, or better still both the UK and the euro area are highly flexible, without settled and sustainable convergence the costs of membership may still be prohibitively high compared to a policy of staying outside EMU.

How might joining EMU affect overall stability?

Macroeconomic stability is important

2.34  Macroeconomic stability matters whether or not the UK joins EMU. Large and unpredictable fluctuations in output, employment and inflation impose significant economic and social costs and, if sustained, can hold back the economy's long-term growth potential. The current UK macroeconomic framework is designed to promote long-term stability by ensuring low inflation and sound public finances. This has helped the UK to maintain steady and stable growth in times of uncertainty, such as the recent global slowdown.

2.35  As discussed above, a decision to join EMU would mark a substantial change in the UK's macroeconomic framework and the mechanisms through which the economy adjusts to shocks. Professor Ray Barrell notes in his contribution to the EMU study Submissions on EMU from leading academics that: "Choosing the best framework for a country requires that we can decide which volatilities matter most and which framework reduces those volatilities at least cost". Any decision on EMU must take into account the expected impact of EMU on stability.

The impact of EMU on stability

2.36  It is not clear in principle how joining EMU would affect overall stability, although the analysis of adjustment mechanisms has framed consideration of the issues. The analysis in Box 2.2 establishes that macroeconomic adjustment tends to be more protracted inside EMU in the face of a particular type of shock; it illustrates the case of a temporary demand shock specific to the UK economy. But it is important to understand how macroeconomic stability would be affected in the face of the full range of shocks that might be expected inside EMU.

2.37  Joining EMU would immediately provide one source of stability: the nominal sterling-euro exchange rate would be fixed. To the extent that this has been volatile in the past, joining EMU would eliminate this volatility. However, since the exchange rate can also act as an adjustment mechanism, cushioning the impact of shocks, joining EMU might act to increase volatility elsewhere.

Two studies assessing volatility inside EMU

2.38  Two academic studies have attempted to weigh up these different influences. They tend to give contradictory messages - one finds that volatility increases inside EMU while the other finds that it falls. Box 2.4 summarises the findings.

2.39  The EMU study Modelling shocks and adjustment mechanisms in EMU uses the same illustrative model featured in Boxes 2.2 and 2.3 to reconcile these different findings. It does so by producing new estimates of the potential effects of EMU membership on UK volatility. And it examines the sensitivity of the conclusions to different assumptions about the structural characteristics of the UK and euro area economies and the types of shocks likely to be experienced inside EMU.

In most cases, macroeconomic volatility increases inside EMU

2.40   The main findings on macroeconomic volatility from the EMU study Modelling shocks and adjustment mechanisms in EMU, also summarised in Box 2.4, are that:

• macroeconomic volatility is expected to be higher inside EMU on a wide range of assumptions;
• if price flexibility is assumed to be higher in the UK than in the euro area, this magnifies the deterioration in inflation volatility inside EMU but makes the deterioration in output variability much smaller (this is consistent with the earlier analysis of the effects of flexibility in Box 2.3);
• an augmented role for fiscal policy can help to mitigate the increased volatility inside EMU; and
• macroeconomic volatility is only likely to fall inside EMU if volatility in the sterling-euro exchange rate has been a significant source of shocks in the past. The EMU study The exchange rate and macroeconomic adjustment presents evidence that this has not been the case, as discussed in the assessment of the convergence test.

Safeguarding stability inside EMU

Inflation volatility

2.41  The above discussion strongly implies that greater inflation volatility would be a feature of EMU membership. Inflation volatility has potentially important implications. For example, it may make it harder to separate relative price signals - important for resource allocation - from more general inflationary pressures. In turn, this makes it difficult to plan ahead and undertake sensible resource decisions to invest and save for the future. This could threaten the realisation of the potential benefits of EMU.

2.42  Inflation also has distributional effects. It can interact adversely with the tax and benefit system as many payments are linked directly to measured inflation. High inflation lowers the real value of interest payments made to savers but makes borrowing more attractive. This sometimes leads people to invest in certain types of assets, like property, which tend to retain value better in times of high inflation. Other things being equal, this inflation effect could unhelpfully serve to boost demand further and could intensify the risks identified in the convergence test.

2.43  In order to limit to the short term the adverse effects of higher inflation volatility, medium-term expectations would need to be firmly anchored to the euro area aggregate. The evidence in the convergence test shows that inflation expectations in the euro area are anchored by the ECB's medium-term price stability objective and are around 2 per cent on the HICP measure.

2.44  As well as requiring a clear medium-term euro area-wide anchor, the Government would have several national policy options to minimise risks to overall stability inside EMU. Ensuring a high degree of market flexibility would lower overall volatility and imply that interest rates were more appropriate for more EMU members more of the time. Fiscal policy could also play a greater role in stabilising the economy and support market adjustment. Together, greater market and fiscal flexibility would help to ensure macroeconomic stability inside EMU.

2.45  These findings highlight important issues that frame the assessment of the flexibility test. Inside EMU, loss of national monetary policy and the nominal sterling-euro exchange rate means that other adjustment mechanisms would have to work harder. Wage and price adjustment are the most effective adjustment mechanisms available, but there is also a potentially enhanced role for fiscal policy. National monetary unions, including the UK, have been successful without high internal mobility. The discussion motivates the next three sections on supply-side flexibility in labour, product and capital markets. The assessment then considers monetary unions in practice, including the experiences of the UK, the US and EMU to date. Finally, the issue of how fiscal policy may need to play a greater role in adjustment in EMU is discussed.

MARKET FLEXIBILITY: ADJUSTMENT THROUGH WAGES AND LABOUR MARKETS

The importance of a flexible labour market for EMU

2.46  This section examines the flexibility of UK and EU labour markets. An efficient and flexible labour market that creates jobs, increases competitiveness and raises productivity is essential to the UK, irrespective of whether it is a member of EMU or not. The analysis of the previous section shows that any decision to join the single currency places a premium on adjustment mechanisms such as prices. In the labour market this equates to wage flexibility. EMU membership also has the potential to create higher levels of employment through greater trade opportunities and market integration. Sufficient wage flexibility, as well as other forms of labour market flexibility, would be necessary to realise the gains.

2.47  An appraisal of the UK labour market was central to the 1997 assessment of the flexibility test, which concluded:

"...in labour markets particularly, the UK has not yet achieved sufficient flexibility to meet the challenges of EMU membership."

A framework for assessing labour market flexibility

2.48  This section assesses detailed evidence of labour market flexibility, particularly wage flexibility. It is based on the comprehensive analysis in the EMU study EMU and labour market flexibility and complements the quantitative analysis of adjustment mechanisms discussed earlier. There is a particular focus on labour market performance since 1997.

2.49  The analysis uses a new framework developed for the assessment to analyse the flexibility of labour, product and capital markets, covering:

• characteristics - the mechanisms through which the labour market adjusts in response to a shock. Wage flexibility is particularly important. However, EMU puts a premium on flexibility in all aspects of the labour market, including the ability of workers to increase their level of training, to adapt their skills and to be more mobile, and the ability of firms to offer diverse working practices;
• outcomes - the key indicators of how well labour markets are functioning, both in aggregate and across different socio-economic groups and regions. This includes an appraisal of job creation, unemployment, wage pressures and job matching; and
• the institutional environment - the policy and social environment in which the labour market operates. The key institutional factors influencing labour market adjustment are analysed and drawn together into a comparative indicator of labour market flexibility in the UK and other countries.

Characteristics of flexible labour markets

The importance of flexible wages in EMU

2.50  Adjustment of wages inside a monetary union is vital because changes in external competitiveness will be driven by inflation differentials alone. A sufficient level of wage flexibility - the ability of wages to eliminate imbalances between the supply of and demand for labour - is therefore necessary to ensure economic stability within EMU. Wage adjustment can occur at the sectoral level - relative wage flexibility - or the aggregate level - real wage flexibility, which in turn is influenced by nominal wage flexibility.

Relative wage flexibility

2.51  The 1997 assessment observed that relative wages in the UK were able to reflect new and changing demands in the economy. This remains the case today. The EMU study EMU and labour market flexibility notes that between 1999 and 2001, regional wages in the UK grew faster in regions of low unemployment, such as the South East. This contributed to the continued narrowing of unemployment rates between regions of the UK. Similarly, the wages of skilled workers have been rising relatively faster than those of workers with lower skills.

Real wage flexibility...

2.52  Historically, real wage flexibility has appeared relatively low in the UK and may have contributed to the high levels of unemployment experienced in the 1980s and early 1990s. Real wages have tended to be rigid in the face of high levels of unemployment but have grown strongly when unemployment has fallen. The 1997 assessment noted that the UK had reached a critical point in the economic cycle where typically wage inflation would have accelerated as unemployment fell further, and that it was too soon to tell whether labour market performance had improved or would revert to past patterns.

...appears to have improved in the UK

2.53  Evidence detailed in the EMU study EMU and labour market flexibility points to an improvement in real wage flexibility in the UK. Importantly, these results are consistent with a wide range of academic work comparing real wage flexibility across countries. New analysis undertaken for the assessment finds that UK real wages have become more responsive to the level of unemployment (see Box 2.5). The analysis on its own is insufficient to conclude with certainty that real wage flexibility has increased because identifying significant changes with confidence is difficult. However, the fact that unemployment has declined sharply in the UK in recent years without igniting inflationary pressures in the labour market suggests this improvement is genuine.

2.54  At the same time, the OECD has recently noted that EMU membership may have increased wage moderation in the euro area, while the IMF has noted how the recent resilience of the EU jobs market reflects greater wage moderation.⁴

Nominal wage flexibility

2.55  Real wages adjust either through a change in the nominal money wage or through changes in the price level. In a low inflation environment, nominal wage rigidities (barriers that prevent nominal wages from changing) may become a more important source of real wage rigidity. This could be a particular problem in EMU, since wage adjustment would be an important adjustment mechanism.

2.56  Nominal wages are generally adjusted annually in UK wage negotiations, potentially allowing for a relatively high degree of nominal flexibility, although at the expense of some short-term adjustment. Moreover, bonus payments have allowed the private sector to be more flexible in the recent downturn, as reflected in the low growth in average private sector earnings over 2001 and 2002.

2.57  In all countries, downward nominal wage rigidity is an issue. Employees are resistant to a cut in nominal wages and many employers reluctant to impose one. The extent to which this became a problem would depend on whether nominal wage cuts were necessary to adjust to a shock.

2.58  The EMU study EMU and labour market flexibility notes that many individuals in the UK do not experience a change in their nominal wage from one year to the next. This suggests that downward nominal rigidities may interfere with labour market adjustment in the UK. However, the degree to which this is a constraint has not been fully tested to date. In recent years, inflation has been close to its target of 2½ per cent a year and average earnings have increased by around 4½ per cent a year, providing considerable scope for movements in real and relative wages even in the face of any resistance to nominal wage cuts.

Conclusion: wage flexibility

2.59  Overall, relative and real wage flexibility seem to be reasonably high in the UK and appear to have improved in some areas since 1997. However, this has not been fully tested in recent years. Wage flexibility would be more severely tested by a decision to join EMU, where price movements would need to play a greater role in adjustment to shocks. There are some signs that EMU membership has facilitated euro area wage flexibility. Because of its key role in adjustment, the level of real wage flexibility in the UK and the euro area poses a risk to successful UK membership of EMU. Budget 2003 announced the Government's intention to increase wage flexibility in the public sector labour market through a stronger local and regional dimension to the setting of public sector pay.

Geographic labour mobility...

2.60  EMU places a premium on flexibility in all aspects of the labour market. One such adjustment mechanism is the ability of individuals to move residence in order to find employment - geographic labour mobility. A number of commentators have suggested that high levels of geographic mobility in the US have been important in allowing it to function effectively as a single currency area, as discussed in the EMU study The United States as a monetary union.

...is low in the EU...

2.61  Geographic mobility in the EU is much lower than in the US. This is also true of geographic mobility within countries, including the UK. Many of the barriers to geographic mobility, particularly across borders, relate to family commitments, career progression and benefits and property. As such, it is unlikely that mobility in the UK or the EU will increase quickly. In his contribution to the EMU study Submissions on EMU from leading academics, Professor Barry Eichengreen notes: "The creation of a single market and the transparency created by the single currency . . . will facilitate greater labor mobility over time. There is some anecdotal evidence of this already . . . but one's main impression is that movement in this direction is slow".

...but should not constrain any decision to join EMU

2.62  Geographic mobility, both across borders and within countries, is undoubtedly desirable and would support a successful EMU for existing members and for the UK and other countries should they decide to join. However, as set out in the EMU study EMU and labour market flexibility, low geographic labour mobility is unlikely to be a primary risk inside EMU, for a number of reasons. National monetary unions, including the UK, have been successful without high internal mobility. Dr Daniel Gros notes in his contribution to the EMU study Submissions on EMU from leading academics that the difference between international and inter-regional mobility in Europe is low, such that: "EMU should thus not be much more difficult to manage than the existing monetary unions in Europe that member states represented up to 1999". Moreover, a decision to migrate often entails significant costs, so geographic mobility is a more suitable adjustment mechanism to permanent shocks. It is not a key substitute for the role of monetary policy, which responds only to temporary or cyclical shocks.

Conclusion: geographic mobility

2.63  Geographic labour mobility is low both within and between EU Member States. However, because geographic mobility would be an imperfect substitute for a national monetary policy, this is not likely to be a significant risk to the viability of EMU either for existing members or for the UK. However, policy measures to increase geographic mobility would improve the performance of the UK labour market and help UK performance in EMU, as well as the performance of existing members. It is therefore a priority for the Government.

Functional flexibility...

2.64  Functional flexibility is the ability of the workforce to perform different tasks and acquire and apply different skills. It is complementary to, but can also act as a substitute for, geographic labour mobility. Inside or outside EMU, but particularly within a single currency area, functional flexibility is important to ensure that individuals have the skills to adapt to increased competition and to compete for a wide range of jobs in a changing economic environment.

...skills shortages have not increased as unemployment fell...

2.65  The 1997 assessment of the flexibility test concluded that the level of skills in the UK might constrain the ability of the economy to respond to the structural changes brought about by EMU. The steady decline in unemployment and the absence of a strong pick up in skilled labour shortages since then (see Chart 2.1) may mean that functional flexibility has been less of a constraint for firms than was feared, although EMU membership would still bring additional challenges.

...but imbalances remain

2.66  However, evidence suggests that, relative to the US, France and Germany, the UK still suffers from significant skills imbalances. While the number of people in the UK with high skill levels compares well internationally, the level of intermediate skills is low and a large proportion of the UK population possesses low skills. While progress has been made since 1997, the stock of low-skilled workers is only being reduced slowly. A continual improvement in skill levels, particularly among those with the lowest skills, is necessary in order for the UK economy to respond to technological change.⁵

Conclusion: functional flexibility

2.67  A highly educated workforce with a culture of lifelong learning is more likely to be able to adapt to economic change. While skills shortages may not have been as large a constraint as previously feared, imbalances still remain in the UK's skills base. Improving the level of skills, particularly among those with the lowest skills, is therefore a focus of the Government's agenda for enhancing flexibility in the UK.

Employment flexibility

2.68  It is important that employers are willing and able to adopt flexible patterns of working. Employment flexibility boosts the available supply of labour by ensuring that employees can combine employment with other activities and responsibilities.

2.69  The 1997 assessment emphasised that the UK is relatively successful at matching the demands of the market to the needs of workers. Part-time workers make up around 25 per cent of the UK workforce, generally as a result of workers' choice. This is high in comparison to much of Europe, although the incidence of part-time employment has also increased in other EU countries during the 1990s. Compared to the EU as a whole there is also a relatively high number of employees with flexible working patterns in the UK, such as shift, night and weekend working, although these are also becoming more widespread in the rest of the EU.

2.70  The European Commission has recently noted that the liberalisation of temporary contracts across the EU may have been an important reason behind the recent strong growth in employment. However, as the EMU study EMU and labour market flexibility notes, caution is needed in drawing conclusions about the relationship between temporary contracts and labour market flexibility.

Conclusion: employment flexibility

2.71  The 1997 assessment observed that the UK already had a relatively high degree of employment flexibility. This has been maintained, as demonstrated by a high incidence of part-time employment and flexible working practices.

Outcomes in flexible labour markets

2.72  The EMU decision must be consistent with the UK Government's objective since 1997 to extend employment opportunity to all in a changing labour market: the modern definition of full employment. High levels of employment help deliver fairness and social inclusion in any economy, irrespective of whether it is a member of a currency union or not. High levels of long-term unemployment or economic inactivity can also prevent the labour market from working effectively, for example if they lead to supply bottlenecks and skills shortages. This may be more of a constraint in EMU where the need for labour market adjustment is greater. This section focuses on employment and unemployment outcomes in relation to adjustment. The assessment of the growth, stability and employment test considers the broader issue of the potential impact of EMU on employment levels.

Employment in the UK...

2.73  The Government's policies to tackle structural weaknesses in the UK labour market have helped to raise employment to its highest ever level. Between the third quarter of 1997 and the first quarter of 2003, the number of people in work in the UK increased by nearly 1.4 million and the employment rate rose from 72.9 per cent to 74.6 per cent. That said, more progress can be made. Employment rates remain low in the most deprived areas of the country and for people from ethnic minorities; and while overall employment has risen, overall inactivity has fallen by less.⁶

...and in Europe as a whole

2.74  The 1997 assessment noted that Europe as a whole needed to be able to create jobs and tackle its problem of high unemployment in order to make EMU work. There has been an improvement in the employment performance of the EU labour market since 1997, a period which has also seen a pick up in economic growth (see Box 2.6).

2.75  However, more still needs to be done. The challenge of invigorating European labour markets is considerable and reform will require imagination and ambition on the part of employees, employers and policymakers. The paper Towards Full Employment in the European Union⁷ identifies priority areas for action along with policy recommendations for how these might be addressed.

Shocks can have long-term consequences

2.76  It is arguable whether the recent improvements go beyond a purely cyclical effect or whether they would unwind if a large shock were to hit the European economy. Historically, Europe's experience has been one of negative shocks raising unemployment temporarily from its equilibrium rate, but slow labour market adjustment then resulting in much of the increase in unemployment becoming entrenched.

2.77  Chart 2.2 indicates that following negative unemployment shocks in the 1970s and 1980s, the unemployment rate remained higher in the euro area and, until recently, the UK than in the US, which has experienced more stable unemployment rates. In other words, shocks have had long-lasting effects on the labour market. As discussed in the Introduction, such effects can become permanent. Most recent data show that the UK currently has one of the lowest rates of unemployment in the OECD, lower even than the US.

Structural unemployment has fallen in the UK...

2.78  Analysis of the structural component of unemployment indicates the extent to which a fall in unemployment reflects greater structural labour market flexibility rather than a purely cyclical effect. Chart 2.3 presents OECD estimates of one measure of structural unemployment. This shows that:

• structural unemployment in the UK has fallen from nearly 8 per cent in the early 1990s to around 5½ per cent at present;
• progress in the other large EU Member States has been slower. Structural unemployment has been relatively stable since 1990 and remains high; and
• there have been significant falls in structural unemployment in some of the smaller EU Member States such as Ireland and the Netherlands.

2.79  This mixed picture suggests that shocks can still have long-lasting effects in EU countries.

Benign wage pressures suggest the fall in structural unemployment is genuine...

2.80  Earnings growth is a simple and timely labour market outcome measure. The recent profile of average earnings growth suggests supply side improvement in the UK and is supportive of there having been a gentle fall in structural unemployment.⁸ Since 1997 unemployment has fallen to rates last seen in the 1970s, yet average earnings growth has remained consistent with the current inflation target and estimates of trend productivity growth (see Chart 2.4). In the past, when unemployment has fallen to such a low level, wage inflation has accelerated significantly.

...as does an improvement in mismatch

2.81  The UK labour market is also now better able to adapt to imbalances across market segments:

• the relationship between unemployment and vacancy rates appears to have improved in the late 1990s, indicating better job matching.⁹ Across Europe the evidence is mixed, with the relationship worsening in Germany and France in the mid to late 1990s, suggesting that job mismatch has increased; and
• the dispersion of regional unemployment rates in the UK has fallen since the beginning of the 1990s. Each region has seen sharp falls in unemployment, although localised pockets of unemployment remain. However, regional unemployment dispersion is more pronounced in other parts of Europe.

Long-term unemployment has fallen...

2.82  The 1997 assessment emphasised the importance of ensuring that specific groups did not become permanently detached from the labour market. This is necessary to ensure that the economy does not run into labour supply bottlenecks and skills shortages. Since 1997, previously marginalised groups have been reintegrated into the labour market. In particular, the level of long-term unemployment, which averaged 710,000 in 1997, had fallen to 324,000 by February 2003.

...but challenges remain

2.83  However, challenges remain to ensure employment opportunities for all in the UK. The employment rates of lone parents, the over 50s, ethnic minorities and people with disabilities remain below the national average, while certain deprived areas continue to endure unacceptably high levels of worklessness.

The institutional environment

Shocks can have long-lasting effects

2.84  The discussion has highlighted how negative shocks to European labour markets have historically led to long-lasting increases in unemployment. Evidence summarised in the EMU study EMU and labour market flexibility indicates that this is a result of the institutional environment interacting with the shocks that hit the economy. This slows the speed at which unemployment returns to its sustainable level, and in some cases can lead to permanent increases in equilibrium unemployment. In EMU, the loss of national monetary policy and the nominal sterling-euro exchange rate as adjustment mechanisms increases the need for an institutional environment that is conducive to flexibility.

2.85  The interaction of the tax and benefit system influences labour market flexibility through its impact on labour supply, unemployment and wages. While maintaining fairness and social inclusion, it is important that the interaction of the tax and benefit system does not erode the incentive to seek work.

Work is now more financially rewarding...

2.86  Since the 1997 assessment, the Government has introduced a number of reforms to the tax and benefit system in order to make work pay, particularly for those on low incomes. Reforms to income tax, national insurance and the introduction of a system of targeted tax credits have:

• increased the minimum income that people can expect when moving into work. The introduction of the Child and Working Tax Credits has increased the gains to work for households with children. The extension of in-work support to workers aged 25 and over without children or a disability will significantly increase work incentives for this group too; and
• increased incentives to move up the earnings ladder, with the number of households facing marginal deduction rates of over 70 per cent falling by over half a million since 1997.

2.87  OECD figures show that the UK has gross replacement rates for different groups (the ratio of out-of-work to in-work income) comparable to the US and lower than many European countries.

...and the unemployed are better equipped to take up jobs

2.88  Increasing the effective labour supply by improving work skills and disciplines can reduce the need for employers to raise wages and therefore increase the medium to long-run responsiveness of wages to unemployment. Although spending on active labour market policies in the UK is low by international standards, it appears to be well targeted. The evaluations of the various New Deal programmes in the UK have shown positive results in terms of reducing long-term and youth unemployment as well as unemployment among those aged over 50.

Labour market regulation remains conducive to flexibility

2.89  Well-designed employment protection legislation (the rules governing hiring and firing) offers clear benefits to employees. Badly designed protection legislation can impose excessive costs on employers and deter them from offering jobs where the returns from creating the job are too low in relation to the associated cost. Where this is the case, protection legislation acts as a barrier to labour market flexibility. Studies suggest that employment protection legislation in the UK is less heavy-handed than in many other OECD countries, and more conducive to market flexibility, although other European economies have also generally improved over the 1990s.

Has the National Minimum Wage reduced flexibility?

2.90  The National Minimum Wage underpins the Government's tax and benefit reforms. By setting a wage floor, it is one piece of regulation since 1997 that might hold back the ability of the labour market to adjust to shocks. This would be the case if it reduced employment or set an inappropriate going rate for wage increases across the economy. However, the evidence so far suggests that the National Minimum Wage is set below the level at which the employment constraint starts to bite and that there has been a negligible impact on the pay of those not directly affected by its introduction.

Is the collective bargaining system conducive to flexibility?

2.91  Since the 1980s the UK has moved to a more decentralised and uncoordinated wage bargaining system. This structure means that relative wages can adjust more readily to industry, sector and regional conditions. However, maintaining balanced pay claims will be essential to ensuring this positive performance can be sustained going forward.

2.92  Collective bargaining structures differ greatly across the EU. Both trade unions and employers' associations are organised in very different ways. However, collective bargaining outcomes in the 1990s, in terms of real wage growth, have shown both long-term moderation and convergence compared with previous decades.

2.93  The EMU study EMU and labour market flexibility presents an estimated summary indicator of labour market flexibility. The indicator confirms that the institutional environment affecting the performance of the UK labour market compares favourably with that in many other countries and is consistent with the improved labour market performance observed in recent years being sustained - see Box 2.7.

2.94  The changes to the institutional and policy framework in the UK - in particular, the reforms to the tax and benefit system in order to make work pay, the introduction of active labour market policies and the enhanced UK regulatory environment - are conducive to labour market flexibility and imply that the recent improvements in the UK labour market can be sustained.

Conclusion: how flexible are UK labour markets?

2.95  UK labour market flexibility has improved markedly since 1997. Significant falls in overall unemployment and long-term unemployment have accompanied strong employment growth, giving the UK one of the lowest levels of unemployment in the OECD, lower even than the US. The 1997 assessment observed that the UK already had a relatively high degree of employment flexibility. This has been maintained, as demonstrated by a high incidence of part-time employment and flexible working practices. Moreover, evidence since 1997 points to an underlying improvement in wage flexibility. However, important challenges remain in the UK to reduce inactivity and repeated spells of worklessness and to enhance skill levels and improve mobility. Adjustment mechanisms have not been fully tested in recent years as the UK has had a relatively stable macroeconomic environment. If the UK decided to join EMU, wage movements would need to play a greater role in adjustment.

2.96  EMU membership puts a premium on the need for institutional structures to cope with shocks. Therefore, while the positive reforms to the institutional and policy framework in the UK suggest that recent improvements can be sustained, more progress on labour market reform would enhance flexibility in the UK and advance the Government's long-term goal of employment opportunities for all. In the context of EMU, it would also increase the durability of convergence between the UK and the euro area.

2.97  It is now recognised across Europe that to realise the full benefits of EMU membership requires more progress on a range of economic reform policies to enhance flexibility and resilience to shocks, particularly in labour markets. Europe as a whole, and especially the larger EU economies, needs to match the impressive flexibility record of some of the smaller EU Member States. The less progress on flexibility that is achieved in the EU, the greater the premium on a high level of flexibility in the UK economy.

Policy requirements

2.98  In the labour market, the Government is continually working to enhance flexibility and is going further through a package of measures designed to increase wage flexibility in the public sector, improve skills, particularly at the basic and intermediate level, give greater local discretion in the delivery of employment policies and increase labour supply by helping more people to move from welfare to work and increasing cyclical economic migration.

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MARKET FLEXIBILITY: ADJUSTMENT THROUGH PRICES AND PRODUCT MARKETS

The importance of a flexible product market for EMU

2.99  This section considers the flexibility of UK and EU product markets. A flexible product market, that promotes competition and encourages innovation and research, is important irrespective of whether or not the UK joins EMU. However, a decision to join EMU would increase the need for rapid price and factor movements and would also make it necessary for firms to be able to respond effectively to shocks and adapt to the competitive challenges that the single currency would bring. Product markets also play an important role in supporting productivity, particularly through competition, enterprise and innovation. This is discussed in more depth in the assessment of the growth, stability and employment test.

Links to labour and capital markets

2.100   Product market flexibility complements labour and capital market flexibility. In the labour market, firms need employees to be able to adapt readily to economic change. Firms also require capital markets to be flexible to ensure access to a wider range of financing options.

2.101  The 1997 assessment observed that:  

"The liberalisation of product markets has progressed further in the UK than in many other EU countries...But some problems remain and new measures are planned to make further improvements, particularly to competition policy."

2.102  This section looks at product market flexibility in more detail with a particular focus on price flexibility - a key adjustment mechanism in EMU in the absence of the nominal sterling-euro exchange rate and independent national monetary policy. It draws on the evidence presented in the Government's White Paper on EU economic reform Realising Europe's Potential: Economic Reform in Europe and the subsequent progress report (HM Treasury, 2002 and 2003). The role that inflation can play as an adjustment mechanism is discussed in the EMU studies Modelling shocks and adjustment mechanisms in EMU and Prices and EMU.

A framework for assessing product market flexibility

2.103  The analysis adopts the same framework as for labour markets:

• characteristics - the mechanisms through which the product market adjusts to a shock. The focus is on the important role of price flexibility;
• outcomes - key indicators of the operation of product markets such as price differentials and mark-ups; and
• the institutional environment in the product market and how it influences the adjustment process.

Characteristics of flexible product markets

The importance of flexible prices in EMU

2.104  Flexible product markets play a key role in promoting price flexibility - a particularly important adjustment mechanism for an economy inside a monetary union. Inside EMU, relative price adjustments are the only means for changes in competitiveness between countries to occur. For example, a country with an overheating economy will have more inflationary pressure, while a country with weaker demand will have less; higher inflation in the rapidly growing economy will lower its relative competitiveness and reduce overheating pressures.

Inflation adjustment in the euro area

2.105  The experiences of Ireland and the Netherlands in EMU provide interesting case studies. Both economies grew strongly over the mid to late 1990s and inflation rates rose well above the euro area average. The resulting real exchange rate appreciation helped their economies to absorb and adjust to the overheating pressures (see Box 2.8).

Price flexibility in the UK...

2.106  Adjustment differs in the UK where, outside EMU, interest rates together with exchange rate movements ensure that inflation remains at target. Nonetheless, relative price movements between regions and industries ensure adjustment and competitive resource allocation within the UK.

...is not instantaneous...

2.107  Like wage adjustment, price adjustment will not be instantaneous. Prices are sticky or slow to adjust due to the costs involved in changing prices, or firms might be reluctant to lower their prices leading to downward nominal price rigidity.

...but there remain a wide range of price movements

2.108  A low and stable inflation environment might lead firms to lengthen the time between price changes. However, analysis of RPIX inflation shows that there have been relative price movements in the UK during the 1990s when the inflation rate was much lower and more stable than in the past (see Box 2.9). In recent years, a high proportion of price movements have been negative, suggesting that UK firms are willing to cut prices as demand conditions change. Evidence from the euro area shows that price falls are also present within the euro area inflation aggregate.