Convergence, business cycle synchronization and the real exchange rate

while Italy and Slovenia are highly “in sync” but show weak resilience. Finally, Romania’s economy is weakly synchronized with the euro area, but demonstrates average resilience.

Real exchange rate pressures within the EU are significant. This report updated the traditional OCA index. It found that Croatia and Romania exhibit indicator values today that are similar to pre-euro Italy and Portugal (two countries that turned out to lack resilience during the crisis). In contrast, Bulgaria would face relatively little real exchange rate pressures: its index level is comparable to pre-euro Netherlands. Moreover, as the history of the eurozone attests, endogeneity—institutional improvement by virtue of being a member of the eurozone—is not a given: while the OCA index indeed improved for Austria, Belgium, Finland and the Netherlands after they adopted the euro, the index worsened for Greece, Ireland and Spain. In other words, additional variables need to be considered for successful participation in the monetary union.

In most countries, the duration or depth of the crisis was longer for bottom 20 percent than for median households. The first part of this report assessed these trends in detail. It demonstrated that countries with high social protection spending directed towards old age and health, but limited spending devoted to poverty-targeted policies and programs, faced deeper poverty increases and longer periods of recovery. However, such poverty-targeted programs are largely absent or have insufficient coverage in many countries in the EU, including in the eurozone.

Social protection programs need to reach the poor, cover enough households and be responsive to additional enrollment during times of need. Social protection programs targeted to the poor and active labor-market policies should ensure that the lower income groups—most of which are typically found in lagging regions—are protected and supported in their adjustment to inevitable shocks. From a macroeconomic perspective, they support “liquidity-constrained” households—this should amplify the fiscal multiplier. Effective social protection can assist in absorbing shocks and help ensure a rebound that is economically inclusive and builds trust.

Institutions that allow wages—an important determinant of the real exchange rate—to adjust, improve resilience. Wages enter the real exchange rate directly, but also indirectly through their impact on local inflation rates: the institutions that govern wage-setting behavior therefore play an important role in responding to shocks. More wage flexibility is, on average, associated with better resilience.

The most resilient economies of the EU are all underpinned by sound labor market conditions. In these countries, labor market institutions combine flexibility with active labor market policies, while benefiting from collective bargaining institutions that yield outcomes that support resilience. For instance, our results suggest that a country with a 20 percentage points higher collective bargaining coverage (the difference between Finland and Spain in 2018) tends to have a 1 ½ quarter shorter half-life of an employment recession—a change of economic significance given that the mean half-life is around 10 quarters.

However, labor market institutions need to be seen in context, as rigidities in one aspect can be compensated by flexibility in another. For instance, rigid employment protection in several western European economies, when combined with high wage flexibility, does not result in worse unemployment trends. And when collective bargaining is buttressed by high levels of trust, resilience is boosted. Conversely, high levels of collective bargaining in a context of low wage flexibility and lack of trust undermines resilience.