Paolo Mauro, Eswar Prasad, and Antonio Spilimbergo

The third stage of European Economic and Monetary Union (EMU) began on January 1, 1999, with 11 countries having participated in the first phase.¹ To achieve this objective, these countries have strengthened various aspects of their macroeconomic policies, notably their fiscal balances. Some of these countries, however, have had less success in making their labor markets more efficient. EMU will get under way against the specter of persistently high unemployment in many of the participating countries. Reducing unemployment, therefore, remains one of the key objectives across Europe.

While the high aggregate unemployment rate in continental European economies has received considerable attention in the academic literature and in policy circles, an equally important issue is the extent of regional disparities in the employment situation in many of these countries. There are three reasons why large and persistent unemployment differences may be considered a problem. First, they may lead to a higher nationwide nonaccelerating inflation rate of unemployment (NAIRU), with inflation pressures arising in low-unemployment areas sooner in a recovery and spreading to the whole country. Second, they constitute evidence of labor market inefficiency, in that adjustment to past shocks is slow. Third, for a given nationwide unemployment rate, they raise the social costs of unemployment: for example, welfare is lower if one family has two members unemployed and another has two members employed than if each family has only one member unemployed.

Regional unemployment in Europe is thus the focus here. The paper analyzes regional unemployment in a set of OECD countries and finds relatively large and persistent differences in regional unemployment rates in several European countries, including some of the initial entrants into EMU. These differences are indicative of labor market rigidities that raise aggregate unemployment and hinder adjustment to shocks. In particular, wages do not seem to reflect local labor market conditions. As a result, neither capital nor labor migrates sufficiently to reduce regional unemployment differences.

Large and persistent regional differences in unemployment could also have implications for the overall success of EMU, and EMU itself could further heighten regional disparities through three mechanisms. First, since nominal wages will be denominated in a common currency, pressures to equalize wages across EMU countries could intensify, with deleterious effects on aggregate unemployment, as well as regional disparities in countries with relatively low labor productivity. Second, in a regime that is expected to be characterized by low inflation, relative wage adjustment could become more difficult, given that nominal wages are usually not flexible downward. Third, in countries where the exchange rate had mitigated the impact of country-specific shocks that had asymmetric effects across various regions, the loss of the exchange rate instrument could exacerbate the variation in unemployment disparities.²

Should EMU result in larger unemployment disparities between regions, the demands for fiscal transfers to high unemployment areas--the tool most commonly used to alleviate the consequences of regional disparities--could breed political and social tensions. Measures to tackle regional differences in unemployment will therefore be needed to avoid such tensions and help in the smooth operation of EMU.

In addition to the cross-country evidence, the paper includes detailed case studies of two euro countries where regional disparities in unemployment are striking--Italy and Spain. Using rich data sets that are specific to each of the countries, the paper correspondingly employs two different sets of empirical techniques that are best suited to each case. The two analyses yield consistent results and are, thus, mutually complementary.

The section on Italy uses data from different levels of disaggregation to provide a synthetic perspective of the main empirical features of the Italian labor market. In particular, it investigates the possibility that the centralized wage-bargaining system has led to a compressed wage structure within both sectors and regions, resulting in the high dispersion of regional unemployment rates. The findings confirm the widely held view that interregional wage differentials are unresponsive to interregional differences in unemployment and productivity. Using a micro data set that contains information on a large sample of individual workers, more precise measures of interregional wage differentials are computed, controlling for observed worker and job attributes. This micro data set is also used to provide a more detailed examination of the effects of demographic attributes on labor force participation and employment propensities in different regions.

The section on Spain analyzes labor market adjustment mechanisms, using a data set that includes levels of wages, prices, employment, labor force, and output by province. The analysis points to labor market rigidities that increase both regional disparities and nationwide unemployment. In fact, real wages and unit labor costs are found to be similar across provinces, despite large and persistent geographic unemployment differences. The section also estimates the dynamic response of unemployment, participation rates, and migration in the adjustment process to province-specific labor demand shocks.

Both case studies relate the labor market rigidities observed in each country to a number of specific policies and institutional features. Therefore, the results could be useful to policymakers in designing effective policies to improve regional labor market adjustment. In particular, both studies emphasize one important theme: wages are unresponsive to local labor market conditions, which has important consequences for unemployment both at the regional and national levels. The de facto centralized wage-bargaining systems in these countries seem to hinder relative wage adjustment, which would help to reduce unemployment differences. The similarity of unit labor costs, as well as real wages, in low- and high-unemployment areas implies the absence of sufficient "price" incentives for either capital or labor to migrate across regions in response to unemployment differentials, which perpetuates regional disparities.

The paper brings together the policy lessons learned from these diverse empirical approaches. The sections containing the two case studies also present a set of policy recommendations tailored to the circumstances and institutional features of each country. The final section presents a broader set of policy implications.