Do Unit Labour Costs Matter? A Decomposition Exercise on European Data

Abstract

From the introduction of the euro up to the 2008 global financial crisis, macroeconomic imbalances widened among Member States. This divergence took the form of strong differences in the dynamics of unit labour costs. This paper asks why this happened. Is it the result of distortionary public spending, or the consequence of economic integration? To answer this question, this paper builds a theoretical framework that provides a decomposition of the growth in unit labour costs into various effects of economic integration and policy intervention. Using a novel dataset, it then measures the contribution of each effect in 12 countries of the euro area from 1995 to 2015. Results show that the process of economic integration was an important driver of increasing unit labour costs in peripheral economies before the global financial crisis.

Keywords: economic integration, productivity, structural change, non-tradable sector, macroeconomic imbalances, capital flows, growth accounting, euro area

JEL Classification: E65, F41, F45, O33, O41, O47, O52