The first of these arguments went as follows: Poland’s competitiveness is mainly due to low wages and low costs rather than brand value or innovation and thus „Poland’s cost advantage would disappear if the złoty were to strengthen sharply” (Belka, 2014). A while ago we examined the competitiveness situation in the „new” EU member states, i.e., those countries that joined the EU in 2004 or later and found some evidence of Kaldor’s paradox. That is, the export market shares of many of the „new” EU member states kept growing despite a worsening of their cost competitiveness position as measured by the real effective exchange rate deflated by the unit labor costs. A relevant chart is reproduced below:
A possible explanation of the above phenomenon is that while initially the „new” EU member states indeed used cheap labor as their main source of competitive advantage, later non-price competitiveness started playing an increasingly important role, which enabled them to keep growing their market shares internationally, despite their wage costs rising faster than productivity. From the above chart it is also visible that Poland indeed has experienced a very benign deterioration of its cost competitiveness position compared to other CEE countries, however, its export market shares have grown at about the same pace as those of Slovakia, the Czech Republic and Romania, where the real effective exchange rates have worsened significantly.
Thus, either the Polish economy is unique in Central and Eastern Europe in the sense that its competitiveness indeed still depends just on cheap labor or there are other more important factors that have supported the increase in Poland’s export market shares. If the former argument is valid, then getting rid of exchange rate flexibility might actually be necessary to push the Polish economy towards more sustainable non-price determinants of competitiveness. If the latter is true, then it might just be that the Polish workers are not getting their „fair share” of income compared to workers in other „new” EU member states.
Belka acknowledges that Poland’s flexible labor market has some advantages in responding to external shocks, but he also claims that „in the longer run, flexible labor markets also increase structural unemployment and fuel the informal economy”. If that were the case, countries should indeed consider limiting the flexibility of their labor markets. This is an unconventional proposition since the original argument by Robert Mundell claimed that labor mobility and a flexible labor market were essential for a currency union, such as the Euro zone. We examined the correlations between labor market flexibility and structural unemployment and the size of shadow economy in the EU. As a measure of labor market flexibility we used the labor market flexibility measure, which is part of the World Economic Forum’s Global Competitiveness Score. It is a composite of five different aspects of labor market flexibility – cooperation in labor-employer relations, flexibility of wage determination, hiring and firing practices, redundancy costs and effect of taxation on incentives to work.
First we plotted the average labor market flexibility score over the five years from 2008 to 2012 against the average NAWRU for the same time period. NAWRU or non-accelerating wage rate of unemployment is a typical measure of structural unemployment. The results are depicted in the chart below.
The above chart, if anything, shows that increased labor market flexibility on average means lower structural unemployment, although the correlation is weak. Thus, there is no evidence that increased labor market flexibility would in the medium term result in higher structural unemployment as measured by NAWRU.
Next, we plotted the labor market flexibility measure by World Economic Forum against the size of shadow economy measured in per cent of the official GDP. In this case we found no correlation whatsoever between the two variables (see below). Thus, labor market flexibility also appears not to have any impact on the size of the shadow economy.
Conclusion
While improving an economy’s competitiveness, flexibility and fiscal capacity are certainly important for countries adopting a common currency with other countries. Evidence from „new” EU member states indicates that low wages have become a less important determinant of their competitiveness during last decade.
Recent evidence confirms that flexible labor markets contribute to lower rather than higher structural unemployment. Also there is no evidence of correlation between labor market flexibility and the size of shadow economy in the EU countries. There might be other reasons for Poland to be cautious about when it joins the Euro zone, but excessive flexibility of labor markets does not seem to be a reason to delay.
References
Belka, Marek (2014), „Poland’s Eurozone Tests”, Project Syndicate, 7 February
Mundell, Robert A. (1961), „A Theory of Optimum Currency Areas”, The American Economic Review, Vol.51, No.4