Economic integration and unit labour costs

Unit Labour Costs (ULC) have increased much faster in the periphery than in core Eurozone countries since 1995. This divergence was pointed as a key amplifying factor in the Euro's 2010 crisis; but there is no consensus to date on its cause. This paper investigates the drivers of ULC divergence. It shows that faster tradable productivity growth in the periphery -i.e. real convergence- contributed to rising real exchange rates and a sectoral shift towards non-tradable sectors, resulting in increasing ULC. This productivity effect explains one-third of the rise in ULC dispersion between 1995 and 2015. This fact bears important implications: it suggests that any effort towards further real convergence in Europe could be associated with a resurgence of ULC divergence, and it questions the use of rising ULC dispersion as an indicator of rising macroeconomic imbalances. (JEL: E65, F41, F45, O33, O41, O47, O52.) (c) 2021 The Bank of England. Published by Elsevier B.V. All rights reserved.