When external shocks occur, fixed exchange rate regimes are usually considered less effective than floating regimes. This column analyses the role of labour market flexibility in the relationship between exchange rate regimes and growth during crises. It demonstrates that fixers can match or even outperform floaters during global recoveries if they have flexible labour market institutions. This finding highlights the importance of labour market reforms for countries that have fixed exchange rates.
Are fixed exchange rate regimes beneficial for economic growth? It’s an important question from both theoretical and policy perspectives, because fixing a country’s currency entails significant trade-offs. Despite numerous studies, the evidence remains inconclusive. Some research suggests that fixed exchange rate regimes promote economic growth (e.g. Cruz-Rodriguez 2022), while others argue the opposite (e.g. Bleaney and Francisco 2007) or do not identify a significant relationship (e.g. Miles 2008).
Nevertheless, scholarship generally agrees that fixed exchange rates hinder growth during economic crises. This is primarily because fixing removes a critical tool for responding to external shocks: the ability to devalue the national currency to boost competitiveness. Additionally, under conditions of perfect capital mobility, fixing the exchange rate leads to the loss of independent monetary policy (Aizenman 2017). In line with this, Terrones (2020) demonstrated that fixers recover more slowly from global crises in comparison to non-fixers.
In our recent paper (Kuokštis et al. 2024), we first examine the exchange rate regime and growth relationship during global economic crises and the subsequent global recoveries – revisiting the question posed by Terrones (2020) and broadly replicating earlier findings. We then explore the role of labour market flexibility in this relationship and find evidence that fixers with flexible labour markets actually recover faster from global recessions than floaters.
The role of labour market regulation
In an earlier paper (Kuokštis et al. 2022), we were the first in the exchange rate regime literature to explore the role of labour market institutions in the choice of exchange rate regimes. We found that the adoption of fixed exchange rate regimes is more likely in countries with more flexible labour market regulation.
These results align with the theoretical predictions of the optimum currency area (OCA) theory (Mundell 1961). Within the optimum currency area framework, labour market flexibility is an important prerequisite for the successful operation of a currency peg, because it substitutes for nominal devaluation in adjusting to asymmetric shocks.
Labour markets can be flexible in several respects. When wages are flexible, firms can adjust prices more quickly and thus be more competitive on the global market. Furthermore, if labour is highly mobile, workers move faster from less productive or internally oriented non-tradable sectors to more productive or tradable sections of the economy. When a crisis hits, both wage flexibility and labour mobility can facilitate the adjustment of the economy towards a new internal equilibrium.
The findings in Kuokštis et al. (2022) suggest that policymakers tend to evaluate aggregate efficiency reasons when choosing the currency regimes. However, this raises a further question: do the potential benefits of labour market flexibility under fixed exchange rate regimes materialise in practice?
Empirical findings
Figure 1 displays the average economic growth for countries with fixed exchange rate regimes as opposed to non-fixers, over time from 1970 to 2016, with shaded areas indicating recovery periods.
Figure 1 Economic growth for fixers and non-fixers during global recoveries
Note: Economic growth refers to year-on-year changes of real GDP per capita (percent).
Source: Data from World Bank Development Indicators and Ilzetzki et al. (2017).
Figure 1, in line with the previous literature, demonstrates that fixers recover slower than non-fixers following each global crisis. However, our analysis shows that the above outcomes can vary significantly depending on the level of labour market flexibility in the studied economies.
We employ extensive econometric tests that verify the relationship between fixed exchange rate regimes, labour market flexibility, and economic growth during global crises and recoveries. Our analysis reveals that, in the aftermath of the crisis, the effect of adopting a fixed exchange rate regime on economic growth is an increasing function of labour market flexibility, as measured by a consolidated labour market flexibility index derived from the data by the Centre for Business Research (CBR) at Cambridge (Adams et al. 2017). Although the CBR indices primarily reflect worker protection, we use them as a proxy for flexibility, given the close relationship between the two concepts.
Figure 2 summarises the main finding, where the marginal effect of fixity (versus floating) on growth during global recoveries is calculated at all levels of labour market flexibility (from ‘0’, rigid labour markets, to ‘10’, highly flexible labour markets). Each point on the graph represents the estimated marginal effect at a specific level of labour market flexibility, with the error bars illustrating the 95% confidence intervals.
Figure 2 Effects of fixed exchange rate (with floaters as a base group) on growth during recoveries
Source: Based on Table 2 in Kuokštis et al. (2024).
As can be seen from Figure 2, fixers actually grow faster than non-fixers in the aftermath of global crises if they have flexible labour market regulation. This finding is both statistically and economically significant. Our estimations show that the total effect of exchange rate fixity on real GDP per capita growth during recoveries in the most flexible labour markets hovers around 4.4 percentage points in the short run and around 3.2 percentage points in the long run.
Conclusions
Fixed exchange rate regimes do impede the recovery from crisis, but only in more rigid labour markets that have restrictive labour market regulations. Conversely, the effect of exchange rate fixity on growth during recoveries is positive and highly significant in the least regulated labour markets. In fact, we show that fixers with flexible labour market regulations tend to recover at a faster pace than non-fixers, in contrast to previous findings.
Our study has important theoretical and policy implications. We provide novel empirical evidence that the effects of exchange rate regimes depend on labour market regulations, questioning the previously established finding that fixed rates are universally bad for growth during crises. From a policy perspective, we highlight the importance of labour market reform for countries that have fixed exchange rates.
Our findings open several avenues for future research. Further work is needed to investigate whether the results hold for different types of economic shocks; whether labour market institutions help to better explain and predict currency crises; and whether there are important interactive effects between labour markets institutions, exchange rate regimes, and the real exchange rate level.
Source : VOXeu
