Labor market reforms and current account imbalances - beggar-thy-neighbor policies in a currency union?

Member countries of the European Monetary Union (EMU) initiated wide-ranging labor market reforms in the last decade. This process is ongoing as countries that are faced with serious labor market imbalances perceive reforms as the fastest way to restore competitiveness within a currency union. Among observers, however,there are fears about a beggar-thy-neighbor policy that leaves non-reforming countries with a loss in competitiveness and an increase in foreign debt. By analyzing the impact of reforms on foreign debt, we contribute to the debate on whether labor market reforms increase or reduce current account imbalances. Using a two-country, two-sector search and matching DSGE model, we analyze the impact of labor market reforms on the transmission of macroeconomic shocks in both, non-reforming and reforming countries.In the case of a positive technology shock hitting a reforming country with the characteristics of a typical EMU member, fears about a beggar-thy-neighbor cannot be corroborated by us for the specic bundle of reforms considered. The positive effect of a reduction in the replacement rate more than compensates negative spillovers from increases in matching ef- ciency and a decrease in vacancy posting costs. This does not hold for a negative productivity shock in the non-reforming country, as the second reform measure, a reduction in vacancy posting costs in the tradable sectors,is dominating the overall impact of labor market reforms and, thus, increasing the foreign debt of the non-reforming country.