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Fiscal Consolidation, Unemployment and Labour Mobility in the Euro Area

Periodic Reporting for period 1 - EuroCrisisMove (Fiscal Consolidation, Unemployment and Labour Mobility in the Euro Area)

Reporting period: 2018-09-01 to 2020-08-31

In the aftermath of the Great Recession, unfavourable socio-economic conditions with high unemployment, decreases in salaries and welfare allowances, and deterioration in career prospects triggered intensified labour mobility, with a direction from the Peripheral countries to the Core of the euro area. Primarily due to the surge in immigration from its EU partners, Germany became the second largest immigration country in the industrialized world, after the United States. Fiscal consolidation policies, which aim to reduce deficit levels and typically involve tax hikes and cuts in government spending, also contributed to the migration outflows from crisis-hit countries. Notably, in countries with a sizeable public sector, like Greece and Spain, cuts and restrictions in new recruitments of public employees further motivated the decision to move abroad. The aim of the project was to study the macroeconomic implications of economic migration both for sending and receiving economies in Europe, since the onset of the Great Recession.
The project first offered an overview of recent migration trends in European countries. Next, we studied the role of emigration in a deep recession when the government implements fiscal consolidation. We built a small open economy New Keynesian model with labour market frictions, emigration of the labour force and fiscal details. Simulations for the austerity mix during the Greek Depression showed that fiscal austerity accounted for one third of the output drop and more than 10% of migration outflows, whereas the rest is attributed to the macroeconomic environment. A counterfactual without migration underestimates the fall in output by one fifth. The model also shed light on the two-way relation between emigration and austerity. Labour income tax hikes induce prolonged migration outflows, while spending cuts exert only a small effect on emigration which can be positive or negative depending on opposite demand and wealth effects. On the flip side, emigration increases the required tax hike and time to meet a given debt target due to endogenous revenue leakage. For tax hikes, emigration acts as an absorber of the austerity shock by diluting the output costs per resident. Yet, in terms of unemployment, temporary gains are reversed over time due to the distortionary effects of taxes on employment. We also studied the effects of consumption tax hikes. We found that VAT hikes induce a fall in consumption, which reduces labour demand and increases emigration. The departure of emigrants reinforces the fall in internal demand and employment, and therefore unemployment costs of VAT hikes over time can be higher than without migration. However, these effects are significantly smaller than in the case of labour tax hikes.

We also examined the interaction of public sector downsizing and emigration in a New Keynesian model with labour market frictions and two sectors. In the absence of emigration, cuts in public sector vacancies lead to a labour reallocation towards the private sector, an internal devaluation from the resulting private wage decline, and a positive wealth effect from the reduction in the public wage bill. Due to workers reallocation across countries, rather than across sectors, emigration attenuates these mechanisms. The implications of emigration for the effect of public sector downsizing on aggregate unemployment become ambiguous: unemployment falls due to job seekers' emigration, but it also rises due to productivity losses in the private sector and a drag in domestic demand. Policymaking should actively support job creation in the private sector when reducing the size of the public sector.

With respect to receiving economies, we provided new evidence on the macroeconomic effects of net migration shocks in Germany, a major destination country, using monthly administrative data (2006-2019) in a structural vector autoregression. The results indicated that migration shocks are persistently expansionary for industrial production, per capita net exports and tax revenue. In the labour market, they boost job openings and, after a year and a half, hourly wages in manufacturing. Unemployment falls for natives (job-creation effect), driving a decline in total unemployment, while it rises for foreigners (job-competition effect). Using a mixed-frequency model, we further documented increases in per capita GDP, investment and hourly wages of the aggregate economy. The findings imply a need for redistributive policies to ensure natives and foreigners share the aggregate gains.
The research conducted is original and innovative from several perspectives. First, the project provided an overview of recent labour mobility flows within Europe. Second, the research contributed to the migration literature by shedding light on the macroeconomic effects for both the sending and host economies. The implications of emigration from developed countries has been a topic very little explored so far. Third, the project contributed to the fiscal consolidation literature by considering the implications of the migration channel, previously left unnoticed. Fourth, the project offered policy recommendations on the comparison of a rich set of fiscal consolidation instruments in the presence of labour mobility.

The work carried out brings important benefits for society and has an impact on policy making. Regarding sending economies, the project has shed light on the joint implications of emigration and fiscal austerity for macroeconomic aggregates by studying the case of the Greek economy. After ten years of a severe crisis, one of the most prolonged debates in Greece is still about the emigration of at least 7% of the labour force during the last years. The policy-making agenda has the reversal of brain drain as a main avenue through which the country can enter in a path of sustainable growth in the post-pandemic era. The policy implications of the project are timely and important.The Covid-19 crisis raises profound challenges for public finances and the macroeconomy. Government deficits are rising while the experience of fiscal austerity during the previous recession is still fresh for many countries in Europe. The experience of these countries can offer valuable lessons. Financing rising deficits by tax hikes can trigger future labour flows from countries worst hit to core countries, like Germany. The project has shown that tax hikes reduce the national tax base, forcing the governments to hike the tax rate even more, which can exacerbate the Covid-19 recession in worst-hit economies.

Regarding receiving economies, a clear insight that emerged from the project is that immigration enlarges the aggregate economic pie. Yet, the growing pie is divided between natives and foreigners in an uneven way. Immigration entails a job-creation effect for natives and a job-competition effect for previous immigrants. The Covid‐19 recession is expected to have long, deep, and pervasive consequences, which may lead to increased immigration. Considering also that migrants have been among the most vulnerable groups, the crisis could exacerbate xenophobic sentiments. The project has contributed to a better understanding of the migration effects in the labour market and the macroeconomy, highlighting a need for policy debates to shift focus from immigration restrictions to redistributive strategies that ensure natives and foreigners share the aggregate gains.