Highlights :

• Since the introduction of the Euro, unit labour costs increased by much faster in the periphery than in core countries. This paper asks why this happened. Is it the result of distortionary public spending, or the consequence of economic integration?
• It builds a model of a small open economy with a tradable and a non-tradable sector. This model provides a decomposition of unit labour costs growth into various effects of economic integration (both trade and financial integration) and policy intervention.
• Using a novel dataset, the contribution of each effect of economic integration and policy intervention are quantified for 12 countries of the Euro area from 1995 to 2014.
• Results show that trade and financial integration is a significant driver of unit labor costs divergence. On the contrary, distortionary public spending plays a minor role.

 Abstract :
From the introduction of the Euro up to the 2008 global financial crisis, macroeconomic imbalances widened among Member States. This divergence took the form of strong differences in the dynamics of unit labour costs. This paper asks why this happened. Is it the result of distortionary public spending, or the consequence of economic integration? To answer this question, this paper builds a theoretical framework that is able to provide a decomposition of unit labour costs growth into various effects of economic integration and policy intervention. Using a novel dataset, it then measures the contribution of each effect to the dynamics of unit labour costs in 12 countries of the Euro area from 1995 to 2014. Results show that trade and financial integration are significant drivers of unit labour costs divergence. Before the global financial crisis, in Greece and Portugal for example, trade and financial integration explain up to 30% of the increase in unit labour costs relative to core countries. On the contrary, distortionary public spending plays a minor role. These results suggest that, in peripheral economies, increasing unit labour costs reflect more the process of real convergence than fiscal profligacy.

 Keywords : Economic Integration | Productivity | Structural Change | Non-tradable Sector | Macroeconomic Imbalances | Capital Flows | Growth Accounting | Euro Area

 JEL : E32, E65, F41, F45, O33