The Effect of Liquidity Provision on Internal AdjustmentAdjustment

We report the results for adjustment in nominal unit labor costs in Table 3.3 and the results for real unit labor costs in Table 3.4. All regressions include the full set of time-varying country-specific and time-varying sector-specific fixed effects. Column 1 in Tables 3.3 and 3.4 shows the results of a “plain vanilla” regression which – besides the fixed effects – includes only the interaction of TARGET2 net liabilities with the measure of financial vulnerability. In the remaining columns we show the results from regressions including additional control variables. Note that all control variables are interacted with the financial vulnerability measure.

In column 2, we show the results of a regression that controls for official rescue packages from the European Union and the IMF. Countries in our sample have had

9 These numbers are based on detailed summary statistics for individual sectors which, for the sake of brevity, are not reported. They may be obtained from the authors upon request.

104

access to official rescue programs, such as funds provided under the European rescue facilities EFSF (European Financial Stability Facility), EFSM (European Financial Stabilization Mechanism), ESM (European Stability Mechanism), bilateral loans from EU countries, and IMF loans. We include the official rescue packages because they are an additional channel through which the effects of the liquidity shock induced by the sudden stop can be mitigated. In column 3 we add employment figures at the sector level. As argued by Kang and Shambaugh (2014), part of the internal adjustment might be induced by mass lay-offs during the crisis. This labor shedding reflects a col-lapse in demand rather than structural internal adjustment. We account for this labor shedding effect. We lag the employment variable by one quarter to avoid simultaneity problems when including this sectoral variable. In column 4 we add the real and nom-inal effective exchange rate as well as the 3-month forward exchange rate. Even in a fixed exchange rate regime, the value of the domestic currency might vary. By including both nominal and real effective exchange rates we implicitly control for trade-weighted inflation differentials. The 3-month forward exchange rate captures potential currency devaluation expectations in the BELL countries. In column 5 we control for the general macroeconomic conditions by including year-on-year growth rates of nominal GDP and of the GDP deflator. In addition, we add trade openness, defined as the sum of exports and imports over GDP. Finally, column 6, which is our preferred specification, includes all control variables simultaneously.¹⁰

Turning to the parameter of interest – the interaction effect of liquidity provision by the Eurosystem and financial vulnerability – the results in Tables 3.3 and 3.4 give a robust message. We find no statistically significant effects in the regressions on nominal unit labor costs. That is, enhanced liquidity provision did not affect the differential adjustment pattern between more and less financially vulnerable sectors. By contrast, for real unit labor costs, the point estimate is always negative and significant at conven-tional significance levels. Based on our preferred specification in column 6, an increase of one standard deviation in liquidity provision reduces real unit labor cost adjustment by roughly 8 percentage points for each one standard deviation higher value of financial vulnerability.

To illustrate the magnitude of this effect, the sector with the highest financial vul-nerability (construction) should reduce real unit labor costs by 1.3% less than the sector with the lowest financial vulnerability (trade, travel and food services) when increasing liquidity support by one standard deviation (approximately 0.19).¹¹ By way of comparison, the average adjustment in real unit labor costs is 2.5%.

10Summary statistics of all control variables are presented in Table 3.2.

Chapter 3: Liquidity Provision, Financial Vulnerability, and Internal Adjustment to a Sudden Stop

The differences in the responses of real and nominal unit labor costs pose the ques-tion as to what mechanism drives the reacques-tion of real unit labor costs but is missing for nominal unit labor costs. To dig deeper into the transmission mechanism, we re-estimate Equation (3.1) for adjustment in real and nominal wages, labor productivity, and prices. We show the results of these exercises in Table 3.5. Column 1 shows the results using real wages as the dependent variable, column 2 using nominal wages, column 3 labor productivity and column 4 prices. We report only the results from our preferred specification including all control variables (interacted with the financial vulnerability measure) simultaneously.

The results show that liquidity support by the Eurosystem does not differentially affect the adjustment dynamics of nominal wages (column 2) and labor productivity (column 3). By contrast, the parameter on the interaction of liquidity support with financial vulnerability is negative and highly significant in the regression using real wages as the dependent variable (column 1). Hence, more financially constrained sec-tors adjust real wages less when liquidity provision through the Eurosystem increases.

This is akin to the results for real unit labor costs. Probably most surprising is the pos-itive and highly significant coefficient in the price regression (column 4). The pospos-itive coefficient implies that, conditional on financial vulnerability, higher liquidity provi-sion by the Eurosystem leads to lower price increases. This is surprising given that non-standard monetary policy measures are considered to be inflationary. Our result, however, reflects the interplay between liquidity provision and a large negative liquidity shock. In this respect, our finding is consistent with theories emphasizing the inflation-ary effects of liquidity shocks as reviewed in the introduction (Gilchrist et al., 2015).

By mitigating the liquidity shock, the liquidity support program has also reduced the inflationary pressure of the shock, and this effect is most pronounced for financially vulnerable sectors.

The results for the components of (real) unit labor costs shed light on the channel through which liquidity provision by the Eurosystem affects adjustment dynamics after the liquidity shock induced by the sudden stop. We find that liquidity provision does not affect adjustment of nominal wages. However, prices increase by a lower amount in countries with access to Eurosystem liquidity (GIIPS countries), and this effect is particularly strong in financially vulnerable sectors. As Equation (3.4) illustrates, a lower price increase coupled with constant nominal wages and nominal unit labor costs leads to a lower reduction in real wages and real unit labor costs in the GIIPS countries relative to the BELL countries (the countries without access to Eurosystem liquidity).

These effects are most pronounced in the sectors that are most financially vulnerable.

106