Most people accept that structural and labour market reforms are needed in Europe.
However few have been undertaken. The usual conjecture is that reforms are costly in
economic performance and costly to finance. Blanchard and Giavazzi (2003) and
Spector (2004) develop a general equilibrium model with imperfect competition to
show the impact of labour or product market deregulation. We extend that model to
combine both reforms, and include the costs of financing them, the conflict between
long run gains and short run costs, and to allow for reforms of distortionary taxation.
We also extend the model to explain the natural rate of unemployment and non-wage
employment costs, to show the impact of reform on the short and long run Phillips
curve parameters. We find that structural reforms imply short run costs but long run
gains (unemployment rises and then falls, while wages move in the opposite way);
that the long run gains outweigh the short run costs; and that the financing of such
reforms is the main stumbling block. We also find that the implications for welfare
improvements and employment generation are quite different: tax reforms are more
effective for welfare, but market liberalisation for employment.