Tuesday, September 15, 2009

A Big-Bang Euroisation? Not Now

Unlike the UK and Denmark, that negotiated an opt-out clause within the Maastricht Treaty, the EU New Member States of the 2004 and 2007 enlargements that have not already done so will have to adopt the euro sooner or later: it is part of their obligations of membership, the so-called acquis communautaire. In this respect their position is formally identical to that of Sweden, although Swedish euro-procrastination was backed by a national referendum. Slovenia and Slovakia have already adopted the euro. Except for occasional contrary remarks by Vaclav Klaus – when he was Minister of Finance, though, not as Czech President – none of the other New Members States has ever indicated unwillingness to join the euro-zone (or Economic and Monetary Union). They have all experienced directly, or indirectly, the high costs of monetary dis-integration – of COMECON (the Council of Mutual Economic Assistance), the Soviet Union, the Czechoslovak Federation, the Yugoslav Federation. Therefore they do not need persuading of the significant, symmetric advantages of monetary unification: lower transaction costs, greater stability in trade relations within the euro-zone, the ability to borrow in their own currency thus avoiding exchange rate risks, the greater attraction for Foreign Direct Investment and portfolio investment, low (though for some of them, like the Czech Republic, not necessarily lower) inflation and interest rates.

The Maastricht Treaty has set for euro-zone candidates a veritable obstacle course, with strict criteria for fiscal convergence, more strictly enforced than for old EMU members and for non-EMU-candidates, who are only subject to the looser constraints of the so-called Growth and Stability Pact. Candidates also have to satisfy criteria for monetary convergence, plus exchange rate stability vis-à-vis the euro for two years. [1] The main reason why the New Member States are not rushing to meet the criteria and join the euro is the pain involved in satisfying fiscal convergence.

The question arises whether early membership of the euro-zone might assist recovery from the deep crisis of 2009, which on average has involved a GDP contraction of 5% in the 28 transition economies that are EBRD clients, ranging from zero growth in Poland to -18% in Lithuania.
There is a presumption that small open economies would probably gain from being part of a large currency area in times of crisis, although Slovakia (where the euro only became legal tender on 1 January 2009) and the Czech Republic who is not a member have done rather well outside of it.

The IMF has been in favour of euro-zone enlargement for some time (see Susan Schadler, Ed., IMF, 2005). Barysch (2009) alleges that “On April 6th [2009] it emerged that the IMF would advise Central and Eastern European countries to adopt the euro, unilaterally and without meeting the EU’s strict criteria for the single currency, if necessary.” This recommendation - which was neither denied nor confirmed - is said to have been made “in a leaked report written in March”; it clashes with the long-standing EC decision that rules out the unilateral replacement of the national currency with euro by EU members and candidates; Kosovo and Montenegro have done it but were neither at the time. The EU allows a hyper-fixed link to the euro through a Currency Board, certainly before EU membership, as in the Baltics, Bulgaria, Bosnia & Herzegovina; presumably also after joining the EU but before applying for EMU membership, though this is not absolutely certain, as there are no precedents.

Currency Boards reduce the probability of a crisis at the cost of making the crisis catastrophic if and when it happens (as in Argentina in 2001), and European Currency Boards are not yet out of the danger zone, especially in Latvia where the Central Bank acts as a Currency Board and the lat has been on the brink of devaluation for the first three quarters of 2009.

The European Central Bank’s role as Lender of Last Resort is remarkably undetermined and left to informal arrangements with the Central Banks of euro-zone member states. Non-members with hyper-fixed links to the euro (whether unilateral euroisation or Currency Boards), or with an ordinary fixed exchange rate, might very well be left high and dry in times of crisis. Sweden and Denmark have been offered swaps by the ECB, unlike other non-members. Loans to Latvia have been primarily in the interest of European banks whose loans would have not been serviced otherwise (Bezemer, Hudson and Sommers 2009). Darvas (2009) points out that “The ECB accepts non-euro denominated securities eligible for refinancing in three currencies (US dollars, British pound, and Japanese yen, provided the security was issued in the euro area), but it should accept high-quality securities issued anywhere in the EU in all EU currencies. The ECB should also give access to ECB refinancing facilities for non-euro-area commercial banks, which could substitute the malfunctioning euro-area money market for these banks.”

The EU could well have admitted at least a few other New Member States to the euro-zone by loosening the Maastricht convergence criteria. In theory the criteria for fiscal convergence are looser than those of the so-called Growth and Stability Pact (GSP, which involves not only a 3% ceiling to government deficit but a stricter zero per cent over the cycle) and apply to all EU members regardless of euro-zone membership. In practice the GSP strictures and the associated penalties were considerably relaxed in March 2005 and further loosened de facto during the current crisis, whereas Maastricht criteria for joining the euro have been very strictly enforced. This glaring asymmetry is unreasonable and injust.

It is also unreasonable to subject countries that grow much faster than the euro-zone members and have relatively low ratios between public debt and GNP to the same fiscal stringency as stagnant and highly indebted euro-zone members (like Italy). It is more unreasonable to apply to prospective members fiscal constraints more stringent and inflexible than those applied to existing EMU members and to non-members who are not candidates. It is even more unreasonable to apply to prospective EMU members an inflation constraint linked to the “three best-performing member states of the EU in terms of price stability”, regardless of whether or not they are EMU members and arbitrarily interpreted as the three least inflationary EU members (with a non-negative inflation rate; see Darvas 2009). The very fact of EU enlargement from 12 to 27 members has implied – Darvas argues – a toughening of the inflation condition by virtue of this interpretation.

Lithuania, for instance, in 2006 was left out of the euro-zone only because its inflation exceeded the average inflation of the three least inflationary EU members by 1.6% instead of the 1.5% prescribed by the Maastricht Treaty – not exactly enlightened or rational behaviour, especially considering that two of those three least inflationary countries (Sweden and Poland) were not euro-zone members. Slovakia, on the contrary, was admitted in 2009 in spite of a 25% nominal revaluation of its crown in the two years before joining, which was a significantly greater departure from the basic parity than the stipulated maximum band of variation of +/-15%. “The EU can certainly be criticised for clinging to criteria ill-suited to catching-up countries and the case for reforming them is strong” (Darvas and Pisani-Ferry, 2009, op.cit.; see also Nuti, 2006).

Piatkowski and Rybinski (“Let us roll out the euro to the whole Union”, FT 11 June 2009) now propose “a ‘big bang’ euro area expansion to introduce the euro in all 27 member states by 2012.” “Such a bold decision - they claim - would give a credibility boost to the enlarged euro-zone, accelerate replacement of the dollar by the euro as the global reserve currency and breathe new life into a united Europe.” This might have been a good idea when the euro was first introduced in 1999 - certainly not now with some of the countries in a financial turmoil, for membership of a single currency area is a preventive remedy, not a cure. The authors point out that “the combined GDP of all euro-zone candidate countries in central and eastern Europe amounts to less than 10 per cent” and therefore costs would be contained, but this “little-me-ism” by itself does not amount to a case.

The idea that Latvia should first devalue substantially with respect to the euro and then join the euro-zone in a hurry (Roubini 2009) does not make sense. Lat devaluation is probably unavoidable. Of course it would aggravate the prospective Latvian insolvency on euro-denominated debt and force a restructuring, but a crisis of the type and scale of Argentina 2001 seems impossible to procrastinate much further. However, euro-zone membership would not reduce the blow of that devaluation, only the risk of future devaluations; immediately after a devaluation there would be no hurry to join - other than to better milk resources from EMU taxpayers. And since the hyper-fixed exchange rate with the euro was Latvia’s problem, currency conversion even at a lower rate cannot be the solution. Yet the OECD (2009) is now advocating a similar solution for Iceland: join the EU, devalue and join the euro-zone as soon as possible. Here as well there is no case other than an unwarranted and expensive benefaction on the part of the rest of Europe. Reade and Voltz (2009) argue that Sweden should join the eurozone: no problem there, if only they asked.

Darvas (2009) recommends new rules which - he claims - are based on greater logic and common sense: 1) “All criteria should be related to the euro-area average”; 2) “The inflation, interest rate, and budget balance criteria should allow some deviation from the euro-area average”; 3) “The requirement for the ratio of government debt to GDP could simply demand that this ratio should not exceed the euro-area average, unless the ratio is diminishing sufficiently and approaching the euro-area average at a satisfactory pace.” “The suggested change in euro-entry criteria would still require substantial effort from the applicants, but it would ease their pain. It would also boost confidence, helping kick-start the private capital inflows – not western taxpayers’ money – that these countries desperately need.” (Darvas 2009).

However, focusing on average EU parameters would be disastrous, for it wouls trigger off a game of self-fulfilling expectations. In a crisis each member expects every other member to raise its deficit and debt, and possibly inflation afterwards; each therefore raises its own target parameters accordingly. Collectively, they cause a rise in average parameters, thus making it easier for them to satisfy average constraints individually: any macroeconomic discipline goes by the board. Imagine a party of diners, each of them on an expense account, and each having to pay out of pocket only the excess cost of their lunch over the average cost for all diners. Insofar as their choices of dishes are affected by cost considerations, each diner will have a more expensive lunch than otherwise. Average limits would tend to be high and to escalate fast,

It would be wiser, in order to encourage euro-zone membership, 1) to exclude any non-EMU member from the determination of monetary convergence parameters, and 2) to end the asymmetry that penalises candidates, thus modifying Maastricht fiscal parameters in line with the changes introduced in March 2005 to the so-called Growth and Stability Pact, softening them for countries characterised by fast growth, low debt, and high public-investment.
[1] The well-known Maastricht conditions are: an inflation rate no more than 1.5% above the average rate of the three least inflationary members of the EU; long term interest rate no more than 2% higher than the average rate of the same three least inflationary EU members; government deficit no higher than 3% of GDP and public debt no higher than 60% of GDP, or within reach of those constraints and falling; and the additional condition of two-year membership of the Exchange Rate Mechanism II, holding a course within a +/-15% band around the euro parity agreed with the EMU monetary authorities before joining the ERM II.

1 comment:

Marcin Piatkowski said...

I have just read your blog. Found it really impressive, in both the form and substance. I agree with much of your analysis on the euro entry criteria, although I think it would still be useful to weigh pros and cons of an early/accelerated euro zone entry for the Central East European countries (as well as Denmark, Iceland, and – possibly – Sweden). One obvious argument in favor, at least of CEE countries, would be to lock in foreign exchange rates at roughly current undervalued levels (perhaps just a bit stronger), giving them an additional breathing space. A bigger point would be the vision of the euro replacing the dollar as a reserve currency; euro-zone expansion would be a natural part of such design.

An accelerated euro zone entry should be subject to tough but achievable conditions, tough like those applied now, but achievable – which current conditions are not. I can't see any CEE country entering the euro-zone anytime soon. I doubt whether this is good news for the whole European project.

Like you, I disapprove of the de facto unequal treatment of euro-zone members and non-members.