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Why Wait for the Euro?

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May 22nd, 2019
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  1. Why Wait for the Euro?
  2. Leszek Balcerowicz
  4. Although the EU's eastward enlargement has not yet happened, the debate is already shifting to ask what will follow: when should the new, predominantly postcommunist, members adopt the euro? Assuming that they comply with the Maastricht Treaty's provisions concerning the EMU - and are not unfairly held to more stringent criteria - the core issue is whether new members would benefit more by waiting or whether they should seek early entry.
  6. At the outset, it must be stressed that, in seeking earlier entry into the EMU a country assumes a more ambitious fiscal and structural program than would be needed if EMU membership is delayed. Early entry, otherwise, would be an empty gesture.
  8. I believe that early adoption of the euro is not only possible, but preferable to delay. By early adoption I mean the shortest permissible period of time - two years - following a new member subordinating its monetary policy to the fiscal and monetary constraints of the exchange rate mechanism (ERM II). Assuming entry into both the EU and ERM II in 2004, new members should aim to enter the eurozone around 2006.
  10. Is this realistic? Well, most candidate countries have already achieved a high degree of structural convergence with the EU. Exports to the Union have soared since 1991, when the collapse of the Soviet-era COMECON trading system forced a radical reorientation of trade - helped by massive foreign investment from the EU - towards Western markets. Most accession candidates now send more exports to the EU than Greece, Portugal, and Spain did when they entered the EU and EMU.
  12. Progress on disinflation is similarly impressive. Annual inflation in most candidate countries has fallen to 4-5% - not much higher than in many EU countries, and lower than in The Netherlands last year. As with structural convergence, EU candidates already outperform Spain, Portugal, and Greece at a comparable time before their EMU debut. Nor is there much risk of large, future corrective price swings because all but a few prices are completely liberalized.
  14. Theoretical studies suggest that inflation in the accession countries will remain stubbornly higher than the Maastricht Treaty allows. The culprit in this pessimistic view is the so-called "Balassa-Samuelson" effect: rapid productivity growth in the accession candidates' tradable sectors - export manufacturing, for example - is pushing up real wages throughout their economies, including in non-tradable sectors like services. This overall rise in real wages in the face of lower productivity growth for the service sector boosts relative prices and keeps inflation above the eurozone average.
  16. The Balassa-Samuelson effect is still evident in Greece, Spain and Portugal. But as empirical research prepared by the CEC5 National Banks estimates, its contribution to total price growth in the candidate countries is 1-2%. With the Balassa-Samuelson effect so subdued and limited scope for future corrective inflation, the EMU criterion regarding price stability - of annual inflation within 1.5% of the average rate for the three best-performing economies in the EU - is within reach.
  18. But is early admission to EMU preferable to postponing membership? From the standpoint of current member states, would admitting Hungary, Latvia, Poland, or Slovakia, sooner rather than later, drag down the euro as many fear?
  20. Fears that extending EMU to new states "too soon" would undermine the euro's external exchange rate are irrational. If all candidate countries join the EU at around the same time, they will together account for a mere 6% of its total GDP. So any negative impact on the euro from rapid accession to EMU would at worst amount to little more than a rounding error.
  22. Delaying entry into EMU could make sense if a longer wait produced more information. But a wait of greater length might produce nothing but added noise. Equally, the transition period is already turbulent, with convergence-driven capital flows driving up exchange rates and complicating monetary policy in several candidate countries, including Poland, the Czech Republic, and Hungary. Indeed, capital-flow volatility could make short work of the flexible exchange rate on offer under ERM II - a 15% fluctuation band either side of a central parity.
  24. Some argue that ERM II membership should be viewed as a longer-term proposition - possibly lasting until 2010 - for the benefit of candidates themselves. The benefit is simple: ERM II permits some exchange rate flexibility, as opposed to the fixed rates implied by adopting the euro. This would help keep the candidates' economic output high and thus sustain real convergence with average EU income levels.
  26. This is an exceptionally weak argument, and a politically suspect one, too. As European Central Bank data shows, average per capita GDP in the accession candidates is 44% of the eurozone level. The size of the income gap combines with the small growth differentials to imply that the process of real convergence will extend far beyond even the most cautious dates for EU and EMU entry, probably lasting several decades. More important, long-lasting economic growth does not depend on the type of exchange rate - whether flexible or fixed (EMU) - while early accession will speed up crucial reforms.
  28. A few years of limited exchange rate flexibility is a poor substitute for rapid completion of structural reforms. In almost all candidates, further disinflation and long-term economic growth require fiscal consolidation, more flexible labor markets, and completion of privatization. Delaying EMU entry risks weakening the incentive to complete these politically costly but necessary reforms.
  30. Any delay in completing reforms will ultimately slow the process of real convergence that EU officials rightly hold dear. Early adoption, by contrast, would be more conducive to these reforms, and thus to real convergence. Success here would allow candidate countries to start reaping the benefits of greater price transparency, reduced transaction costs, and a solid macroeconomic framework. This strategy, not one of deferred entry, promises the most for both the EU's current and its future members.
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