The euro. When to join, and when not to

Date: 13/05/06

Small countries should adopt the euro--if they can

IN THEORY, the European Union has a bracing and rational membership regime. Getting in means meeting Brussels standards in everything, from aviation to zoos. Once in, members take the next step, joining the euro, when they have slain inflation and sorted out public finances.

Reality is different. The three small countries that hoped to join the euro soonest are all solvent, and have creditably low inflation. But only one, Slovenia, strictly meets the criteria for new members, and is therefore likely to get the nod. The finance minister, Andrej Bajuk, looks forward to the end of exchange-rate risk, and says it both signals the "maturity" of his country's economy, and proves that the euro is not an "elitist, impenetrable club".

For Estonia and Lithuania the story is not so good. Both countries fail (in Lithuania's case by less than a decimal point) the criterion that new members must have inflation no more than 1.5% above the average of the three lowest rates in the EU. In March, these came from Finland, Poland and Sweden. Yet the resulting target, of 2.6%, is artificial, since Poland and Sweden are not in the euro. A fairer test, argues Charles Robertson of ING, a bank, would be the average of the three lowest inflation rates in the euro area, which would mean a target of 3%.

The European Central Bank and European Commission will publish their assessment of would-be entrants next week. Estonia has put its plans on hold. Its problem is double-digit growth, which would normally be reflected in a rising exchange rate. But the Estonian currency has been pegged since 1992, so rapid growth is expressed in rising prices instead. Lithuania is still trying to get in, despite warnings that it won't succeed. Rolandas Krisciunas, a deputy finance minister, says his country will be "somewhat puzzled" by a negative ruling. It will press its case when the EU's finance ministers decide in June. "It doesn't make sense for us to stay out. It doesn't make sense to keep us out," he says.

Yet many politicians in old Europe think the single currency has quite enough members already, having stretched the rules for countries like Greece. They worry that giving Lithuania even the teeniest wiggle-room would set a deplorable precedent. Big countries like Poland and Hungary, with soggier public finances, may then want exceptions too.

In fact, these countries are sensibly warier than they once were about early euro entry. Smaller countries with vulnerable currencies need the euro more. They cannot realistically have an independent monetary policy, and they gain from making trade cheaper and easier. It also makes them safer, notes Edward Parker of Fitch, a ratings agency. Their growth is stoked by big current-account deficits. Outside the euro, a crunch could be damaging.

One oddity in this tale is that many existing euro members, notably France, Germany and Italy, now fail the criteria on public finances--yet nobody throws them out. An even bigger curiosity is that the inflation and public-debt criteria make little economic sense. The real test for joining the euro should be whether an economy is flexible enough to cope with the strain of a permanently fixed exchange rate. On that score the bigger central European countries--and, indeed, big existing euro members--have much work still to do.