Eastern Europe and the euro: Flights to Frankfurt

Tall order in Tallinn

Ex-communist countries are struggling to adopt the euro on time

CHAMPAGNE and flowers would seem the rational way for a club to welcome such a desirable applicant. Estonia, due to adopt the euro on January 1st 2007, is a rare economic star by the debt-drenched, slow-growing standards of the euro zone. Instead of national debt, the state has net assets equal to about 6% of GDP. Whereas growth in the euro area is well under 2%, Estonia's economy last quarter expanded at a cracking 9.9% annual rate.

Estonia's €10 billion ($12 billion) economy makes up just 0.1% of the euro zone's GDP. So it won't change the big picture. Nor will Lithuania and Slovenia, also due to adopt the euro in 2007. But such new members raise big questions about the merits and methods of expanding the euro zone. In old Europe, some Italians are openly questioning the decision to adopt the single currency. But the newcomers are convinced that joining makes sense. They will lose no flexibility: Estonia and Lithuania have currency boards; Slovenia's exchange rate is fixed. Joining will save money (running a separate currency is costly) and, most important, end the risk of speculative attack - a nasty business for a small open economy.

The next question is whether new members would be good for the euro area. The European Central Bank (ECB) expects applicants to meet four criteria. Three are easy for Estonia and the others: sound public finances, low interest rates and consistent exchange-rate stability. But the fourth is that inflation should be no more than 1.5% above the average for the three best EU countries. The bank's assumption is that this will produce a target of around 2.4%. Lithuania and Slovenia might squeak under the bar. But Estonia, with inflation of 4.9%, stands almost no chance.

One reason for Estonia's high-ish inflation is the rise in the oil price, which, according to the Bank of Estonia, accounts for 2.4 percentage points of the current figure. That will eventually work its way out of the system. The bigger problem, though, is the effect of fast economic growth coupled with a fixed exchange rate. Normally, rising productivity would lead to exchange-rate appreciation; when that can't happen, prices rise instead. Even the ECB accepts this "Balassa-Samuelson effect" (named after the economists who first investigated the issue) could add two percentage points to inflation in a country experiencing fast productivity growth.

In theory, a government could use monetary and fiscal policy to hold back inflation. But in Estonia's case, that is hard. Monetary policy is largely out of the state's hands because of the currency board. The only lever left is to insist that banks have large reserve ratios - Estonian banks already keep 13% of depositors' cash to hand, compared with 2% in the rest of Europe. Fiscal policy offers little scope either. The budget surplus is 2% of GDP, by the Bank of Estonia's estimate. Inducing an artificial recession in order to meet the inflation criteria would be the "economics of the madhouse", according to Willem Buiter, a former chief economist of the European Bank for Reconstruction and Development now at the London School of Economics.

There is another option: to fiddle the figures, perhaps by cutting fuel taxes to depress inflation. But that horrifies the free-market purists who run the Estonian economy. That is commendable - but also pragmatic. Any one-off measures probably would not work. "They've left it pretty late," says Edward Parker, who analyses post-communist countries at Fitch, a rating agency. "January 2007 is looking increasingly unlikely." Estonian officials insist that they are committed to joining as planned. Privately, many acknowledge that a postponement is all but inevitable.

Assuming, that is, that there is no flexibility in Frankfurt. Yet there may be some. Estonia could be assessed a few months after the other two entrants: by then its growth and inflation may have slackened. The ECB can exclude countries with freakishly low rates from its inflation target. And the final decision is made by politicians from the existing euro zone. They may forgive Estonia for getting rich so quickly.

But once you start this, where do you stop? Of the former captive nations that want to adopt the euro, only Slovakia looks on course to meet its target of 2008. Latvia is likely to have to postpone because of high inflation (its growth rate exceeds Estonia's). The Czech Republic and Hungary are unlikely to adopt the euro in 2010 as planned unless they radically change their approach to public spending.

That is particularly true of Poland, which is bigger than all the other new member states combined, and the only one with a free-floating currency. It originally planned to join the euro in 2009, but that now looks very unlikely. Although inflation is low, public finances were already soggy before recent presidential and parliamentary elections. The victorious party, Law and Justice, is a populist, high-spending outfit that shows little enthusiasm for the euro. Lech Kaczynski, the newly elected president, said this week that Poland would "definitely" hold a referendum on adopting the euro, probably in the second half of his five-year term of office.

Estonia's enthusiasm for the euro, and any willingness in Frankfurt and Brussels to tailor the rules to suit new applicants, may thus prove to be a one-off. In the longer run, disdain between moneymen and politicians may prove to be mutual.

Ex-communist countries are struggling to adopt the euro on time.