Why early expansion of eurozone is in everybody’s best interest

Date: 03/10/02

By Alexandr Hobza and Jacques Pelkmans

ONE of the obligations for candidate countries after becoming an EU member is to join the eurozone. However, there is no timetable for this passage to the euro.

The EU position under the Maastricht criteria means that, at the earliest, some of the newcomers might enter the eurozone in 2006. This assumes that enlargement takes place as planned in 2004 and that candidates follow the requirement to stay for at least two years in ERM II, the new exchange rate mechanism.

There is little doubt that the longer-term benefits of eurozone membership outweigh the costs, even more so if appropriate policies are adopted to reduce these costs. In the short-term, these might well be unnecessarily high but there are ways to lower them sufficiently for the passage to be smooth.

The short-term costs consist of the risk of significant instability inside the ERM as well as the adjustment costs implied by two other Maastricht criteria, namely, a low budget deficit and an inflation rate very close to that of the best performers in the eurozone.

First, the passage through the ERM II could induce volatility of candidates' currencies. The ERM is an adjustable peg system, known to be prone to instability under free capital movements.

Instability can emerge if markets perceive that mismanagement in domestic macroeconomic policy, prudential control of financial institutions, or policy reversals after a change of government could lead to a weakening of the currency.

Moreover, instability can also be of a speculative nature, largely detached from economic fundamentals. This can eventually lead to a so-called one-way bet that will turn into a self-fulfilling prophecy if 'herd behaviour' is strong enough.

Dampening such volatilities requires drastic and costly measures. There is no way of forecasting whether ERM II will actually be unstable.

Why then force the candidate currencies to assume such risks?

The idea behind the passage through ERM II is that central bankers become convinced about the stability of the exchange rate in the currency markets, following two years of trying. This doubtful search for the equilibrium rate of entry into the eurozone may be hit by the costs of dampening volatility and it is far from clear how policymakers can avoid it.

One accommodation is to shorten the period (as in fact happened with Italy and is sometimes suggested in case the UK joins).

Another is to allow 'quasi-euroisation' by adopting the euro as a parallel currency in the candidate country, but at a rate agreed by the Ecofin Council or the eurogroup before the official entry into the eurozone.

Circulation of the local currency would gradually reduce and eventually become trivial, the interest rate would drastically fall and the ERM II would de facto become irrelevant, without any legal evasion of the rules.

This idea, previously put forward by economists Willem Buiter and Clemens Grafe, is a heresy in central bank circles but it is hard to find disadvantages, even more so because the Maastricht criteria would be retained.

Second, the Maastricht entry conditions require the entrants to have a budget deficit below 3 and low levels of inflation (1.5 above the best three EU countries, strictly speaking) and long-term interest rates. The debt/GDP ratio should be below 60 or falling sufficiently rapidly towards that level. This position of the EU policymakers will, in all likelihood, not prevent the eager countries from coming in soon.

The four 'Club Med' countries in the eurozone have smoothly entered but in 1993-5 this seemed most improbable.

2001 data for central Europe show that the candidate countries are doing as well or better, five years before they can enter.

With the same political will as demonstrated by the Club Med countries in the run-up to the 1998 euro decision, the candidates can pass the Maastricht test relatively easily.

Yet, it would be unduly costly for most of them. After all, they do not face a deadline, as did the first euro participants, and should not force themselves to suffer unnecessarily from a temporary throttling of growth. They can go slower in their own enlightened self-interest.

Even though the budget deficits might temporarily be suppressed to below 3, the real issue in many candidates is deep fiscal reform which will be difficult enough without monetary union.

In particular, pension systems, already in deficit, are unsustainable and some hard tax issues have to be resolved.

Third, inflation in candidate countries will remain somewhat higher than in today's eurozone due to catch-up growth. For all candidate countries of central Europe the objective of catching up to the levels of prosperity of western Europe is paramount.

This 'real (income) convergence' is not a necessary condition for membership of a monetary union.

However, in the process of catching up, the long-term productivity increase of industry tends to determine the wage increases of the country, without the services sectors, as a rule, being able to follow the productivity race.

And over the long-term, this causes a higher inflation rate than in the more-developed eurozone, even though the reason is not overspending or excessive printing of money.

Applying the Maastricht criterion of inflation close to that of the eurozone is likely to unduly lower their long-term growth path, the most important economic aim of the candidates and one in the common interest of east and west in the larger Union.

This cost is unreasonable, and a wise form of accommodation ought to be found.

One idea is to bring inflation down to the required level (probably around 3) but only for one year, which could be somewhat costly in terms of lost growth, and then let inflation rise gently 1-1.5 higher so as to accommodate this catch-up effect.

Because a steady rise of productivity in the tradeables sector lies behind this extra inflation, such a differential with the average rate in the eurozone will not harm their external competitiveness.

Since the impact on the overall eurozone inflation rate is going to be negligible (the economic weight of the candidates is still tiny) it will not harm the euro.

Another strategy to reduce the short-term costs stemming from an early accession would simply be 'wait until you catch up'.

Then, structural characteristics of the candidates would presumably be in line with the current eurozone members and the costs would be minimised.

However, this is not a question of years but decades. Moreover, experience of the current eurozone countries has amply demonstrated that successful existence of a monetary union is fully compatible with different income levels.

Therefore, an early enlargement of the eurozone should not be feared as long as it is supported by healthy and flexible macroeconomic policies and reform programmes.

• Alexandr Hobza is a research fellow at the Centre for European Policy Studies; Jacques Pelkmans is associate fellow and holds the Norsk-Hydro/Jan Tinbergen Chair. He is also director of the economic studies department at the College of Europe in Bruges, and a council member of the Dutch Scientific Council for Government Policy in The Hague. www.ceps.be.

Authors discuss the potential benefits to candidate countries of an early enlargement of the eurozone.