ECB and European Commission are right on euro accession, but for the wrong reasons

By: Paul De Grauwe, University of Leuven

 

Two issues will dominate the workings of the euro area in the coming years. The first one relates to the question of euro-enlargement. The recent reports of the ECB and the European Commission warn that that new member states will have to make extra efforts in order to meet the convergence criteria and to be accepted in the euro area. The second issue has to do with the divergences observed within the euro area. Both issues are related.

 

As is well known, entry into the euro area is made conditional on achieving sufficient convergence in a number of macroeconomic variables (inflation, interest rate, budget deficit and debt, exchange rate stability). Of the new member states, only one country, Slovenia, satisfied these convergence criteria last year and will enter the Euro area on January 1, 2007. Using a sharp photo finish Estonia and Lithuania were declared to have failed one or more of the tests. There can be no doubt that the entry exams for the new member states are less lenient than the same exams organized at the start of the euro area when half of the present members did not meet one or more of the convergence criteria. The difference between now and then is political. At the start of the euro area the political will to start EMU was overwhelmingly strong. Today the political will to allow new members into the euro area is fading.

 

The insistence of the euro area gatekeepers on strict adherence to the convergence criteria stands in stark contrast with the irrelevance of these criteria in ensuring a smooth functioning of a monetary union. The irrelevance proposition was stressed by many academic economists during the 1990s, but they were brushed aside. It is becoming increasingly evident today that while these criteria enforce temporary convergence they do not ensure sustainable convergence. An example is the inflation convergence. The Maastricht criteria were successful in bringing about a strong convergence of inflation rates prior to the start of EMU. Convergence of inflation rates was seen as necessary to avoid large changes in relative competitiveness of the member countries, and rightly so. However, since the start of the euro area large and sustained differences in inflation rates have been observed.  For example, Spain, Greece and Ireland experienced a rate of inflation that on average exceeded 3% per year (much more than poor Lithuania that failed on its inflation test) while Finland and Germany had an average inflation rate below 1.5%. Part of these differences can be said to be the result of differences in productivity growth (the so-called Balassa-Samuelson effect). But this can only be part of the story. Spain for example certainly did not experience larger productivity growth than most other Euro area countries. 

 

These large and sustained divergences in inflation rates (and in wage increases) have led to large and sustained changes in the relative competitive positions of member countries of the euro area. Countries like Spain, Portugal and Italy have seen their competitive positions decline significantly while Germany has improved its competitive position dramatically. These trends will force the former countries into long periods of disinflation. They will have to impose difficult policies of wage moderation to restore their competitiveness.  As these policies are uncoordinated, they risk leading to reactions and similar policies of disinflation in those countries that loose competitiveness as a result of the formers’ countries successes.

Why do we observe these sustained divergences in the euro area? The answer is that too many national idiosyncrasies continue to exist (asymmetric shocks as economists would call these). The whole panoply of economic policies (government spending and taxation, wage policies, social security) remains firmly in the hands of national governments, creating sources of divergent movements. These in turn induce different ‘national spirits’ that can lead to boom situations in some countries and slowdowns in other countries. These structural differences are at the core of the problem. The source of these structural differences is the lack of political union. Each member state continues to follow its own path in too many areas of the economy. 

 

Another way to put this is that the euro area is unfinished business. Monetary union was created (a great success) but political union that is necessary to embed the monetary union was put on the back burner. There is very little prospect today that it will be brought back to the front burner. This situation creates a dynamics in which national economies will continue to diverge. And the mechanisms to correct for these divergences are slow and painful. 

 

All this leads to the conclusion that the insistence of the ECB and the European Commission on strict adherence to the convergence criteria by the new member states is misplaced. These convergence criteria only work temporarily. They are neither necessary nor sufficient to guarantee a smooth functioning of the monetary union. There is no reason to believe that Slovenia, which now satisfies the convergence criteria, will maintain this happy state of affair once in the union.

 

Paradoxically this may also be the reason why the present member states may be right in not allowing the new member states into the Euro area too quickly. After all, enlargement also means that the euro area will contain more countries with divergent national economic policies. These will lead to divergences in inflation, output and employment trends, making it even more difficult to manage the system than it is already today. Thus, the ECB and the European Commission may be right when they act as tough gatekeepers. They are right for the wrong reasons, though. 

 

Paul de Grauwe, Professor for  K.U. Leuven

 

---