This opinion piece has been published in Aspen Review Central Europe
The debate on euro-zone entry of central European EU Member States has intensified after Jean-Claude Juncker, president of the European Commission, expressed the Commission’s ambition to accelerate the process and suggested a special pre-accession financial instrument to increase the euro’s attractiveness. Are central European countries ready to join? Would it be beneficial for their economies or, conversely, would euro membership lead them to the same fate that southern euro members suffered after their own entry?
With the exceptions of Denmark and the United Kingdom, two countries that have a Treaty-based opt-out, all EU countries have a legal obligation to join the euro. But the EU Treaties do not specify a timeline for this obligation and, in practice, countries can delay their entry as long as they wish. Sweden, for example, would have been ready to join in 1999 or anytime since then; but since a referendum in 2003 turned down euro membership, Sweden intentionally does not join the European Exchange Rate Mechanism (ERM II), and thereby does not meet one of the entry criteria.
Central European governments – especially in the Czech Republic, Hungary and Poland – have a wait-and-see attitude and do not show an interest in joining. Sometimes the unfavourable examples of southern euro members – Greece, Italy, Portugal and Span – are used to argue against euro membership. These countries suffered from unsustainable development between 1999 and 2008, which was partly related to their euro membership, and they had great difficulties after 2008. The overall economic record of these countries has been rather weak; looking into the reasons behind these weak outcomes can produce lessons for central Europe to follow.
Clearly, southern European developments should not provide a template for central European countries.
When southern countries joined the euro, the interest rate fell to the relatively low German interest rates from their previously higher levels. At the same time, these countries had higher price and wage inflation, partly reflecting the convergence of their lower price level to the euro-area average. But lower interest rates – coupled with somewhat higher wage and price increases – lowered the real value of the interest rate, which in turn fuelled consumption and credit booms, raised wage growth beyond productivity growth, and generated large external imbalances such as large current account deficits. These external deficits were primarily financed by borrowing from abroad; thereby, external indebtedness also increased to very high levels in these countries.
At the same time, these countries also had structurally weak public finance positions. Greece and Italy had rather high public debt levels even before 2008. Spain had a seemingly good fiscal position with public debt below 40% of GDP and, in some years before 2008, it had a budget surplus. But too much revenue came from the construction industry and other booming sectors, while major vulnerabilities were built up in the banking sector.
Ultimately, pre-2008 southern European developments turned out to be unsustainable. When the crisis hit, private capital inflows stopped. This necessitated harsh current account adjustments, even if European Central Bank’s financing of banks helped to cushion the speed of adjustment. Strained fiscal positions necessitated procyclical fiscal tightening. Painful wage falls, unemployment increases and emigration followed. Inadequate crisis management framework of the euro area exaggerated the problems. Eventually, southern European countries came out of the deep economic contraction after 2008, but the recession lasted too long and inflicted major social pains.
Clearly, southern European developments should not provide a template for central European countries. To the extent that the euro was responsible for the pain in the south, insofar as it fuelled unsustainable developments, a degree of central European caution is warranted.
But the euro was just part of the story in the south. Other factors also played important roles in the fate of the southern members. Improper functioning of the labour market allowed for excessive wage growth relative to productivity growth in the boom phase, and made the necessary reduction in wages more painful in the bust phase. Inadequate control of the banking sector did not prevent major vulnerabilities building up before 2008, which led to painful and costly bank restructuring after 2008. What’s more, fiscal policy mistakes before 2008 necessitated sharp fiscal tightening during the recession after 2008, so that fiscal policy could not be used to cushion the economic shock. The euro might have played a role in these pre-2008 policy mistakes too, if it led to complacency based on the belief that a crisis inside the euro area is unlikely to happen. Yet these policy mistakes could have been avoided and lessons from these mistakes have to be learnt.
Important conclusions can be taken from the experiences of central European countries too. Developments in the three Baltic countries – Estonia, Lithuania and Latvia – which maintained tightly managed exchange rates before entering the euro between 2011, 2014 and 2015, respectively, were rather similar to developments in southern euro members in the pre-crisis period, and in fact were more extreme in a number of aspects. The economic contraction of the three Baltic countries after 2008 was much sharper than in southern Europe, but these countries were able to return to growth much faster, partly due to their higher level of microeconomic flexibility.
Perhaps more relevant for the Czech Republic, Hungary and Poland is the experience of Slovakia, a country that joined the euro in 2009. Slovakia had a floating exchange rate before entering the ERM, and within the ERM the value of the Slovak koruna appreciated sharply. The euro conversion rate for Slovakia was fixed in the summer of 2008, when central European currencies were at record high levels relative to the euro. A few months later, the collapse of Lehman Brothers in September 2008 resulted in a massive currency depreciation of the Czech koruna, Hungarian forint and the Polish zloty, but not the Slovak koruna. The currencies of the three central European currencies depreciated relative to the Slovak currency by about 30% – a huge change. If exchange rates matters so much, the three central European ‘outs’ should have had better economic performance than Slovakia. But this did not happen.
Slovakia was one of the best performers in terms of economic growth after 2008 and outperformed the Czech Republic and Hungary. Apparently, the lack of a stand-alone exchange rate and monetary policy in Slovakia did not hinder good economic developments. On the other hand, Hungary had a flexible currency both before and after 2008, yet there were unsustainable macroeconomic developments before 2008 and the growth record after 2008 was one of the weakest in the region.
The example of Bulgaria is also telling. Bulgaria tied its currency to the D-mark in 1997, and then to the euro in 1999, without any change since. The only reason Bulgaria has not adopted the euro is that it was not allowed to do so. One of the conditions of euro entry is a stable exchange rate inside the Exchange Rate Mechanism – but there are no transparent conditions on entering the ERM II and Bulgaria was not allowed to join it. Anyhow, the fixed exchange rate of Bulgaria makes this country a quasi-euro member.
Bulgaria also accumulated a large current account deficit before 2008, though it was mostly financed by foreign direct investment and not by loans as in southern Europe. Despite the fixed exchange rate, Bulgaria had a relatively mild recession after 2008 and recorded faster growth between 2009 and 2016 than the floating-rate Czech Republic and Hungary. This good Bulgarian growth performance is especially remarkable, since Bulgaria had to manage a major macroeconomic adjustment by reducing the current account deficit (24% of GDP in 2007) to a surplus in recent years. Export market share of Bulgaria developed almost the same way as that of floating-rate Poland, and better than that of the Czech Republic and Hungary.
Clearly, euro membership (or the use of a fixed exchange rate) was not a factor determining economic success in central Europe. There were both good and bad macroeconomic performances in both the flexible and the fixed exchange-rate regimes of central European countries. The implication is that the Czech Republic, Hungary and Poland, as well as the other central European ‘outs’, could be successful both with and without the euro.
Euro entry is therefore more of a political than an economic decision.
Much more important than euro membership is the prevention of the build-up of macro vulnerabilities, like large foreign indebtedness and bank balance sheet fragility. Policymakers should develop tools to address such imbalances if they happen to occur. Macroprudential policy and sustainable fiscal policy should have key roles in prevention, while flexible labour and product markets should help the adjustment if such imbalances occur.
Another important point is the maintenance of healthy fiscal positions, so that fiscal policy can facilitate stabilisation in an economic downturn. The Maastricht fiscal criteria (public debt must be less than 60% of GDP; budget deficit less than 3% of GDP) are unsuitable for assessing the healthiness of fiscal position. For example, Ireland and Spain had budget surpluses and a debt-to-GDP ratio of only 25-40% in 2007, yet a few years later the public debt ratio soared to close to – or even above – 100% of GDP. Instead of focusing on these headline fiscal numbers, it is of greater importance to analyse the underlying weaknesses of fiscal positions – such as an excessive reliance on certain revenue streams (like those coming from the construction sector in Spain and Ireland before 2008); the existence of economic vulnerabilities, which might undermine fiscal revenues; and the sustainability of public expenditures, like pension and health care systems, in light of demographic changes. These lessons are equally important for countries both inside and outside the euro area.
The Maastricht criteria are clearly inadequate for assessing a country’s readiness to join the euro, but due to legal reasons they have to be met. The level of economic development is also an irrelevant factor in the euro-entry decision; a number of less developed central European countries experienced overall favourable macroeconomic developments under the euro or a fixed exchange rate. Likewise, the possible pre-accession financial instrument that the European Commission will likely soon propose is not relevant for the entry decision. At best, such a financial instrument could provide a relatively small amount of money, which should not play any role in the major decision of whether to join the euro or not. Furthermore, Central European countries receive about 3-5% of their GDP from the EU budget – even if that would be lower in the EU’s next Multiannual Financial Framework of 2021-2027, which further underlines the irrelevance of a relatively small amount of pre-accession instrument.
Similarly, the future reform of the euro, or the ability to influence it, is not a relevant issue from the perspective of euro adoption. The euro’s architecture has been significantly improved since 2008 – most importantly by the establishment of the Banking Union, which should reduce the likelihood of the build-up of financial sector vulnerabilities and help to address them should they occur. The development of the EU’s Macroeconomic Imbalance Procedure can foster discussions about emerging vulnerabilities, which is helpful in avoiding the repetition of the pre-2008 fate of southern euro members. Given that growth has returned to the euro area, including to southern Europe, euro-zone politicians might not feel the urgency to make further major reforms. In short, the euro area has become much better than it was before 2008, and no major changes to euro governance are expected.
Euro entry is therefore more of a political than an economic decision. In economic terms, central European ‘outs’ could perform well both inside and outside the euro area. Yet the EU is not only about economic benefits. The EU represents our shared commitments to European values, such as the respect for human dignity and human rights, freedom, democracy, equality and the rule of law. These values, as well as our striving for peace and the well-being of citizens, define the EU. The euro is the EU’s currency. The legal commitment to join the euro must be honoured, a step that should also strengthen members’ commitment to European values.