Join the Euro Area: if Slovakia can, you can too!

Slovakia have done it! They have got the nod both from the European Commission and, albeit reluctantly, from the European Central Bank. Following the confirmation of these recommendations by the European Council, Slovakia will join the Euro Area on January 1, 2009. The only question mark that hung over this application for Euro Area membership was Slovakia’s inflation performance. The European Commission was unambiguous on the issue in its Convergence Report 2008: Slovakia fulfils the criterion on price stability.”

From the language used by the ECB in its Convergence Report 2008 , it is clear that it would have preferred for Slovakia to be refused Euro Area membership at this point: To sum up, although the 12-month average rate of HICP inflation in Slovakia is currently well below the reference value, there are considerable concerns regarding the sustainability of inflation convergence.” Fortunately for Slovakia, and for the future of EMU and the EU, the ECB has only an advisory role in the process of Euro Area enlargement. Progression to stage 3 of the ERM is, appropriately, a political decision. Unlike monetary policy, where the ECB reacts furiously when it believes politicians try to lean on it, Euro Area enlargement is an area where the ECB gives way, even against its better judgement, when firm political pressure is applied.

The price stability criterion is defined in the first indent of Article 121(1) of the Treaty: “the achievement of a high degree of price stability […]will be apparent from a rate of inflation which close to that of, at most, the three best performing Member States in terms of price stability”. Article 1 of the Protocol on the convergence criteria further stipulates that “the criterion on price stability […] shall mean that a Member State has a price performance that is sustainable and an average rate of inflation, observed over a period of one year before the examination, that does not exceed by more than 1.5 percentage points that of, at most, the three best-performing Member States in terms of price stability.

Here the insanity starts. First, the reference group of Member States is taken to be all EU members, including those who are not in the Euro Area. This may have made sense before there was a Euro Area, that is, for the initial creation of the Euro Area with 11 member states on January 1, 1999. Now that the Euro Area exists, the European Central Bank/Eurosystem are Treaty-bound to target only Euro-Area- wide price stability. Therefore, only the inflation rate of the Euro Area as a whole should be used to operationalise the price stability criterion.

The Treaty was poorly drafted here (as in many other places), and it may be hard for the legalistically minded among the Brussels/Frankfurt crowd to do anything other than consider three Member States. The Treaty, however, says nothing that rules out the interpretation of ‘Member States’ in Article 1 of the Protocol on the inflation criteria as referring to the Member States of the existing Euro Area. But that obviously was too simple a solution to be acceptable.

To include in the calculation of the inflation benchmark even those EU member states that are not Euro Area members, and at least two of which are under no obligation ever to become Euro Area members (the UK and Denmark), makes as much sense as would the inclusion of Zimbabwe in the benchmark.

Second, the misguided gatekeepers in Brussels and Frankfurt use a definition of “best performing in terms of price stability” for the candidate Euro Area members that is different from (and in practice more demanding than) the operationalisation of price stability used by the ECB for the Euro Area itself.

From the ECB’s own website, one can derive the information that “The primary objective of the ECB’s monetary policy is to maintain price stability. The ECB aims at inflation rates of below, but close to, 2% over the medium term.” So the natural definition of “the three best-performing Member States in terms of price stability“ should be the three existing Euro Area member states whose rates of inflation are below 2 % but closest to 2% (or closest to 1.8% or 1.9%) over the medium term.

But no, for reasons understood only by the Brussels/Frankfurt squad (and possibly not even by them), “the three best performing Member States in terms of price stability” has been defined as the three lowest inflation rates (as long as these are not negative). So the benchmark for candidate Euro Area members is 1.5% plus the unweighted average of the CPI inflation rates (on the Harmonized Index of Consumer Prices definition) of the three EU member states with the lowest non-negative rates of inflation during the year prior to the examination (March 2008 for Slovakia).

I will gloss over further idiocies, like the use of a price index that is subject to the Balassa-Samuelson effect: emerging markets and other countries in the process of real convergence and productivity catch-up are likely to experience an equilibrium appreciation of their real exchange rates vis-à-vis mature industrial or post-industrial economies. With a fixed nominal exchange rate, real appreciation means higher equilibrium inflation in a converging country than in a mature (post) industrial economy.

Over the 12 month period covering April 2007- March 2008, the three best-performing Member States in terms of price stability were Malta (1.5%), the Netherlands (1.7%) and Denmark (2.0%), yielding a reference value of 3.2%. Note that Denmark is not a member of the Euro Area and has an opt-out from euro adoption.

The Protocol on the convergence criteria not only requires Member States to have achieved a high degree of price stability but also calls for the price stability achieved by a candidate Euro Area member to be sustainable. In 2006, Lithuania had its Euro Area membership application rejected both because its inflation rate was 0.1 percent above the 2.6 percent inflation benchmark, and because even this near-miss was not deemed sustainable[1]

Operationalising ‘sustainability’ is difficult: how long is a piece of string? In practice, the convention has been adopted that a candidate country’s price stability performance is deemed sustainable if the inflation forecast for the country made by the European Commission for the year during which the decision is made (and possibly also for the following year), meets the inflation benchmark. For Slovakia this means that the Commission’s forecast for its inflation rate during 2008 (and possibly also for 2009) was decisive. There are some other qualitative ‘tests’, but the only one that binds is the Commission’s inflation forecast.

According to the Commission Spring 2008 Forecast, the reference value for inflation is forecast to stand at 4.3% in December 2008. Slovakia’s inflation rate is assumed to rise faster than the benchmark, but to remain below it.

The sustainability of Slovakia’s current low rate of inflation is highly doubtful. Slovakia’s disinflation since the beginning of the decade has been assisted greatly by the appreciation vis-à-vis the euro of the Slovak koruna. From around the middle of 2006, the nominal exchange rate strengthened significantly, and the central rate was revalued by 8.5% in March 2007. Since that date, the koruna has consistently fluctuated on the strong side of its central parity vis-à-vis the euro, with a maximum upward deviation of 8.9%. Presumably, there will be one final revaluation of the koruna before the irrevocable fixing at the end of 2008, but after that the disappearance of nominal exchange rate appreciation means that the inflationary pressures in Slovakia, driven both by the Balassa-Samuelson mechanism and by an excessive degree of domestic capacity utilisation, will show up as an inflation rate that will both be higher than expected and above the benchmark.

The European Commission’s inflation forecast, which permitted Slovakia to squeeze in, is so optimistic that it is difficult not to see it as the ex-post technocratic ratification of a political decision reached regardless of the medium and long-term inflation outlook. While any kind of fudge is in principle undesirable, it makes sense in my view for the politicians to twist the arms and the forecasts of the technicians in this case.

The inflation criterion, exchange rate criterion and interest rate criterion for Euro Area membership are an economic nonsense. The best solution would have been for the Commission and the ECB to excuse themselves from the fig-leaf activity of writing Convergence Reports for would-be Euro Area members. Alternatively, they should have stated that the low inflation performance of Slovakia (at 2.2 % below the Euro Area average of 2.5 %) is highly unlikely to be sustainable, but that this has no bearing on the case for Euro Area membership. If high inflation in 2009 and beyond undermines Slovakia’s competitiveness, the pain of adjustment without having the nominal exchange rate as an instrument will fall on the Slovaks. They break it, they own it. No need for the Commission or the ECB to get their knickers twisted. Negative externalities for the rest of the Euro Area are not a material issue here. That’s the way it worked for Slovenia, whose inflation rate shot up following Euro Area membership in 2007, and for Malta and Cyprus, who are showing the same steep up-tick in inflation. This is the way it ought to have been for Lithuania, if only they had been advised properly. With a few administrative price controls and a VAT cut or two, they could have met the letter of the inflation criterion. The spirit of the inflation criterion would have been pushed back into the bottle, and Lithuania would have been in. It’s clear that learning took place and that neither the Commission nor Slovakia repeated the mistakes made by the Commission and Lithuania.

Euro Area membership for Slovakia and all other EU members not currently in the full EMU is desirable not only because it enhances macroeconomic stability, but also because it is a precondition for financial stability: it is the only way for most of the current non-members to gain access to a credible lender of last resort and market maker of last resort.

The only credible lender of last resort and market maker of last resort for a country where the financial instruments held and traded by the private financial sector are to a significant degree denominated in foreign currency is a central bank that issues a currency that is also a global reserve currency. There are only two global reserve currencies in the world today – the US dollar and the euro. There are lessons here not only for Iceland (join the EU and adopt the euro asp), but also for the Divided Kingdom: sterling is no longer a world reserve currency. Better get yourself a fully functional lender of last resort and market maker of last resort in Frankfurt.

Everyone who can should get on board the good ship Eonia.

[1] In 2006, the benchmark was defined by Sweden, Finland and Poland; neither Sweden nor Poland were or are part of the Euro Area.

Maverecon: Willem Buiter

Willem Buiter's blog ran until December 2009. This blog is no longer active but it remains open as an archive.

Professor of European Political Economy, London School of Economics and Political Science; former chief economist of the EBRD, former external member of the MPC; adviser to international organisations, governments, central banks and private financial institutions.

Willem Buiter's website