May 8, 2008
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.
Is the ECB really a lender of last resort? In his interview of 2001 at http://woodrow.mpls.frb.fed.us/pubs/region/01-12/padoa-schioppa.cfm , Tommaso Padoa Schioppa appeared to argue otherwise, indicating that this role is left to each national central bank:
“Now, we agree that it can happen, and that, if it happens, the national central bank would be the lender of last resort; that is, the national central bank of the jurisdiction where the illiquid but solvent bank needing lending of last resort is licensed. Is that clear? Normally, if it happens, it would be for a small amount, negligible as compared to the amount that is allotted weekly through the tender procedure I was describing a moment ago. But if the amount happened to be very big, then it would be relevant from the point of view of monetary policy and in that case the national central bank would seek a decision or a consultation of our council.”
Posted by: Enzo Michelangeli | May 9th, 2008 at 1:18 am | Report this commentBefore assuming the desirability of de jour Euroisation, a few points must be made.
- Sometimes, especially during a large exogenous shock, price stability can be of second-order importance to output stability. Small, open, specialized countries, are often more susceptible to these kinds of shocks, so in order to maintain a steady, predictable tax-take, the optimising government will allow the price level to absorb some of the shock (Sims, 2001). This, it turns out, is better than that exogenous shock lowering output, and cannot happen when a country is constrained by a currency union.
- I agree that the criteria for Euro Area membership are ridiculous. The optimal currency area criteria change over time, as member countries’ economies change. Also, those economic conditions of prospective member countries may satisfy membership criteria ex post, even if they aren’t satisfied ex ante. This would happen if ECB credibility is imported with Euroisation (lowering inflation expectations), and if trade effects of Euroisation eventuate (due to lower hedging costs) (Frankel, 1999).
- There is also the question of lost seigniorage, which a country will necessarily have when Euroising. While the ECB does repatriate lost seigniorage, this amount is both hard to calculate, and proportional to the volatility of the prospective member country. Small, open countries stand to lose more than large ones, because of their lost ability to expand money supply in a shock. The present value of this cost is not small (Yeyati & Sturzenegger, 2002), and must be taken into account.
Jim Savage
Posted by: James Savage | May 9th, 2008 at 4:04 am | Report this commentMelbourne, Australia
Surely the sensible thing to do is for a nation state (EU member or otherwise) to make the Euro and its own currency both legal tender on its territory. Then the market would decide the currency of the country.
Posted by: John Harmer | May 9th, 2008 at 9:15 am | Report this commentThe market, not ‘officials’using dubious criteria, would decide whether a country was part of the Eurozone.
On the UK should joining the Eurozone, while I have often considered this both inevitable and desirable in the med/long term, I think the economies are still not in synch. Arguably much more in synch than in the past, but it seems to me that the ECB rate policy (while adequate for the EZ) would have wreak havoc on the UK economy over the last few years. And i’m not even talking about the large differences in the mortgage market between the UK and continental Europe - I don’t think there are that significant overall, but they do affect virtually every one in the UK. And if a charismatic polititian like Blair (who took the country to war against a very significant opposition) cannot get into the EZ, the chances for Brown or any tory leader are clearly near zero.
Also, practically, at current ex-rate (EUR/GBP: 0.78/80) the UK would lock in a rather massive ex-rate advantage, something I doubt politicians in the EZ would accept.
Posted by: Anon | May 9th, 2008 at 11:18 am | Report this commentRecently the SEPA payment system has been approved in the Eurozone…but before the Euro has had an important consequence on Trade among Eurozone member states:
Traditional markets for British goods like Portugal and Spain now have changed their preferences in exports and imports and the UK has been set aside.
Since 2002, the UK has fallen to 6th place in Portugal´s Imports when traditionally it was nº 2.
Since 2002, the UK has fallen to 4th place in Spain´s Imports when traditionally it was nº 3.
Posted by: Enrique | May 9th, 2008 at 1:49 pm | Report this commentThe current exchange rates of GBP/EUR 1.20 to 1.30 are precisely the rates the UK Government of the day was informally invited to move to in the four days before Black Wednesday, the rates which would have attracted Deutchebank support for the pound and averted Black Wednesday (at very little cost to UK inflation). This has looked like the proper medium term excahnge rate range ever since. If we were to lock into it, all concerned are likely to accept the rate.
The large scale exogenous shocks which threaten the UK economy are high international commodity prices, international finacial turbulence and major possible restrictions on international trade. All these are best handled by a large currency bloc.
Mortgage markets differ substantially between euro zone members. The present day UK market is not of a radically different nature. An attraction for politicians of joining the euro at present would be lower interest rates (somewhat less than a full 1% lower I would guess).
So this appears to be a very good time for the UK to join the euro. Even the Gordon Brown/ Treasury tests are pretty well satisfied. It is a pity that UK inflation is too high for them to let us in. But John Harmer’s solution of simply declaring the euro legal currency in the UK looks just what is wanted to get past the preentational problems on both sides of the Channel. All we need to back it is an exchange rate fixed at 4 pounds = 5 euros.
Posted by: David Heigham | May 9th, 2008 at 3:51 pm | Report this commentYou are a little dismissive of sterling as a reserve currency. According to the IMF COFER tables, sterling is the third most important reserve currency, accounting for about 5% of allocated reserves globally, compared with 64% in dollars, 26% in euros and 3% in yen. Sterling seemed to benefit from the creation of the euro, which meant that there were at a stroke less alternative major convertible currencies, and no doubt sterling reserve accumulation (eg by Russia) is one reason why sterling has been generally strong in recent years.
Nevertheless, there is something to be said for merging sterling with the euro from a position of strength. Such a merger would probably confirm the euro as the equal of the dollar as an international currency.
Posted by: Tim Young | May 9th, 2008 at 6:06 pm | Report this commentThe larger the supply of a particular paper currency the more inefficient such trading capital inevitably becomes (i.e. trade regulations, bureaucracy, taxes, big goverment, armed forces, etc.). On the flip side, pure or liquid barter is the most efficient way of trade as the cost of “money” remains current with the actual trade, and debt levels remain linked to real assets (Schumpeter and Walrus describe such debt to asset links in their vision of Economic Equilibrium).
As the Euro makes its way into Eastern European countries, those countries local economies will inevitably inflate and get more inefficeint; as rents and wages will increase proportionately as a function of the Euro’s relatively inflated value.
Although the Euro will seemingly increase the liquidity of these underlying economies, it will be short-term and artificial in nature. For example, as Spain adopted the Euro, property prices skyrocketted and wages followed to keep up with ever increasing rents. However, such prosperity is short-term in nature as Spain’s property market is in the mist of an inflationary cycle.
Don’t get fooled by the short-term strength of the Euro as an international currency. The lifestyles of Europeans are inflating (labor time is increasing relative to free time, time being the true denomination of inflation) as land rents and labor wages are perpetually increasing, until they too cycle. Although the Euro looks exceptionally strong relative to the dollar, that is certainly nothing to be proud of as supply of such western paper currencies are perpetually increasing (yet assets remain fixed by Capitalism’s nature).
The bottom line is that the smaller the supply of a currency, the more precious and stable are the assets (i.e. land and labor) linked to that currency long-term.
Posted by: Doug Wolkon - Author of The New Game | May 10th, 2008 at 8:06 pm | Report this commentLabor wages are not perpetually increasing, Doug…as German and Spanish Unions know, when taking into account inflation.
About small currency, you can tell that to Iceland, Vatican City, Monaco, Andorra or Liechenstein..
I think the opposite about costs, as economies of scale demonstrate the big currency means less costs as thousands of employees are not needed. In fact, I can tell you many provincial offices of the Bank of Spain closed as a consequence of the Euro.
Also, the SEPA payment system for trade among member states lowers transaction costs….
Also important, of course, is the Schengen Treaty which allows citizens from all member states to travel to another member state without borders and that means saving time and money.
For Spain the Euro by itself has allowed the international expansion of our companies: Telefonica (now one of the three biggest Telecom companies in the World), Santander (which last year bought Abbey), Ferrovial (which bought BAA), Endesa, Iberdrola, Zara (Inditex), Repsol (which bought YPF and participates in the third biggest oil field recently found in Brazil)….etc.
That couldn´t have been possible without the Euro.
According to the CIA Factbook Spain now has the same per capita income as Japan (33,800 USD, Japan and 33,700 USD, Spain) And Spain´s GDP is still growing more than Japan´s in spite of the recent slowdown so we expect to have a higher income per head than Japan during the next years.
Posted by: Enrique | May 10th, 2008 at 9:19 pm | Report this commentEnrique,
The Economic Law of Proportions dictates that labor wages must rise in order to pay for increasing land rents. If labor wages are not increasing proportionately, the economy is inevitably prone to cycle, and cycle it will.
“Inflation” is one of those words that we all just accept as a fact of economic life but have no idea what it really means, why it happens, or how to combat it. Inflation is a function of perpetually rising land rents (oil and other land commodities included) based on land’s scarce nature (Ricardian Rent Theory). The higher land rents go in relation to labor wages, the more inflation exists (see Today). On the flip side, labor wages that grow in relation to land rent levels result in net profits or free time in an economy, which in turn create more time for more human innovation and net profits (i.e. progressive economy as described by Walrus)
I agree that economies of scale do allow for a company to get bigger and bigger for a period of time. But bigger has absolutely nothing to do with better or efficiencies. The same goes for per capita income, for if living costs (i.e. rents) are also higher; a higher per capital income may generate a bigger whole but is certainly not better on a net, net basis. Economies of scale do work with regards to scaling “fixed” assets, but they also reach a point of finite potential as human innovation is “scaled” out of the equation. As a result, economies inevitably become stagnant as it relates to the value of their fixed assets (i.e. Germany and Japan). In essence, the economies reach full potential and then run in place until the labor gets tired stripping out more value from scarcer and scarcer resources and eventually cycle.
With regards to small and large currencies, all other things being equal, “money makes money”; but the currency’s long-term value deteriorates as former land and labor resource value sits idle in the form of paper currency. The paper currency is then used to scale fixed assets (rich get richer) in the form of more and more debt and increase rents/fixed costs as well as economic risks. You are seeing it today as huge amounts of paper currency sits on the sidelines increasing costs and losing value visa vie commodities/gold.
Although I am not familiar with Schengen Treaty or SEPA payment system, it sounds like they addressed problems of economic freedom that are unrelated and independent to a common currency such as the Euro.
With regards to the expansion of Spain’s international companies, they have been short-lived and time will tell whether such expansion is sustainable (ask Citigroup which seems to be in liquidation phase or denial).
If Spain is really aspiring to be like Japan, I would think again. Japan is certainly the poster child of Capitalism, as land and labor wages have increased proportionately out of control. The economy is forced to work harder and harder as they run in place and strip out the last remaining land and labor resources available; all the while producing less and less future labor (children). Such a future for an economy is downright sad. Unfortunately for Japan, their long-term future will not include the most popular fiestas so many cherish in Spain today. Does the CIA factbook measure fiesta’s per capita?
I am not arguing that there is not significant economic gain from working together or cross border. That being said, the European Union could certainly help Slovakia’s economy without the Euro recapitalizing their relatively cheap land and labor; as such economic gains are a function of education and communication, not paper.
Posted by: Doug Wolkon - Author of The New Game | May 11th, 2008 at 5:29 am | Report this comment