Assessing The Economic merits of Joining The Euro

The Policy Questions: What strategy do SGE recommend for prospective members looking to adopt the Euro, concerning when to join, what to do before, how long to wait in ERMII, and how to prepare for shocks after joining?

SWISS GLOBAL ECONOMICS

Policy BriefApril 13, 2011

The ScenarioThe Swiss Global Economics has been appointed by the Central Bank of Poland to prepare a brief on the policy approach to Euro accession. In contrast to the situation of Euro enthusiasm of a few years ago, this is in the context of rising fragility and defaults on the Eurozone periphery. So, the proposal will have to be justified on its merits.The issue is not whether Poland joins the Euro: it formally committed to do so, as part of the overall agreement on joining the European Union. (Unlike Denmark and the UK, the new countries did not get the right to an “opt-out” from the Euro.) But there are important questions of when to do so and how Poland should prepare. The SGE is aware of the classic arguments around the costs and benefits of joining a currency union. The SGE is also all too aware of the lack of consensus over policy in Poland, especially around the budget, the labor market and other structural reforms. Some people argue for early accession, with the minimum time possible in the transitional Exchange Rate Mechanism II, to force the pace of internal reform. Others argue that Poland needs more time to get its act together to consolidate the underlying bases for both “nominal” and “real” indicators of convergence to the criteria for Euro accession. In crafting its accession proposals, the SGE will face questions of design detail, that could nevertheless have real consequences: should we push for an inflation target well within the probable nominal criterion of 2.5%, to ensure Poland qualifies, or for a less restrictive approach?

The Current Scene: A Euro In CrisisAssessing the responses to the crisisThe lack of a robust mechanism•Over the past three weeks the euro area governments has embarked in a series of measures to come up with a comprehensive response to the sovereign debt crisis. Any attempt to resolve the crisis, should mean a return to a situation where governments funding is ensured on affordable terms and on a lasting basis. This would require a dual filter response by ensuring both the solvency of vulnerable economies and securing their continuous access to credits.•Access to liquidity is a necessary condition for a sovereign to avoid default in the near term but far from sufficient to prevent default in the medium term. To eliminate the risk of default, liquidity support needs to be combined with a restoration of solvency.•The conditions that has been spelt out for the liquidity support schemes through the EFSF and its successor ESM do not provide the sovereigns with more control over the timing of a hypothetical restructuring of their debts. Strictly adhering to those conditions will make sovereign debt restructuring much less hypothetical and will likely bring its timing forward.•The uncertainty surrounding the specifics of delivering the expanded lending capacity of both the EFSF and the ESM should be of secondary importance, for two reasons: first, because the commitment of European governments should be taken at face value; second, because there is a low expectation that the full fund of both the EFSF and ESM will be disbursed.•The guiding principle of the combined expanded lending capacity of both the EFSF and the ESM with the IMF is to simultaneously refinance the entire marketable debt of Ireland, Greece, and Portugal with some room to spare. The uncertainty as to the continued willingness of the EU governments to keep financing their fiscally challenged peers to the full capacity of the EFSF, will underscore the question of solvency.•Liquidity if provided on favourable terms , could morph into a marginal solvency support maximizing the probabilities of success of fiscal adjustments programmes enabling governments to stabilize its debts without imposing additional austerity measures on its constituents. •A lower funding cost does not eliminate the need for growth and revenue –enhancing measures. It does, however, help at the margin, by a small amount initially but by a much larger amount eventually. This underscores the first of several inconsistencies in the architecture of the European Union’s financial assistance schemes, which undermine their effectiveness.

The question of Euro accession for new members is a central, practical policy issues for these countries. It is an issue that illustrates some tradeoffs over macroeconomic policy, that require evaluations of those tradeoffs and their implications for design. Two of big areas of potential tradeoffs are:•Between the trade benefits of joining a common currency area and the loss of independence in monetary and exchange rate policy to manage shocks uncorrelated with those of the rest of the union; and•Between the credibility-enhancing advantages of joining, with potential beneficial consequences in terms of internal discipline and lower risk premia, and the political and economic challenges of effecting structural changes, in the budget and the real economy.

Analytical Context:Rethinking Monetary policy•There are two main concepts pertinent to optimum currency area: first, there is the Mundell-Fleming and the Monetarist Model of the Balance of Payments that state that monetary policy is ineffective under fixed exchange rates. Second, both fiscal policy and monetary policy are ineffective at influencing GDP in the long run due to a vertical aggregate supply curve. So taken into account these two facts, why should a country consider giving up it monetary independence?•In reality, macroeconomic policy has an important role to play. Economies often experience demand-side shocks. To maintain output at potential, prices should decrease. However, prices are much stickier downwards than upwards, so the economy may end up in a protracted recession. Macroeconomic management policy can come to the rescue: government can compensate the decrease in private demand by complementing it(fiscal expansion) or boosting it(monetary policy).•The economic consensus is that of the two instruments, monetary policy is the better one. Fiscal policy acts with lags, since governments can’t increase spending overnight when faced with a drop in demand. Introducing changes into the budget for the current year is not supposed to be an easy and fast process, and even when changes are finally introduced, expenditures are usually made in smaller installments over time. Monetary policy, on the other hand, acts swiftly. An independent Central Bank generally doesn’t need parliament’s approval to print more money or change policy interest rates and monetary expansion can happen literally overnight, e.g. by reducing interest rates faced by commercial banks.

The meaning of giving up Monetary Independence

Countries decide to fix its exchange rate relative to some other currency. When a country fixes the exchange rate to a foreign currency, it voluntarily puts itself at the mercy of the foreign central bank.

Poland as a test case: A hypothetical Scenario•Let us imagine that the European Central Bank (ECB) decides that Europe’s core economies – Germany and France – are overheating. To remedy the situation, ECB may engineer a monetary contraction, e.g. by increasing interest rates. As a result, the Euro will appreciate relative to other world currencies. If Poland pegs its currency to the Euro, the Polish Zloty will have to appreciate by the same amount. Is this a problem? And if yes, how big of a problem it is? Let’s analyze what happens to trade by considering two extreme cases. If Poland only trades with the Euro area, then it’s not a problem at all – the Euro prices of Polish goods will remain the same and vice versa, so trade will not be affected. If, on the other hand, Poland trades with everyone else but the Euro area, the appreciation of the Euro (and hence of the Zloty) will negatively affect the competitiveness of Polish exports on world markets. All in all, ECB’s desire to prevent overheating in Germany and France may lead Poland into a recession.•Let us Imagine that Poland experiences a demand-side negative shock. The optimum reaction would be to conduct a monetary expansion. However, we know from the monetary approach of the balance of payments that under a fixed exchange rate regime the increase in net domestic assets will be perfectly compensated by a decrease in reserves, leaving the overall money supply unchanged. In this case, Poland can only hope that the Euro area is experiencing a slowdown at the same time, to which ECB will respond by a monetary expansion, part of which will be “imported” by Poland.To summarize, in the first case Poland is made worse off because of ECB’s actions, in the second—because of ECB’s inactions.

Optimum Currency AreaApplication of classic Optimum Currency Area criteria to Poland

Criterion Rule Poland’s rationale Preliminary assessment

Bilateral trade

Accept the Euro if the Eurozone is your main trading partner.

Fluctuations of the Euro will not affect relative prices between Poland and the Euro zone. The higher the share of “old EU” in Poland’s trade, the lower the impact of Euro fluctuations on Poland’s overall relative prices.

No problem. The Eurozone is Poland’s main trading partner.

Symmetry of shocks

Accept the Euro the Eurozone and Poland have similar business cycle.

If Poland’s shocks (both demand-side and term of trade) are correlated in time with shocks for the Euro zone, the ECB is more likely to conduct a policy that’s in line with the Poland’s interests even if ECB itself doesn’t care about Poland’s macroeconomic stability.

Problem. German and Polish economy are different. No reason to expect symmetry of shocks, at least in the short run.

Labor mobility

Accept the Euro if there is free labor mobility between Poland and the Eurozone.

Even if Poland’s business cycle is generally in line with that of the Eurozone, there will definitely be some idiosyncratic shocks. Solution: reduce level of potential output through outward migration (notice that per-capita output will increase).

Problem? Poland is EU member, so no institutional barriers to labor mobility. However: language/ cultural barriers.

Fiscal cushions

Accept the Euro if can use fiscal policy for macro stabilization.

Even if less effective, fiscal policy is not completely incapable at dealing with demand shocks. Best case scenario: the currency area and the fiscal area overlap (like US states). In this case, fiscal policy provides automatic mechanisms of adjustment: a poor country/ region within the Eurozone would collect less taxes and would receive more funds for unemployment benefits, etc.

Problem. Poland’s fiscal policy is restricted by Maastricht criteria. Fiscal transfers across countries are relatively limited.

Why introduce the Euro in the first place?

The discussion above analyzes the conditions under which Poland can, without major losses, adopt the Euro. But what would make Poland want to join the Euro? There are many advantages to accepting a foreign currency (and, more generally, for fixing currency):

•Increased trade (and therefore growth) due to lower transaction costs and lower currency premium. Evidence: Rose (2000) changed the debate on currency unions with a paper that found that countries in currency unions trade among themselves three time more than otherwise (and that this is trade creation, not diversion); Frankel and Rose (2002) show that increased trade within currency unions leads to higher growth, essentially as a consequence. The “three times” has been questioned by others, but a “substantial” impact is now generally accepted.•Increased investments, for the same reason as above.•Import sound monetary policy by using the fixed exchange rate as a nominal anchor. Objective: reduce inflation expectations arising from the time-inconsistency problem (Barro-Gordon). This may be a marginal issue for Poland and other CEE countries (most have achieved low inflation), but is a relevant question for other regions (e.g. Africa, Latin America).•Import credibility through providing a anchor for the direction and design of policy in the lead-up to joining the Euro, and through increasing the costs of “bad” policy.Other considerationsA major factor to be taken into account when deciding upon the introduction of the Euro in CEE in the Balassa-Samuelson effect. CEE is growing more rapidly than old Europe, productivity gains being registered primarily in the non-traded sector. The Balassa-Samuelson effect states that this leads to an increase in the relative price on non-traded goods PN. We know that the effect will eventually slow down, as Poland approaches mean EU income. However, if Poland fixes too early (when the effect is still strong), the increase in PN will translate into inflation.What does old Europe stand to lose?The extension of the Euro zone provides “old Europe” with the same benefits as it does to new entrants: more trade and growth. There are however drawbacks for the other members of the currency union. Bad conditions in Poland can create spillovers, creating both an externality for the rest of the currency union, and, in some areas, reduced incentives for “good” policy for Poland. For example, if Poland enters the Euro zone without meeting the most of the OCA criteria, it may have to rely extensively on fiscal policy for macroeconomic stabilization. Fiscal expansion in one country of the Euro zone may be inflationary for the entire Euro zone, since Poland’s budget deficits will increase aggregate demand throughout Europe. Similarly, if there is a banking crisis in Poland that could have spillover effects for the European Central Bank. That is the whole rationale for the Maastricht criteria, which prescribe countries to pursue prudent macroeconomic policy, including low budget deficits, with sanctions for misbehavior. This creates a further collective action problem, especially for large countries, for whom the sanctions may not be credible (as illustrated by their relaxation for France and Germany).

Varieties of conditions: A brief qualitative account •In those countries which made an early commitment to ERMII and the resulting schedule for Euro adoption, it has functioned as a policy anchor (like EU accession earlier though in a more narrow context with fewer sanctions). This is evident in the behavior of the markets and surely that "anchor" function is more important than the precise timing. Indeed, one could argue that in some countries a more extended schedule would have allowed more room for structural adjustments that would have improved longer term competitiveness (Slovenia with its incomplete public sector restructuring and Slovakia with its significant employment and regional problems).•The important thing from a policy anchor perspective is to have a schedule that is (and is perceived as) realistic and then stick to it. This has clearly benefited the Czechs where in spite of having no government for the past 6 months and none in sight, the broad political acceptance of Euro accession and its policy implications have kept significant political uncertainty from having much economic impact. The contrast, which everyone is aware of, is of course Hungary where for two years following EU accession there was a clear lack of consensus on the Euro with the result that unrealistic targets were set, not met, reset, and finally abandoned in the lead up to the PMs admission of lying about the state of the economy (of course every informed person knew that the economy was in bad shape - the PMs real "lie" was his claim that there was a trade off between Euro adoption and "growth" when by the latter he actually meant continued failure to reform public administration, the health and pension systems etc - in this respect the opposition was certainly no more trustworthy given their earlier record). Now finally Hungary has a convergence program endorsed by the EU which seems reasonably credible but will require a difficult period of building a track record before they are even back to square one with a program that serves as an anchor for policy makers, government officials and investors.•With the Czechs at one end of the spectrum and Hungary at the other, Poland is somewhere in between. There is no political consensus on economic policy in Poland. The previous and current governments however have at least recognized that it would be a worst case to set a specific target for Euro Accession and then fail to meet it. The current government with its 5 Finance Ministers during the past year seems now to be headed toward a "soft landing" for Euro Accession that allows them to move toward the budget criteria gradually. The unfortunate thing is that they are probably not going to use the fiscal space to tackle the structural problems that give them the lowest employment rate in the EU nor do they seem willing to divest remaining state productive assets (coal, freight rr, etc), nor accelerate badly needed infrastructure investments. The nature of the coalition with rural/family/populist/xeno and otherphobe parties channels the "extra" resources into transfers and subsidies. •In the case of the Baltics, the early timetable for Euro accession was appropriate especially for Estonia and Lithuania with their currency board arrangements. The case of Lithuania and the inflation criteria is interesting and does underscore the challenge of achieving the kind of stability that the Maastricht criteria demand for countries that are still undergoing significant restructuring even with low budget deficits and high growth.