Eurozone Watch

Since 2004, the drive of the new EU members to adopt the euro has clearly slowed. Ognian Hishow, senior research fellow at the Stiftung Wissenschaft and Politik has offered us a guest commentary why he thinks that this tendency is dangerous for the countries in question:

In their rush to join the European Union the former communist countries in Central and Eastern Europe (CEEC) readily agreed on any condition insisted by the old members and EU institutions, just not to endanger the accession. They accepted in compliance with the EU Treaty to abandon their national currencies after having joined the Union (Slovenia did it and Malta is following). Yet there is no guarantee this is paying-off in a cost-benefit sense, especially because the euro zone is not expected to transform itself to an optimum currency area soon. Is, then, not better to stay on the sidelines like Sweden which preferred to retain its monetary autonomy?

Is a quiet opt-out the right option?

Since Central and Eastern Europe is highly heterogeneous, one should recall that CEEC have chosen different exchange rate regimes in the past. Most of the smaller new members had pegged their currencies to the euro back in the 1990s. Therefore the way to the EMU membership of this country group has been paved at the moment of their decision to eliminate any exchange rate volatility with respect to the common European currency. Those countries have deliberately granted their national monetary policy first to the former German Bundesbank and later to the ECB. Because of the hard peg they cannot gain much by not adopting the euro whereas the danger of suffering macroeconomic costs by delaying the adoption could be significant, especially in the case of speculative attacks.

But the bigger ones prefer to operate some form of exchange rate float. Poland, the Czech and Slovak republic as well as Hungary and Romania have retained their national monetary independence and thus more economic liberty before the ultimate introduction of the euro. Although the Slovaks decided to join the exchange rate mechanism II in late 2005, they still enjoy reasonable currency flexibility, so they can wait. Same applies to Warsaw, Prague Bucharest and Budapest, and that is why they announced not to be in hurry with their euro related decisions.

Then the question is whether a “Swedish model” of a quiet opt-out is advantageous for those countries regarding that all of them must fight unemployment. Besides, especially Hungary and Romania must further reduce inflation. The answer is that the macroeconomic cost of keeping the national currencies in place is a matter of credibility.

Central bankers tend to be more devoted to low inflation than to other macroeconomic indicators like employment or growth, since a “hard” currency is improving their image. But policymakers usually are concerned about short-run success and thus face a trade-off between lower unemployment and lower inflation. When the Central bank is credible, economic agents form their expectations of inflation according to the pre-announced inflation rate (just 2 percent in the euro area), so actual and expected inflation coincide. The problem is the level of actual unemployment: if it is currently high, a low inflation policy by the monetary authorities will run counter the political goal of cutting unemployment (this has been for longer the case in Germany and France reporting nasty high unemployment rates). As long as the European Central bank (ECB) is determined to keep inflation low and unless some structural reforms have been introduced, this situation can last indefinitely, as the example of the EU 15 proves.  

What, if the Central bank is less independent? Even if the monetary authorities promise a low inflation, economic agents may not buy it. But when anticipated inflation exceeds actual inflation, unemployment will be above its natural level – a highly undesired outcome. Then the policy maker will tend to press for small amount of higher inflation for the purpose of fighting unemployment, which in turn will only confirm the expectations of the public. The Central bank will have no choice but to adapt its inflation target in accordance with the expectations. The outcome of this so called dynamic inconsistency between short run goals (low unemployment rate) and long term ones (price stability) is other things equal, a permanently rising natural rate of unemployment.

Join Euroland soon

Empirical data tend to prove the inflation performance of the new member economies with an exchange rate float is in line with the theoretical model of dynamic inconsistency. The rate of inflation in Hungary, Romania and Slovakia has been exceeding the euro zone inflation in the last seven years although some convergence has taken place. In the Czech Republic and Poland inflation has been since mid-2004 below the Euro area consumer price index (HICP) after considerable price hikes in the early 2000s. Moreover, the Czech and Polish inflation performance has been strikingly volatile with strong fluctuations around the euro zone HICP average between 2000 and 2006, giving an idea about the difficulties of the Central banks in these countries to deal with the dynamic inconsistency. In all five countries unemployment is an issue of concern: it has been rising in Hungary, remaining intolerable high in Poland and Slovakia inspite of an impressive improvement over the past years, or falling only reluctantly in the Czech Republic and Romania.

Why this outcome? While the ECB stands out in terms of credibility, the young Central banks in CEE cannot boast the same reputation. A credibility gap tends to produce higher inflation expectations than in the Eurozone. A persistent inflation differential between the old and new members could be the outcome. In theory, a determined central banker in Poland and elsewhere in CEE may be helpful, as she may be sticking to a policy of low inflation. In the EMU, such a central banker is the incumbent ECB president, defending its independence while maintaining inflation targeting as the major Bank’s objective. But in the new member states guarding a Central bank’s independence is politically harder to achieve.

It seems that only the accession of the euro area can solve the dynamic inconsistency problem. Hence, a Swedish style opt-out in Eastern Europe is a suboptimal choice to which a swift adoption of the common currency is superior.

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