The ECB seems to be getting things right these days. The inflation rate in the eurozone is stable even in the current situation with exploding energy prices and the eurozone economies picking up. Slovenia entered the Economic and Monetary Union (EMU) in January this year, and Malta and Cyprus are following suit on the first of January next year. The other countries that joined the EU in 2004 and 2007 are, however, still in the waiting room and may stay there for a while. For most of these countries the problem is that they do not satisfy the inflation criterion of the Maastricht Treaty.
The irony is that for the countries waiting to join the eurozone, the recent expansions of the EU have made it harder to satisfy the inflation criterion. This piece summarises some recent research seeking to quantify the effect on the inflation reference value of 12 new countries having joined the EU within the last 3 years. For further reading I refer to my joint working paper with John Lewis: “The Maastricht inflation criterion: What is the effect of expansion of the European Union?, http://www.dnb.nl/dnb/home/file/Working%20Paper%20No%20151-2007_tcm47-164976.pdf.
The inflation criterion of the Maastricht Treaty says that to join the EMU a country must have an inflation rate lower than or equal to a reference value defined as the average inflation rate in the three EU countries with the best performance in terms of price stability, plus 1.5 percentage points. The reference group of the three best performing countries has been taken to comprise the three EU countries with the lowest non-negative inflation, so that countries with negative inflation are excluded from the reference group, although this procedure may not necessarily be employed in all future convergence assessments.
The impact of the expansions of the EU can be assessed via a counterfactual experiment using monthly inflation data since 1999. Comparing the inflation reference value with respectively 15 and 27 EU members, it follows that if the EU had comprised 27 Member States instead of 15, the reference value would have been substantially lower (up to 0.5 percentage points) in relatively long periods since 1999. The analysis also shows that the inflation reference value fluctuates considerably from month to month as countries with inflation around zero shift in and out of the reference group.
An alternative methodology is to use Monte Carlo simulations to ascertain the distribution of the inflation reference value for different sets of EU countries. The inflation distributions and their parameters can be derived from previous inflation data or be based “expert assessments”. The figure below shows the distributions of the inflation reference value (in the baseline scenario) with 15 and 27 EU countries, respectively.
The simulations show that the distribution of the inflation reference value shifts to the left after the increase of the number of EU members from 15 to 27. The expected reference value has decreased by 0.15–0.2 percentage points depending on the specific assumptions employed. There is around a 25 percent change that the gap is 0.3 percentage points or larger. The relatively large standard deviation of the reference value is a result of the exclusion of countries with negative inflation from the reference group.
The treatment of countries with negative inflation in the calculation of the reference value has a large impact on the results. The simulations suggest, for instance, that if countries with negative inflation are retained in the reference group, the average reference value is likely to be around 0.5 %-points lower with 27 EU countries than with 15 EU countries.
The analysis summarised above shows that it has become somewhat harder to join the eurozone now than it was in 1998 when the first round of countries were admitted to the EMU. With the current relatively high inflation rates in the Baltics, Hungary and Bulgaria, a lowering of the reference value by 0.2 %-points is without importance for the prospect of these countries shortly joining the EMU. Inflation rates, however, can change rapidly, and a 0.2%-point lowering of the reference value can then be enough to keep these countries out of the EMU.