The conventional wisdom is that, when the seas get rough, it’s better to be in a big boat. But being in the European Monetary Union (EMU) hasn’t exactly been smooth sailing for all its members. On the contrary, as I argued in my blog posted January 21, the crisis has highlighted that sound policy frameworks are more important than ever.
Let’s look at this experience from the perspective of the European Union’s new member states in the East, who are still outside the EMU but are set to join sooner or later. Should they accelerate or delay their applications? And what are the conditions for success, once they have gained entry?
Fixers and floaters
The answer to the first question depends in large part on the currency regime. For small and very open countries with fixed exchange rates—the three Baltic republics and Bulgaria—there is really no alternative to seeking EMU membership as fast as possible. They have been particularly hard hit by the crisis, partly because of their currency regime; in fact, Latvia had to rely on massive external support to pull through the crisis. But they all have managed to hold on to their long-standing currency pegs against the euro. Once in EMU, their economic policy frameworks would remain virtually unchanged. At the same time, euro adoption would remove residual currency and liquidity risks, which during the recent crisis have driven up borrowing costs, dented investor and consumer confidence, and contributed to their sharp output contractions. So for the peggers, joining the club is all gain and no (additional) pain.
The picture is less clear cut in the larger new member states, who on the whole have been served well by their flexible exchange rate regimes. During the boom years, currency appreciation and monetary tightening helped prevent overheating, and their recent downturn was relatively muted. Some, notably Poland, benefited from a temporary boost to exports as their currency depreciated during the crisis.
But when foreign capital inflows suddenly dried up in the wake of the Lehman bankruptcy, several of the floaters found themselves short of euro liquidity needed to supply banks, households, and enterprises indebted in foreign currency. To fill this funding gap, Romania and Hungary drew on balance of payments support from the IMF and the European Union; Poland, too, topped up its available foreign currency resources with the IMF’s new Flexible Credit Line. These extraordinary actions helped stabilize the situation. But the unpleasant experience of sudden euro shortages and currency volatility will weigh on policymakers’ minds as they decide how quickly to move toward euro adoption.
The euro is for the agile
More fundamentally, however, potential new applicants should ask themselves: are we ready for life in the eurozone? Here I don’t mean meeting Maastricht criteria, which in any event are ill suited to assess rapidly converging economies (as many observers, including myself, have pointed out over the years). Rather, what I have in mind is a more profound question: are institutions and society as a whole prepared to make the adjustments—painful at times—that continue to be necessary once the country has stepped on board the EMU? In particular, what is the political feasibility of fiscal and structural reforms of the kind now required of EMU member countries like Greece and Ireland? If anything, the crisis has confirmed that the euro is for the agile, as aptly observed by Alan Ahearne and Jean Pisani-Ferri already in 2006.
While there are differences between countries, the new member states on the whole do not score badly on this account. Over the past years, they have proven nimble in adjusting their trade and production structures to new opportunities, and they have become increasingly integrated both with EMU members and other new member states; productivity levels have increased; job markets are flexible; and labor mobility, including across borders, is high.
But what I find most impressive, especially in the fixed exchange rate countries, is the ability to maintain fiscal discipline and take tough adjustment measures when needed. Take Estonia, which is hoping to introduce the euro in January 2011. Despite losing almost one-fifth of its output, it has kept its public deficit below the required 3 percent of GDP. As documented in the IMF’s recent Article IV report, this reflects swift adjustment when the crisis hit, sound institutions and, importantly, prudent policies during the boom years. Having been at the helm of government myself, I can appreciate how truly remarkable this accomplishment is.
Policymakers in the West, who are often struggling to push through relatively modest changes to entitlement and subsidy programs, may wonder how their Baltic colleagues have been able to pass tax hikes and spending cuts worth some 10 percent of GDP in a single year without prompting mass protests on the streets. Let’s not forget that economic and political pain is a relative concept. People in Eastern Europe, having only recently gone through the wrenching experience of transition from planned to market economy, know that there is a price to pay to preserve stability and sustainability. Nowhere is this insight stronger than in the Baltics.
Of course, not all new member states share such determination, instilled by running a currency board for almost two decades. Policymakers need to do more to explain that euro adoption is not a goal in itself and that sacrifices will need to be made to fully reap its benefits. For whether pegger or floater, a country’s ability to adjust in the face of new challenges is the true test of whether it is fit for life in the eurozone.
Originally published at iMFdirect and reproduced here with the author’s permission.