Märten Ross. Thoughts on the adoption of the euro, financial crisis and currency board

THOUGHTS ON THE ADOPTION OF THE EURO, FINANCIAL CRISIS AND CURRENCY BOARD

Märten Ross, Deputy Governor of Eesti Pank

Speech at the International Conference
"Common Currency and its Future: Lessons for the New Member States"
organized by the National Bank of Poland
Warsaw, 15 October 2008

PROLOGUE

"Yes, we are living in interesting times" - that is how most of my friends have recently said goodbye to me. Indeed, the current times are fascinating. Even if thus far our own corner of the world has weathered the turbulences relatively well, one just feels these tense emotions that the current global affair generates everywhere and among everyone. Therefore, maybe it is not appropriate to discuss the adoption of the euro today at all? Clearly, this is not the issue that has come to the minds of most of us recently. However, there is one paradox: Why is it actually surprisingly acute to talk about the adoption of the euro now? Namely, there are some reasons to believe that the current global turbulences may have brought the euro closer to many countries than was previously hoped for, let's say, even only two weeks ago.

We are just now finalising our autumn forecast. Useless as this exercise probably is in this environment, one thing is clear: While we are certain of our monetary policy of delivering a fast deceleration of inflation over the next year, the chances of an even faster decline have improved even more almost literally by the hour. What I mean by this is that the main obstacle to joining the euro so far - fulfilling the inflation criterion - becomes more likely to be removed in the foreseeable future. So, there is at least some sense in spending a few minutes here today on the adoption of the euro in Estonia.

During the rest of my speech, I will touch upon three issues in that regard. Firstly, has the global financial crisis changed something in the euro adoption process? Secondly, with the benefit of hindsight, how do we assess the pros and cons of our strategy towards the euro? And thirdly, might there still be some sense in delaying the adoption of the euro due to the still ample potential for real convergence?

THE FINANCIAL MARKET CRISIS AND ADOPTION OF THE EURO

We are still in the midst of the crisis and therefore can only speculate how, if at all, it influences the adoption of the euro in the region. However, two points can be brought up.

Firstly, the conclusion is self-evident as there are so many other things to be concerned about in this turbulent world; the case of looking for membership in the most stable currency region is more than natural. During this crisis, I have not felt for even one second that I am losing anything by not having an independent monetary policy, and once you have gone that far, giving up your national currency for the euro is just more than logical.

However, the second point can soundly contradict this first conclusion. Namely, as the financial crisis has ravaged the most advanced financial systems and institutions in the world, it has shown that no financial system is safe from these kinds of circumstances; and this is true irrespective of the currency system.

As a result, one of the frequently used arguments for joining the euro area has maybe become less obvious to the public. Indeed, as proponents of joining the euro area, including myself, have used the reference to financial stability among numerous other arguments as a basis for advocating the adoption of the euro, then now it is probably just a question of time before somebody starts asking if this is really the case. Indeed, if they see financial turbulences everywhere, including within the euro area, the benefits of adopting the euro are less than overwhelming when seen from this angle.

Therefore, in some sense the recent turbulences can take some energy away from those who advocate a fast joining of the euro area. However, even if this is the case, I do not think that it is actually bad strategically for the adoption of the euro. Why? Well, I will definitely continue to advocate that joining the euro can only benefit the financial stability of new member states. Of this, I have no doubt. However, maybe it is indeed a good idea to stop putting too much sugar on the cake of the benefits of joining the currency union. It has always been an unnecessary act to draw the picture that joining the euro will somehow solve all the problems the economy can ever face. It will not! And drawing this picture does nobody any favours. If this story is really believed, it leads to the present situation where for example in many rating arguments we see very strange lines of reasoning. There you very often see that we are believed to be bedevilled with all sorts of afflictions under the present monetary arrangements and that, for example, in Estonia these risks will somehow magically disappear once we join the euro area. This fairytale is no good for us or anybody else. Without it, the ratings might see more the strengths regarding the assessment of the present day and stop creating an overly-technical picture of the risks we face.

Strategically, it is of the utmost importance to stress that the adoption of the euro will not save us from the possibility of an irrational build-up of overly-optimistic (or pessimistic) expectations. Nor will it solve the problems of cross-border financial supervision or from the need to keep fiscal house in order to push for improvements in the competitiveness of private enterprises. Even without all this, there is still the over-arching case for joining the single currency as soon as possible. So, let it be.

ADOPTION OF THE EURO AND THE CURRENCY BOARD: MID-TERM REVIEW

Once all that has been said, one could probably ask why we ourselves have not done more to join the euro area. Indeed, not so many years ago many people believed that as we had already been fixed to the euro for some 15 years through the currency board arrangement, then joining the euro area should be a quick job, particularly in light of the fact that we do not have a notable amount of government debt and the budget constantly remained in hefty surplus from 2000 to 2007. But here we are still without the euro. So, isn't it contradictory?

Well, the answer is quite simple and I do not find a contradiction here. It lays in the build-up of the euro application procedures. The rules set up for joining the single currency area tend to assume that countries in structurally different (and I am not talking here about simple business cycles) phases of development should rather avoid joining the single currency area. So, even if the criteria do not directly talk about real convergence, the build-up clearly benefits those whose further needs for convergence are smaller. Therefore, it can be regarded as paradoxical that the strategies that aim for maximum integration in the monetary and financial spheres or in the labour markets do not necessarily fit well into the monetary integration process itself in the short term. Indeed, as a fixed exchange rate does not allow nominal appreciation to hide inflation differentials during a time of real income convergence, it puts very clear obstacles in front of these countries that want to join the euro are in the form of the inflation criterion.

One here could continue arguing whether this is sensible or not, but this is not very practical as the possible setbacks for applicants are obviously outweighed by the benefits from the overall system point of view, so I will rather refrain from this argument today. "Let the rules rule" and try to cope with them.

However, at this point one could of course ask why not change strategy then? For example, try to float the kroon and play on a gradual revaluation and hope to join the euro area partly through the backdoor? Well, I have always been appalled by these proposals. Firstly, strategies are meant to be strategies, not something you just jump into and out of. Strategies are meant to give guidance for the long term, so that the public and private sectors can realign their activities based on these assumptions. It would be strange indeed to start playing around with our hard-won credibility for just a few years of expectations about joining the same monetary regime again. Particularly, as we see now, the euro area cannot and should not be regarded as a magic bullet to save the economy from all sorts of challenges.

However, more importantly, it has been scandalous how the strengths of our strategy have been systematically overlooked by many who take their floating currency dogmas from economics textbooks or somewhere else. The period of preparation for entrance into the euro area is really meant to be preparing to live under one currency. Our fixed exchange-rate target has done that for many years now and in key points very successfully. There are most probably good reasons for some countries to follow different strategies, but once you are on this road, leaving it should not be an option.

The currency board has provided the same nominal anchor as there would have been within the euro area, thereby bringing the business cycles closer to each other. There is no expectation among the public that playing around with the exchange rate could somehow solve somebody's political or other problems in Estonia, just like one would not expect it to be in the single currency area. In addition, it has facilitated integration in the financial and labour markets by also supporting price transparency vis-à-vis the euro area. This is crucial in order to live within the currency union. People really compare today's prices on a very practical level to those in the euro area, particularly Finland.

So, for my first conclusion I would say that the limits of the accession procedures are there to stay and could indeed be needed for the bigger picture. We simply have to live with them. However, this is not an argument to give up otherwise strong strategies to prepare the economy to live under the limits of the currency union.

SHOULD WE WAIT EVEN LONGER?

Finally, a question could arise from a totally different angle. Despite fast growth during this decade, our real income convergence has only reached about 70% of the European Union average and prices are roughly at the same level. Therefore, at least from an optimistic point of view, there is still ample room for further catching-up. That, at least in theory, could lead to the situation whereby our growth and inflation would tend to be considerably higher than the rest of the union.

Therefore, while this is not a question for this year or the next, then one could still ask if 2011 or 2012 might be too early to join the single currency. Leaving aside possible disputes about the sustainability of fulfilling the inflation criterion, one could also ask if staying outside the currency union for much longer is also within our own interests, because this could arguably hold down the possible re-emergence of overheating pressures as a result of the "wrong monetary policy". Strangely enough, this advice does not necessarily come hand-in-hand with the advice of giving up the present monetary regime. Simply, as the thinking goes, by keeping one's own currency the risk margins resulting from its lesser credibility could serve as an implicit capital control and thereby limit the swings in asset prices, etc. My reaction to that would be no.

Though there is still ample room for convergence if policies support it and luck is with us, there are hardly similar shocks emerging that could reinvigorate the extent of growth we experienced during the post-EU accession period. At that time, at least three elements temporarily added to the potential for growth. Firstly, was the abolition of the final trade and travel restrictions within the EU. Secondly, was the opening of the labour market with the resulting increase in income expectations. And thirdly, was the final integration of our banking sector into the Scandinavian banking sector. These types of landmark changes are hardly on the horizon anymore and therefore one can expect a much more stable growth path in the future.

However, even leaving aside this argument, I have grave difficulty in finding the benefits of staying out of the currency union "for our own benefit". Even the argument of the debatably too low real interest-rate levels is at least questionable. As convergence-related inflation reflects cost-push factors from the labour market and shows up primarily in the price of services, the usual "loss of the value of money" argument is, broadly speaking, not true. In that case, the euro should be declared as unstable a currency as the kroon is today. So even from that angle, the benefits of staying out of the union are difficult to envisage.

Märten Ross. Thoughts on the adoption of the euro, financial crisis and currency board