Tanel Ross. Postponing euro-area expectations: why and for how long?

2nd OeNB Brussels Economic Round Table, July 5, 2006
Enlargement of the Euro Area: Which countries will join next?

Postponing Euro-Area Expectations: Why and for How Long?

Introductory remarks by Tanel Ross, Eesti Pank (Bank of Estonia)

Thank you, Chair. I am delighted to be a part of this excellent panel and would like to thank Oesterreichische Nationalbank for this wonderful event.

The adoption of the euro is the key priority for a number of new member states, including Estonia. In my introductory remarks I will touch upon some political-economic issues of the enlargement and provide a brief update on Estonia's position.

Euro area enlargement will benefit all Member States

The starting point for the adoption of the euro is rather straightforward. The elimination of the exchange rate risk and promoting real exchange rate stability boosts both intra-EU trade and GDP growth. The adoption of the euro would foster financial diversification and investment flows. The enlargement has provided substantial benefits for the new and old member states alike.

There are economic and political lines of scepticisms

If the simple cost-benefit analysis is so straightforward, why are there still lingering doubts? To the best of our understanding, there are two lines of argument cautioning against a speedy enlargement. The first, or the "economic" line, points at the different stages of the economic cycle of the euro area and most of the new member states. The other, or the "political" line, dwells on the governance of the euro area and, indeed, of the EU in general.

The "economic" line of scepticism

The "economic" line of scepticism notes that the new member states are in a fundamentally different cyclical position than the old ones. Economic convergence results in higher GDP and productivity growth rates, a somewhat higher CPI inflation and often in current account deficits. The sceptical view states that exchange rate flexibility is needed at some point to adjust to a lower growth path. A premature entry to the euro area would make that adjustment much too difficult.

However, these arguments omit the single most important feature of the EMU - its members should be agile enough to make use of the opportunities provided by a stable monetary framework. To this end, economic flexibility is needed in all euro area member states. On some occasions, the Balassa-Samuelsson effect will push an equilibrium inflation rate above the euro area average. Yet on other occasions, a shock to retail trade or telecoms will result in a depreciated real exchange rate and lower inflation as these services can not be easily traded across the single market. In either instance the divergence of inflation rates is not a sign of weakness, but the contrary.

Clearly, euro area members will continue to specialize in the single market and face asymmetric shocks. The divergence of inflation rates and external positions is thus expected, be there an enlargement or not. Whether this will create any negative side effects is a different story, depending predominantly on the flexibility of economic structures. In any case, the suggestion that new member states should postpone joining the euro area simply because of rapid output growth or current account deficits is flawed. The assumption that all potential euro area entrants are not flexible enough to adjust to the currency union without taking recourse to nominal exchange rates does not live up to the hard facts from the recent past.

The "political" line of scepticism

In addition to the scepticism of economists, there are political arguments. They can be divided into two broad categories, even leaving aside general "enlargement fatigue".

First, it is said that the enlargement of the euro area will be difficult without further political integration. This argument, as I understand it, implies that the credibility of the euro would suffer without closer coordination in other areas, such as fiscal and structural policies.

However, the existing toolbox for policy coordination within the EU is already impressive. The renewed Stability and Growth Pact and the new Lisbon strategy for growth and jobs together provide a full framework of coordination and peer pressure. The fulfilment of commitments by individual member states would suffice for the efficient functioning of the monetary union for years to come. The enlargement of the euro area would not deter the proper functioning of any of these mechanisms.

There is another and more subtle way of thinking. It has sometimes been said that central bank governors from the new member states are somehow more "accustomed" to inflation rates exceeding 2 per cent. Ironically, there is also another school of thought suggesting that governors from the new member states would be too hawkish as higher interest rates would be "preferable" in their home countries.

Frankly, these arguments should be dismissed. The members of the Governing Council do not represent their central banks, but the entire euro area. This applies equally to the present and future members of the Eurosystem. Looking at a similar situation in another part of the world, it is my understanding that there is little evidence that local economic conditions have had an impact on the voting pattern in the Board of the Federal Reserve.

Estonia will stay on course for the adoption of the euro

I will now turn to Estonia's views on the adoption of the euro.

I would like to recall that by adhering to a fixed rate of exchange and the currency board framework, Estonia has been a de facto member of the common currency area since June 1992. With complete liberalization of capital movement and full integration of our financial system with the European markets, we have been as close to the currency union as an independent country can possibly be. Hence, the early adoption of the euro is the only realistic policy goal. As you may know, Estonia has met all the Maastricht criteria with ease - except for the current interpretation of the inflation criterion. In this context, we decided not to submit our application earlier this year and the government has established the 1st of January 2008 as the next target date for joining the euro area.

It is against this backdrop that we have drawn some conclusions from the discussions of the last twelve months.

First, the Treaty provisions should be honoured and within this framework, we should revisit the interpretation of the inflation criterion. The three countries with the lowest inflation rates are not necessarily the three best performers of the 25 Member States of the EU. Take the latest convergence reports - two out of the three reference countries were ones with floating exchange rates, perhaps not the most suitable benchmark for joining the currency union. Thus, new and meaningful ways should be explored, for instance, by taking into account the ECB's explicit numerical target for calculating the reference value of the price stability criterion, or looking at the inflation rates of euro area members only. Autumn 2006 is an opportune time to this end. We expect the issue to be taken up by the EFC and ECOFIN before the Commission and the Central Bank to finalize their regular convergence reports later this year.

Second, the new interpretation of the criterion would not set an unwelcome precedent for any future enlargements. It would demonstrate that the adoption of the euro would be assessed only by economic policy merits. Indeed, it would be rather odd if a combination of, say, low inflation and a fluctuating nominal exchange rate would be preferred to a strictly fixed rate when deciding about euro area membership.

Third, the communications strategy becomes increasingly relevant as Estonia's new target date and the implied time for submitting the request for the convergence report approaches. In a fixed exchange rate system, we are facing questions of when Estonia will adopt the euro and what the rate of conversion will be on a daily basis. In this context, we should explain the application of the rules governing the adoption of the euro and their evolution over time to the general public in detail.

Finally, it has been customary to ask what will happen if entry to the euro area is indefinitely postponed. At one extreme, our own calculations put the economic costs in terms of a cumulative loss in GDP growth at 10 percentage points over five years, compared to the baseline. Of course, strong policies can reduce the impact of the postponement quite a bit or even render it negligible. In any case, the fixed rate of exchange remains the sole anchor for Estonia's monetary policy and we may consider additional measures to reinforce monetary integration with the euro area.

Thank you once again, Chair.

Tanel Ross. Postponing euro-area expectations: why and for how long?