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Policy challenges of euro area enlargement

Speech by Lucas Papademos, Vice-President of the European Central Bank, at the 37th Economic Policy Panel Meeting, Athens, 11 April 2003

Dear colleagues, Ladies and Gentlemen,

I. I am delighted to have the opportunity to address you in the context of the 37* Economic Policy Panel Meeting. I am particularly pleased to be among distinguished economists and friends from the academic and research communities as well as from central banks. The ECB and I personally appreciate the valuable contributions to economic analysis and policy-making of this Forum, which is organised by three leading European research centers.

Athens, and the Bank of Greece in particular, is the venue of this Economic Policy Panel Meeting. The choice is based on a rotation system but it turns out to be an appropriate one. I am not saying this because I am a native son, but because Athens is a place steeped in history, and not only ancient history. Next week, history will again be made in this city: ten countries in central, eastern and southern Europe will sign the Accession Treaty to join the EU, stamping a formal seal on the largest ever expansión of the Union.

An EU of 25 Member States will soon be a reality. Not quite so soon - but sooner than we might have imagined a few years ago - a substantial enlargement of the euro area will also become a reality. The challenges associated with this prospect will no longer be only the object of academic interest; they will also become the subject-matter of real policy decisions. For this reason, I thought it would be useful to address some policy issues and challenges relating to the future adoption of the euro by the acceding countries.

II. How can it be ensured that the integration of the new Member States into the euro area will proceed smoothly? What should be the overall economic policy strategy, including fiscal, monetary, exchange rate and structural policies of the acceding countries, in preparation for the euro? And, equally important, what should be the preparations on our side, within the EU and, specifically, within the ECB? After all, we should not forget Benjamin Franklin's warning that "failure to prepare is preparing to fail." These are the issues I would like to address tonight, and I will try to be as brief as possible.

Speaking to a group of economists, the first topic that should naturally be discussed is whether theory can tell us something about the preconditions that must be fulfilled for a monetary union to function smoothly. More specifically, whether theory can help us identify the essential conditions which can facilitate entry and ensure successful participation of new Member States in the euro area. In general, a necessary condition both for the smooth functioning of monetary union and the successful participation of new Member States is the attainment of a high degree of convergence. I use the concept of convergence in a broad sense to include not only nominal convergence but also convergence in real terms: institutional and structural convergence. How important is each aspect of convergence and what is the necessary or minimum degree of real convergence required? A starting point for tackling this topic is the theory of Optimal Currency Áreas and the criteria that determine the symmetry of external shocks and the capacity of a country to absorb shocks. In line with this theory, the new Member States should actively seek to fulfil these criteria in preparing to join monetary union and thus should strive to make their economic structures more similar to those of the euro area. And they should introduce the necessary measures to increase the degree of trade and financial integration, the flexibility of pnces and wages, and factor mobility.

But perhaps it is the other way round: Is it possible to put Robert MundelPs "cart before the horse" and rely on the endogeneity of his criteria? In other words: is it likely that joining monetary union will reduce transaction costs and market imperfections, and thus entail increased trade and financial integration as well as price and wage flexibility? Can entry into the euro area be expected to lead to an adjustment of economic structures and a synchronisation of business cycles? Recent research, such as that summarised by Micco, Stein and Ordoñez on the effects of EMU on trade[1] , and that presented by Angeloni and Ehrmann on the monetary transmission mechanism in the euro area[2] , suggests that the answers to these questions are generally positive. I think Mundell himself would tend to agree with this conclusión.

Nevertheless, the answers to these questions cannot be regarded as definitive. Further work in this area will be useful as the answers have important policy implications for the manner in which each of the accession countries prepares for the eventual adoption of the euro. More specifically, they may also determine the priorities to be set in achieving nominal and real convergence: whether inflation and public sector déficits are reduced fast, in the expectation that the necessary structural adjustments in the real sector "will look after themselves" once the country is inside the euro area; or whether "catching-up" in real terms takes priority and the public sector should aim at financing infrastructure investment, improving market efficiency and flexibility, and cushioning social and economic change. In my view, the approach to the euro by the acceding countries should be a balanced one, involving, on the one hand, macroeconomic policies aiming at nominal convergence, which is absolutely necessary for EMU entry, and, on the other hand, structural and institutional reforms, which will be essential for securing faster growth within the euro area.

As we know, most of the acceding countries are in a process of "catching-up" in real terms and economic conditions differ considerably among them, in nominal, real and structural terms. This fact implies that it is unlikely that we can define a unique path to the euro that would be appropriate for all. It is impossible to formulate a single strategy and a set of policies that can be applied uniformly to all the acceding countries. There are, of course, certain similarities among some of these countries, with regard to their state of nominal convergence or their exchange rate strategies, but there are also differences, including differences in fiscal positions and financial structures. For this reason, the chosen economic and monetary policy strategies on the way to the euro vary, and their effectiveness will have to be assessed on a case-by-case basis.

Although initial conditions differ, the final aim of the new Member States is the same: the adoption of the euro as soon as appropriate conditions are established. So, "all roads lead to Rome", or, given our subject, I should perhaps say "to Frankfurt". Indeed, most acceding countries have declared that they plan to join the euro area as soon as possible, and some have announced specific target dates, in 2006 and 2007. The plurality of approaches to the euro, however, should not stand in the way of the equality of treatment when it comes to examining the degree of convergence.

The Treaty is very explicit on the need for nominal convergence, and even quantifies what is to be understood by it, in the famous Maastricht convergence criteria. I would like to address the challenges stemming from these nominal criteria, notably for monetary and exchange rate policies and public finances, before turning to issues related to real convergence.

III. As a central banker, I naturally start, and predictably so you might say, by emphasising that the achievement of sustained convergence to price stability is the fundamental prerequisite for the adoption of the euro. Consequently, the primary objective of each country's monetary policy should be to attain convergence to price stability, irrespective of the specific conditions - economic or institutional -which may warrant the adoption of different national strategies, at least for some time. What is crucial is that nominal convergence is sustainable. The successful performance of an economy within the euro area hinges precisely on that. Thus, the appropriate strategy should aim at securing the sustainability of inflation convergence. What are the challenges in this regard?

I would emphasise three of them: First, there is the Balassa-Samuelson effect, which is often mentioned in discussions, but which should not be overstated. According to a number of estimates, the magnitude of this effect is unlikely to be more than 1%. Second, we should not lose sight of the fact that in several acceding countries a range of prices is still administered. The necessary progress towards price liberalisation is likely to be gradual, but nevertheless has the potential to impede a smooth path towards inflation convergence. Third, accession itself could be expected to boost economic activity. Such an acceleration of output growth could put upward pressure on prices. All these factors will need to be taken into account, especially by those acceding countries that aim at the earliest possible adoption of the euro. It should also be kept in mind that, once these countries are inside the euro area, inflation differentials are likely to persist for some time. This theme is dealt with in more detail in the paper by our Irish colleagues. [3] The Greek experience also highlights the persistence of inflation differentials.

In this context, we should also be mindful of structural differences in the dynamics of economic growth between the new Member States and the current euro area. For instance, recent research at the ECB [4], based on the empirical evidence of the past seven years, finds that the acceding countries' growth is higher on average but is characterised by wider fluctuations when compared to the euro area and other EU countries. In addition, business cycles in the Central European acceding countries (Hungary, Poland, Slovenia, Czech Republic, Slovakia) have on average been less synchronised with the euro area than the so-called "euro pre-ins" (United Kingdom, Sweden and Denmark). However, the business cycles in these acceding countries did not show a worse alignment with euro area fluctuations when compared to the cycles in some euro area members on the "periphery" (Greece, Portugal and Ireland).

This leads me to my next point: considerations regarding the symmetry of growth dynamics and the size and degree of openness of an economy influence the choice of the exchange rate strategy of acceding countries, notably the desired degree of exchange rate flexibility or fixity. There is consensus, however, that the different orientations of the exchange rate policies currently pursued will gradually have to converge, not least because the new Member States are required to treat their exchange rate policies "as a matter of common interest" following EU accession. One aspect of this is ERM II membership. What is the role and purpose of ERM II in the process of monetary integration of the new Member States into the euro area? We, at the ECB, see ERM II as a useful framework to foster convergence and thus support the policy efforts to adopt the euro. In our view, (i) the voluntary nature of the mechanism, (ii) the combination of features of fixity and flexibility which are provided by the fixed but adjustable central parity and the relatively wide fluctuation band, and (iii) the multilateral character of its management make participation in ERM II a valuable testing phase before euro area entry in many ways: for testing the appropriateness of the central rate and of the eventual conversión rate of the national currency to the euro; and for testing the consistency of domestic macroeconomic policies and the sustainability of convergence.

That said, it would be naive to believe, and I do not want to imply, that joining ERM II is a panacea. The new Member States will undoubtedly be confronted with a number of challenges. One is the likely upward pressure on the exchange rate, which might arise from the catching-up process, from further structural reforms -particularly in the financial sector - and /or from potential asymmetric shocks. In particular, large capital inflows and the need to pursue a tight monetary policy to complete the disinflation process might lead to a prolonged period of overvaluation of the national currency, which might nevertheless be to some extent transitory. On the other hand, strong productivity growth combined with low inflation could lead to a durable appreciation of the exchange rate, which needs to be reflected in an adjustment of the central parity. Obviously, these phenomena have to be taken into account when deciding the modalities of ERM participation and in the conduct of monetary policy within that framework. They should also be taken into account when assessing exchange rate stability in the context of the convergence examination. This was indeed the case for both Ireland and Greece.

After all, exchange rate stability within ERM II is no pie in the sky. It can be achieved, and sustainably so, if monetary policy is credibly geared towards convergence to price stability and provided that fiscal and structural policies are supportive of this orientation. It obviously also requires an appropriate choice of the central rate which is in line with the fundamentals and can be expected to remain in line with the fundamentáis if the right policies are pursued.

This brings me to my final point on nominal convergence: fiscal policy. I think we all agree that economies going through a catching-up phase undoubtedly require substantial public investment in infrastructure, both physical and in terms of human capital, in order to close the development gap with the mature economies of Europe. To that end - it is argued - déficit spending is not only legitímate but, seen from a perspective of inter-generational income distribution, even rational and advisable.

Deficit spending, however, is not devoid of problems, not least because it can set in motion a dynamic that is difficult to contain. The experience of my home country in the 1980s is telling in this respect. In about a decade of déficit spending partly related to public investment, Greece's public debt had more than doubled, to over 120% of Gross Domestic Product. Even though public finances were consolidated later on in preparation for the euro, public debt today - despite a sustained effort lasting almost 10 years - still stands at over 100% of GDP. The need to service this "debt mountain" continúes to severely restrict the room for manoeuvre for fiscal policy.

Moreover, the argument that increased public investment in infrastructure justifies déficit spending is further weakened by the fact that the EU's structural funds provide substantial resources for regional development projects. The new Member States - just like Greece, Ireland or Portugal - can expect net transfers from the Union of around 4% of GDP.

Last but not least, the Treaty provisions on excessive déficits and the convergence criteria clearly and appropriately stipulate sustainable public finances as a guiding principle for the economic policies of all Member States. After all, substantial public investment, successful catching-up and sound fiscal positions can go hand in hand. As pointed out in the paper by Gali and Perotti [5] , the Stability and Growth Pact has not impaired the ability of EU governments to conduct discretionary countercyclical fiscal policy effectively and it cannot be considered responsible for the observed decline in public investment. More generally, there is ample evidence that fiscal consolidation is often, if not usually, associated with higher growth [6]

IV. Thus far, I have dwelled on nominal convergence. As I stressed earlier, this is essential for EMU entry. It is also relatively easy to assess and the Union has experience in measuring and evaluating it. Convergence in real terms, by contrast, is much less well-defined and henee subject to controversy. Some interpret it in rather narrow terms to simply denote convergence in real incomes. If this form of real convergence was a prerequisite for the adoption of the euro, then - according to estimates by the IMF - it would be many years, if not decades, before the new Member States (Malta and Cyprus apart) could enter the euro area. But this form of real convergence is not necessary.

I suggest, however, that real convergence in the broader sense is important. What I have in mind is the convergence of institutional and administrative structures and of the legislative framework; infrastructure modernisation; trade and financial integration. On many of these fronts, the new Member States have achieved significant progress: the data on trade flows and foreign direct investment speak for themselves. With the signing of the Accession Treaty, the new Member States have accepted the acquis communautaire, and thus should have in place a regulatory framework equivalent to that of the current EU. Needless to say, acceptance of the EU rules is not enough; what really matters is implementation. In this field, a lot of work still needs to be done in many of the acceding countries, for instance in modernising the judicial system or reforming administrative practices - not least to enable them to make effective use of the expected influx of EU funds.

The attainment of real convergence obviously involves enormous challenges in practice. Implementing the necessary structural, institutional and legislative reforms may not be easy as it requires political resolve and social consensus. "Necessary reforms, political resolve, social consensus" - all that sounds as if I am talking not about the new Member States but about some of the current euro area countries! In this context, I should also point out that when it comes to labour and product market flexibility, many of the new Member States are in fact ahead of several EU countries, and the task of "catching-up" definitely lies with some of the current Member States. In particular, those acceding countries that have been operating currency board arrangements in a sustainable fashion over a long period have developed alternative adjustment mechanisms, which involve greater price and wage flexibility and will be crucial for their successful participation in the euro area.

V. These remarks bring me closer to home and to the end of my speech. What are the challenges of enlargement for the EU, and specifically for the ECB? A I have to be brief, I should like to mention two: the impact of future euro area enlargements on the ECB's monetary policy and on its decision-making structures.

Several arguments have been advanced about the allegedly inflation bias of the new Member States: one is that inflation dynamics in these "catching-up" economies are different, influenced by the Balassa-Samuelson effect and other factors; another is that invisible inflationary pressures may be artificially suppressed in the drive to fulfil the convergence criteria; a third is that in these countries there is no established "stability culture". For all these reasons, it is sometimes maintained that many new Member States would have a preference for higher inflation and a less ambitious definition of price stability. Although these factual arguments are partly correct, the conclusión is not warranted.

Some have even speculated that the review of the ECB's monetary policy strategy, which is currently underway, may be influenced and anticipate the alleged inflation bias of the governors from the new Member States. This is simply not the case. There is no connection between the review of our monetary policy strategy - which is expected to be completed in May - and future euro area enlargements.

There should be no doubt that in an enlarged euro area the ECB will continue to fulfil its mandate, which is to formulate and implement the single monetary policy in order to maintain price stability in the euro area as a whole. This is done on the basis of aggregate euro area data, which are averages of the national data, weighted by country GDP shares in the euro area total. I mention this to remind you of the proportions of this enlargement. Even though the 10 new acceding countries will add some 70 million citizens to the 300 million of the current euro area, their combined GDP is of the magnitude of around 5% of euro area GDP. It is therefore somewhat far-fetched to predict that specific developments in the new Member States will "drown out" the signáis emanating from the data of the current euro area.

Moreover, it should be recalled that inflation in many new Member States is below or close to the euro area average and their national central banks and governors are committed to the price stability objective. The members of the Governing Council of the ECB particípate in the discussions and decision-making as independent personalities pursuing the ECB's euro area-wide mandate. I can confirm this on the basis of my own experience both in my former position at the Bank of Greece and in the present one at the ECB.

Finally, great efforts have been made to prepare the ECB's infrastructure and its decision-making structures for enlargement. The new voting system for the Governing Council, adopted in March by the Heads of State or Government, will ensure that decisions continue to be taken in a timely and efficient manner, also when the membership of the Governing Council increases to over 30. Although the new voting system is not as simple as we would have liked, it fulfils a number of generally accepted principles, such as the "one person, one vote" and that of "representativeness", which is considered important in an enlarged euro area. Given the legal limits imposed by the so-called "enabling clause" of the Nice Treaty, I believe that the new voting system for the Governing Council is suitable to accommodate a future substantial enlargement of the euro area. Much has been written and said about this system - some of it rather critical - and I could dwell on this subject for much longer. But given that this is a dinner speech, I doubt whether doing so would be a good idea. After all, "the supply of words on the world market is plentiful, but the demand is falling" - as former Polish President Lech Walensa once aptly remarked. I hope that demand has held up reasonably well for so long tonight. Thank you for your attention.

  1. [1] Alejandro Micco, Ernesto Stein and Guillermo Ordoñez: "The Currency Union Effect on Trade: Early Evidence from EMU" (at http://www.cepr.org/meets/wkcn/9/963/papers/stein.pdf)

  2. [2] Ignazio Angeloni and Michael Ehrmann: "Monetary Policy Transmission in the Euro Area: Any changes after EMU?", ECB Working Paper no 240, 2003.

  3. [3] Patrick Honohan and Philip Lañe: "Divergent inflation rates in EMU" (at http ://www. cepr. org/meets/wkcn/9/963/papers/honohan.pdf)

  4. [4] Ralph Süppel: "Do Central European Accession Countries Benefit From Exchange Rate Flexibility?", only submitted for publication as ECB Working Paper in 2003.

  5. [5] Jordi Galí and Roberto Perotti: "Fiscal Policy and Monetary Integration in Europe" (at http://www.cepr.org/meets/wkcn/9/963/papers/perotti.pdf)

  6. [6] See Giavazzi F. and M. Pagano (1990), "Can severe fiscal contractions be expansionary? Tales of two small European countries", NBER Macroeconomics Annual, 5, pp. 75-111; Perotti R. (1999), "Fiscal policy in good times and bad", Quarterly Journal of Economics, 114, pp. 1399-1436; Giavazzi F., T. Japelli and M. Pagano (2000), "Searching for non-linear effects of fiscal policy: Evidence for industrial and developing countries", NBER Working Paper Series, 7460; Alesina A., S. Ardagna, R. Perotti and F. Schiantarelli (2002), "Fiscal policy, profits and investment", American Economic Review, 92, pp. 571-89.

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