On April 27, Estonia ditched its bid to take on Europe’s common currency by next January, admitting it can no longer meet the strict inflation target required of new members. Last week, the European Commission rejected Lithuania’s proposal to adopt the euro – the first country to be blocked from doing so – in 2007, after the tiny Baltic state failed to bring down its inflation rate. Of the three new EU members originally slated for a January entry, Slovenia will be the only one to adopt the new currency on time.
Debates over Europe’s single currency have dragged on interminably since the idea was first mooted over 35 years ago. But the faltering of the two Baltic nations has reopened the debate – not only about the stability of monetary integration but also about the wisdom of institutions tasked to steer it.
At issue, according to some observers, is the very legitimacy of the European Commission (EC) and the European Central Bank (ECB) in deciding who can join the club. “They [EC and ECB] are making an historic political mistake, and they will have to pay the price for that,” says Willem Buiter, professor of economics at the London School of Economics and, until this January, chief economist at the EBRD.
“They [EC and ECB] bullied Estonia into withholding its application in 2007, and they’re turning down Lithuania on grounds that – even by their own ridiculous criteria – are illegitimate,” Buiter adds.
Both Brussels and Frankfurt have been quick to praise Estonia’s move to delay euro entry by another year while explaining the rationale for Lithuania’s rejection. Joaquin Almunia, European commissioner for economic and monetary affairs, called Estonia’s decision a “wise one”. “Establishing a new target date for euro adoption helps to focus the preparatory work and provides an anchor for economic policies,” he said.
Lithuania, in contrast, filed its euro bid in March, defying warnings it was likely to be rejected. Commission forecasts put the nation’s inflation rate at 3.5% this year, above the euro target of 2.7%. Estonia shelved its goal of joining in 2007 because of rapid inflation. At 3.6% it too will top the EU target this year, although inflation is set to ease next year to 2.9%, putting the country back on track to join the euro in 2008. In order to qualify, countries must have an inflation rate that is no higher than the average of the three lowest rates in the EU plus 1.5%.
Morgan Stanley’s chief economist Stephen Roach believes the hold-up may not be such a bad thing. “EMU enlargement has gone too far too fast, and it’s an appropriate time to stop and think about the next steps,” he tells Emerging Markets.
Indignation
But Lithuania’s rejection has led to indignation in the Baltic state, which boasts a fast-growing economy (6.5% per annum), sound public finances and low levels of government debt. In Vilnius there is astonishment that Lithuania could be excluded on such a small technicality, particularly in view of the leniency shown towards high-debt candidate countries such as Belgium, Greece and Italy when they joined the new currency.
Even Jean-Claude Juncker, prime minister and finance minister of Luxembourg and chair of the “Euro group” of eurozone finance ministers, weighed in last week to challenge the inflation criteria for new entrants. “We must watch out that the Maastricht treaty is interpreted sensibly; that the ERM inflation criterion is based on EU rather than eurozone inflation is not necessarily the wisest course,” he said.
The ECB’s constitution is enshrined in an annexe to the Maastricht Treaty that unambiguously sets out the bank’s primary goal as price stability (in contrast to the US Federal Reserve, which has the dual mandate of price stability and economic growth). ECB executives, it says, are not to seek or take instructions from any other institution or government body, European or national, and governments are expressly enjoined against trying to sway the central bank’s decision-making bodies.
Much of the criticism levelled at the ECB has tended to focus on its undemocratic nature. For instance, the bank does not release the voting record of the governing council – an act that could provide cover for nationalistic voting preferences.
Brussels and Frankfurt, however, strongly deny that opposition to Lithuania’s membership has political overtones. Defending the central bank’s impartiality, Otmar Issing, the ECB’s outgoing chief economist, tells Emerging Markets: “The Maastricht Treaty has made the ECB independent of any political influence, so that it is able to fulfil its clear mandate of pressuring price stability. Monetary policy-making is hence not only centralized but depoliticized.”
But Buiter, a former member of the Bank of England’s monetary policy committee, believes the institution’s so-called detachment is on flimsy ground. “The ECB should move out of the politics business. They should stop speaking out on fiscal issues, stop speaking out on structural reforms and just stick to their main job,” he says.
“It [deciding who should adopt the euro] is a competence that is well beyond them, in terms of their analytical capacity. They [ECB] are a bunch of humble technocrats who should do a job and not play such a role by claiming real political power for themselves,” he says. “The risk is people will now expect accountability. Who’s going to face the music when they [ECB] screw up?”
The ECB’s “complete immunity” on all matters except in the very narrow realm of interest rate policy sets a dangerous precedent for European institutions, Buiter argues. “I want the ECB to be a central bank and not to act as a political entity that has a role in European-wide fiscal decisions.”
“Once it becomes clear what the ECB and EC are doing in terms of enlargement and how they are flouting the letter and spirit of their mandate, I think a broader consensus will emerge on this point,” Buiter says. “It should be possible for the [European] parliament to send the lot home, fire the lot if they screw up.”
The Italian job
Concerns are also growing that monetary union could come unstuck from within. Most observers agree that Italy is the most likely candidate for exiting the union – or, in the extreme, for even triggering its demise. Of course, from the point of view of the ECB, the idea that Italy’s economic despair could prompt it to leave the eurozone is outrageous. But the hardship of the euro area’s third largest economy has at least forced the debate.
“Problems can develop – you cannot go on having a deficit of 4-5% of GDP,” Vito Tanzi, Italy’s former deputy finance minister under Silvio Berlusconi’s government and a past fiscal affairs director at the IMF, tells Emerging Markets. In three of the past four years, Italian economic growth has hovered around zero. In 2004 it managed a rate of just 1%.
More outspoken still is Nouriel Roubini, professor of economics at NYU’s Stern School of Business, who told an audience at Davos earlier this year: “If Italy does not reform, an exit from EMU in five years is not totally unlikely.”
“Unless Italy and other eurozone laggards change their policies to pursue serious economic reforms that restore competitiveness and growth, they will eventually be forced to exit the EMU,” he added.
Tanzi, however, reckons there is cause yet for hope. “My impression is that the new Italian government will be more pro-European than the former,” he says. “The political risk coming from the policy-makers having an interest in pulling out [of the euro] has been reduced. But the objective risks, these remain. I’m curious to see what the new government will do.”
Of course, the problem with any arrangement that depends on voluntary membership is that anyone can walk out at any time, Buiter points out. But he also stresses that the likelihood of that happening, at least on economic grounds, is slim. “There is no economic argument for any country to leave monetary union. Divergence of economic performance is not something that is aggravated by
membership of EMU or that could be improved by leaving it. So the basket cases in the EMU would be basket cases outside,” he says.
“It would be very much against the self-interest of current members to walk out, especially since leaving the EMU would mean leaving the EU,” he adds, noting that Italy’s exit would be nothing short of “disastrous”.
Political constraints
Nevertheless, nagging doubts remain about the wisdom of monetary union itself. The hair-breadth by which Maastricht passed, and the wide margin by which the constitution failed are reminders that Europeans are still wary of giving up their national sovereignty.
Although EMU is reality, many across Europe are still grappling with the question of how truly unified they care to be – as witnessed by last year’s constitutional votes in France and the Netherlands. “The fundamental question has always been: can monetary union work without a fully-fledged political union?” the ECB’s Issing tells Emerging Markets. “The answer is clear: yes.”
“Given the achievements of economic and political integration in Europe over the past 50 years, we should remain confident that we will also find answers to our current problems ... To expect that such challenges and debates will threaten EMU is to underestimate the strength of European institutions, our willingness to make this project work, and our ability to knock our heads together when tough decisions are required,” Issing says.
Others, however, are less sanguine. Buiter, for one, doubts whether there is sufficient momentum in today’s institutions to preserve the eurozone’s longevity.
“It is not clear to me whether what we have there is enough to maintain monetary union in the longer term,” he says. “It’s going to be a close-run thing since the institution [of monetary union] has such weak institutions and because the EC is viewed as legitimate by nobody. But if you can build on existing institutions and develop a constitution that’s not a 600-page telephone directory but rather a short, snappy text with principles and regulations that can be worked out elsewhere, maybe you have a chance.”
The future of EMU enlargement, though, hangs in the balance as the bigger central European EU members – the Czech Republic, Hungary, Poland – are struggling with their own economic turbulence. “They are too messed up to contemplate joining,” says Buiter.
“I hope that despite the blind obstructionism of Brussels and the ECB, the countries that are qualified to join will do so. The rest will depend on their getting their fiscal houses in order,” he adds.