Rafael Pampillón. Professor. IE Business School
5 September 2006
As Eastern European countries knock on the EU door for entry, many members of the single currency are suffering from growing pains. Will membership of the Euro-zone bring prosperity to new members?
Joining the Eurozone with a high inflation rate can spell trouble
Of the three Eastern European countries that applied to join the Euro-zone in January of next year, only one, Slovenia, has complied with the economic criteria laid down in the Maastricht Treaty. However, Estonia and Lithuania have failed to maintain inflation rates within European Union limits and will have to wait. We in Spain know what it means to have an inflation rate that runs higher than the EU average. Since 1996, prices in Spain have increased 14% more than the EU average (whereas, for example, Lithuania´s differential during the same period was only 8.5%). Inflation in Spain stood at 3.9% in April 2006-- a differential with the Euro-zone of 1.5 percentage points. If this price differential were to continue to widen over the next 10 years, Spanish exporters would encounter great difficulties trying to sell their products abroad.
Another indicator that illustrates how Spain is heading up the wrong economic road is the foreign deficit, which ended 2005 at 7.4% of gross domestic product. The European Commission has predicted a deficit of 8.7% of gdp for this year and 9.2% of gdp for 2007. These levels clearly show that Spain’s competitiveness is waning.
Looking at the last seven years of the EMU
Now that the European Monetary Union (EMU) is seven and a half years old, we know that complying with the Maastricht criteria is necessary, though it doesn’t guarantee we will feel comfortable with the euro. One reason is that countries can maintain their inflation rates artificially low by using perfectly legal tricks to pass the entrance exam without a hitch. We also are now aware that it may have been a mistake allowing Portugal to join the EMU. What is more, some Italian politicians now advocate the idea of allowing Italy to opt out of the Euro-zone in order to devalue its currency. The reason is that the Italian economy has high salaries and low price flexibility, which leads to rising inflation even during recession. The inclusion of highly inflationary countries such as Portugal, Italy, Spain and Greece represents a persistent and irretrievable loss in competitiveness for the Euro-zone. One of the main lessons learned during these seven years is that for a country to be successful in the EMU, it must have a stable and flexible economy.
Beware of inadequate exchange rates!
In addition to a high inflation rate, candidates seeking to join the Euro-zone must be wary of entering with an inadequate exchange rate. Germany entered the Euro-zone in January 1999 with a slightly overvalued mark and has been paying for this error ever since. The same happened with the Portuguese escudo. However, Spain joined with a very weak exchange rate thanks to the devaluation carried out by the then economy and finance minister, Pedro Solbes, in 1995.
Since that devaluation, however, the price levels in the Spanish economy have increased alarmingly in comparison with the EU average. Consequently, we need to stabilise prices in order to remain competitive. Increasing competitiveness is the only way that the Spanish economy can guarantee economic growth and a sustained increase in employment over the long-term.
In conclusion, because devaluation is impossible, our competitiveness, and our ability to balance the current account on the balance of payments can only be achieved through price stability which, in turn, is attained through restrictive taxation policies, structural reform and incentives for increasing competition. The Spanish Parliament must also do its part to control inflation by passing a restrictive budget for 2007—a difficult task considering that both 2007 and 2008 are election years. The other (unthinkable) possibility is to opt out of the Euro-zone and devalue or, like Germany and Portugal, enter a ten-year economic recession that causes incalculable damage.
Learning lessons from others
What lessons can Slovenia, Estonia, Lithuania and other countries that want to enter the Euro-zone learn from past mistakes?
(1) That to be part of the Euro zone, you need to have a flexible economy and a balanced budget - which is the case of Finland and Ireland, successful members of the Euro-zone.
(2) That it is better to wait than to join the trade bloc with an overvalued exchange rate or high inflation.
(3) That joining the Euro zone does not necessarily translate into success. Great Britain, Sweden and Denmark are not in the Euro-zone. What is more, they have no intention of joining. They have reached high levels of economic growth, low unemployment levels and strong price stability. However, France, Germany and Italy are in the Euro-zone and their performance has been relatively weak during the last seven years. The poor economic performance of these three economies constitutes a strong argument for the pound and the Swedish and Danish crowns not to join the EMU, at least for the moment.