Treaty change is needed to make sense of euro-area entry criteria

Zsolt Darvas

23 July 2009

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Rules are generally useful, and rewards typically require effort in all areas of life. For example, a university degree is awarded only after having completed all classes; with the degree the graduate has better chances to find a good job. However, what if a rule does not make sense, the stakes are now higher, and everyone is aware that? The answer is simple – the rule should be changed.

Euro-area entry criteria

Even before the crisis, a lot of discussion took place about euro-area entry rules, but a lot more has taken place in response to it. Some say that entry rules should be completely dropped and all aspirants should be allowed to join the euro area immediately. Others say rules are important, contribute to stability and credibility, and euro-area entry rules are in the Maastricht Treaty, which is, in practical terms, impossible to change.

Euro-area entry criteria were set up in the early nineties when the euro area did not exist and the EU had 12 members. Intense discussion preceded the drawing up of the rules, and the end result was a compromise between economics, politics, and simplicity. Now the euro area exists and there are 27 members of the EU, but the rules are still the same. It is easy to show that keeping the same rules in an expanded EU violates the equal treatment principle – new applicants have to meet tougher criteria than previous ones because two of the criteria are benchmarked on the “three best-performing member states of the EU in terms of price stability”, which have been interpreted in a special way. The Treaty does not specify how to determine the “three best performers”, which in practice has been defined as the three EU countries having the lowest non-negative inflation rates.

Nevertheless, before the crisis I shared the view that a Treaty change may not be needed, partly because of the difficulties in changing the Treaty and partly because of the principles behind the criteria make sense even considering the specific features of the new EU member states (Darvas and Szapáry, 2008). I only advocated a change in the misguided interpretation of inflation criterion mentioned above. As a consequence of the adopted interpretation, Lithuania’s euro application was rejected in 2006 partly on the basis of inflation rates in Sweden and Poland, two floating exchange-rate countries where inflation may also have been influenced by temporary exchange rate shocks.

Still, four new EU member states have managed to join the euro area so far. The Slovakian case, though it did not violate the text of the Treaty, did violate the spirit, because the exchange rate appreciated by about 25% in the two-year run-up period to the euro, which does not look like a stable exchange rate to me. Despite that, letting Slovakia to join was a great decision. Some countries joined the euro area without formally meeting all criteria (De Grauwe, 2009) and these countries likely praise their luck now, as the euro proved to be a major sheltering factor at the time of the crisis. Amongst non-members, those countries with inappropriate policies have been the hardest hit (Darvas, 2008), and the external financial constraints imposed by the crisis may present the best opportunity since transition to implement long-needed but always-delayed structural reforms.

The need for rethinking the criteria

However, the crisis has prompted rethinking many positions, and we ought to rethink the euro-area entry criteria too, because serious asymmetry and serious stakes are in play.

Asymmetry. Once a country is inside the euro area, it can do almost anything it likes. The Stability and Growth Pact in principle limits the scope of government action inside the euro area as well, but not much, as many examples indicate both in the pre-crisis period but especially during the current crisis. Government deficits and debt are ballooning in euro-area countries. On the other hand, countries wishing to join are subjected to extremely tough and painful measures if they are to be eligible in a few years.

High stakes. One may say that the new applicants should have pursued policies similar to those of the four newest EU members. However, the stakes are much higher now than just naming and shaming. For example, GDP in the three Baltic countries is expected to drop by about 20% in the space of two years. Financial integration with Europe, a policy promoted from both Brussels and Frankfurt, strongly contributed to both their previous growth and their current pain. A Baltic exchange-rate peg failure would not just hurt the population of these countries even more, but it may undermine the trust in our common European values as well and lead to a new divide within Europe (Darvas and Pisani-Ferry, 2009).

Options toward the euro

The menu is not abundant.

One option is preserving the status quo and hoping for the best. This is not the best option. There is a contradiction between the huge loans granted from the EU and elsewhere to support Latvia in maintaining its exchange-rate peg and the denial of Latvia’s euro-area prospects by EU officials. This mix intensifies the agony of the country and at the end may not save the peg, risking a new Argentina (Levy-Yeyati, 2009).

A better option would be to use the very limited flexibility of the Treaty and offer a better prospect of euro-area entry, supplemented by temporary ECB support. The ECB offered swaps to Denmark and Sweden; it should also offer them to non-euro-area member states. The ECB accepts non-euro denominated securities eligible for refinancing in three currencies (US dollars, British pound, and Japanese yen, provided the security was issued in the euro area), but it should accept high-quality securities issued anywhere in the EU in all EU currencies. The ECB should also give access to ECB refinancing facilities for non-euro-area commercial banks, which could substitute the malfunctioning euro-area money market for these banks. Besides direct help, these actions would boost credibility, with all associated consequences.

A change in the attitude toward unilateral euroisation with external support from the ECB may also be a better solution than the status quo, though the recently emerged risk of a crisis-driven exit from dollarisation in Ecuador highlights that such a unilateral move is not necessarily the end of the line and domestic policies have crucial roles.

Further options would require a change in the Treaty.

Some have suggested a “big bang” euro area expansion to swiftly introduce the euro in all EU member states without any condition. While this suggestion has many merits (e.g. Piatkowski and Rybinski, 2009), there are important country-specific features that should be taken into account. For example, this would be the best solution for the Baltic countries, provided that it is done at an appropriate exchange rate and accompanied by a proper burden-sharing agreement among those (there are many!) who were responsible for the outrageous credit and housing booms in these countries. However, for countries with floating exchange rates the case is less clear (Darvas and Pisani-Ferry, 2009). Furthermore, this option would imply a complete departure from previous policies and hence the chance of it obtaining EU-wide support is tiny.

The more realistic option is to make the euro-area entry rules sensible.

The proposal

It would be tempting to drop one or the other criterion or to phrase the criteria in terms of more meaningful indicators, but simplicity is an important principle and a good compromise is to stick to the current four indicators but to make the numerical requirements sensible. Economic theory does not provide clear guidelines about how to determine the magnitudes, but a few principles can be laid down.

  • All criteria should be related to the euro-area average for at least three reasons. First, all prospective applicant countries are highly integrated into the euro area (if not, they should be), and hence what happens inside matters a lot for those outside. Second, it would abolish the peculiar possibility that non-euro-area countries or very small countries with which the applicant has virtually no trade may affect the criteria. Third, it would alleviate the asymmetry of unpunished fiscal profligacy in euro-area countries and painful austerity in applicant countries during a crisis.
  • The inflation, interest rate, and budget balance criteria should allow some deviation from the euro-area average. For example, the budget balance criterion could be the average euro-area balance minus 1.5 percentage points (all measured as a percentage of GDP) and the inflation criterion could be the average euro-area inflation rate plus 1.5 percentage points. New EU member states are small and open economies characterised by larger cyclical swings and thus need greater scope for counter-cyclical fiscal policy. Moreover, the need for public sector investment is larger than in old EU member states. With regard to inflation, new EU member states have a higher potential growth rate, which implies structural price level convergence that should be acknowledged. Whether the deviation should be 1.5 percentage points, similar to the current inflation criterion, or another close number should be the subject of discussion.
  • The requirement for the ratio of government debt to GDP could simply demand that this ratio should not exceed the euro-area average, unless the ratio is diminishing sufficiently and approaching the euro-area average at a satisfactory pace.

Feasibility

Would this change jeopardise the stability and credibility of the euro area? Certainly not. There would still be criteria (but more sensible ones) to meet to keep applicants on their toes. Furthermore, in good times, the new criteria would be tougher. For example, when the budget deficit is balanced in the euro area, then the new criterion would (rightly) require a better budget position from the applicants as well. And in any case, prospective applicants from the new member states would make up a very small share in the total euro area, and their inclusion would hardly be noticeable in euro-area aggregates.

Would it be difficult to reach a consensus among the 27 member states on this particular treaty change? I think not. Countries outside the euro area would certainly support it. Countries inside would feel more comfortable having rules that make more sense. They initiated a weakening of the Stability and Growth Pact some years ago when they had problems with it. Now the goal is not to weaken the euro-entry criteria but to make them more sensible. The change should be carefully orchestrated and initiated by euro-area member states or European institutions, not applicant countries.

The suggested change in euro-entry criteria would still require substantial effort from the applicants, but it would ease their pain. It would also boost confidence, helping kick-start the private capital inflows – not western taxpayers’ money – that these countries desperately need.

References

Darvas, Zsolt (2008), “Should the crisis be the trigger for a reshaping of euro-area entry rules?”, VoxEU.org, 11 November 2008.

Darvas, Zsolt and György Szapáry (2008), “Euro area enlargement and euro adoption strategies”, European Economy - Economic Papers 304, DG ECFIN, European Commission.

Darvas, Zsolt and Jean Pisani-Ferry (2009), “The looming divide within Europe”, VoxEU.org, 23 January 2009.

De Grauwe, Paul (2009), “The politics of the Maastricht convergence criteria”, VoxEU.org, 15 April 2009.

Levy-Yeyati, Eduardo (2009), “Is Latvia the new Argentina?”, VoxEU.org, 22 June 2009,

Piatkowski, Marcin and Krzysztof Rybinski (2009), “Let us roll out the euro to the whole Union”, Financial Times, 11 June 2009.

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Topics:  EU institutions EU policies

Tags:  euro, financial crisis, new member states, Maastricht

Research Fellow, Bruegel; Research fellow, Institute of Economics of the Hungarian Academy of Sciences and Associate Professor at the Corvinus University of Budapest

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