Joining the eurozone can mean higher inflation for the new member, but if that brings structural reform, the euro is still a good thing
As Slovakia prepares to adopt the euro, crowning a decade of impressive economic achievement, we should stop for a moment to ponder one of the most conspicuous characteristics of European integration: its audacity.
It is evident in so many places: from the basic objective of European unity with its optimism that is unimaginable today, to the plan itself—betting that the removal of economic barriers will inevitably lead to the rise of common institutions and to political unity.
The euro itself is a glorious example of that improbable daring. On paper, the EU is far from an optimal candidate for a single currency. Not because its sub-economies are prone to diverging wildly: various regions of the United States do that, too, and as a result might be better served by individual monetary policies (as indeed they were at times in the past).
Rather, the standard criticism leveled at the euro zone, and one that prompted skepticism among many leading economists in the 1990s, is that it lacks the mechanisms necessary to survive a major downturn. The United States has a large federal budget to do that. Through federal taxation and spending Washington can effectively step in if something goes awry in the monetary zone, as it did with the recent economic-stimulus package.
That is not an option in the EU. Whereas U.S. federal spending represents about 20 percent of gross domestic product, in Europe there is hardly any federal spending at all (about 1 percent of GDP). The EU cannot transfer large funds from one end of the currency zone to another in case an economic crisis requires quick rebalancing.
The United States has another built-in advantage. As a nation, its people share so many attributes, including, crucially, a language, that they can easily move around within the country if circumstances demand it, making the economy much more flexible. That, again, is not really an option in culturally and linguistically diverse Europe. Here less than 2 percent of the bloc's people live outside their own states.
Still, the theoretical inflexibility of the euro zone is not necessarily a big problem because breaking the system apart would probably require an economic shock on a scale that simply doesn't happen in Europe. Or at least hasn't happened since the last world war. In the long term, of course, anything might happen, but, as John Keynes used to say, in the long term we'll all be dead.
"You could come up with a hundred different scenarios that the euro zone simply couldn't survive, such as a major war followed by a big depression," observes Guillaume Durand, formerly of the European Policy Center in Brussels. "But frankly, these things simply aren't going to happen in the foreseeable future."
The real problems are less apocalyptic. One springs from the fact that although there is no question of having a European federal budget and a single fiscal policy, there needs to be at least some kind of fiscal coordination among the members of the euro zone, since they now have a single monetary policy. That exists but hasn't worked terribly well even during the relatively prosperous and stable economic times the euro has so far enjoyed.
EASING THE SHACKLES
When large states really wanted to shed the fiscal constraints imposed on them by the EU, such as Germany and France did in November 2003, there was no stopping them. There is no way to know how EU fiscal coordination would work in a bigger downturn, but there is no reason to be optimistic. Taxation and spending are ultimately controlled by national politicians with their predominantly national political concerns. They will bow to no one.
Still, even this need not necessarily worry us. The real concern, and one that a fast-growing and small country such as Slovakia ought to be looking at very closely, has to do with long-term inflation. The rules specify only that new members, upon entering, must closely converge their inflation rates to that of the euro zone's average low so that they are not out of sync and their economies don't get hurt by the straitjacket of a single monetary policy.
The cautionary example usually cited is Ireland, which entered the euro zone with a growth rate of 9 percent and a correspondingly high inflation rate. The European Central Bank maintained an interest rate of 2 percent for most of the early 2000s, leading to a massive price boom in the already overheated Irish economy: prices between 2000 and 2004 went up by 16 percent, nearly double the Continental rate.
This is an issue that the European Commission itself raised in its (ultimately positive) report on zippy little Slovakia. It has also surfaced with Slovenia, the first new member to join the euro zone and another Eastern European tiger. It's a particular concern for the relatively underdeveloped new members because they have a lot of catching up to do. Things like large-scale infrastructure development and high foreign direct investment mean that their long-term inflation potential is likely to be higher than that of the western states.
Unless, of course, they want to keep things slow, even artificially slow, just to fit within the European monetary straitjacket. Crudely put: do you want more motorways, or do you want the euro?
No doubt the big political prize that is the euro means that politicians will try to have both. That is not impossible. It does mean, however, that they have to work extra hard to ensure that inflation stays low and public spending doesn't get out of control, a task made very difficult in places like Hungary, with its extravagant social security system. If the euro encourages them to further pursue structural reform—and there is some evidence of that—then going for the currency is already a good thing.