Should Central European EU Members Join the Eurozone?

Central European governments—especially in the Czech Republic, Hungary, and Poland—have a wait-and-see attitude and do not show an interest in joining. Yet the EU is not only about economic benefits.

The debate on eurozone entry of the Central European EU member states has intensified after Jean-Claude Juncker, President of the European Commission, expressed the Commission’s ambition to accelerate the process and suggested a special pre-accession financial instrument to increase the euro’s attractiveness. Are central European countries ready to join? Would it be beneficial for their economies or, conversely, would eurozone membership lead them to the same fate that southern eurozone members suffered after their own entry?

With the exceptions of Denmark and the United Kingdom, the two countries that have a treaty-based opt-out, all EU countries have a legal obligation to join the euro. But the EU treaties do not specify a timeline for this obligation and, in practice, countries can delay their entry for as long as they wish. Sweden, for example, would have been ready to join in 1999 or anytime since then; but since a referendum in 2003 turned down the eurozone membership, Sweden intentionally does not join the European Exchange Rate Mechanism (ERM II), and thereby does not meet one of the entry criteria.

A Wait-and-See Attitude in Czechia, Hungary, and Poland

Central European governments—especially in the Czech Republic, Hungary, and Poland—have a wait-and-see attitude and do not show an interest in joining. Sometimes the unfavorable examples of southern eurozone members—Greece, Italy, Portugal, and Spain—are used to argue against EU membership. These countries suffered from unsustainable development between

When southern countries joined the eurozone, the interest rates fell to the relatively low German interest rates from their previously higher levels.

1999 and 2008, which was partly related to their eurozone membership, and they had great difficulties after 2008. The overall economic record of these countries has been rather weak; looking into the reasons behind these weak outcomes can produce lessons for Central Europe to follow.

When southern countries joined the eurozone, the interest rates fell to the relatively low German interest rates from their previously higher levels. At the same time, these countries had higher price and wage inflation, partly reflecting the convergence of their lower price level to the eurozone average. But lower interest rates—coupled with somewhat higher wage and price increases—lowered the real value of the interest rate, which in turn fueled consumption and credit booms, raised the wage growth beyond productivity growth, and generated large external imbalances such as large current account de cits. These external de cits were primarily financed by borrowing from abroad; thereby, external indebtedness also increased to very high levels in these countries.

Southern European Developments Are Not a Template for the CEE Countries

At the same time, these countries also had structurally weak public nance positions. Greece and Italy had rather high public debt levels even before 2008. Spain had a seemingly good fiscal position with public debt below 40% of GDP and, in some years before 2008, it had a budget surplus. However, too much revenue came from the construction industry and other booming sectors, while major vulnerabilities were built up in the banking sector.

Ultimately, pre-2008 Southern European developments turned out to be unsustainable. When the crisis hit, private capital inflows stopped. This necessitated harsh current account adjustments, even if European Central Bank’s financing of banks helped to cushion the speed of adjustment. Strained fiscal positions necessitated procyclical fiscal tightening. Painful wage falls, unemployment increases, and emigration followed. Inadequate crisis management framework of the eurozone exaggerated the problems. Eventually, Southern European countries came out of the deep economic contraction after 2008, but the recession lasted too long and inflicted major social pains.

Clearly, Southern European developments should not provide a template for Central European countries. To the extent that the euro was responsible for the pain in the south, insofar as it fueled unsustainable developments, a degree of Central European caution is warranted.

The Lessons from the Mistakes Have to Be Learnt

Still, the euro was just part of the story in the south. Other factors also played important roles in the fate of the southern members. Improper functioning of the labor market allowed for excessive wage growth relative to productivity growth in the boom phase, and made the necessary reduction in wages more painful in the bust phase. Inadequate control of the banking sector did not prevent major vulnerabilities building up before 2008, which led to painful and costly bank restructuring after 2008.

To the extent that the euro was responsible for the pain in the south, insofar as it fueled unsustainable developments, a degree of Central European caution is warranted.

What is more, fiscal policy mistakes before 2008 necessitated sharp fiscal tightening during the recession after 2008, so that fiscal policy could not be used to cushion the economic shock. The euro might have played a role in these pre-2008 policy mistakes too, if it led to complacency based on the belief that a crisis inside the eurozone is unlikely to happen. These policy mistakes could have been avoided and lessons from these mistakes have to be learnt.

Important conclusions can be taken from the experiences of central European countries too. Developments in the three Baltic countries—Estonia, Lithuania, and Latvia—which maintained tightly managed exchange rates before introducing the euro between 2011, 2014, and 2015 respectively, were rather similar to developments in southern eurozone countries in the pre-crisis period, and in fact were more extreme in a number of aspects.

The economic contraction of the Baltics after 2008 was much sharper than in Southern Europe, but these countries were able to return to growth much faster, partly due to their higher level of microeconomic flexibility.

The Lack of a Stand-Alone Monetary Policy in Slovakia Did Not Hinder Good Developments

Perhaps more relevant for the Czech Republic, Hungary, and Poland is the experience of Slovakia, a country that introduced the euro in 2009. Slovakia had a floating exchange rate before entering the ERM, and within the ERM the value of the Slovak koruna appreciated sharply. The euro conversion rate for Slovakia was fixed in the summer of 2008, when Central European currencies were at record high levels relative to the euro. A few months later, the collapse of Lehman Brothers in September 2008 resulted in a massive currency depreciation of the Czech koruna, Hungarian forint, and the Polish złoty, but not the Slovak koruna. The currencies of the three central European currencies depreciated relative to the Slovak currency by about 30%—a huge change. If exchange rates matter so much, the three central European “outs” should have had better economic performance than Slovakia, but this did not happen.

The economic contraction of the Baltics after 2008 was much sharper than in Southern Europe, but these countries were able to return to growth much faster, partly due to their flexibility.

Slovakia was one of the best performers in terms of economic growth after 2008 and outperformed the Czech Republic and Hungary. Apparently, the lack of a stand-alone exchange rate and monetary policy in Slovakia did not hinder good economic developments. On the other hand, Hungary had a flexible currency both before and after 2008, yet there were unsustainable macroeconomic developments before 2008 and the growth record after 2008 was one of the weakest in the region.

Eurozone Membership Did Not Determine Economic Success in Central Europe

The example of Bulgaria is also telling. Bulgaria tied its currency to the D-mark in 1997, and then to the euro in 1999, without any change since. The only reason Bulgaria has not adopted the euro is that it was not allowed to do so. One of the conditions of eurozone entry is a stable exchange rate inside the Exchange Rate Mechanism—but there are no transparent conditions on entering the ERM II and Bulgaria was not allowed to join it. Anyhow, the fixed exchange rate of Bulgaria makes this country a qua- si-eurozone member.

Bulgaria tied its currency to the D-mark in 1997, and then to the euro in 1999, without any change since. The only reason Bulgaria has not adopted the euro is that it was not allowed to do so.

Bulgaria also accumulated a large current account deficit before 2008, though it was mostly financed by foreign direct investment and not by loans as in Southern Europe. Despite the fixed exchange rate, Bulgaria had a relatively mild recession after 2008 and recorded faster growth between 2009 and 2016 than the floating-rate Czech Republic and Hungary. This good Bulgarian growth performance is especially remarkable since Bulgaria had to manage a major macroeconomic adjustment by reducing the current account de cit (24% of GDP in 2007) to a surplus in recent years. Export market share of Bulgaria developed almost the same way as that of floating-rate Poland, and better than that of the Czech Republic and Hungary.

Clearly, eurozone membership (or the use of a fixed exchange rate) was not a factor determining economic success in Central Europe. There were both good and bad macroeconomic performances in both the flexible and the fixed exchange rate regimes of Central European countries. The implication is that the Czech Republic, Hungary, and Po- land, as well as the other Central European “outs,” could be successful both with and without the euro.

The Maintenance of Healthy Fiscal Positions

Much more important than euro membership is the prevention of the build-up of macro vulnerabilities, like large foreign indebtedness and bank balance sheet fragility. Policymakers should develop tools to address such imbalances if they happen to occur. Macroprudential policy and sustainable fiscal policy should have key roles in prevention, while flexible labor and product markets should help the adjustment if such imbalances occur.

Another important point is the maintenance of healthy fiscal positions, so that fiscal policy can facilitate stabilization in an economic downturn. The Maastricht fiscal criteria (public debt must be less than 60% of GDP; budget deficit less than 3% of GDP) are unsuitable for assessing the healthiness of fiscal position. For example, Ireland and Spain had budget surplus- es and a debt-to-GDP ratio of only 25-40% in 2007, yet a few years later the public debt ratio soared to close to—or even above—100% of GDP. Instead of focusing on these headline fiscal numbers, it is of greater importance to analyze the underlying weaknesses of fiscal positions—such as an excessive

Macroprudential policy and sustainable fiscal policy should have key roles in prevention, while flexible labor and product markets should help the adjustment if such imbalances occur.

reliance on certain revenue streams (like those coming from the construction sector in Spain and Ireland before 2008); the existence of economic vulnerabilities, which might undermine fiscal revenues; and the sustainability of public expenditures, like pension and healthcare systems, in light of demographic changes. These lessons are equally important for countries both inside and outside the eurozone.

Eurozone Entry Is More of a Political Than an Economic Decision

The Maastricht criteria are clearly inadequate for assessing a country’s readiness to join the eurozone, but due to legal reasons they have to be met. The level of economic development is also an irrelevant factor in the eurozone entry decision; as I argued, a number of less-developed Central European countries experienced overall favorable macroeconomic developments under the euro or a fixed exchange rate. Likewise, the possible pre-accession financial instrument that the European Commission will likely soon propose

The Maastricht criteria are clearly inadequate for assessing a country’s readiness to join the eurozone, but due to legal reasons they have to be met.

is not relevant for the entry decision. At best, such a financial instrument could provide a relatively small amount of money, which should not play any role in the major decision of whether to join the eurozone or not. Furthermore, Central European countries receive about 3-5% of their GDP from the EU budget—even if that would be lower in the EU’s next Multiannual Financial Framework of 2021-2027, which further underlines the irrelevance of a relatively small amount of pre-accession instrument.

Similarly, the future reform of the euro, or the ability to influence it, is not a relevant issue from the perspective of euro adoption. The euro’s architecture has been significantly improved since 2008—most importantly by the establishment of the Banking Union, which should reduce the likelihood of the build-up of financial sector vulnerabilities and help to address them should they occur. The development of the EU’s Macroeconomic Imbalance Procedure can foster discussions about emerging vulnerabilities, which is helpful in avoiding the repetition of the pre-2008 fate of southern eurozone members.

Eurozone entry is therefore more of a political than an economic decision. In economic terms, Central European “outs” could perform well both inside and outside the eurozone.

Given that growth has returned to the eurozone, including Southern Europe, eurozone politicians might not feel the urgency to make further major reforms. In short, the eurozone has become much better than it was before 2008, and no major changes to euro governance are expected.

Eurozone entry is therefore more of a political than an economic decision. In economic terms, Central European “outs” could perform well both inside and outside the eurozone. Nevertheless, the EU is not only about economic bene ts. The EU represents our shared commitments to European values, such as the respect for human dignity and human rights, freedom, democracy, equality, and the rule of law. These values, as well as our striving for peace and the well-being of citizens, define the EU. The euro is the EU’s currency. The legal commitment to introduce the euro must be honored, a step that should also strengthen members’ commitment to European values.

Zsolt Darvas

is a Senior Fellow at Bruegel. He is also a Senior Fellow at the Corvinus University of Budapest and the Institute of Economics of the Hungarian Academy of Sciences. He was previously Deputy Head of the research unit of the Central Bank of Hungary and was a Research Adviser to a financial research group in Budapest. His research interests include macroeconomics, international economics, central banking, and time series analysis.

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