Comments on “Two Roads to the Euro: The Monetary Experiences of Austria and Greece,” by Mitja Gaspari
- Susan Schadler
- Published Date:
- April 2005
Policymakers from one country study other countries’ relevant prior experiences. As their country prepares to enter the euro area, Slovenia’s policymakers have shown particular interest in the case of Austria, neighbor country, and the case of Greece, the newest country to join the euro area. Slovenia is similar to Austria, especially in economic structure; Slovenia is also similar to Greece in level of real convergence and inflation development.
In looking at Hochreiter and Tavlas’s paper from a Slovenian perspective, I will address several questions. When should Slovenia give up its own currency, the tolar, and adopt the euro? What should be the monetary policy for Slovenia prior to and during participation in the Exchange Rate Mechanism II (ERM II)? What should be the optimal policy mix supporting the monetary policy in the run-up to euro adoption? What are the risks of ERM II participation?
Assessing the Readiness for Euro Adoption
Maastricht criteria are intended to guide the assessment of readiness for euro adoption for each country. The criteria summarize substantive arguments regarding the readiness of Slovenia and other countries to adopt the euro as the common currency. Beyond the Maastricht criteria, two relevant economic theories can be specified: the theory of optimum currency areas and the Ballassa-Samuelson effect in connection with the catch-up process.
First, based on the theory of optimum currency areas, Slovenia is ready to adopt the euro.
Slovenia’s small size facilitates integration. Because of its small size, Slovenia is unlikely to jeopardize the efficiency of the common monetary policy operated by the European Central Bank (ECB). Slovenia’s economy is tiny in relation to the other countries, representing only between 0.3 percent (at constant prices) and 0.4 percent (in Purchasing Power Standard, PPS) of total European Monetary Union (EMU) gross domestic product (GDP).
Purchasing power indicates a comparable level of development. The fact that Slovenia’s level of income per capita is comparable with that of some EMU countries (Figure 4) ensures that the EMU’s homogeneity will not be substantially changed by Slovenia’s entry and therefore that the ECB’s common monetary policy will be no less effective.
The probability of an asymmetric shock in Slovenia vis-à-vis the EMU is relatively small because (i) there is a high degree of heterogeneity in Slovenia’s economic structure, (ii) the structure of the Slovenian economy is similar to that of the EMU countries (Figure 5), (iii) Slovenia is heavily involved in trade with the countries of the euro area (Figures 6 and 7), (iv) the business cycles are synchronized, and (v) the process of transition and structural reform is approaching completion.
Slovenia can absorb shocks independently. The maintenance of the main macroeconomic balances in Slovenia allows economic policy greater flexibility in responding to asymmetric shocks. However, the remaining elements of wage and social transfer indexation are an important factor reducing fiscal policy flexibility and hence Slovenia’s ability to absorb shocks by itself. Although some rigidities in the labor market still exist, as they do in most European Union (EU) countries, the flexibility of economic policies as well as the flexibility of labor and capital markets ensure Slovenia enough flexibility to participate in the euro area.
Figure 4.GDP per Capita, EU12 = 100, at PPS, 2001
Note: EU = European Union; GDP = Gross domestic product; PPS = Purchasing Power Standard.
Figure 5.Value Added by Activities, 2001 Figure 6.Openness (Exports and Imports), 2001 Figure 7.Foreign Trade with the EU, 2001
Second, the process of long-term adjustment should not create an obstacle to price stability (Figure 8). The main emphasis is on the finding that adjustment effects, such as the Ballassa-Samuelson effect, do not have a significant impact on inflation and the implementation of the Maastricht criteria. The associated inflationary effects will most probably last another two or three decades but will be moderate and within a range that permits the economy and common monetary policy to function normally.
Figure 8.Price Level, EU12 = 100, 2001
Monetary Policy Prior to ERM II Participation
Bank of Slovenia monetary policy will continue to be oriented toward reducing inflation. The Bank of Slovenia will take account of the need for nominal convergence and the macroeconomic factors underlying it in simultaneously determining movements in nominal interest rates and the exchange rate.
Interest rate policy prior to ERM II participation is oriented toward a gradual reduction of the interest rates differential. The underlying reduction of tolar interest rates is limited by the still relatively high domestic inflation. The Bank of Slovenia is approaching the necessary reduction in nominal interest rates in a prudent manner, since the opposite approach can lead to increased credit activity and threaten the achievement of Maastricht criteria.
Exchange rate policy seeks to help close the interest parity along with the gradual reduction in nominal interest rates. An appropriate differential between interest rates in Slovenia and interest rates in the euro area equalizes the conditions for borrowing in domestic and foreign currency. This policy is oriented toward maintaining stable long-term financial conditions without increasing inflation risk over the long run. This approach aims at restraining the motives triggering inflows of speculative capital, which in the short term could destabilize the financial market and consequently the stability of prices (Table 3). The gradual convergence of nominal interest rates is narrowing the gap between interest rates in domestic and foreign currency to the extent that stabilization of the exchange rate will be possible on entry to the ERM II. With approximately equal levels of nominal interest rates, monetary policy will be oriented toward maintaining interest parities within limits that do not give rise to speculative movements in short-term capital and consequently do not cause large fluctuations in the exchange rate. The Bank of Slovenia will try to maintain a positive level of real interest rates, which will make it possible to fulfill the Maastricht inflation criteria.
|Exchange Rate Policy||Interest rate increase||Interest rate decrease|
|Faster depreciation||Restrictive monetary policy:||UIP not respected.|
|In case of demand-determined inflation, high financing costs prevent inflationary consumption or credit expansion.|
|In the medium run:|
|Slower depreciation||UIP not respected.||Exchange rate channel disinflation:|
|In case of supply-determined inflation (cost-push), the exchange rate transmission channel may dominate the interest rate channel (no danger of demand-pulled inflation).|
|In the medium run:|
Monetary Policy During ERM II Participation
During ERM II participation, monetary policy will focus on exchange rate stability. The intention of the policymakers is not to fix the exchange rate but to stabilize it around the central parity. Slovenia does not intend to ask for the narrow fluctuation bands but will operate under the standard ERM II fluctuation bands of ±15 percent and no unilateral commitment of narrower bands. However, the aim of the monetary authorities will be to minimize the volatility of the exchange rate around the central band. The policy interest rates will be subordinated to the exchange rate policy and will be set according to the interest parity considerations.
An Appropriate Policy Mix Is a Necessary Condition for Euro Adoption
Changes in economic policy are necessary for completing the stabilization of the economy and for successful participation in the ERM II, leading to the adoption of the euro as soon as possible. Ever since Slovenia gained independence, the policy mix has been based on a restrictive monetary policy and a relatively loose fiscal policy. Within the ERM II, monetary policy will be less restrictive—it will no longer be independent—and so a more restrictive fiscal policy will be required.
Upon ERM II entry, Slovenia will gradually begin to lose monetary policy independence. The Bank of Slovenia will have to conduct an exchange rate policy in line with the fixed central parity and entry exchange rate, while interest rate policy will be subordinated to the exchange rate policy and oriented toward closing the uncovered interest parity.
In ERM II, it is most likely that the Bank of Slovenia will be forced to conduct a much less restrictive monetary policy; external circumstances mean it will actually have to conduct an expansive monetary policy. The lowering of nominal interest rates will probably mean that real interest rates will become negative because the process of real convergence will mean that Slovenia–s inflation rate will be higher than that in the rest of Europe for at least the next two decades. The expansive monetary policy and the probability of an increase in demand (because of negative real interest rates) point to the need for an adjustment across the whole range of economic policies, with the primary need being for more restrictive fiscal and incomes policies. Further reductions in inflation will thus be less and less dependent on the monetary and exchange rate policies of the Bank of Slovenia. Other economic policies will have to take over this function to curb potential demand-side and supply-side inflationary pressures.
Over the next few years, fiscal policy will play an important role in supporting Slovenia’s monetary integration. During ERM II, the public finance position and the restrictiveness of fiscal policy will be especially important factors; fiscal policy will have to take on a stabilizing role because unfavorable movements in public finances can be an important source of exchange rate instability in the ERM II mechanism.
A negative structural deficit in the general government budget means an unfavorable starting position for Slovenia in the period leading up to inclusion in ERM II, because discretionary fiscal policy measures are required to achieve a reduction in the structural deficit, and these can have a destabilizing effect on the fulfillment of the other Maastricht criteria (i.e., those concerning inflation, long-term nominal interest rates, and exchange rate stability within the ERM II framework). The need to improve public finances also arises out of the provisions of the Stability and Growth Pact (Figures 9 and 10). The large structural deficit in public finances means the automatic stabilizers have insufficient room in which to operate fully without exceeding the budget deficit limit of 3 percent of GDP, and all EU member states are bound in the medium term to achieve balanced budgets.
Figure 9.Government Deficit, 2002 Figure 10.Public Debt, ESA95, 2001
Note: ESA = European System of Accounts; EU = European Union; GDP = Gross domestic product.
Risks of ERM II Participation
ERM II participation involves certain risks. These risks can be grouped into three categories: an asymmetric aggregate demand boom, exchange rate pressures, and inconsistency between the exchange rate stability and the inflation criterion.
There is a risk that a credit-generated demand boom may occur in the ERM II. The exchange rate stability required within the ERM II implies convergence in the nominal interest rates. In Slovenia, where high interest rates reflect the need for a restrictive monetary stance, ERM II entry may therefore significantly reduce the nominal and thus real interest rates.
There is a risk that the economy may be subject to excessive capital flows generating exchange rate pressures and instability. Free capital flows may generate an excessive instability in the exchange rate, which is not in line with the exchange rate stability criterion. Capital flows are not necessarily generated by fundamentals.
There is a risk of inconsistency between the exchange rate stability and the inflation criterion. This risk arises when the stable exchange rate is not a sufficient nominal anchor for keeping inflation in line with the inflation criterion, in the case of exogenous and asymmetric supply- or demand-side shocks to inflation.
Slovenia took measures to cope with these challenges. The first and most important measure was to create awareness among all policymakers, the Bank of Slovenia, the Slovenian government, labor unions, and the general public about the need for an appropriate policy mix. In November 2003, the Bank of Slovenia and the government adopted the Joint Programme for ERM II Entry and Adoption of the Euro,26 in which policy mix is a key topic. Both institutions acknowledged that monetary policy will be less restrictive during the ERM II participation period and that other economic policies should be more restrictive. It was agreed that the fiscal policy stance would support the common objectives. The government intends to reduce its general deficit. It was also agreed that the conduct of economic policy should take account of the following elements to smooth the transition through ERM II participation:
While allowing for adjustment, administered price and other prices under indirect influence of the government should not be the source of inflation pressures.
Tax adjustments such as excise duties and tariffs should not be an important source of inflation pressures.
Implementation of budget spending should be flexible downward if downward adjustments are needed.
Wage indexation should be eliminated.
Privatization and public debt management should not be sources of pressure in the foreign exchange market.
This program is widely supported by the business community, as well as by social partners.
The second measure was to strengthen the banking supervision. First, the Bank of Slovenia stopped merging financial supervisory agencies into a single one. Second, the Bank of Slovenia adjusted the internal organization to strengthen banking supervision and established a new unit to deal with financial stability issues to complement the banking supervision department. Third, some new measures (e.g., dynamic reservations) are to be put in place to strengthen supervision and prudent banking during the ERM II.
The third measure was to increase the flexibility of fiscal and wage policy; the backward-looking indexation was abandoned and replaced by a forward-looking wage-setting mechanism.
The policy goal of adopting the euro is based on the assessment that Slovenia is able to operate efficiently in the euro area. This assessment relies on the following facts related to the Slovenian economic and policy environment:
The Slovenian economy is strong and robust enough to cope with changes in its environment and does not require special treatment by the ECB.
The probability of an asymmetric shock (a shock specific to Slovenia) is low, because the structure of the Slovenian economy is sufficiently similar to that of the European economy.
Slovenia has the ability to absorb any asymmetric shock. Although there are some rigidities in the labor market, maintained macroeconomic balances create the environment necessary for policy reactions. Fiscal policy is balanced enough and capable of responding to asymmetric shocks. However, there is a need to further modify the wage-setting mechanisms in the public sector so that they are tied to real economic developments. At the same time, there is a need for restrictive planning and control of non-investment public spending, although major steps to abolish indexation have already been taken.
The transition of the Slovenian economy to a modern market economy is nearly complete. The process of catching up with the most advanced EU states, however, will be of long duration and low intensity, with the result that there will be no major impact on the achievement of price stability in Slovenia and the euro area.
Economic policymakers are sufficiently experienced and competent to assume a portion of the responsibility for managing the euro as the common currency.
Slovenia will soon also satisfy the formal condi-tions—the Maastricht criteria—which serve as a formal substitute for economic reasoning with regard to Slovenia’s readiness to adopt the European single currency.
Slovenia’s participation in the European System of Central Banks (ESCB) will not constrain the ECB in its conduct of an effective common monetary policy, not merely because of the small size of the Slovenian economy in relation to the euro area.
On the grounds of these arguments, the Bank of Slovenia and the Slovenian government favor joining the euro area as soon as possible. Their joint objective is therefore to enter the ERM II before the end of 2004 and make the ERM II policy mix fully operational before that date. Both institutions are confident that the appropriate macroeconomic policies and a favorable macroeconomic perspective should enable Slovenia to adopt the euro at the beginning of 2007.
Eduard Hochreiter is Senior Advisor and Head of Economic Studies at the Oesterreichische Nationalbank. George S. Tavlas is Director-Advisor of the Economic Research Department at the Bank of Greece.
The 10 accession countries are Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, the Slovak Republic, and Slovenia.
Denmark and the United Kingdom have an opt-out clause, while Sweden has been excluded on technical grounds (i.e., it has not fulfilled the exchange rate criterion).
The ERM II was established by a European Council Resolution in Amsterdam in 1997. It replaced the European Monetary System as of January 1, 1999. It is based on a central rate of the currency of each participating country against the euro with a standard fluctuation band of ±15 percent. Narrower bands can be set by mutual agreement.
Council decision of May 3, 1998, in accordance with Article 109j(4), “Greece does not fulfill any of the convergence criteria mentioned in the four indents of Article 109j(1)”—that is, the inflation, interest rate, exchange rate, and fiscal criteria, as Greece still was subject to the Excessive Deficit Procedure.
Note that the use of many of these arguments by the Austrian policymakers (foremost in the central bank) preceded the emergence of the arguments from rigorous economic analysis (e.g., both the import of stability through a hard fixed peg and the “stabilization of (long-term) price expectations” surfaced in Austrian debates in the mid-1970s).
Initially (as of 1974), the policy of orienting the ATS more closely to the DEM used explicit temporary real revaluations with a view to influencing inflation expectations and anchoring them to the (low) German inflation rate.
According to OCA theory, an important requirement for a monetary union between two economies is that the economies are subjected to symmetric shocks so that a single monetary policy is feasible. For a survey of OCA theory, see Tavlas (1993). For a reformulation of OCA theory, see Dellas and Tavlas (2004). Hughes-Hallett and Piscitelli (1999) show that differences in the monetary transmission mechanism and in asset effects significantly affect economic performance despite symmetry of shocks.
One strand of recent research on OCA theory postulates a positive link between a common currency and trade integration. The basic idea underlying this hypothesis is that monetary integration reduces trading costs beyond the elimination of the costs from exchange rate volatility. Frankel and Rose (1997) argue that Countries which join EMU may satisfy OCA properties ex post even if they do not ex ante. Controversial empirical work by Rose and Van Wincoop (2001) suggests, for example, that the euro will cause trade among EMU economies to rise by more than 50 percent.
The Austrian experience stands in stark contrast to the Finnish experience despite a number of formal similarities. As had been the case in Austria, in Finland the financial sector was tightly regulated, and capital controls were in place into the 1980s. Similarly, early deregulation measures took place around 1980 (1979 in Austria and 1983 in Finland), with the bulk of deregulation and liberalization measures introduced in the second half of the 1980s. In Finland, tight regulations in financial markets were evaded by enterprises and banks, leading to speculative attacks on the Finnish markka, forcing a devaluation and a move to floating. See Hochreiter (2000).
For evidence, see Brissimis and others (2003).
The hardening of the EMS during 1987–92 gave rise to the term “the new EMS.” See Tavlas (1993).
An international investment bank reported that a devaluation of the ATS on the order of 10 percent was unavoidable because budget policy was getting out of hand and because of a massive loss of competitiveness vis-à-vis Germany. The former assertion was not credible given the good fiscal consolidation track record, and the latter assertion was based on misinterpreted statistical data.
On August 11, 1993, the bank sold DEM 2.478 billion, which at the prevailing exchange rate was US$1.5 billion.
According to the central bank’s records, interest rates for some small transactions were as high as 70 percent—and for very short-term money, even 100 percent.
Cf. Moesen and Schollaert (2003, Figures 3 and 6).
For a detailed discussion of political and economic issues surrounding Austria’s run-up to EU accession, see Handler and Hochreiter (1998).
For technical reasons, the date of participation in the ERM was January 9, 1995.
For an appraisal of the uses of the exchange rate as a nominal anchor, see Tavlas (2000). Note also the similarity of the arguments with those used in Austria in the 1970s (see the “Increasing Economic Divergence” section above).
This prohibition was mandated by the Maastricht Treaty.
Cf. the Resolution of the European Council on the establishment of an exchange rate mechanism in the third stage of economic and monetary union, Amsterdam, 16 June 1997, and Agreement of 1 September 1998 between the European Central Bank and the national central banks of the member states outside the euro area laying down the operating procedures for an exchange rate mechanism in stage 3 of economic and monetary union.
See, for example, Buiter and Grafe (1999), Eichengreen (2003), Kontomelis (2003), Padoa-Schioppa (2003), and Kopits (2004). The official position of the European System of Central Banks or ESCB, is contained in a European Central Bank press release from December 2003 (ECB 2003).
The authorities had determined that the early 1990s represented a period near equilibrium in the balance of payments.
Note that the width of the standard band has been defined in the Council Resolution on the establishment of an exchange rate mechanism in the third stage of economic and monetary union (see footnote 20 above) to be ±15 percent. In the agreement between the ECB and the national central banks, closer exchange rate links may be agreed upon on a case-by-case basis. Yet, in the assessment of the fulfillment of the exchange rate criterion, a market exchange rate “close to the central rate” will presumably be looked at, taking into consideration factors leading to an appreciation of the exchange rate. The experience of Greece might be relevant in this context.
For a lucid discussion of standard and non-standard routes to the euro, see von Hagen and Zhou (2003).
A simple credibility test based on Svensson for the two countries is contained in Hochreiter and Tavlas (2004).
Programme for ERM II Entry and Adoption of the Euro: http://www.bsi.si/html/eng/publications/europe/ERM2_BS_Vlada _200311.pdf.