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To Euro or Not To Euro: From the Enlargement of the European Union to the Enlargement of the Euro

To Euro or Not To Euro: From the Enlargement of the European Union to the Enlargement of the Euro. Larry Neal Professor Emeritus of Economics University of Illinois Research Associate, NBER Visiting Professor, LSE. St. Antony’s College Oxford University January 30, 2006.

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To Euro or Not To Euro: From the Enlargement of the European Union to the Enlargement of the Euro

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  1. To Euro or Not To Euro:From the Enlargement of the European Union to the Enlargement of the Euro Larry Neal Professor Emeritus of EconomicsUniversity of IllinoisResearch Associate, NBERVisiting Professor, LSE St. Antony’s CollegeOxford University January 30, 2006

  2. Outline: Enlargement of the EU • The problems of transition, 1990-2005 Washington consensus Copenhagen criteria • Varieties of solutions National experiments International initiatives • Assessments Growth rates Inflation rates Unemployment rates • The Great Divide – Brussels 1, Washington 0

  3. Outline: Enlargement of the eurozoneAnother transition? • Initial problem Maastricht criteria transition goals • Balassa-Samuelson effects Irish & Greek examples Potential problems in CEEC • Assessments revisited • Conclusion?

  4. The Initial Problem: Transition Economies • Collapse of central planning administration • Loss of legitimacy of existing government • Uncertainty over contracts • No property rights Result: Criminalism was the transition from communism to capitalism!

  5. Initial Solutions • The Washington Consensus 1. Stabilization 2. Privatization 3. Liberalization (All to create market incentives; failed to create sustainable finance) • The Copenhagen criteria 1. Political 2. Economic 3. Administrative(All to delay entry and deny disruption of existing arrangements of EU)

  6. Eventual Solutions: US & EU approaches complementary • EU’s acquis provides institutions for US approach • Foreign Direct Investment Vouchers Joint ventures • Domestic Investment Vouchers Trade credit Bank lending • Monetary policy re:exchange rates

  7. Assessments: • “Shock treatment” worked to create growth in Poland, but with enduring costs of unemployment • Currency boards worked to curb inflation, but at expense of growth • Acquis of EU helped promote FDI & growth • Gradualism (Czech case) not working

  8. Lessons from Previous Enlargements? • Ireland & Greece entered quickly; exploited EU redistribution policies – CAP & structural funds • Spain & Portugal kept out even after democratic reforms • Results: Ireland & Greece stagnated without structural reforms after entry; growth only after major institutional reforms in each case Spain & Portugal expanded rapidly after entry, having made reforms before entry

  9. Lessons from previous enlargements for accession countries • Mobilize domestic savings for domestic investment Use a variety of financial institutions Allow competition from foreign banks Monitor uses of funds publicly • Establish and enforce property rights to allow ease of transfer & of use as collateral • Allow repatriation of foreign investment • Adoption of euro not sufficient, and maybe not necessary

  10. Results to Datefor accession countries • Trade opening rapidly, mostly with the EU • Import deficits continue, even in agriculture • Implies continued foreign direct investment • Comecon trade becoming more intra-industry trade, but still more vertical, than horizontal(so EU firms taking advantage of low wages and taxes, not comparative advantages) • Baltic trade still inter-industry, not laying basis for domestic structural change • Varied exchange rate policies

  11. When to Join the Euro? • All accession countries will adopt the euro, eventually. • They must meet Maastricht criteria stable exchange rate for 2 years inflation w/in 1.5% of lowest 3 rates interest rate w/in 2.0% of lowest 3debt ratio less than 60% GDP deficit ratio less than 3% GDP

  12. Current Eurozone • Only 12 countries now use the euro • Denmark and Sweden have opted out in popular referendums • United Kingdom is not ready to vote • All 3 doing better economically than most of eurozone • Germany, France, Italy all violate Stability and Growth Pact

  13. Accession to euro? • None of the accession countries have high debt ratios, most have low deficit ratios • Public finance argument does not hold for them • Inflation rates vary now, some lower, some higher than 2+% of eurozone • If join EMU, inflation rates should be higher (Spain, Portugal, Ireland) • Balassa-Samuelson effect depends on fixed exchange rates

  14. Definition of Balassa-Samuelson Effect • The Balassa-Samuelson effect depends on inter-country differencesin the relative productivity of the tradable and non-tradable sectors. • Summary of the empirical effect to be explained • The exchange of tradable goods & services should lead to price converge, but convergence is only partial, because some products are not tradable. (Software development is an example tradable service.) The interesting Penn effect is that the RER deviations usually occur in the same direction: where incomes are high, prices are relatively expensive compared to an international average, and where they are low, the CPI tends to be below the average. • Basic form of the effect • If productivity gains against foreign countries are concentrated in the tradable sector, the domestic relative price of non-tradables will increase, and as the relative average price rises the RER appreciates. If typical productivity gains are concentrated in tradables, high productivity will ultimately be correlated with high RER. • In economic growth theory it is generally postulated that productivity is increasing, so the Balassa-Samuelson effect is usually stated as: "The traded goods sector has a higher productivity growth than the non-traded goods sector, leading to higher relative non-traded goods' prices". Since traded goods' relative prices are constant (at PPP), but non-traded goods' relative prices are higher, the CPI rises with average productivity growth.

  15. Results to date for member countries • Maintaining current system of redistribution of agricultural subsidies and regional funds • Countries with high taxes and rigid labor markets losing employment to accession countries and elsewhere (Germany, France, Belgium) • Confronting capable political leaders in accession countries with different visions for the future(a result of their long preparation!)

  16. Conclusions? • Other decisions more important than euro • Tax regime • Legal regime • Financial sector • Banking reforms will take time and experience, euro will help • Credible gov’t debt will help

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