Lesson #1: EMU entry should not be rushed, time should be left for real convergence.

For new accession states, the introduction of the common currency is not just a right but is also an obligation, as these countries do not have an opt-out option, like the United Kingdom and Denmark do.

Until the onset of the global economic crisis, the dominant view among new EU members had been that the adoption of the common currency should occur as soon as possible. One of the main arguments for adoption was that the rules governing the monetary union would automatically result in fiscal discipline. Several studies aimed to prove the quantitative and qualitative benefits of euro adoption, having assumed that the satellite states around the EMU match Mundell’s OCA criteria, i.e. they form an optimal currency area with the eurozone. There were other authors (Frankel and Rose, 1998) who even declared that countries which are less OCA-compatible should also join, as membership could accelerate their integration and make them more apt for membership in the currency union.  (Of course, it also has to be mentioned that there are studies, which argue that the EMU itself is not an optimal currency area either).

Even well before the crisis, there were experts who had argued just the opposite: they had claimed that forced nominal convergence means great sacrifices, that ample time should be left for real convergence, and that the constraints of the common currency should only be accepted once the economy is fully prepared for them. Such opinions against the „rush for the euro”, however, clearly represented a minority view.

It has become obvious based on the sovereign debt crisis of the periphery that the common currency could be not just a blessing but also a curse for economies that were not fully prepared for it. The starting positions of Greece, Ireland, Spain and Portugal were very different, but it is still not a coincidence that it was these countries that had to face the most severe problems. The peripheral countries in question are less developed, have a higher potential growth rate and a more elevated equilibrium level of inflation. 

In order to join the currency union, these countries gave up their monetary independence, while other branches of economic policymaking remained under national jurisdiction. The interest rate that was appropriate for the most advanced countries, particularly Germany, proved to be too low for the fast-growing periphery and led to the overheating of the real estate market, lending markets and consumption, thereby resulting in severe external imbalances.

Meanwhile, the euro concealed accumulating tensions within these economies, the forming imbalances were hidden from the public eye for a long time (or, perhaps, market players and European authorities chose to ignore them). When the crisis made it obvious that the process was unsustainable, it was already too late.

Another great lesson from the crisis is that if a community of sovereign states creates a monetary union and uses a common currency, this common currency will not be a national and internal currency for any of its members. This practically means that if there is a „no bailout” clause, then, differently from the view that has prevailed before, any member of the monetary union can become insolvent. The EMU was completely unprepared for this almost evident eventuality.

Under these circumstances, it is not surprising that a fundamental shift can be seen in accession strategies around the region (admittedly, the monetary union would also be less prone to welcome newcomers). The earlier minority view that real convergence should be a more emphatic element of the accession process has, by now, become dominant.

A country should not seriously consider the introduction of the euro until its economy has reached a certain degree of real convergence. The ordeal of peripheral countries clearly shows that a „one-size-fits-all” monetary policy is not optimal for emerging economies and early accession can lead to grave conflicts.

According to the Balassa-Samuelson effect, productivity improvements in various sectors of a converging economy differ in their extent. In sectors producing tradable goods, the growth in productivity is faster than in sectors producing non-tradable goods. The rise in productivity in the tradables sector drives wages higher, which, however, does not cause any deterioration in relative productivity. Higher wage growth in the tradables sector, however, trickles through into the non-tradables sector, where the growth in wages does exceed the growth in productivity, thereby leading to inflation. Studies prove that the traditional Balassa-Samuelson effect works within the EMU as well (Szapáry, 2000) but in converging economies there is an additional effect. This effect has not been talked about before and we could name it “the reverse Balassa-Samuelson effect”. Unified monetary policy (which is too loose for faster-growing economies) results in excessive credit demand in the non-tradables sector, hence the sector’s labor-market demand picks up, wages rise, which also passes through into the tradables sector, thereby worsening productivity. This, in turn, manifests itself in the deterioration of external balances.

If independent monetary (and economic) policy is not available to maintain a balanced economic path both on a micro and a macro level, then processes can sooner or later become uncontrollable. Consolidation efforts can be much more painful and, surely, more time-consuming in the absence of an independent exchange rate and monetary policy.

Lesson #2: Fiscal discipline is necessary but it is always external balances that represent the true constraint.

It has been signaled in the past by various economists and has also become evident even in practice that the rules governing the Union and the Monetary Union (the Stability and Growth Pact and the Maastricht Criteria) are overly simplistic, inconsistent and that even a formal adherence to the rules does not necessarily play a stabilizing role. In fact, the rules are especially inappropriate for economies located on the periphery of the Union, which have a higher potential growth rate, including the converging countries. Instead of having a stabilizing role, the rules have led to the formation of imbalances.

The main deficiency of the system was that it equated financial stability with fiscal equilibrium, while almost fully ignoring the question of external balances. Unfortunately, the crisis has verified views, which had been minority views in the past, that the sustainability and financeability of external positions represents the real policy hurdle. In terms of the sustainability of an economic trajectory, the key question remains the position of the current account and the capital account (i.e. the net domestic savings and investment balance and the ratio of total debt to GDP). Therefore economic policy should not focus single-mindedly on fiscal equilibrium, as growth in private-sector debt represents risks that are similar to those posed by public-sector indebtedness.  

The SGP has been reformed as a result of the crisis: rules pertaining to fiscal budgets have been strengthened, the Pact now includes a rule on debt and a framework has been created for monitoring and sanctioning excessive imbalances. The changes point in the right direction, since they take into account the fact that a common currency and a shared monetary policy cannot be successful if other branches of policymaking (especially fiscal policies) are not tightly coordinated. The emphasis, however, is still mostly on the fiscal position. Policy-setters in EU states should learn from past lessons: economic policy should be set in a way that the sustainability of external balances is also maintained. 

Lesson #3: Harmony between fiscal and monetary policy is key; monetary policy cannot focus exclusively on inflation

The crisis has taught some serious lessons to monetary policymakers as well. Over the past decades, inflation targeting has become the single most dominant monetary-policy framework. External factors have contributed greatly to the success of this system, which was mainly observed in large, closed economies. Inflation remained stable without practically any special effort made by central banks during the period of the „Great Moderation”. Thus the achievements related to inflation are not just attributable to central banks’ activity, but they also came about largely as a spillover of globalization. Paradoxically, it was global imbalances that contributed greatly to controlling inflation in the short term.

It was, however, undoubtedly the responsibility of central banks that they focused single-mindedly and exclusively on inflation and shaped their monetary policies accordingly. As they celebrated short-term successes in the fight against inflation, they did nothing to tackle problems related to severe external imbalances, unsustainable debt accumulation, credit expansion and asset price bubbles, which arose in several countries.

Therefore, the main lesson for central banks was that much more attention would have to be devoted to matters regarding financial stability. The rate of inflation should not be the only targeted indicator (especially not short-term CPI developments), as successes reached in one area can easily lead to severe damage in others. (In small open economies, which use their own currency, it is clear that excessive external imbalances could be nicknamed „inflation”.) The security and economic benefits of the currency union can result in severe external imbalances and consolidation can only occur through an internal devaluation, which, in turn, can lead to an equally risky phenomenon: deflation.  Additionally, the feasibility of such consolidation measures is not entirely clear and these programs can also be rather time-consuming.

Hungary’s painful case shows what can happen when coordination between the two branches of economic policymaking breaks down. Differently from popular belief, it was not just fiscal policy that played a role in the formation of imbalances and the undermining of financial stability in Hungary, monetary policy also had its own responsibility in the process. The National Bank of Hungary ’overtightened’ in order to counteract loose fiscal policy and to reach its inflation target at all costs. The maintenance of overly strict monetary conditions is even harder to defend when we take into consideration the fact that the turn in fiscal policies had taken place earlier on and significant consolidation had begun to take place.

The elevated domestic interest rate and the belief that the central bank will not allow for a depreciation of the forint (as that could jeopardize the achievement of its inflation target) was a strong incentive for growth in FX-based private-sector indebtedness. This process caused a drastic deterioration in the external position of the economy, thereby boosting the country’s vulnerability. Although the Hungarian crisis did not turn out to be fatal, we will still have to live with the consequences of FX-based private-sector indebtedness for a number of years.

Lesson #4: In the case of economies with liberalized capital accounts, the ’regulation’ of capital flows is fundamental

The use of unconventional tools could come in handy in the regulation of capital flows not only in small, open economies similar to Hungary but also in larger economies. If capital flows cannot be constrained within the appropriate limits, control over inflation, credit growth and the external position becomes impossible and significant disequilibria come to life within the economy.

Seeing the consequences of the rapid growth in FX-based indebtedness in Hungary, it is evident that allowing transactions between residents in foreign currencies is not advisable. A clear banning of FX-based transactions should be considered or, if this is not possible, such transactions should be limited to the anchoring currency.

Summary

Looking at the way in which the eurozone is entangled in the crisis, it is understandable that the drive for euro adoption has subsided and that new entrants would be less welcome at this point in time. It is still indubitable, however, that euro adoption in a small open CEE economy is desirable at an appropriate point in time. Economies in the CEE region have integrated so deeply into Europe that staying outside the monetary union for an extended period of time could cause more harm than good in the longer term and could conserve the relative lag in their development.

One has to reject the illusionary notion that the monetary union represents some kind of special protective shield, one that provides unilateral benefits, resolves all problems of an economy, enforces fiscal discipline, prevents the overheating of the economy and, with time, makes risk premia disappear automatically. The crisis has proved just the opposite: severe imbalances can also take shape within the currency union, insolvency remains a real potential risk even for EMU members, and the correction of imbalances might take much longer and can be much more painful in the absence of an independent monetary and exchange rate policy. Constraints within the currency union also make the operation of „demand management” (meant in a traditional sense) more challenging.

It is of utmost importance to countries heading towards the EMU that their accession take place at the right moment in time. During the preparations, much greater emphasis should be laid on real convergence than had been customary and required before. Taking on the limitations and benefits represented by the common currency only makes sense once an economy is competitive and economic policy tools are available to ensure not just fiscal, but also external stability.

György Surányi is CEO and Chairman of CIB Bank and former President of the Hungarian National Bank between 1990-1991 and 1995-2001. gsuranyi@cib.hu