EU Would Be Foolish To Bar Lithuania From the Euro

Next week, the EU Commission will present its opinion about whether or not the two countries that have applied for entry into the euro-zone in 2007, Slovenia and Lithuania, should be admitted. They are widely expected to recommed approval of Slovenia's application, but recommend denial of Lithuania's application. Estonia and Latvia had wanted to join by next year too, but they gave up in advance knowing their inflation was too high to have any chance of approval.

The reason given for denying entry to Lithuania is that Lithuania had a too high inflation rate, 2.7% on average in the 12 months to March 2006, compared to the upper limit of 2.6% derived from adding 1.5% to the 1.1% average inflation rate of the three lowest inflation countries in the EU -Poland, Sweden and Finland- that month.

Lithuanian officials have protested that apart from the breach being so small (just 0.1%), this was calculated from a mean that included the two non-euro countries Poland and Sweden. Had they instead used the 1.5% average of the three lowest euro-zone countries -Finland, Holland, Austria-, they would have made it. Jean-Claude Juncker, head of the eurogroup agreed with them and said that it should be based on the average of the three euro-zone countries with the lowest inflation. Since it is ultimately EU finance ministers and not the EU Commission that decides, it is still an open question as to whether Lithuania will be admitted or not (That they will follow the recommedation to admit Slovenia seems like a foregone conclusion).

Many Lithuanians would also add the hypocricy of shutting out Lithuania over a mere 0.1% in inflation when three existing euro-zone countries (Spain, Greece and Luxembourg) had even higher inflation than Lithuania yet they are not thrown out of the euro-zone. Similarly, countries like Greece, Portugal, Italy, Germany and until recently France have regularly ignored the 3% of GDP budget deficit limit, yet they are not punished in any way.

But the more fundamental issue here is not really whether Poland and Sweden or Holland and Austria should be used as comparison, nor whether new applicants are put to a higher standard than existing members, the most fundamental point is that the whole inflation criteria really makes no sense.

When some country or some region have higher real growth rate than others, they usually tend to experience a higher real exchange rate. This could either express itself as a higher nominal exchange rate or as a higher inflation rate (or a combination of the two). And as Lithuania whose growth is the third highest in the EU after its fellow Baltic countries Estonia and Latvia have a fixed exchange rate versus the euro, this means that they must have a higher inflation rate than the rest of the EU. This relatively higher inflation is very much a natural process, similar to how any adjustment within a fixed exchange rate system, including the free market monetary system known as the gold standard, would operate (Although due to the ECB's far too loose monetary policy, the absolute level of inflation is too high). This ois similar too how fast growing Ireland, Spain, Greece and Luxembourg within the euro-zone experience higher inflation than the more stagnant parts of the euro-zone.

As the relative difference in inflation is natural and more or less unavoidable for fast growing countries given the fixed exchange rate that is also a requirement, this criteria makes no sense at all and it will effectively shut out all rapidly growing countries like the Baltics. That might perhaps be intentional as inclusion of these countries would raise the average of both real growth and inflation for the Euro-zone and thus make the ECB raise rates faster. But given how small these countries (The economies of the three Baltics are together smaller than Ireland) are, they won't make much difference in the aggregate Euro-zone statistics and in any case, it would only be healthy both for the existing Euro-zone countries and for the Baltics (who due to their fixed exchange rates have to follow ECB policy anyway) if the ECB raised its far too low interest rates.

By shutting out the Baltics, the ECB is only hurting the reputation of the Euro who despite Ireland, Luxembourg, Greece and Spain, is associated with low growth due to the weak growth in Germany and Italy. Were the Baltics included (Which they de facto already are with their fixed exchange rate) the Euro would too a higher extent be associated with high growth, something which would help them convince voters in the U.K. and Sweden to join. Not that this would be a valid line of argument. The Euro per se have very little effect on growth, and Ireland and Estonia would be successful with or without the euro, just as Germany and Italy would be unsuccessful with or without the euro. But despite not being really valid, it would still be effective in public perception as most people are still convinced by such associations of one economic factor and economic success.