Wednesday, December 06, 2006

Rather Impudent After Lithuania Rejection

Next year, Slovenia will be the 13th EU country that will formally be part of the Euro zone. In addition to that, there are a number of smaller European countries which have unilaterally started to use the euro as currency, like Andorra, Monaco, San Marino, Montenegro and Kosovo. Also, Denmark and all Eastern European EU states except Poland, the Czech Republic and Hungary have pegged their currencies to the euro, which in effect forces them to follow the monetary policy of the ECB.

Yet that leaves 12 EU countries that do not use the euro, of which only two (Britain and Denmark) have an opt-out that permits them to continue to do so. Now the EU Commission and the ECB will issue a report which criticizes the remaining 10 states for not doing enough to meet the criteria for joining the euro.

But while it is obvious that Sweden is dragging its feets for purely political reasons (the no-vote in the 2003 referendum) and while particularly Hungary have pursued extremely irresponsible fiscal ( with a budget deficit of 10% of GDP) and monetary policies, it is quite impudent for the EU Commission to criticize Lithuania and the other Baltic states, after rejecting Lithuania on extremely flimsy and invalid grounds earlier this year.

As I explained at the time, the reason why the Baltic states have so high inflation is because they have extremely high economic growth and fixed exchange rates versus the euro. Because high economic growth drives up land prices and wages in the non-tradable sectors of the economy, high economic growth will inevitably raise the real exchange rate. This can be achieved either by a higher nominal exchange rate or by higher price inflation. Yet the EU Commission demands the for the Baltic states impossible combination of fixed exchange rates and a moderate consumer price inflation rate.

The only way the Baltics could lower their inflation rate while keeping a fixed exchange rate would be to either wreck their economies through statist policies or to start adopting the kind of currency market interventions used by China and some other countries, where the central bank accumulates massive foreign reserves which are later "sterilized" to limit domestic price inflation. The first alternative would be bad for quite obvious reasons, the second would probably not be permitted by the EU.

For reasons that I explained earlier, admitting the Baltic states would certainly be in the best interest of both the Baltic states and the existing euro zone members. I suspect that the real reason why the EU have suddenly started care about the formal rules (which they have ignored in the past, for example with regard to the excessive budget deficits in Germany and France) is that with their higher growth and higher inflation, admitting the Baltics would raise both aggregate Euro-zone growth and aggregate Euro-zone inflation. That in turn would force the ECB to pursue a less inflationary monetary policy, which I think would be a good thing, but which most politicians think is a bad thing.


Blogger Flavian said...

I think you oversee the fact that a country can have a low real exchange rate, a fixed nominal exchange rate and yet very moderate domestic inflation given that the currency is pegged to something secure. (I admit that there will be a tendency towards slightly higher domestic inflation in countries with low real exchange rates in comparision to those with a higher real exchange rate in any system of fixed echange rates.) Still a large portion of the domestic inflation problems in the baltic countries are related to the fact that they peg their currencies to a weak inflationary currency.

With gold as nominal anchor I think that they could maintain a low real excahnge rate, a fixed rate against gold and still very moderate domestic inflation.

10:16 PM  
Blogger stefankarlsson said...

Flavian, first of all, you seem to be discussing something sligthly different than I, namely initial real exchange rates and their effects on domestic inflation given fixed nominal exchange rates. I was discussing the effects of economic growth on real exchange rates, an issue which in principle is different.

But I agree with you that it would be better for the Baltic states to link their currencies to gold rather than euros. But, unfortunately gold is not a politically realistic alternative. And if we compare the two politically realistic alternatives, namely status quo with national Baltic currencies pegged to the euro or introduction of the euro as currency in the Baltic states, the latter would be preferable for two reasons. First because it would eliminate transaction costs and secondly because the inclusion of the Baltic states into the Euro-zone would force the ECB to pursue less inflationary monetary policies.

11:22 PM  
Blogger Flavian said...

What I wanted to point out is that some countries under a fixed rate regime face three problems.

1. If the initial exchange rate is low as the currency is pegged to something else, there will be a tendency towards appreciation of the real exchange rate by means of domestic price inflation. That could occur even under a gold standard.

2. The second problem is that if one country pegs it's currency to something inflationary and the other to something secure it seems to be the case that the country pegging it's currency to something less secure will see a tendency towards a higher real exchange rate than the country pegging it's currency to something more secure. I am looking for empirical evidence for this guess.

3. The real exchange rate seems to soar under protectionism and fixed exchange rate, due to the fact that if imports are held back the domestic money supply will expand instead of being "exported" to pay for imports making the country even less competitive.

My conclusion is that optimum is to peg to gold and go for 100% free trade and also that it may be the case that you overestimate the impact of growth on the real exchange rate. I think that there are some studies indicating that Britain was the richest country of the 19:th century and that still Britain had a very low real exchange rate in comparision to other gold standard countries.

Still, when you argue that a full participation in the eurozone by the baltic countries would force the ECB to tighten monetary policies you are perfectly right. The key reason for this is that the Baltic countries have lower real exchange rates than for example Germany. This might also be a reason for some inflationists to refuse the Baltic countries full membership in the euro zone.

The price of one Big Mac in terms of euros in the Baltic countries in comparision to Germany clearly indicates this difference in real exchange rates.

The sum of my argument is that the impact of growth should not be overestimated.

12:30 AM  

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