Atlantic Community:Open Think Tank Article "Will the Global Financial Crisis Affect EMU Enlargement? "

Will the Global Financial Crisis Affect EMU Enlargement?

C. Fahrholz, J. Börner and C. Wójcik: The current global financial crisis is creating new challenges for the European Monetary Union (EMU) that may threaten its credibility, its enlargement through the addition of member nations and even put the long-term stability of the euro at risk. The European Union must create new institutions that can balance short term needs during the crisis with long term sustainability.

When the euro was launched in 1999, most experts believed that the new policy
regime would be conducive to economic discipline. Many had hoped that by increasing price transparency and cross-border trade, the euro would force reluctant European Monetary Union (EMU) members into structural reform. However, as time has passed, this hope has proved too optimistic.

Structural fiscal deficits in the euro area have tended to deteriorate since the introduction of the currency and there is evidence of reduced appetite for structural reforms. Since the beginning of the global financial crisis, the financial situation of EMU-member countries has worsened further and governments all over Europe have spent billions of euros on attempting to mitigate the blow to their economies.

At the same time, these countries have also tried to assist some EMU applicant countries by providing additional financial rescue packages (directly or indirectly through the IMF), as borrowing funds in capital markets has become increasingly difficult for some EMU candidates. While these policies have cushioned against
short-term detrimental effects of the global financial shock, they may create negative political economy spillovers and moral hazard problems in the long-run.

As enlargement of EMU will increase its diversity, it is possible that some EMU member states may try to exert political pressure on other nations to provide additional financial bail-outs, possibly threatening the sustainability of the monetary union. The effectiveness of such pressure will depend on the magnitude of the economic woes and the size of the given country, as well as hinge upon the capabilities to form coalitions with other affected countries.

The provision of rescue packages (as has recently been the case with, for example, Hungary, Latvia, and Romania) would create an extra fiscal burden for EMU members. The costs of a bail out, in turn, would add to the risk of an inflationary debt, which would have a negative effect on the monetary policy credibility and thus price stability within the euro area.

Eventually, the increasing fiscal burden paired with high inflation may reduce the advantages of some EMU members of sticking to the euro. As the opportunity costs of possibly deteriorating price stability within the euro area decrease, not only individual exits but an entire breakdown of EMU will become more likely.

While all European countries will face short-lived costs in the course of the financial crisis, the long-run costs in terms of deteriorated monetary credibility particularly concerns EMU-members. The latter costs occur in the form of a surge in inflation rates and country-risk premium due to ever increasing levels of fiscal debt. It is therefore in the long-term interest of the European Union, to create an institutional set-up that would balance the needs for short-term flexibility with the demands of long-term sustainability demands - particularly, by effectively preventing the possibility of inflationary debt bail-outs.

The increasingly exposed structural deficits of EMU members and applicants will result in more pressure on the already battered Stability and Growth Pact. It remains to be seen, whether the global financial crisis will wreck the sustainability of the euro area and the ambitious goal of unifying Central and East Europe economically.

Christian Fahrholz is Chair of Political Economy at the University of Mannheim. Julian Börner is Junior Researcher at the Chair of Political Economy, University of Mannheim. Cezary Wójcik is at the Polish Academy of Sciences.

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June 24, 2009

Marek Swierczynski, journalist at TVP, Diamond Contributor (1090)

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The greater the toll that the crisis takes on European public finance systems, the more apparent it is that the EMU enlargement plans will have to be adjusted if not put on halt until the situation gets stable again. Or until the EMU accession rulest ie. the Maastricht criteria are amended. But from what is offcially said, there is little hope for the latter to become reality. The opposite is likely to happen: in order to reduce the risk, the EMU rules may be tightened but not eased. And as deficits go beyond the 3% level, it is unlikely that any EMU enlargement takes place soon. The largest of the EMU hopefuls, Poland, has just announced increasing of this year's budget deficit by a half, raising it to approximately 6% in relation to the GDP. Next year the figure is expected to be more than 7%. According to the European Commission It is unlikely that Poland meets the Maastricht criteria before 2013, whereas the government planned to be euro-ready in 2012. It became clear that a window of opportunity for joining the euro-zone has closed for a few years.

June 24, 2009

Donald Stadler, Self-employed, Diamond Contributor (1052)

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I think the Euro is having a similar effect within the EMU as the Chinese policy of keeping the yuan low against the dollar is having - it actually prevents structural reform and prevents the market from operating efficiently. Until the crisis it did this, anyway.

Without the EMU we would have seen the value of the DM soar against most other EU currencies - as the euro has increased against non-euro currencies like the British pound and the prospective EMU entrants from Eastern Europe.

Similarly the yuan would have risen against the dollar in recent years had the Chinese authorities permitted, and instead of the credit crisis we would have seen a gradual shift with the US exporting more into China, and importing less. The balance of payments would have moved toward equilibrium.

I have sympathy for the plight of China and Germany, but the fact is that frozen or manipulated exchange rates do not work well over long periods without adjustment unless there are mechanismes to relieve the pressures.

Within the US those mechanisms are a common culture & languiage and the lack of any internal trade barriers and the lack of barriers to the movement of labor. That includes barriers of cul;ture and language as well as legal barriers.

Within the 'dollarzone' (that is the countries who peg their currency to the dollar) things work less well. But those countries can abandon dollar pegs to devalue if they need to.

The problem within the Euro is that the weaker EMU members cannot abandon the euro peg and devalue as they need to do. So it's radical structural reform or nothing for them; and that kind of reform has deep human costs.

The US has been reluctant to force the issue with Chinese curency manipulation, but heavy stimulation spending may amount to a de-facto devaluation of the dollar against the yuan. CHina objects emphatically. But China is in effect demanding that the US government join CHina in manipulating the dollar-yuan exchange rate at an unsustainable level, a level which strongly disadvantages the competitiveness of US capital and labor.

Chances are the US government won't do that. Not unless it has much better reasons to act that way than any advanced to date - by China or anyone else!

June 24, 2009

Donald Stadler, Self-employed, Diamond Contributor (1052)

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Addressing the main issue - I would submit the answer is obvious; how could the crisis NOT impact EMU enlargement plans? Massively, I'd say. Look at the major potential entrants in Eastern Europe. Is there a single one whose finances and exchange rate hasn't suffered major blows in the past year? Assume that the UK decided to join the Euro at long last. At what level would it join? The traditional exchange rate of about 1.50 euro to the pound, or the curent level of about 1.10 euro to the pound?

That is an impact!