Playground logic necessary for successful entry into eurozone

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Croatia is looking to join the eurozone. The National Council for the Adoption of the Euro by Croatia held its first meeting at the end of November last year to kick off preparations in earnest. The next big step, likely this year, is to determine at which exchange rate Croatia will join the European Exchange Rate Mechanism (ERMII). After a minimum of two years in that mechanism, should Croatia meet all qualifying criteria, the EU Council will decide, with input from the European Commission and European Central Bank (ECB), whether Croatia will adopt the euro. Assuming entry into ERMII during 2020 that would mean becoming a member of the eurozone during 2022, at the very earliest. Wisely, government officials have stressed there is no deadline for joining, because like an application to any club, existing members have a say. Having achieved the two crucial strategic goals of joining NATO (in 2009) and the EU (in 2013), entry into the eurozone would mean Croatia will have met another of four large strategic goals (joining the passport-free Schengen area would be the other one) that would give the country of a place in the inner circle of EU member states. In the context of Croatia holding the EU’s rotating presidency in the first half of 2020, to be followed by a general election, the confirmation of the validity of economic policy inherent in being accepted into ERM II would be an evident boon to the government and policy makers at just the right time. When I look at the presentation of the Strategy for adopting the euro, there is much I agree with, especially the rationale for economic reforms towards the end of the presentation and the illustration of the benefits in the medium to long term of implementing them effectively – in other words you give up already limited (as the central bank correctly points out) monetary policy space and lose a degree of freedom in the realm of fiscal policy, so you’d better have a more flexible economy to deal with shocks. On the benefits of euro adoption, I would broadly agree with the list provided in the presentation – improved international trade and investment prospects, elimination of currency risk, reduction of transaction costs, lower risk premia, improved price transparency, access to euro area financial assistance mechanisms. There is also merit to the argument that with such a high degree of euro savings in the economy (which I wrote about here) Croatia is well placed to adopt the euro. But I do think the proponents of euro adoption overstate their case by claiming the risk of banking and balance of payments crises is reduced because of euro adoption. Just about all euro members of Mediterranean Europe after 2008/09 would beg to differ. Given the infrastructure for a functioning monetary union is not complete, there is nothing to suggest this benefit is guaranteed. Closely related, in terms of downsides, the risk of excessive capital inflows and growing imbalances is something which is understated in the presentation in my opinion – the strengthening of the currency and interventions (over EUR1bn or more than 2 percentage points of GDP) by the central bank to tame appreciation pressures in December 2018 as talk of beginning the process of euro adoption gathered pace provided a timely reminder of how quickly things can take off. Slovenia had excessive capital inflows in 2007, the year it joined the euro, resulting in a pronounced credit boom which did not end well. As Spain and Ireland could attest following 2009, even with nominally solid fiscal positions heading into the crisis, the pernicious effects of capital inflows to economic stability in the current eurozone can be extreme. Forgive me for being sceptical about the impact of the Macroeconomic Imbalance Procedure, European Systemic Risk Board and common banking regulation in mitigating this risk which are offered up on slide 13 as bulwarks against excessive capital inflows and growing imbalances. Perhaps they’d work in a world of perfect information, but policy making, even assuming away political constraints, works a long way from such an environment. My biggest concern though with the approach outlined in the Strategy is that it is totally devoid of the political realities of the eurozone policy debate. The essence of that debate is creditor nations are unwilling to expose their taxpayers to the obligation of transferring funds to struggling eurozone members. Those who have suffered as a result of policy rigidity in the eurozone (inherent when you give up monetary policy flexibility and find your fiscal policy capabilities constrained) are understandably unhappy. The focus of policy in response to the financial crisis was on reducing fiscal deficits (rather than thinking through the impact of excessive capital flows in the monetary union) which saw countries such as Spain, which, ahead of the crisis, was in compliance with the Stability and Growth Pact (aka Maastricht) criteria but had a current account deficit of 10% of GDP in 2007 (a metric not taken into account by those same criteria) and many others, in mainly Mediterranean Europe, go through a deep recession and weak recovery accompanied by political turmoil. As a second recession was beginning to manifest increased risks of another fully-fledged crisis, the July 2012 intervention of European Central Bank (ECB) governor Mario Draghi “[w]ithin our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.” saw risk premia fall and stresses on weaker eurozone member state banking sectors dissipate. A programme to buy distressed member state bonds called Outright Monetary Transactions was announced a week later, but never used. Reaction in stronger, creditor states was negative (Alternative für Deutschland arose in response to what it saw as the ECB overstepping its mandate) and gathered pace when the ECB began buying eurozone member state government bonds in March 2015 (quantitative easing) or when any policy initiative implying a transfer of resources from stronger to weaker member states was discussed. As a result, the politics of eurozone reform is atrocious. For all the policy responses since 2009, the truth is that the infrastructure of the eurozone is incomplete. The link between sovereign bond prices and domestic banking sectors has not been severed, common banking regulation has arrived, but there is uncertainty about how that plays out in a crisis with national level regulators and there is no unconditional fiscal policy capacity to automatically help navigate macroeconomic imbalances in the eurozone. The eurozone does not even have a common deposit insurance scheme. In the context of a European Union exposed to existential threats and the prospect of European Parliamentary elections in May delivering a large cohort of anti-EU politicians of all stripes, the scope for cooperation to resolve these open issues is minimal. A strategy to adopt the euro which does not explicitly mention this vital backdrop is incomplete. It is the large and creditor eurozone member states, whose taxpayers would have to be convinced of the benefit of providing support to weaker member states, that will determine whether the infrastructure of the eurozone will be sufficiently constructed. The recently agreed truce between the European Commission and the Italian government over Rome’s 2019 budget proposal should fool no one that the differences of opinion among important EU members have been resolved. This is a classic case of big boys fighting it out in the school playground. And when the big boys fight it out, the smarter smaller ones stay away until the dust has settled. This should be Croatia’s guiding principle in adopting the euro while implementing as many of the reforms outlined in the Strategy as well as possible. The macroeconomic costs of being on the wrong end of eurozone policy (as it currently stands) in a crisis are significant as at least Ireland, Spain, Portugal, Italy, Cyprus and Greece can testify. The next recession in the eurozone will again test the politicians’ resolve to keep the euro alive (something which confounded many non-European observers during the financial crisis) and the skill of policymakers. There is no doubt joining the eurozone has the strategic value of placing a country in the inner circle of European Union policy making. Yet, considering the evidence of the economic (and political) risks of being in a eurozone with incomplete infrastructure, that strategic goal should not cloud policymakers’ judgement on the timing of entry into ERMII. EU membership has already played a vital role in improving macroeconomic stability in Croatia, so that the country is far better placed to deal with the next downturn in Europe. It would be prudent for Croatia to see how the eurozone navigates the next recession, implement the reforms outlined in the Strategy to strengthen the resilience of the economy, thus generating additional credibility with European partners, and join a eurozone which will have to evolve in response to that next recession. As with many things in life, timing is crucial.

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