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Europe must relax its inflation test for euro entrants
By Willem Buiter and Anne Sibert
Published: May 3 2006 19:30 | Last updated: May 3 2006 19:30

Estonia, Lithuania, Slovenia, Latvia and Slovakia have joined the exchange rate mechanism of the European monetary union and are candidates for near-term eurozone membership. Estonia, Lithuania and Slovenia hope to join the eurozone next January, Latvia in 2008 and Slovakia in 2009.

In the short period since their independence, these countries – especially the Baltic states – have been remarkably successful at transforming themselves into flexible market economies. The World Bank ranks Lithuania and Estonia ahead of Germany in terms of ease of doing business. The Heritage Foundation, the US think-tank, ranks all five ahead of France in its index of economic freedom and Estonia, in seventh place, is ahead of the US.

All candidate countries easily meet most of the Maastricht criteria for eurozone membership. They satisfy the exchange rate and interest rate criteria and only Slovakia narrowly misses one of the two fiscal criteria. This is in contrast to Belgium, Germany, France, Italy and Greece, which, if they were not already eurozone members, would not be able to join today, as they do not meet the fiscal criteria. However, according to the European Central Bank and the European Commission, only Slovenia satisfies the inflation criterion, which specifies that annual inflation cannot exceed the average of “the three best performing EU member countries in terms of price stability” by more than 1.5 percentage points in the year prior to the examination.

Forcing candidate countries to meet both an exchange rate criterion and an inflation criterion makes no economic sense. Neither the ECB nor the Bank of England attempts the impossible: to control both inflation and their exchange rate. Opting for stable exchange rates, the Baltic candidate countries have seen their inflation rates rise with energy price increases and impressive productivity gains in their traded sectors. The latter factor, which occurs as the candidate countries rapidly catch up with the eurozone, means that the relative price of non-traded goods rises faster than in the eurozone and is known as the Balassa-Samuelson effect. A conservative estimate of its contribution to the candidate countries’ inflation is 1.5 per cent per year.

It is perverse that the inflation criterion is defined with reference to the inflation performance of all 25 EU member countries instead of just the 12 eurozone members or the average inflation rate of the eurozone – the only inflation rate that matters from an economic point of view for countries contemplating joining the eurozone. The ECB’s egregious misinterpretation of the term “best performing” further compounds the injustice. In March 2006 (the most recent month for which we have data), the three lowest inflation rates belonged to Sweden, Finland and either Poland or the Netherlands. These countries, two of which are not eurozone members, had an average inflation of 1.2 per cent. Adding 1.5 points to this rate yields an inflation criterion of 2.7 per cent. Slovenia meets this benchmark and Lithuania, with inflation of 2.7 per cent, scrapes by. Estonia, Slovakia and Latvia do not.

Defining “best performing” as having the lowest (positive) inflation rate contradicts the ECB’s own formulation of price stability for the eurozone. The ECB defines price stability as inflation below, but close to, 2 per cent. By its own definition, inflation in Sweden, Finland, Poland and the Netherlands is far too low. The ECB itself has not managed to maintain inflation in the eurozone as a whole below 2 per cent. If we accept the ECB’s own definition of what price stability means, then the target, achieved by several EU countries, should be about 1.8 per cent, putting the benchmark at 3.3 per cent. Slovenia, Lithuania and Slovakia satisfy this criterion but Estonia and Latvia do not. We maintain that sound economics would increase the benchmark by 1.5 points to allow for the Balassa-Samuelson effect, allowing Estonia to pass the test.

All that stands between Estonia, Lithuania and Slovakia and near-term eurozone membership is a rigid application of an inconsistent interpretation of a flawed inflation criterion. What should be done when “the law is an ass”? Failure to enforce a law weakens the rule of law and respect for rule-bound behaviour, but so does enforcing a harmful and senseless rule. The Maastricht criteria have been violated in spirit and in the letter so frequently and opportunistically that little further damage would be done by an interpretation of the inflation criterion that differs from the one favoured by the ECB and the Commission but respects the spirit and letter of the treaty.

If there are doubts about which interpretation conforms to the treaty, its protocols and the ECB’s operational practice, the obvious institution to settle the matter is the European Court of Justice. Fortunately, it need not come to that. The membership decision will be taken by the European Council, rather than the ECB and the European Commission. Economic and monetary union was a triumph of political will over technocratic timidity, obstinacy and ignorance. It could happen again here.

Willem Buiter is professor of European political economy at the London School of Economics’ European Institute; Anne Sibert is professor of economics at Birkbeck College, University of London

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