Introduction
The Euro, currently in circulation in 19 of the European Union (EU) member states, first came into physical circulation in 2002 following the electronic adoption in 1999. The introduction of the euro was originally manufactured as part of the Union’s broader plan to limit extreme nationalism following World War II and the fall of the Soviet Union. Caps on nationalism and closer economic interdependence would limit the likelihood of war breaking out again on the European continent. While originally introduced in 6 of the member states, the Euro’s rollout has extended due to the requirement, as spelt out in the Maastricht Treaty, of all member states to join. The treaty, however, does not spell out an exact timetable for accession into the Eurozone.
Accession into the Eurozone is contingent on 6 convergence criteria. The criteria as spelt out by the ECB include:
Low inflation: max 1.7% 2. Less than 3% budget deficit
Debt-to-GDP ratio less than 60%
ERM II Membership for minimum 2 years
Stable interest rates
Stable long-term interest rate max 6.7%
Once it has been determined a country satisfies the convergence criteria, a vote is taken in Council to permit the state to join the Eurozone. Since its conception, 8 member states have completed the accession process bringing the total membership to 19. The Euro was most recently introduced in 2015 replacing the Lithuanian lita.
In this paper I will discuss the economic basis of the euro, introduce theory behind Eurozone accession, and apply the two discussions to the current debate over Poland’s accession to the Eurozone and address some of the major concerns of citizens.
Economic Basis and the Theory of the Optimum Currency Area
Euro accession begins with the alignment of a country with the convergence criteria which cover conditions from inflation, deficit, and debt. Additionally, the national Central Bank must be independent of political control as it will be folded into the structure of the European Central Bank.
The economic benefits of switching a country’s currency to the Euro are undeniable: elimination of transaction costs of converting currencies and allowing for further integration of Eurozone economies. It contributes to the development of the single market’s free flow of goods, labor, and people which can be facilitated even easier with common currencies.
However, there are very clear economic disadvantages of joining the Eurozone. Accession to the Euro means the member state gives up its control over its monetary policy to the ECB. While that member state’s central bank will have a vote in the ECB, policies and positions contrary to that country’s interest could still be voted upon and carried out. Additionally, the ECB’s sole-mandate of price stability might play contrary to the needs of particular member states such as achieving full employment, the two of which sometimes can seem mutually exclusive.
For the majority of this paper I will be discussing the economic situation of Poland vis-à-vis accession into the Eurozone. To chart this discussion, I want to begin by discussing the economic basis of the Euro as theorized by the so called ‘Optimum Currency Area’ (OCA). The OCA theory, as developed and attributed to Robert Mundell, stresses the need to be able to control asymmetric shocks in order to build a currency union. The four main criteria he lists as needed to achieve a successful currency Union are:
i. Labor mobility across the region
ii. Open capital mobility; price and wage flexibility across the region
iii. A risk sharing system (such as a taxation redistribution)
iv. Similar business cycles across the region
If a region can meet these criteria, then Mundell stipulates it very well may be an optimal currency area. It is interesting to note that these currency areas don’t need to be multiple countries, but in fact a single country could have several optimal currency areas—but are tied under a single currency system for geopolitical reasons rather economic.
The Case of Poland
The presence of a resistance to Euro accession in Poland is clearly evident through the results of the Flash Eurobarometer 418 (FEB418). The FEB was conducted in April of 2015 in the 7 non-Euro member states with legal and treaty obligations to accede to the Eurozone. The goal was to measure public knowledge, perceptions, support, and expectations of the Euro.
In response to the question “Do you think the introduction of the Euro would have positive or negative consequences for (OUR COUNTRY)?” 54% of Poles said ‘negative’. When asked about the consequences on a personal level, 53% anticipated ‘total negative’ consequences. These results reveal that a majority of Poles see Euro introduction as a negative event (however the wording of the question does not indicate exclusivity of economic impact). This perceived negative impact, however, seems to be a native phenomenon as in the same FEB, 53% of Polish respondents indicated they believed Euro introduction has had an overall positive impact in other countries that have already introduced it versus a minority of 34% stating it was negative. The disparity in results suggests that in fact Poles do not have negative perceptions of the Euro as a whole, they just have negative perceptions about implementation of the Euro in place of the Polish Złoty.
Prior to the recent October 2015 election, Poland was under political pressure from the ECB and in particular Germany, to push towards meeting the convergence criteria, in particular officially joining the Exchange Rate Mechanism (ERM II). Political attitudes were split at the time, with justifiable economic concerns about speculation driving down the value of the złoty. However, with the outright majority victory of the right-wing, euroskeptic Law and Justice Party in the October national elections, discussions about the Euro are now a non-starter, politically speaking.
This shift in the Polish political regime has halted progress towards accession to the Eurozone. It also raises the question of whether Poland should join economically. When I posed this question to my International Economics Professor Steven Silvia at American University, he argued the most important indicator in determining the economic vitality of accession to the Eurozone (or any shared currency regime) is understanding the business cycles of the currency regime and the country in question—the fourth of Mundell’s principles. This information can be found in DG Economic and Financial Affairs’ 2014 Report in European Business Cycle Indicators. The below graphs compare growth with the Economic Sentiment Indicator (ESI).
The above graphs show the disparity of the economic conditions that struck the Euro area in the 2008 downturn versus the less dramatic recession in Poland. It is important to highlight how dramatic the disparity is: Poland’s growth rate never went negative, which cannot be said for the Eurozone. Poland’s ability to remain above the red line while the rest of Europe succumbed into recession is due to many reasons, but the main being the successful exercise of monetary policy of ‘Narodowy Bank Polski’ (National Bank of Poland).
Accession to the Eurozone, as stated earlier, means the National Bank would lose its monetary policy autonomy, and rather the country would be subject to the decisions taken at the ECB. Often portrayed as “giving up sovereignty” to Brussels, many opponents to the Euro like to leave out the fact that the National Bank will have a voting seat in the ECB. On the other hand, Poland is a single vote, and can be easily outvoted. The National Bank representative sitting on the ECB will take an oath stating that he will put the economic interests of the Eurozone as a whole before national interests. And at the end of the day, what is best for the Eurozone might not necessarily be best for Poland and vice versa.
The graphs above regarding the business cycle are telling because any central bank makes its monetary policy decisions based on the business cycle. In general, (along with other policies as well): when growth is slowing down, they will buy back bonds and infuse more money into the market, and when inflation gets too high, they will sell bonds to restrict money flows. The ECB follows the same basic logic and premises. So, with that in mind, if the Polish business cycle aligns closely with that of the Eurozone, it is safe to say we will see a history of similar policy actions taken by the ECB and the Polish National Bank. And theoretically, if Poland were to accede into the Eurozone, we should continue to see the two business cycles stay similar and thus ECB policies will continue to help the Polish economy grow.
On the other hand, if the business cycles did not align, it makes a very clear case to not accede. If the ECB sells bonds at the same as the Polish business cycle is at a peak and inflation is increasing, the ECB decision would wreak havoc on the Polish economy with high inflation. The same goes for buying bonds at a low in the business cycle: the constriction of cash will mean even less growth will occur, and the economy could experience negative growth and even go into recession if the adverse policies are sustained for a prolonged period of time.
Looking at the above graphs of Poland and the EU, there is visually a generally similar trend of business cycles. There were disparities in growth from 2004-2006(ish) but then the trends seemed to converge. This is very much likely due to business cycle synchronization which can be achieved through strategic trade. 2004 marked Poland’s entry to the single market, and thus trade between the Eurozone (and the EU as a whole) has increased dramatically, allowing for convergence to be achieved through trade.
To address the issue of business cycle synchronization, the EU has a long-standing Exchange Rate Mechanism (ERM II) which is designed to help move a country’s economy towards convergence with Eurozone trends in terms of inflation, long-term interest rates, fiscal deficit, public debt, and exchange rate stability. The goal of business cycle convergence explains why membership in the ERM II for at least 2 years is one of the 6 convergence criteria a state must reach to accede to the Eurozone. Poland has not of yet joined the ERM.
The remaining three ‘criteria’ for an OCA are all semi-related. They are labor mobility, capital mobility, and a risk sharing system. These three elements are seen as necessary in forming an OCA as they are essentially for “promoting balance-of-payments equilibrium and internal stability”. BOP instability was a major concern of Mundell’s as well as concerns over balancing inflation and unemployment. He argues “the pace of inflation is set by the willingness of central authorities to allow unemployment in deficit regions”—essentially one region benefits at the expense of another in a common currency area in a monetary policy decision. In order to limit these type of situations, the three criteria are needed.
If unemployment rises in one region due to higher inflation in others, it is essential that labor has free mobility to move within the currency area. If labor can move, then the region can maintain full employment without having to enact monetary policies that might decrease unemployment in one region at the expense of another. Eventually, ideally, as the economy recovers, employment levels will balance back out across the region. The single market (all EU-28 member countries) allows for the free movement of goods and labor. Within that market, the Schengen zone allows for the free movement of peoples. Poland is part of both.
Capital mobility coupled with openness of wage and price flexibility acts part of a natural economic mechanism to redistribute supply and demand across the region. This ensures that should there be any supply or demand shocks, the impacts of such will not be isolated to one area of the currency region. If it were to be isolated as such, it would result in a disparity in BOP, which can cause undue stress and uneven economic development in the currency region. Free mobility of capital and flexible prices and wages will allow the economy to naturally adjusts to those shocks and the whole region will be affected similarly. The Eurozone (as well as the EU as a whole) has these sorts of mechanisms.
The last component: a risk sharing system. The ideal example of a risk sharing system would be an automatic fiscal transfer mechanism; think government bailouts or tax redistribution. The idea is that the governing authorities should be able to reallocate resources (money) to areas and sectors that are falling behind. The EU’s cohesion funds could have been seen as a sort of risk sharing system, as it redistributes money from wealthier regions to poorer less developed regions, but it is not an ideal example. EU law forbids state aid to business, including bailouts. However, bailouts were given out in April 2010 during the Eurozone crisis. Poland is a major recipient of cohesion funds; and has not been in need of any bailouts.
Analysis
Looking at the four factors often used in considering OCAs, Poland and the current Eurozone seem compatible on all four components. In fact, the National Bank of Poland released a report in 2004 following its EU Accession about the status of Poland’s accession to the Eurozone. The Bank indicates “there is a relatively low risk of monetary policy of the ECB being inappropriate for economic conditions prevailing in Poland after euro entry”. In reaching this conclusion, the authors of the report cite several reasons including the role that free movement of capital will have on stabilizing the exchange rate, high levels of cyclical convergence due to high trade volumes, and reductions in government debt will allow for stronger fiscal stabilizers.
Economically, the transition to the Euro makes sense in theory. The people of Poland themselves have acknowledged the benefits the Euro has. So what is the problem? In talking informally with several of my colleagues and friends in Poland, a common concern kept emerging: switchover would trigger a rise in prices, which would hurt the people. More formally, they are concerned about losing their purchasing power parity (PPP). I initially suspected this concern has emerged out of Polish people’s interactions with the Euro taking place in countries where price levels are higher compared to those in Poland (such as Germany, Belgium, and other western European countries) leading to false connotations that “euro = expensive”.
This concern, however, is not unique to Poland. Giovanni Mastrobuoni of Princeton University discusses how incomplete information led to similar “euro-biases” as they are generally referred to in other Eurozone states. In Lithuania, the most recent country to switch to the Euro, Flash Eurobarometer 412, taken in the weeks following the dual-circulation period, revealed that 58% of citizens felt the Euro has increased inflation with only 26% say it maintains stable prices. Models revealed that inflation during changeover was higher for cheaper goods, which are purchased more frequently by consumers, like food and drinks. Therefore, they make overall assumptions about the status of the economy on that limited piece of information, making it seem like there is overall greater inflation than actually present in the economy.
But, why are there different inflation rates? It turns out it is a vicious cycle. Mastrobuoni extends his model to include price uncertainty. He argues that on-the-spot conversions of the new price (in Euros) to the old currency involves a level of uncertainty “about the old-currency-equivalent of the price in euros [which] is higher the higher the price in euros is”. The graph below illustrates the vast effect of this problem as more than half of citizens in new Eurozone states still thought about prices in their own currency following switchover. Each of the results are from surveys taken in the weeks after the dual-circulation period.
This phenomenon creates an artificial demand curve by consumers, which yields a higher general equilibrium. The table below, borrowed from Mastrobuoni’s paper illustrates the difference between actual and perceived inflation pre- and post- accession to the Eurozone. He also includes Denmark, Sweden, and the UK in the chart as a means of comparison to nations that were not included in the Euro switchover and consequently did not adopt the Euro.
Mastrobuoni concludes that once consumers begin to think in Euros rather converting to their old currencies, the effects of the artificial inflation will be reduced if not eliminated.
Returning to the case of Poland, the phenomenon of “euro-biases” and price hikes is founded in a widespread economic phenomenon. While citizens are rightfully worried, the EU has taken steps to try to reduce such effects. During euro switchovers, a period of “dual price display” occurs in which stores and firms are required to display prices of goods in both euros and the former currency for a designated period of time. This is an improvement from the original switchover in 2002 where dual price display was not mandated. Mastrobuoni remarks that surveys in Belgium indicated only 50% of stores participated in the dual price display, and all for varying amounts of time during the two-month switchover process. The room for error in converting currencies was much higher under those conditions. During dual price display it limits the number of conversion errors that may occur.
However, some have expressed concerns that the dual-price display may be harmful in the long-term, as displaying prices in the former local currency encourages citizens to continue to rely on that price marker rather that of the Euro. This means that once the dual display period (usually 2 weeks for new member states) ends, consumers will have to go through the same process of conversion miscalculation as discussed prior. The EU also now provides a currency calculator to citizens of new Euro member states to help them make more accurate conversions on the spot. This enables citizens to continue to gauge euro price levels in their former national currencies beyond the dual display period.
Drawing Conclusions
The case of Poland is nothing unique from an economic aspect. We saw similar concerns in other countries including Lithuania only last year in 2015. However, the political conditions of the country simply do not permit for Euro accession to happen in the next couple of years. Will we see Poland in the Eurozone? Absolutely, but it very well may be 5-10 years down the line. Poland has a legal obligation to do so under the Maastricht treaty, and no one is denying that. Concerns are about when is the best time to join.
Poland first needs to join the ERM II to bring stability to its exchange rates, and it will have to remain in the ERM II for atleast two years (unless the ECB and Council waive the requirements—which the political will to do so seems present). However, Poland will not join the ERM II under the current euroskeptic government, which will remain in power for nearly another three and a half years, and then we will have to a wait for the election results.
While citizen’s fears of price increases very well may come true: we have to remember that any shocks to the economy will be bore by the Eurozone as a whole and limit the impact on Poland. Joining the Eurozone will also only increase high levels of trade between Poland and other countries. This small economic stimulus may be essential for Poland as it struggles to keep its young population from moving to other countries and create more jobs at home to keep them.
To ultimately answer the question of whether the Euro is a potentially win or loss for Poland: I argue that it will someday be a “win”. It is hard to draw a conclusive conclusion now due to the simple fact that we don’t know what will happen were Poland to accede to the Eurozone. While the country is close to converging on the requirements for Eurozone accession, there are valid concerns about the state of the economy and how Eurozone policy will be appropriate for the economy. The government should continue to develop the economy in order to catch up with other Eurozone countries to ensure a smoother transition.