Managing the European economy after the introduction of the Euro
Managing the European economy after the introduction of the Euro

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Managing the European economy after the introduction of the Euro

1.6.2 Joining the Euro-zone

For all the new members there will be a process of ‘catching up’ with the older members before the former can join the Euro-zone. The GDP gap between them remains considerable. In 2002 the GDP per capita was 60 per cent of the EU average for Slovenia and the Czech Republic (in PPP terms (see the footnote to Table 1 for an explanation of PPP)), it slid to 50 per cent for Hungary, 40 per cent for Poland, Estonia and Latvia, and just 35 per cent for Lithuania. But the growth rates of these counties had been faster than the EU average during the early 2000s.

If these states want to join the Euro-zone there must first be some GDP convergence, which itself will entail a sizable influx of capital for investment. In addition, there will probably need to be some appreciation in their real exchange rates (i.e. exchange rate minus domestic inflation rate) before entry can be justified. The problem is that none of this may be compatible with the exchange rate ‘stability’ required for Euro-zone entry. To join the Euro-zone candidate countries are required to pass through a phase termed Exchange Rate Mechanism II (ERM II), similar to the ERM I which characterised the run-up to the introduction of the Euro for the older members prior to 1999 (see Linter, 2001, on the ERM). Broadly, the ERM II regime requires exchange rates to operate within a wide band around a central parity (plus or minus 15 per cent), which will become the equilibrium exchange rate of choice for the final conversion process. Interest rates must be low (within 2 per cent of Euro-zone average) and there is a time period over which this regime must operate (a minimum of two years) to demonstrate the ‘stability’ of the central rate, when no substantial or erratic revaluations are allowed. But note that this is a form of ‘pegged’ (to the Euro) or fixed rate system, which are particularly prone to speculative attacks (as happened against the UK pound in 1995). To achieve the required stability, then, will either take a long time or a lot of resources to ensure first adequate ‘catch-up’ and later the ability to withstand speculative pressures.

In addition, there is a potential problem if all the countries want to join at about the same time (which looks possible – around 2010 is often suggested). Countries can gain some competitive advantage if their final conversion exchange rate is slightly lower than their competitors, so there is a potential ‘beggar-thy-neighbour’ (or perhaps better expressed as 'threaten-thy-neighbour’) problem in the run-up to Euro-zone entry, which could also undermine stability. What is more, neither the Council of Ministers nor the Commission has much control over the rates involved here, since this is a decision for each country individually operating in conjunction with what ‘the market’ will tolerate.

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