The Euro: A Win or Loss for Poland?

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:

1. Low inflation: max 1.7% 2. Less than 3% budget deficit

2. Debt-to-GDP ratio less than 60%

3. ERM II Membership for minimum 2 years

4. Stable interest rates

5. 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.

The Euro Mistake: The Good, The Bad, and Potential Solutions

Introduction and Background

The Economic and Monetary Union (EMU) consists of a single currency, the Euro, and the Eurosystem, made up by the ECB and national central banks of Euro member states. The Euro, introduced in 1999 in 12 states that “abandoned their national currencies in favour of a European alternative” had been in development since 1992 . It now covers 19 EU member states, and for the first time since the Roman Empire, much of Europe has one currency. Member states control their national budgets and structural policies while staying within deficit and debt limits the EMU imposes.

The European Central Bank (ECB), the central bank for the Euro controls monetary policy.  Its primary goal is price stability but is also responsible for defining and implementing euro area monetary policy, foreign exchange operations portfolio management, and smooth payment systems in addition to other tasks . Despite the many benefits of the Euro, the European Monetary Union (EMU) was a mistake because the negatives, such as asymmetric shocks, outweigh its positive effects, like greater economic integration. However, dismantling the Euro would create substantial economic setbacks and is not a viable option, meaning the Euro will remain regardless of its problems.

Benefits of a Single Currency

The Euro, despite its controversy, has played an important role in the development of the EU’s economic integration. Its introduction lowered barriers to trade, which increased competitiveness of and trade between Eurozone businesses. Business contracts are no longer subject to exchange rate uncertainty, increasing certainty and investment while lowering business’ capital costs . The Euro has not only stimulated trade, but also the free movement of capital, goods, and people.

The Euro has also strengthened the EU’s single market. The introduction of the Euro increased transparency and allowed simpler comparison of cross-border prices. With transparent prices, it is easier to see whether the EU single market has achieved price convergence, indicating the level of market integration. Eurozone states will cooperate more closely with one another to create a stable currency and economy, thus making the Euro a “tangible sign of a European identity.” Additionally, countries around the world are using the Euro for reserves, and some are even pegging their currencies to the Euro, demonstrating the importance of the Euro and the EU as a global economic power. Since the introduction of the Euro, there has been a “stronger presence for the EU in the global economy”, and the Euro is “considered a viable alternative global reserve currency and competitor to the US dollar” (564).

The Euro was a major political accomplishment of EU member states, and politicians and citizens believed that the Euro “would lead to peace and prosperity”. The recent economic crisis proved that the Euro, in fact, heightens asymmetric shocks due to the lack of cyclical correlation. Overall, “the euro is an integral part of the economic, social and political structures of today’s European Union”, but was ultimately a result of political desire for more European integration rather than an economic motivation.

Negative Effects of a Single Currency

The Euro created a loss of economic sovereignty and individual monetary policy, making it difficult to respond to national economic problems. The ECB sets monetary policy even if it helps some countries while hurting others in order to act based on “what is good for the whole Euro zone, rather than any individual economy”. Individual exchange rates can no longer respond to national economic booms and busts, but rather, the Euro exchange rate responds to the Eurozone as a whole. Eurozone countries can neither devalue their currencies nor use interest rate policy in order to achieve their national objectives. Additionally, the Euro weakened “the market signals that would otherwise warn a country that its fiscal deficits were becoming excessive”. Although countries willingly gave up their right to control monetary policy, the Euro has had an overall negative effect on the economy of many, if not most, Eurozone countries.

For instance, Greece is suffering at the expense of the Euro. Although Greece began failing before the financial crisis, European authorities failed to intervene at the first sign of trouble. The introduction of the Euro lowered interest rates in Greece, who previously had high interest rates, which increased borrowing, leading to more problems. A “Grexit” might end up improving the Euro credibility because it would remove a member who “should never have been allowed to join in the first place”. The ECB was not supposed to bailout countries, so Greece had to choose either to leave the euro or achieve an unsanctioned bailout. Without borrowing from other Eurozone countries, Greece would have failed to pay its national debt or other payment obligations such as salaries or pensions.

The EU and EMU economic governance has been unsuccessful. Despite the fact that the Euro helped capital movement within the EMU, it led to the funding of bubbles like the property bubble in Ireland and many Eurozone countries still have other barriers such as intense administrative regulations, immovable labor markets, and high business expenses. If individual states have negative economic indicators, they can cause an overall euro depreciation. Finally, the Euro was supposed to increase price transparency and bring about a single price, which it has not yet done.

Optimum Currency Area

An optimum currency area is “a phrase used in economic theory to define the geographical area in which the conditions are most favourable for sharing a single currency.” A single currency implies imposing a single monetary policy, meaning countries must be similar in order for all to benefit.  One monetary policy is only appropriate if countries have similar economies and similar economic cultures. In order to have similar economic cycles, member states must have similar shocks, institutions, and policies in addition to economic integration. If a currency union does not have synchronized business cycles, “the common monetary policy does not satisfy the needs of all and may even contribute to cyclical divergence,” which the Eurozone has been experiencing.

The convergence criteria in the Maastricht Treaty of 1992 addressed exchange rate, inflation, and interest rate stability as well as debt and deficit limits in the attempt to create an optimum currency area; however these convergence criteria should have also considered economic structures, cycles, and political culture. This condition of similarity in the optimum currency area theory implies that “countries suffering from asymmetric shocks should not yet join the eurozone,” which the convergence criteria did not address, thus leading to problems.

There are two main groups in the Eurozone with opposite business cycles: the north, or core, and the south, or periphery. The core wants the periphery to take on economic reforms and has allowed the ECB to provide relief to struggling countries in the periphery. Although reforms in the periphery could help the Euro, the main challenge is whether those countries will do what is necessary and whether a compromise between the core and periphery is possible. Despite convergence criteria, some periphery countries joined the Euro with high debt and deficits.  The main problem with the Euro that signals that it might not work is that “European economies are too different” and “going in two opposite directions”.

For example, in 2001, the Eurozone’s main economies, France and Germany, slowed with increased unemployment while Ireland and Spain experienced a boom. These groups needed opposite solutions; however, the ECB lowered interest rates to help France and Germany prosper, which made Ireland and Spain suffer, contributing to a crisis in the periphery. Similarly, after the economic crisis, France and Germany are booming but Ireland, Greece, and Spain are in a recession, so the “core needs higher interest rates whereas the periphery needs lower interest rates”. Thus, the ECB has a choice to make between inflation in the core or unemployment in the periphery, but since the core has more power within the EU and the Eurozone, generally, monetary policy benefits the core and hurts the periphery.

Adjustment mechanisms such as labor movement, price and wage flexibility, and “interregional fiscal transfer payments” that work in the United States when only certain areas are under duress are less likely in the Eurozone due to linguistic and cultural barriers, limited labor market reform, and the political impossibility of core countries paying to support periphery countries. Without these mechanisms available to the Eurozone as they are to the United States, the euro-area will struggle with asymmetric shocks and divergent cycles among many other difficulties. The Euro will not work while the core and periphery have opposite economic conditions with no possible adjustment mechanisms and will further fiscal problems in the periphery because the Euro is “a one-size-fits-all policy for fundamentally different economies”. Despite economic changes, “the fundamental problems of forcing disparate countries to live with a single monetary policy and a single rate” persist.

Analysis and Conclusion

As a whole, the Euro has been an unsuccessful monetary union for many reasons, most importantly because of the lack of an optimum currency area and the divide between core and periphery economies. Despite the trade and job creation and greater European integration, the euro was mainly a politically motivated rather than an economic decision. However, despite the mistake of this monetary union, the euro is irreversible and will survive because of Germany’s economic influence, risk-averse voters, and potential further ECB powers.

One potential solution to the divergent economic problem is for the outliers to leave. Leaving the Euro could be disastrous for both the Euro and those countries that leave and thus is not a viable option. If the struggling countries formed a new currency union separate from the core countries’ currency union, there would be greater economic harmonization and more similar business cycles since the periphery and core separately would be closer to creating optimum currency areas. This solution would mean that the separate central banks would be able to help all countries in its optimum currency area by setting one monetary policy. Since the core and periphery states are on opposite boom-and-bust cycles, the ECB is unable to set monetary policy without hurting one set of countries. However, the periphery countries will not want to leave the euro because they desire to be part of a strong currency. If the periphery countries had their own currency, it would be weak even though the monetary policy would be better suited to those states’ economic situations. Additionally, the unplanned change of currency could lead to a market panic or loss of investor confidence, which could spark bank runs leading into another financial crisis. Thus, the breakup of the Euro is not a viable future option.

The EU must do something to improve the Euro situation, though. The EU plans to “improve the economic governance framework” of the EMU by improving and reinforcing the EMU. By the end of June 2017, the EU will complete the financial union, enhance democratic accountability, and increase competitiveness and convergence of structures. By 2025, the EU plans to increase convergence through legal means and to have established a treasury for the EMU. There is no correct solution to the Euro problem, and it is clear that the monetary union was a mistake. The Euro will not break up because it would create instability and potential crises. The EU’s plan going forward will not solve all of the Euro’s problems nor will it make up for the economic mistake it made by introducing the Euro, but it might bring the Euro closer to what politicians tried to start. The mistake of introducing the Euro is now an important part of the global economy and cannot easily be broken up without economic backlash, so it is important that EU institutions attempt to fix what they can to increase harmony in the EMU.