Early euro adoption may mean economic slowdown, inflation and high unemployment

Czech politcians have been discussing the possibilities of adopting the single European currency between 2006 and 2010. At least two years before that, the country would have to join the ERM-2 exchange rate mechanism and fix the currency in a relatively narrow fluctuation band. The Czech National Bank has urged the government to stay out of the ERM-2 as long as possible so that the economy has enough time to ready for such a step.

The Czech central bank recommended to the government on Tuesday that the country should stay out of European Union's ERM-2 exchange rate mechanism for some time after it joins the EU in May next year. The central bank said in report prepared for the cabinet that it wanted to stay in the ERM-2 for only the minimum period of two years required to join the euro.

At the same time, Bank of France Governor Jean-Claude Trichet, the likely next head of the European Central Bank, suggested that there would be no softening of the criteria applying to future European Union members which want to adopt the euro currency. On the contrary, Mr. Trichet said candidates would be deemed fit only if they steady their currencies close to a central parity to the euro, possibly in a narrower, +/- 2.25 percent band. Within the ERM-2, an exchange rate must be kept in a +/-15 percent band against the euro.

How difficult will it be for the Czech Republic and other candidates which have fully floating or managed float currencies to keep their currencies within this range? I put that question to the chief economist at Volksbank in Prague, Marketa Sichtarova.

"It will be very difficult. First of all, I have to say that the exchange rate mechanism is not very good for the Czech economy and it is not important how broad the fluctuation range is. Any currency bound to some fluctuation range is more vulnerable than a currency that fluctuates according to normal market pressures. A currency bound by the central bank within a fluctuation band alarms speculators who often try to play against the central bank and make profit. That means that those countries that adopt the ERM are more vulnerable to financial crisis and that is the case of the Czech currency, too. Basically, the narrower the fluctuation band, the bigger the threat of a crisis and the harder it is for the central bank to keep the exchange rate within the given range. If we have to keep our currency in the range of +/- 2.25 percent, it will be a difficult task for the central bank to manage it. That is why the Czech National Bank will try to postpone entering the ERM for as late as possible to have more time to prepare for the step."

Joining the ERM systems and adoption of the single currency has two inherent risks: inflationary pressures and a loss of autonomous monetary policy. Ms. Sichtarova maintains that the economy must be first well prepared for the step: the sooner we join, the greater the risks.

"The first risk is the price level and potential inflation. The price level in the Czech Republic is much lower than abroad. After joining the single market, it will be impossible to have very different prices here than elsewhere. Of course, we can have slightly different prices even within countries, but never so much different. It is clear that the difference will have to be levelled out. There are two ways to achieve that: first, prices can simply increase. In other words, inflation will grow, which is not very comfortable for us as customers as the inflation erodes our savings. The second way is strengthening the national currency. If koruna strengthens, then prices, recalculated with the exchange rate, are the same as prices abroad, which is much more comfortable for us. But strengthening of the currency is possible only as long as we do not fix the exchange rate or join the euro. Afterwards, there will be only the inflation option. It would be very easy to avoid this problem: we could simply let koruna strengthen until prices come to the same level and adopt euro afterwards. This is a very strong argument for postponing joining the eurozone."

However, Ms. Sichtarova believes, the loss of independence in setting the monetary policy in fact poses a much greater risk than consumer price growth:

"We will lose our monetary policy in two steps. First, we will join the ERM-2 and the central bank will bind itself not to let koruna weaken. Let's suppose there is a sudden pressure to weaken koruna and the Czech National Bank has to react. The remedy is hiking the interest rates. But hiking the interest rates makes credit more expensive for firms, causing an overall economic slowdown. The remedy then is to cut interest rates. But lower rates mean a weaker currency. It is a vicious circle. Most probably, the central bank would eventually lose the battle on both fronts. I suppose, in such a case, koruna would weaken and the economy slow down.

But that is not all. We will lose our independent monetary policy also in the second step, when we join the eurozone. The eurozone coprises very different countries. There are countries such as Ireland which suffers from high inflation. It is relatively easy to fight inflation by higher interest rates. But there are also countries like Germany which have fallen into recession and suffer from high unemployment. It is also relatively easy to fight unemployment by cutting interest rates. Now, what should the European Central Bank do? Hike the rates to help Ireland or cut the rates to help Germany? Countries within the eurozone are very different but they seem almost the same when compared to the new candidate countries, such as the Czech Republic. Here I no doubt that the policies of the ECB will be a deadly for the Czech economy. Adopting euro is a very good idea, however, adopting euro too early would mean high inflation, economic slowdown and high unemployment."

But can we see any convergence of the business cycles, considering that Germany has been going through a long recession while the Czech economy keeps growing?

"If we do not regulate the economy too much and if we let foreign trade to do the major work, we can expect that within several years, we will have the same business cycle as Germany, which means we do not need the same monetary policy. It is just a matter of time and we can observe the same process in the European Union. Member countries are become more and more similar and it is again a matter of time before the whole European Union falls into the same business cycle."

Do you think this will an ideal situation when all of Europe is falling into recession at the same time and recovering at the same time, that different stages of the business cycle in different countries do not counterbalance each other?

"From the European Central Bank's point of view, it will be an ideal situation. Of course, it will not be ideal from the consumers' point of view. However, having one monetary policy and having one currency requires having the same business cycle across Europe. Otherwise, we would not be able to fight inflation and unemployment. So, this is just what we need."

The exchange rate mechanism is not the only requirement - candidate countries must, besides other things, keep their public finance deficits to three percent of GDP. The government's proposed fiscal reform aims to cut the public budget gap to four percent of gross domestic product in 2006. Realistically, when could the Czech Republic adopt the euro?

"I am afraid that adopting the euro will not be an economic decision but will be politically motivated. Politicians will probably try to adopt euro as soon as possible because it will be a target for them, a kind of victory they can present to the voters. However, I suppose that there will be one big obstacle to adopting euro - the bad condition of the Czech public finance. In my opinion, we can meet the Maastricht criteria and adopt euro most likely in 2010. The year 2007 is the earliest date, including the two-year pre-accession period. But I suppose 2010 is the most realistic prediction."