Machiavelli - The First Century: Studies in Enthusiasm, Hostility, and Irrelevance

Enlarging the Euro Area

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Enlarging the Euro Area External Empowerment and Domestic Transformation in East Central Europe

Edited by Kenneth Dyson

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3 Great Clarendon Street, Oxford ox2 6dp Oxford University Press is a department of the University of Oxford. It furthers the University’s objective of excellence in research, scholarship, and education by publishing worldwide in Oxford New York Auckland Cape Town Dar es Salaam Hong Kong Karachi Kuala Lumpur Madrid Melbourne Mexico City Nairobi New Delhi Shanghai Taipei Toronto With offices in Argentina Austria Brazil Chile Czech Republic France Greece Guatemala Hungary Italy Japan Poland Portugal Singapore South Korea Switzerland Thailand Turkey Ukraine Vietnam Oxford is a registered trade mark of Oxford University Press in the UK and in certain other countries Published in the United States by Oxford University Press Inc., New York ß Kenneth Dyson 2006 The moral rights of the author have been asserted Database right Oxford University Press (maker) First published 2006 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, without the prior permission in writing of Oxford University Press, or as expressly permitted by law, or under terms agreed with the appropriate reprographics rights organization. Enquiries concerning reproduction outside the scope of the above should be sent to the Rights Department, Oxford University Press, at the address above You must not circulate this book in any other binding or cover and you must impose the same condition on any acquirer British Library Cataloguing in Publication Data Data available Library of Congress Cataloging in Publication Data Data available Typeset by SPI Publisher Services, Pondicherry, India Printed in Great Britain on acid-free paper by Biddles Ltd., King’s Lynn, Norfolk ISBN 0-19-926776-6 ISBN 0-19-927767-2

978-0-19-926776-7 978-0-19-927767-4

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Acknowledgements

This study follows on from four previous books on Economic and Monetary Union (EMU) in Europe. The first two dealt with EMU as European integration. Elusive Union (1994) examined the deeper historical and structural conditions that shaped EMU; whilst The Road to Maastricht (1999, with Kevin Featherstone) investigated in depth how EMU was negotiated. The Politics of the Euro-Zone (2000) was concerned with the nature and implications of European economic governance: in short, with EMU as a technocratic form of ‘ECB-centric’ polity specialized in the provision of economic stability. The fourth book and this study are companions. They are focused on EMU as Europeanization, investigating how and in what ways it affects domestic institutional arrangements, policies and politics. European States and the Euro (2002, 2nd edition forthcoming 2008) dealt with EMU’s impacts on the pre-2004 EU member states, both ‘ins’ and ‘outs’. Enlarging the Euro Area reflects a broader eastward shift in scholarly research on Europeanization to examine the different context and experience of this phenomenon in the new accession states of east central Europe, in particular during the pre-accession period of 1996–2003. It aims to add to the body of knowledge about how ‘accession’ Europeanization works by asking what euro entry means for, and tells us about, the direction, content, and processes of transformation in east central European states, the extent to which domestic transformation is to be understood in terms of ‘conditionality’ and external empowerment, and the role of these states within the wider EU. In editing this book I have benefited enormously from the kindness and support of many people. As earlier with European States and the Euro, I am greatly indebted to the British Academy. The Academy generously funded a research workshop in February 2005 so that draft chapters could be discussed. My special thanks go to Angela Pusey and her staff and to the Public Understanding and Activities Committee for their support in organizing this workshop.

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Acknowledgements

In addition, I would like to express my gratitude to the German Academic Exchange Service (DAAD) for making it possible for me to spend a period as Visiting Professor at the Free University of Berlin and to Professor Thomas Risse and his colleagues who were my kind hosts. This period enabled me to undertake early fieldwork for the volume. DAAD support over the years has been vital for my academic career. I am also much indebted to the discussants at the British Academy workshop for their generosity in commenting on the first drafts. A special debt is owed to: Willem Buiter (European Bank for Reconstruction and Development, London), Gabriel Glockler (European Central Bank, Frankfurt), Klaus Goetz (Potsdam University), David Phinnemore (Queens University Belfast), Lionel Price (Fitch Ratings, London), and Daniel Wincott (Birmingham). As with European States and the Euro, it has been a great privilege to work with, and learn so much from, the team of contributors. They have shown great patience in dealing with increasing editorial ‘guidance’. I can only hope that they have enjoyed the experience half as much as I have. The staff of Oxford University Press has, as ever, shown exemplary efficiency in handling the book at every stage. My particular thanks go to Dominic Byatt. Over the years I have benefited enormously from his wise advice and efficient, practical support. These many debts cannot absolve the editor from final responsibility for the quality of this book. In particular, he decided to limit sectoral coverage because of problems of availability of sufficient high-quality comparative research on labour markets and wages. This omission will be rectified in the second edition of European States and the Euro. The book remains, like its objects of investigation—EMU, Europeanization and the accession states—a ‘work-in-progress’. Its contribution rests more in highlighting and clarifying the role of uncertainty than in stripping it away. It also reflects the greater problems in understanding the newer and less familiar environments of east central Europe than in those of the old core states of the EU. Moreover, Euro Area enlargement has implications that extend beyond the new accession states to institutional and policy reforms at the EU level (see Chapter 5 by Linsenmann and Wessels) and to developments within the traditional core states like France and Germany (see Chapter 4 by Jones and the conclusion (Chapter 15)). The book’s agenda will continue to be pursued in other forms. The second edition of European States and the Euro (forthcoming 2008) provides an opportunity for comparative examination of EMU as Europeanization in the older member states and in the new accession

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states and for a wider sectoral coverage. Work on EU enlargement and the euro will continue as part of a ‘network of excellence’ that is led by the editor under the EU Framework 6 programme CONSENT. Anyone interested should contact the editor. Kenneth Dyson Cardiff University, Wales [email protected]

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Contents

List of Figures List of Tables Notes on Contributors

Introduction Kenneth Dyson 1. Euro Entry as Defining and Negotiating Fit: Conditionality, Contagion, and Domestic Politics Kenneth Dyson

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Part I. European and Global Contexts

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2. EMU and the New Member States: Strategic Choices in the Context of Global Norms Jim Rollo

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3. Real Convergence and EMU Enlargement: The Time Dimension of Fit With the Euro Area Iain Begg

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4. Economic Adjustment and the Euro in New Member States: The Structural Dimension of Fit Erik Jones

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5. Optimal Economic Governance in an Enlarged European Union: Scenarios and Options Ingo Linsenmann and Wolfgang Wessels

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Part II. Domestic Political and Policy Contexts

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6. The Baltic States: Pacesetting on EMU Accession and the Consolidation of Domestic Stability Culture Magnus Feldmann

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7. From Laggard to Pacesetter: Bulgaria’s Road to EMU Vesselin Dimitrov 8. From Pacesetter to Laggard: The Political Economy of Negotiating Fit in the Czech Republic Frank Bo¨nker 9. The First Shall Be the Last? Hungary’s Road to EMU Be´la Greskovits 10. Poland: Unbalanced Domestic Leadership in Negotiating Fit Radoslaw Zubek

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160 178

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11. Persistent Laggard: Romania as Eastern Europe’s Sisyphus Dimitris Papadimitriou

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Part III. Patterns of Sectoral Governance

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12. Financial Market Governance: Evolution and Convergence Piroska Moha´csi Nagy

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13. EMU and Fiscal Policy Vesselin Dimitrov

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14. EMU and Welfare State Adjustment in Central and Eastern Europe Martin Rhodes and Maarten Keune

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15. Domestic Transformation, Strategic Options and ‘Soft’ Power in Euro Area Accession Kenneth Dyson

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References Index

328 353

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List of Figures

3.1. The euro membership ‘J’-curve

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5.1. The Institutional Setting of European Economic and Employment Policy

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8.1. Support for EMU accession

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12.1. Foreign ownership and EBRD index of banking sector reform

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12.2. Share of CEE market in a bank’s total assets

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12.3. EBRD index of banking sector reform in 1997 and 2004

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12.4. EBRD index of non-bank financial institutions in 1997 and 2004

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12.5. Non-performing loans in the CEE and the EU15

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12.6. Capital adequacy ratios in EU15 and EU10 (%)

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14.1. Wage coordination and wage moderation 1997–2003

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14.2. ‘Welfare Stress’: social risk and public debt in the new member states

292

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List of Tables

2.1. Membership of IBRD, IMF, WTO, and OECD

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2.2. Private sector share of GDP in %

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2.3. General government expenditure (% of GDP)

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2.4. Foreign direct investment, net inflows (% of GDP)

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2.5. GDP (constant 1995 US$) 1990 ¼ 100

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2.6. Inflation, consumer prices (annual %)

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2.7. General government balance (% of GDP)

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2.8. General government debt (% of GDP)

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2.9. Monetary and exchange rate strategies in accession countries

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3.1. The Maastricht fiscal criteria: recent values and prospects

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3.2. Various indicators of competitiveness

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4.1. Nominal convergence indicators

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4.2. Fiscal convergence indicators, growth potential, and the need for structural reform

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4.3. Size, openness, and trade with Europe

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6.1. Annual inflation rates in Baltic states, in %, measured by CPI

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6.2. General government budget balance in Baltic States, in % of GDP

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6.3. Estonia: prime ministers, finance ministers, and central bank governors

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6.4. Latvia: prime ministers, finance ministers, and central bank governors

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6.5. Lithuania: prime ministers, finance ministers, and central bank governors

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7.1. Bulgarian governments, prime ministers, finance ministers and governors of the Bulgarian National Bank (1990–2005)

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8.1. Czech general government balances, 2000–6 (ESA 95 definitions)

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8.2. Czech prime ministers, finance ministers, central bank governors and party composition of cabinets

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List of Tables 8.3. Euro-scepticism in EU-accession states

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9.1. Transnationalization of selected ex-socialist economies

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9.2. Hungarian prime ministers, ministers of finance and central bank presidents (1990–2005)

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10.1. Poland: fiscal and monetary convergence with the Maastricht criteria 1997–2004

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10.2. Polish prime ministers, finance ministers, central bank governors, and party composition of cabinets

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11.1. Prime ministers, finance ministers, government coalitions, and central bank governors in Romania, 1989–2004

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12.1. Summary of financial sector transformation in the CEE Region, 1989–2005

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12.2. Share of foreign ownership in new EU member states (2003, % of total assets)

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12.3. Summary of CEE deposit insurance schemes, end-2004

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12.4. Portfolio structure of banks in Hungary and the EU15

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12.5. Bank profitability and efficiency, 2003

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14.1. Social expenditure in the new CEE member states and the EU15, 2001 282 14.2. Old-age dependency ratio, 2003–20

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14.3. Purchasing power standard (PPS) income levels in the CEE countries, 2003

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14.4. Social risk indicators: absolute values

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14.5. Social risk indicators: normalized (0–1) values (max ¼ 1)

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14.6. Social security contributions and social transfers

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14.7. Fiscal imbalances in the new CEE member states

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Notes on Contributors

Iain Begg is a visiting professor in the European Institute at the London School of Economics and Political Science, UK. He was the co-editor of the Journal of Common Market Studies from 1998–2003. Recent books include Funding the European Union (Federal Trust 2005); (co-edited with J.H.H. Weiler and John Peterson) Integration in an Expanding European Union: Reassessing the Fundamentals (Blackwell 2003); EMU and Cohesion: Theory and Policy (with Brian Ardy, Waltraud Schelkle and Francisco Torres, Principia 2002); (edited) Urban Competitiveness (Policy Press 2002); (edited) Europe Government and Money: Running EMU, the Challenges of Policy Coordination (Federal Trust and Kogan Page 2002) and Paying for Europe (with Nigel Grimwade, Sheffield Academic Press 1998). His research focuses principally on the political economy of European integration and EU economic policy. ¨ nker is assistant professor in the Department of Economics at Frank Bo European University Viadrina, Frankfurt an der Oder, Germany, and Research Officer in the Frankfurt Institute for Transformation Studies. His recent books include Institutional Design in Post-communist Societies: Rebuilding the Ship at Sea (with Jon Elster et al., Cambridge University ¨ rgen Press 1998); (co-edited with Eckehard F. Rosenbaum and Hans-Ju Wagener) Privatization, Corporate Governance and the Emergence of Markets ¨ ller and Andreas Pickel) Post(Macmillan 2000); (co-edited with Klaus Mu communist Transformation and the Social Sciences: Cross-Disciplinary Approaches (Rowman and Littlefield 2002); and The Political Economy of Fiscal Reform in East-Central Europe (Edward Elgar 2005). His main research interests are in the political economy of post-communist economic transformation and in German welfare state reform. Vesselin Dimitrov is senior lecturer in the Department of Government at the London School of Economics and Political Science, UK. His research interests focus on executive structures, public policy, and Europeanization. He recently led, with Klaus H. Goetz and Hellmut Wollmann, a

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Notes on Contributors

research project on the development of core executive institutions in Central and Eastern Europe and their effect on fiscal policymaking. His recent publications include Bulgaria: The Uneven Transition (Routledge 2001) and Governing after Communism: Institutions and Policy Making (co-authors: Klaus H. Goetz and Hellmut Wollmann; with contributions by Martin Brusis and Radoslaw Zubek) (Rowman and Littlefield 2006). Kenneth Dyson is research professor in the School of European Studies at Cardiff University, Wales. He is a Fellow of the British Academy and an Academician of the Learned Societies of the Social Sciences. His recent books include Elusive Union: The Process of Economic and Monetary Union in Europe (Longman 1994); The Road to Maastricht: Negotiating Economic and Monetary Union (with Kevin Featherstone, Oxford University Press 1999); The Politics of the Euro-Zone: Stability or Breakdown? (Oxford University Press 2000); (edited) European States and the Euro: Europeanization, Variation and Convergence (Oxford University Press 2002); (co-edited with Klaus Goetz) Germany, Europe and the Politics of Constraint (Proceedings of the British Academy vol. 119, 2003); and (co-edited with Stephen Padgett) The Politics of Economic Reform in Germany (Routledge 2006). He is co-editor of the journal German Politics and was adviser to the BBC2 series on the making of the euro. His main research interests are in German policy and politics, comparative political economy, and the EU. Magnus Feldmann is a Ph.D. candidate in Political Economy and Government at Harvard University, where he is also affiliated with the Weatherhead Center for International Affairs and the Minda de Gunzburg Center for European Studies. His articles have appeared or are forthcoming in Comparative Political Studies, The World Economy, Government and Opposition, Demokratizatsiya and in various edited volumes. His main research interests are comparative and international political economy, post-socialist transition and European politics. Be´la Greskovits is professor at the Central European University Budapest, Hungary. In 1998–9 he held the Luigi Einaudi Chair at the Institute for European Studies at Cornell University, and in 2003–4 he taught as a Visiting Professor of Social Studies at Harvard University. He has published The Political Economy of Protest and Patience. East European and Latin American Transformations Compared (Central European University Press 1998) and numerous articles and book chapters on the politics of policy reform. His recent publications include ‘Beyond Transition: The Variety of PostSocialist Development’ in Ronald Dworkin et al. (eds.) From Liberal Values

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Notes on Contributors

to Democratic Transition (Central European University Press 2003), ‘The ¨ nker, Klaus Mueller, and Path-Dependence of Transitology’ in Frank Bo Andreas Pickel (eds.), Post-communist Transformation and the Social Sciences: Cross-Disciplinary Approaches (Rowman and Littlefield 2002), and ‘Brothers in Arms or Rivals in Politics? Top Politicians and Top Policy Makers in the Hungarian Transformation’ in Ja´nos Kornai, Stephan Haggard, and Robert Kaufman (eds.), Reforming the State: Fiscal and Welfare Reforms in PostSocialist Countries (Cambridge University Press 2001) Erik Jones is resident associate professor of European Studies at the SAIS Bologna Center of the Johns Hopkins University. He is also Research Associate in the International Economics Programme at Chatham House, London. His recent publications include: (co-edited with Amy Verdun) The Political Economy of European Integration: Theory and Analysis (Routledge 2005); The Politics of Economic and Monetary Union (Rowman and Littlefield 2002); (co-edited with Paul Heywood and Martin Rhodes) Developments in West European Politics 2 (Palgrave); and special issues of International Affairs, the Journal of Asian Economics, and the Journal of European Public Policy. Maarten Keune has a Ph.D. in political and social science from the European University Institute, and is currently a senior researcher at the European Trade Union Institute in Brussels. He has published on labour markets, social policy, and institutional change in Central and Eastern Europe. Recent publications include: ‘The European Social Model and Enlargement’, in M. Jepsen and A. Serrano Pascual (eds.) Unwrapping the European Social Model (Policy Press 2006); and ‘Changing Dominant Practice: Making Use of Institutional Incongruence in Hungary and the UK’ (with C. Crouch) in: W. Streeck and K. Thelen (eds.) Beyond Continuity: Institutional Change in Advanced Political Economies (New York: Oxford University Press 2005). Ingo Linsenmann is project manager of ‘NEWGOV—New Modes of Governance’, located at the Robert Schuman Centre for Advanced Studies, European University Institute, Florence. Piroska Moha´csi Nagy is currently senior banker at the European Bank for Reconstruction and Development, while on leave from the International Monetary Fund, where she is adviser. She is author of the book The Meltdown of the Russian State (Edgar Elgar 2000). She is a member of the editorial board of the journal Finance and Development, Washington, DC.

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Notes on Contributors

Dimitris Papadimitriou is lecturer in European Politics in Government, International Politics and Philosophy (GIPP) at the University of Manchester, UK. He is also visiting research fellow in the Hellenic Observatory at the London School of Economics and Political Science. In addition to his book Negotiating the New Europe (Ashgate 2002), he has published on Europeanization and EU enlargement strategy and on aspects of domestic reform in Romania. Between 2002 and 2004 he was co-holder (with David Phinnemore) of a British Academy grant to study the impact of Europeanization on Romanian public administration. Martin Rhodes is currently professor of Comparative Political Economy at the Graduate School for International Studies at the University of Denver, Colorado. Between 1999 and 2006 he was professor of Public Policy at the European University Institute in Florence, Italy. He is the author of numerous works on European Union social policy and the comparative analysis of welfare states and labour markets. Recent publications include ‘Employment Policy: Between Efficacy and Experimentation’, in H. Wallace, W. Wallace and M. Pollack (eds.), Policy-Making in the European Union, Fifth Edition, Oxford: Oxford University Press, 2005; ‘EMU and Labour Market Institutions in Europe: The Rise and Fall of National Social Pacts’, Work and Occupations: An International Sociological Journal, 32, 2, 2005 (with B. Hancke´) and ‘Varieties of Capitalism and the Political Economy of European Welfare States’, New Political Economy, 10, 3, September 2005. Jim Rollo is professor of European Economic Integration at the University of Sussex and Director of the Sussex European Institute. He is editor of the Journal of Common Market Studies and Director of the Centre on European Political Economy at the University of Sussex. Between 2001 and 2003 he was Director of the ESRC research programme ‘One Europe or Several’. Until December 1998 he was Chief Economic Adviser in the British Foreign Office and before that director of the International Economics Research Programme at the Royal Institute of International Affairs in London. Wolfgang Wessels is holder of the Jean Monnet Chair of Political Science at the University of Cologne, Germany, and is Visiting Professor at the College of Europe, Bruges and Natolin. Furthermore, he is member of the executive ¨ r Europa¨ische Politik (IEP, Berlin), and Chairman of board at the Institut fu the Trans European Political Studies Association (TEPSA, Brussels). Most recent publications include: ‘Theoretischer Pluralismus und Integrations¨r den acquis acade´mique’, in H.-J. Bieling dynamik: Herausforderungen fu

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and M. Lerch (eds.), Theorien europa¨ischer Integration (Wiesbaden 2005), pp. 431–61; ‘A ‘Saut constitutionell’ Out of an Intergovernmental Trap? The provisions of the Constitutional Treaty for the Common Foreign, Security and Defence Policy’, in J. Weiler and C. Eisgruber (eds.), Altneuland: The EU Constitution in a Contextual Perspective, Jean Monnet Working Paper 5/04, New York/Princeton 2004; ‘Die institutionelle Architektur nach der ¨ here Dynamik—neue Koalitionen?’, IntegraEuropa¨ischen Verfassung: Ho tion, 3, 2004, pp. 161–75; ‘Theoretical Perspectives. CFSP beyond the Supranational and Intergovernmental Dichotomy’, in D. Mahncke, A. Ambos, and C. Reynolds (eds.), European Foreign Policy: From Rhetoric to Reality?, College of Europe Studies No. 1, Peter Lang, Brussels 2004, pp. 61–96; (with A. Maurer), Das Europa¨ische Parlament nach Amsterdam und Nizza: Akteur, Arena und Alibi (Baden-Baden 2003). Radoslaw Zubek is research fellow at the University of Potsdam in Germany. He holds a Ph.D. from the London School of Economics and Political Science.

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Introduction

This book seeks to make two contributions to the scholarly literature on European integration. First, it addresses important questions about the relationship between two central projects in European integration: Economic and Monetary Union (EMU) and eastern enlargement of the European Union (EU). What are the implications of these projects for each other, for the wider process of European integration, and—above all—for east central Europe? What do they tell us about the asymmetric nature of power, and about how power is exercised, and its location changing, in contemporary Europe? The book extends EMU studies eastwards. Second, the book seeks to add to the body of knowledge about the process of Europeanization. Europeanization studies has grown and matured over the last decade as a major research agenda. It attempts to explain the effects of European integration on domestic institutional arrangements, policies, and politics (see Graziano and Vink 2006). To what extent, and how, can continuities and changes at the domestic level be attributed to European integration? Within this fast-developing field there is an emerging literature that examines the notion of different ‘worlds’ of Europeanization (Featherstone and Kazamias 2001; Goetz 2002; Dyson and Goetz 2003). Existing studies of EMU as Europeanization have concentrated on its effects on ‘older’ member states, comparing traditional North-West core states like France and Germany with states in the Nordic and Mediterranean worlds. A question with which this book is concerned is whether accession to EMU reveals east central Europe as a distinctive ‘world’ of Europeanization in institutional traits. Alternatively, do its states differ at least as much from each other as they differ from traditional member states in North-West, Nordic, and Mediterranean

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Introduction

Europe? Are at least some states converging with traditional member states in their institutional characteristics? In addition, Europeanization studies have moved eastwards and begun to take an interest in ‘accession’ Europeanization (e.g. Grabbe 2001, 2003; Schimmelfennig and Sedelmeier 2002, 2005, and 2006; Dimitrova 2004; Hughes, Sasse and Gordon 2005; van Stolk 2005). However, this ‘accession’ Europeanization literature has largely ignored EMU. EMU offers an interesting case study of extreme Europeanization: in part, because it is an advanced policy project that requires domestic macro-institutional transformation in core executives; in part, because it goes to the heart of party political competition, especially over preferences for economic stability, fiscal discipline, and consolidating and strengthening the welfare state; and, in part, because ‘accession’ Europeanization continues and intensifies after EU membership. It provides an extended opportunity for ‘conditionality’ to operate: for EU entry, for Exchange-Rate Mechanism (ERMII) entry, and later for Euro Area entry. EMU enlargement as continuing ‘accession’ Europeanization, post-2004, poses ongoing major challenges for east central European states and for their governments in negotiating ‘fit’ with EMU entry requirements. It also raises questions about the way in which European economic governance evolves and about how EMU intensifies the pressures for domestic adjustment on traditional EU member states. The book’s principal argument is that the domestic effects of EMU are best understood by focusing on euro entry as a process of defining and negotiating fit in a complex framework of formal and informal conditionality (direct Europeanization), contagion (indirect Europeanization), and domestic politics. The key elements of this argument can be unpacked as follows. The emphasis on ‘negotiating fit’ draws out the multi-level context in which Europeanization is to be understood. Domestic, European, and global dimensions have to be accommodated in devising strategies for EMU accession. The emphasis on ‘defining fit’ highlights that EMU accession is a cognitive as well as a strategic process, one of argument and persuasion rooted in ideas. These two interconnected aspects—of defining and negotiating fit—suggest that EMU conditionality requirements are not a fixed given. Because of a residual room for manoeuvre, the evolution of EMU over time, domestic politics, and contagion processes from markets and from the policy behaviour of ‘significant others’, euro entry is an ongoing matter of debate and contest. This combination of uncertainty with EMU as unfinished business means that accession states have strategic options.

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Introduction

Nevertheless, an analysis of conditionality indicates that the room for manoeuvre of accession states is tightly circumscribed at the level of basic economic policy paradigm. Informal conditionality and its effects of domestic empowerment reduce the element of domestic discretion. EMU also illustrates that Europeanization involves not just direct effects from European integration through conditionality but also indirect effects through contagion. Contagion operates through effects both on markets and on policies of ‘significant others’. There is, in short, a complex dynamics that can produce ‘tipping points’ in the process of negotiating fit: moments of radical change. Finally, EMU accession involves the elite management of tensions and conflicts within the domestic structure of economic interests, domestic party and electoral competition, and domestic bureaucratic politics. This domestic context highlights the central strategic role of managing political time. Room for manoeuvre can be recaptured by acceleration or delay in moving to the next stage in EMU accession, by shifting between ‘pace-setting’ and ‘laggard’ roles. Developing on Dyson and Goetz (2003), this book addresses the following questions: . What are the effects of EMU on the policies, politics, and public institutions of east central European states? To what extent are changes in these three dimensions attributable to European integration or to global or domestic factors? Is the EMU acquis detailed and specific in its prescriptions? Are domestic changes broad or narrow in scope, shallow, or deep in impact? . How have these effects occurred? Are EMU effects to be understood in terms of ‘top-down’ conditionality requirements, exposing a ‘misfit’ with domestic economic arrangements and challenging domestic actors? Are its effects to be understood in terms of the way in which domestic actors use EMU to legitimate domestic reforms and overcome domestic veto players? To what extent have domestic executive institutions proved weak and adaptive to external challenge or sufficiently robust to persist and constrain domestic effects? . Which actors are empowered and which disempowered by EMU, and to what extent are those empowered able to shape its domestic effects? Does EMU reveal learning processes that are confined to a few small ‘islands of excellence’ within east central European core executives? Are there different categories of domestic technical elite in terms of how embedded they are in global, EU, and domestic institutional networks? . In what ways do EMU’s effects vary over time? Are they shaped by the relative newness of the Euro Area and the evolving nature of the EMU

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Introduction

acquis? Do they reflect a protracted and changing process of ‘accession’ Europeanization with distinct stages of pre-EU entry, pre-ERMII entry, and pre-euro entry? . Is the experience of these states with EMU distinctive? Are they likely to remain exceptional, because of their different status as ‘post-communist’ and their recent transition to liberal democratic systems and market economies, their particular pre-accession experience, and their specific problems of matching compliance with the Maastricht convergence criteria (nominal convergence) and of building capacity (through real convergence)? Are we seeing the emergence of different ‘clusters’ that cut across the distinction between ‘old’ and ‘new’ members? . Is EMU accession associated with patterns of convergence and divergence with the Euro Area and the wider EU? These questions are addressed within a three-part structure. This structure is designed to capture the multiple sources and drivers of transformation in east central Europe by offering different levels of analysis of Europeanization. Dyson, see Chapter 1 below, tries to integrate these levels in the notion of Europeanization as a process of defining and negotiating ‘fit’ between the EU and the domestic settings. The first part sets domestic institutional and policy transformation in its wider global, EU, and regional east central European contexts. Dyson focuses on the interaction between domestic political economy, formal and informal conditionality for EMU accession, and contagion processes in markets and policies within east central Europe. Europeanization is shaped by the large role of the euro in the relatively small banking systems and financial markets of east central Europe. Compared, for instance, to Britain, the banking and financial systems are euro-centred. Market-led processes of use of the euro drive the agenda of ‘accession’ Europeanization in euro entry policy. Equally, the policy choices of some east central European states—especially whether ‘pace-setter’ or ‘laggard’ roles are associated with successful economic performance or systemic crisis—are likely to induce lesson-drawing by other states. In short, there are distinctive dynamics within east central Europe. Rollo offers an international political economy perspective that stresses the embedding of EMU policy requirements in global norms. To the extent that EMU anchors these norms, it is difficult to disentangle its independent effects, other than in focusing and speeding up domestic transformation. The Single Market programme and EMU have themselves been pacesetters in the spread of global norms. Accession states are caught up in this dynamic.

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Introduction

Begg (Chapter 3) focuses on the economic and temporal dimensions of the problem of negotiating fit. His analysis centres on the tensions and potential conflicts between nominal and real convergence and the importance of adjustment once within the Euro Area—in short, the dynamics of endogenous development in a currency area. Jones (Chapter 4) stresses the structural determinants of fit and of whether particular east central European states emerge as pacesetters or laggards in euro entry. He also highlights the significant gains through lower real interest rates and trade effects. However, optimizing these gains depends more on internal reforms within the existing Euro Area than on domestic adjustment. Linsenmann and Wessels (Chapter 5) highlight the problems of designing optimal economic governance in an enlarging EU and different scenarios for development. Four themes emerge: the difficulties of moving beyond ‘soft’ coordination; the rationalization of forms of coordination; the increasing focus around the Euro Group of finance ministers from the Euro Area; and the continuing problems of compliance even amongst existing Euro Area member states and their implications for Euro Area enlargement. The early chapters offer an essentially ‘top-down’, ‘outside-in’ perspective on transformation in east central Europe. The second part provides a more in-depth, ‘inside-out’ analysis of how policy elites in east central European states define and negotiate fit with euro entry requirements. The focus is on the relationship between endogenous domestic factors and EMU conditionality in domestic transformation and on whether, and why, states adopt a ‘pace-setting’ or ‘laggard’ role in euro entry. The chapters map the range of Europeanization effects and the strategic use that domestic elites make of EMU accession. They highlight domestic institutional, especially executive, structures, which actors are empowered and which disempowered by EMU, the nature of political leadership, and the ability of political leaders to exploit the essentially voluntary nature of domestic timetables for euro entry. The final part assesses whether, and in what ways, EMU ‘accession’ Europeanization is linked to patterns of institutional convergence amongst east central European states in financial market, fiscal and welfare-state policies and whether these patterns are distinctive from those in the existing states in the Euro Area. The picture that emerges is not of a single ‘world’ of east central European Europeanization. Comparative analysis of domestic fiscal policy regimes reveals different clusters that overlap with traditional member states. Financial market regulation and supervision reveals a paradox: substantial and rapid convergence with the traditional member states on the basis of exceptional ‘top-down’

5

Introduction

Europeanization. In this sector different clusters are harder to identify. The comparative analysis of how EMU accession is affecting labour markets and wages is a matter for the second edition of European States and the Euro, by which time a substantial body of comparative research will be available for these sectors.

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1 Euro Entry as Defining and Negotiating Fit: Conditionality, Contagion, and Domestic Politics Kenneth Dyson

An Extreme Case of Europeanization Economic and Monetary Union (EMU) and the post–Cold War waves of eastern enlargement are two of the boldest policy projects in European integration since the Treaty of Rome established the European Economic Community (EEC) (now European Union (EU)) in 1957. Both are legitimated as historic. EMU is justified as making European integration irreversible and as securing the unification of a formerly war-stricken continent in peace and prosperity (Dyson and Featherstone 1999). Enlargement represents the ‘return to Europe’ of east central European states, Europe’s re-unification after the collapse of communism and their four decades of isolation, and a powerful tool for levering domestic change through accession negotiations (Vachudova 2005). At the same time EMU and eastern enlargement represent relatively new and untested projects. They present EU institutions, member states, and accession states with complex risks and uncertainties and represent serious challenges to engage in deep-seated domestic transformation. Eastern enlargement contrasts with earlier enlargements in 1973, 1981, 1986, and 1995. In the post-1997 accession negotiations the acquis communautaire was more comprehensive and detailed, and thus more demanding for accession states. In addition, the economic disparities in living standards, productivity, and costs with existing member states were very much starker. The result was that the effects on existing member states were

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more profound. Eastern enlargement extended the single European market to lower-cost countries, part of whose post-communist legacy was skilled labour forces. Enlarging the Euro Area to these states locked in the attractiveness of eastern Europe for foreign direct investment. The firm rejection of the European Constitutional Treaty in the French and Dutch referenda of 2005 embodied a strand of fear about what EU enlargement was doing to the traditional core of the EU. Both projects also overlapped in their timing. EMU was enshrined in the Maastricht Treaty (ratified in 1993) and led to the creation of the Euro Area in 1999. Its origins can be traced back to the Exchange Rate Mechanism (ERM) of 1979. The discipline of the ERM served as a training ground for EMU entry, and member states displayed some evidence of anticipatory Europeanization (Dyson 1994, 2000). However, EMU as a process of ‘accession’ Europeanization for the EU member states was concentrated in the period 1994–9 (stage two of EMU). During this period they focused on domestic institutional and policy reforms to ensure compliance with the convergence criteria and with the Statute of the European System of Central Banks (ESCB) in the Maastricht Treaty (for details, also on the two states with opt-outs, see Dyson 2002). On 1 January 1999 eleven member states joined the new Euro Area (Greece a year later). East central European states began preparations for the accession negotiations in 1996–7, with EMU as one negotiating chapter. On 1 May 2004 the first wave of eastern enlargement involved eight east central European states (Cyprus and Malta also joined). The second wave was to comprise Bulgaria and Romania in 2007–8. In the case of EMU and Euro Area membership they became ‘member states with a derogation’ (Article 109k of the Maastricht Treaty). EMU is an extreme case of Europeanization in three senses. First, the Euro Area represents a new historic project for its existing members. They are absorbed in a long-term and difficult process of adapting—or failing to adapt—to its effects, alongside the effects of eastern enlargement and potential enlargement of the Euro Area. The result is additional political stresses and strains from intensifying competitiveness. Second, the Euro Area has a better claim that any other policy sector to represent an embryonic ‘core’ Europe. Euro Area accession is correspondingly bound up with matters of state identity, with what kind of European state its elites seek to create. EMU accession is a profoundly important statement of where one belongs in Europe, alters the parameters of core and periphery, and raises questions about whether east central Europe is an exceptional ‘world’ of Europeanization or fragmenting into different clusters (some of which

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make them closer to older member states). Third, EMU is an extreme case of Europeanization because entry remains a protracted and unfinished project after EU accession. It extends over several phases, beginning in 1996 and continuing beyond 2004. To a greater extent than any other policy area, euro entry offers the EU an extended opportunity to shape domestic transformation in east central Europe. This shaping takes place through mechanisms of formal and informal conditionality and through an intensification of institutional ties in preparing for euro entry. The combination of extended accession in time with increasing constraints makes enlarging the Euro Area an extreme case of accession Europeanization. EMU as accession Europeanization is extreme in two other ways. First, the detailed specification and prescription of EMU templates has implications for domestic adaptation not just within different policy sectors but also in macro-institutional arrangements, especially within core executives. EMU differs from agricultural and regional policies (cf. van Stolk 2005) and from justice and home affairs (cf. Grabbe 2002, 2003) in its linkage to macroinstitutional effects in core executives. However, these effects are much more pronounced in the monetary than in the fiscal policy pillar of EMU, while in competitiveness policies they are even less visible. Second, EMU goes to the heart of domestic party competition, especially over preferences for fiscal consolidation and conserving and developing welfare states.

The Argument Outlined Defining and negotiating fit provides an approach to studying ‘accession’ Europeanization or ‘Europeanization East’ that avoids the excessively simplifying and constraining expectations from two contending literatures: the external incentives literature that stresses the efficacy of EU conditionality in promoting convergence (Schimmelfennig and Sedelmeier 2005), and the domestic opportunity structure literature that emphasizes variegation (Goetz 2005). The domestic politics of EMU accession are caught up in larger EU- and global-centred dynamics that testify to the pervasive influence of external incentives and the actors that define and apply these incentives. However, despite the extreme nature of EMU as a case of accession Europeanization (as outlined above), its domestic effects in east central Europe are complex. The domestic effects of external incentives are mediated by specific national executive characteristics, party political factors, and economic

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structures, which result in divergent as well as convergent outcomes. In addition, domestic effects are conditioned by the varying margins of uncertainty surrounding the conditionality attached to euro entry across policy areas and over time. EU actors, and some domestic actors like central banks, seek to reduce these uncertainties so as to maximize their leverage over domestic change. In contrast, many in domestic political and technical elites attempt to use these uncertainties to retain or to increase their room for manoeuvre over the scope, timing, and pace of change. Domestic change is, in short, caught up in a process of defining and negotiating fit between euro entry requirements and domestic constraints. Defining and negotiating fit is a dynamic and political process of seeking to shape the direction, scope, sequencing, and pace of change across EU and domestic levels—it begs questions about who shapes this process. Put simply, the accession states have no power over defining fit; what power they possess relates to negotiating fit, where they face domestic strategic choices about how—using negotiation as a nautical metaphor—they navigate by reference to the European ‘map’ of entry conditions. The room for manoeuvre of domestic east European elites in defining and negotiating fit is tightly constrained by three structural phenomena. First, an enduring asymmetry of power privileges Euro Area member states, the European Central Bank (ECB), and the European Commission. After EU accession they continue to act as the ‘gate-keepers’ of euro entry, especially in defining what precisely constitutes fit. This asymmetry above all empowers central banks in the accession states and creates opportunities for them to reframe domestic debates. Second, formal EMU conditionality is framed by an ascendant economic paradigm of ‘sound money and finance’ whose guardian is the ECB. This background conceptual and theoretical underpinning to conditionality poses questions about whether, and to what extent, domestic elites and publics fully understand what is meant by its formal requirements. Put another way, it tests whether post-communist legacies endure at the level of ideas and how well definitions of fit are domestically embedded. Third, the process of negotiating fit is bound up in contagion processes within the east central European region and the larger EU. Contagion operates through two main mechanisms: the unofficial use of the euro as a parallel currency in the region (as cash holdings and foreign currency deposits by private agents), for invoicing exports and imports, and in international financing (making it part of the euro ‘time zone’); and sensitivity to each other’s, and to existing EU member states’, policy choices and their effects. This sensitivity takes the form of fear: of being left behind as a laggard,

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consigned politically to the periphery and economically to lose out on foreign direct investment; or of being exposed to economic and political crisis from acting as an over-ambitious pacesetter. Negotiating fit in this constraining structural context is made difficult by varying domestic contexts, in particular, structures of economic interest, executive configurations, bureaucratic politics, and party and electoral competition. These contrasting domestic opportunities and constraints mean that domestic economic policymakers face different ranges of potentially acceptable and credible policy reforms to comply with EMU requirements. Hence, the Baltic States are able to act as pacesetters; euro entry locks in pre-existing domestic policy regimes. In contrast, Hungary moved from pacesetter to laggard. Governments are politically vulnerable to opposition attacks on their insensitivity to the welfare costs of policy reforms, notably fiscal consolidation. They are disposed by electoral timetables to defer reforms, while oppositions are tempted to engage in europopulism. In consequence, EMU conditionality is likely to have relatively short-term, shallow effects on attitudes within political elites and to elicit opportunistic behaviour (cf. Taggart and Szczcerbick 2001). These domestic political problems give an added incentive to central banks in accession states to seek sharper and tougher definitions of EMU templates to more strongly lever change. Because asymmetry of power offers no opportunity to press for change in EMU templates, accession state governments revert to manipulation of the timetable for euro entry as a means of retrieving room for manoeuvre over economic policy. EMU conditionality is complex: sometimes extremely strong, sometimes weak, and occasionally non-existent. There is an obligation to prepare for euro entry. However, and critically, individual accession states retain responsibility for their own euro entry strategies. Dates for entry are a voluntary matter. Moreover, accession states have a good deal of discretion over the sequence of policy reforms. In major areas, like exchangerate policy before entry into ERM II, there is no detailed prescription. The implications of the EMU and related acquis are also often complex, problematic, and even paradoxical. EU actors send confusing signals of tightening and loosening. On the one hand, they provide a tight interpretation of conditionality, for instance, on the minute details of national central bank independence for EU entry, on inflation rates, and on ERM II membership. Its roots are not only in a shared policy paradigm of ‘sound money and finance’ but also in lessons acquired from statistics and policy experience. The sharp economic disparities between east central European states and existing member states highlight their long-term

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‘catch-up’ requirements in living standards. They also imprint in key Euro Area policymakers, notably in the ECB, a sense of the risks and uncertainties surrounding their euro entry. This caution was further magnified by the emerging scale of the policy problems with Mediterranean Euro Area members like Greece, Italy, and Portugal. On the other hand, internal problems of compliance with the Stability and Growth Pact (SGP) in the Euro Area led to reform in 2005 in the direction of a greater flexibility in fiscal policy rules on public debt and budget deficits and in their application. The result is potential uncertainty about what exactly is required to enter. Uncertainty is compounded by tensions and potential conflict between compliance and capacity: compliance with the nominal Maastricht convergence criteria and the SGP, and capacity to promote and deliver stronger economic and social cohesion within the EU through ‘real’ convergence in GDP per capita, wages, and social benefits. Though the European Commission and the ECB stress compliance with the nominal criteria, they do not wish to see compliance achieved at large costs to the real economy and to economic and social cohesion. Party political and electoral incentives in east central European states encourage the priority of real over nominal convergence. Further uncertainty is added by the question of which model from the previous 1995 EU enlargement to follow: Austria and Finland, which rapidly joined the Euro Area in 1999, or Sweden which—though not having an opt-out like Britain and Denmark—behaved as if it had. East European states face different role models. Pacesetters could seek to emulate Austria, Finland, Ireland or Greece; laggards could look to Sweden. These paradoxes and uncertainties offer space in which east central European governments can manoeuvre with the objective of negotiating a politically and economically credible fit between EU requirements and domestic constraints. EMU accession is a complex and dynamic political process of defining and negotiating fit with EU conditionality in a context of, first, crossnational contagion processes in markets and policies and of, second, the domestic realm of economic structure, party and electoral competition, executive configurations, and bureaucratic politics. The process is constrained and shaped by formal and informal conditionality. However, conditionality highlights only the direct effects of Europeanization, and thus a small part of the underlying dynamics of change at work. Contagion captures the indirect effects of European integration. These effects are produced by the policy behaviour of ‘significant others’ and by market behaviour, especially in financial markets. Processes of contagion have been neglected in Europeanization research.

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Defining and negotiating fit is about reconciling external conditionality and contagion with domestic political constraints. It is a dynamic process in which east European states must formulate euro entry policies that command credibility with the EU, with financial markets, and with domestic economic structures, bureaucratic interests, party supporters, and voters. Hence credibility requirements stretch beyond EMU conditionality (which itself is complex, multifaceted, and often imprecise). In consequence, equilibria in defining and negotiating fit are likely to be different across cases and unstable over time. There will be pacesetters and laggards, who in turn may change position.

Formal and Informal Conditionality: Paradox and Variation The room for manoeuvre of east central European accession states in defining and negotiating fit with the Euro Area is bound up, and constrained by, an asymmetry of power that characterizes their ‘accession’ Europeanization. This asymmetry of power rests in large part on the requirement of their compliance with an acquis communautaire that they had no part in agreeing. It might seem to be less stark in EMU than in other cases: the EMU acquis differs in being less focused on legal convergence and more on coordination of economic policies, especially to promote nominal convergence. Compared to other negotiating chapters like environment, agriculture, and free movement of goods, the number of domestic legislative changes consequent on EMU is very tiny. However, this limited formal conditionality has a deeper, more pervasive significance because it is reinforced by a tightly defined informal conditionality: the ‘sound money and finance’ paradigm. In addition to this ideational character, the asymmetry of power has a material basis. EU and Euro Area enlargements pose a numbers problem. In terms of numbers eastern accession states had weight. Previous EU enlargements involved three (Britain, Denmark, and Ireland) in 1973, one (Greece) in 1981, two (Spain and Portugal) in 1986, and three (Austria, Finland, and Sweden) in 1995. In contrast, the first wave of eastern enlargement in 2004 added ten states (eight in east central Europe, and Cyprus and Malta) and the second in 2007–8 promised another two (Bulgaria and Romania). The numbers problem forces attention to the composition of, and voting rights in, the structures of European economic governance like the ECB governing council and the Economic and Financial Committee. However, numbers do not translate into matching power over EMU accession.

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On other material indicators—weight of GDP and financial assets—the impact of eastern enlargement is relatively small compared to previous enlargements, like those of 1986 and 1995. On average (and including Cyprus and Malta and excluding Bulgaria and Romania in these figures), GDP per capita is, in terms of purchasing power parity, around 44 per cent of that of the Euro Area. For the same countries, compared with the size of their combined population (around 35 per cent of the Euro Area’s population), their GDP amounts to only some 7 per cent of Euro Area GDP. The east central European states have small consumer markets and limited financial weight to bring to EMU accession negotiations, compared for instance to Britain. In addition, they have not developed regional cooperation as a means of projecting their interests more strongly in EMU accession. There was less incentive to make the case for euro entry on the basis of arguing that they were a special case as a regional grouping than to pursue individual strategies of euro entry. The significance of conditionality in shaping domestic transformation in east central Europe is only fully appreciated if one looks beyond EU insistence on formal compliance with the EMU acquis communautaire to informal acceptance and understanding of the core policy beliefs that underpin EMU (cf. Hughes, Sasse, and Gordon 2005: 2). This deep, informal conditionality tightly constrains the room for manoeuvre of east central European states. As Rollo (Chapter 2 below) argues, EMU anchors and reinforces global norms. These norms were part and parcel of a process of post-communist transition that preceded EU accession negotiations. Though there was some ‘anticipatory’ Europeanization like central bank independence on the German model (cf. Goetz 2001), EMU formal conditionality is embedded in pre-existing global and domestic processes of transition. It forms an element in a more complex constraining framework. Paradoxically, however, many in both the political and the technical elites have little contextual understanding of the meanings that formal conditionality carries (cf. Dimitrov, Goetz, Wollmann, with Brusis, and Zubek 2006).

Formal Conditionality: ‘Hard’ and ‘Soft’ The two modes of conditionality operate according to different mechanisms. Formal conditionality in EMU takes five forms (cf. Grabbe 2001): . Institutional models. The most important example is the alignment of national central bank independence with the requirements of the ESCB.

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.

.

.

.

National legislation must comply with rules on functional, financial, personal, and institutional independence and with prohibitions on direct central bank financing of the public sector. The ECB plays a central role in defining very strictly what constitutes fit and promoting a close legal convergence. Aid and technical assistance in preparing for accession. Mechanisms include the (formally voluntary) Pre-accession Fiscal Surveillance Procedure (PFSP) and mission visits by Eurostat to help develop national accounts capacity. Benchmarking and monitoring. This mechanism takes place through the ECB Convergence Reports, the European Commission’s Regular Reports on accession states, and the review of the annual Pre-accession Economic Programme (PEP) of each accession state. Advice and twinning. This mechanism includes the secondment of accession state officials from and to EU member state central banks and finance ministries, and from and to the ECB and Eurostat. Another example is observer status in the Committee of Monetary, Financial, and Balance of Payment Statistics (CMFB), which develops statistical policies to inform the preparation of national accounts and support the excessive deficit procedure. Central banks in accession states have benefited enormously from this mechanism. ‘Gate-keeping’. This mechanism involves controlling entry into EU accession negotiations, EU membership, ERM II membership, and finally membership of the Euro Area. A variety of actors are potential veto players: the ECB governing council, the European Commission, Eurostat, the Euro Group, the Economic and Financial Committee and ECOFIN.

During the pre-EU accession phase (1996–2003) the absence of specific, detailed EU prescriptions for domestic fiscal policies and macroeconomic policy coordination meant that ‘soft’ mechanisms of conditionality prevailed in this sector—technical advice and aid, twinning, benchmarking, and monitoring. This prevalence of soft mechanisms was reflected in the European Commission’s Regular Reports on individual states, to the extent that they focused on monitoring domestic progress in fulfilling the Copenhagen economic criteria—namely ‘the existence of a functioning market economy and the capacity to cope with the competitive pressures and market forces within the Union’. These criteria left considerable room for interpretation about precisely which economic reforms were required, for instance, in setting wages in the public sector and social benefits.

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However, the Commission’s reports were ‘harder’ when they monitored progress in transposing the EMU acquis into national laws. The key elements of hard conditionality in the EMU acquis were derived from Treaty provisions: . The complete liberalization of capital movements (including unilateral liberalization towards the international economy)—Articles 56–60. . The prohibition of direct central bank financing of the public sector (no overdraft facilities, no credit facilities, no direct purchases of debt instruments)—Article 101. . The prohibition of the privileged access of the public sector to financial institutions (so that public sector borrowing is subject to market discipline)—Article 102 and Regulation 3604/93. . The independence of the national central bank (functional, institutional, financial, and personal). In these areas the Commission conducted a critical monitoring of compliance with legal convergence. These requirements were designed to provide a framework for monetary and fiscal discipline and to develop a robust financial sector. However, in the area of macroeconomic stability and sustainability of public finances the EU did not attempt to develop any clear criteria by which readiness for EU accession was to be assessed. The tough ‘gate-keeping’ mechanisms of ERM II and of Euro Area entry were post-EU accession and potentially long delayed before their increasingly constraining effects were felt. Though their effects could be apparent in ‘anticipatory’ Europeanization, such effects were domestically originated and voluntary. The EMU negotiating chapter was not in itself complex, long or detailed and proved one of the easiest and quickest to negotiate. Most of the problems of domestic adaptation were deferred. In any case, the EMU negotiating chapter was caught up in the broader political dynamics of accession negotiations and the overwhelming pressure to close deals to ensure an overall successful outcome. For these reasons formal conditionality proved a limited instrument. More importantly, the EMU chapter was nested within much larger and more complex chapters dealing with the single European market acquis. EMU had always been understood as about the completion of the single market and as intimately tied to this project (Dyson and Featherstone 1999). Compliance with the single European market programme of market liberalization was understood as central to creating the economic pillar of EMU. Consequently, EMU accession became bound up in the contagion processes of indirect Europeanization attributable to the single European market programme.

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Soft mechanisms of formal conditionality played a more significant role across the fiscal and competitiveness policy sectors in EMU as pre-EU accession. In this period, the PFSP was the European Commission’s main policy instrument for technical assistance and benchmarking and monitoring in these sectors. Its aim was to prepare accession states for their future role in EU policy coordination mechanisms, notably the excessive deficit procedure, and to foster the adoption of appropriate budgetary rules and procedures. Beginning in early 2001, the PFSP had three main elements: . Accession states were to comply with an annual ‘fiscal notification procedure’, which was designed to ensure that their definitions, reporting rules and coverage were consistent with EU standards. National accounts were to be presented according to the European System of Economic Accounts (ESA95) methodology. The objective was to ensure a clear, reliable statement of budget deficit and public debt positions on the basis of meaningful EU and international comparisons. In particular, they were to be prepared on a multi-annual basis and to integrate the special budgets of different agencies into a single consolidated public budget. In this way accession states were introduced to an expanding EU statistical case law (Savage 2005). . Accession states were to submit annual PEPs. The objective of PEPs was to develop a coherent and credible domestic macroeconomic framework. They focused on strengthening analytical and institutional capacity in fiscal policy and identifying appropriate structural reforms and their budgetary effects. The PEPs were targeted on promoting real convergence rather than on the Maastricht convergence criteria. They were seen as forerunners and training mechanisms for the convergence programmes that would have to be submitted under the SGP after EU entry. . Accession states were part of a regular multi-lateral Economic Policy Dialogue at technical and ministerial levels. This dialogue assessed the results of the PFSP issues surrounding the relationship between real and nominal convergence, exchange-rate policies, financial sector reforms, and the European Commission reports on macro-economic and financial stability in the accession states. The PFSP process was a device through which the European Commission sought to accelerate domestic transformation on two fronts: . Macroeconomic stabilization so that accession states had sufficient room for manoeuvre to adjust through fiscal policy once exchangerate flexibility was lost.

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. Acceleration of structural reforms in order to speed real convergence and improve economic flexibility to cope with shocks. PEPs were expected to set clear priorities for public expenditure, tax reforms, and the most effective use of EU financial assistance before and after accession. The European Commission used PFSP to argue that the ‘catch-up’ process was likely to be long (with many states taking a generation or more to reach 75 per cent of the average GDP per capita in the EU of 15), but that it could be shortened by urgent structural reforms. At the same time it cautioned against haste. Though structural reforms would support both nominal and real convergence, the Commission encouraged accession states to retain and use their room for manoeuvre in economic policy by avoiding being too specific in their euro entry strategies and committing to too early a date for ERM II entry and for eventual euro membership. The Commission gave high marks to the Czech, Estonian, Hungarian, and Slovak PEPs of 2001. However, it criticized the Polish PEP on two counts: its objective of complying with the Maastricht convergence criteria by 2005 was viewed as unrealistic and excessively risky; and its lack of firm policy commitments in structural reforms and of quantification in some aspects of the medium-term framework reduced its credibility. The Polish case illustrated how the voluntary nature of the process could be used by domestic technical elites to reduce the impact of benchmarking and monitoring by an absence of clarity about details. Commission criticisms of inadequate structural reforms and fiscal policy frameworks were also taken up in its Regular Reports on individual accession states. However, more serious were the Commission and, above all, ECB criticisms of the failure of accession states to take sufficiently seriously EU institutional templates for the independence of national central banks. Their criticisms were forcefully directed at Hungary and Poland, and—as the chapters in this book show—were influential in the domestic debates. In its 2003 report on Romania the Commission noted only limited progress in adopting the EMU acquis, and no progress since the 2002 report. The institutional constraints on domestic fiscal policy tightened with EU entry in 2004. At this point the SGP provided a harder formal conditionality in the form of an EU template of fiscal rules on deficits and debt (see later). This template was reinforced by the requirement of compliance with ESA95 on national accounts and with the statistical case law of the EU on harmonizing budgetary data. New accession states were required to submit annual convergence programmes that showed how they intended

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to comply with the fiscal rules. These programmes were subjected to Commission monitoring, peer review in ECOFIN, and the excessive deficit procedure. The SGP exemplified how the EMU acquis could be a moving target, and hence contain considerable uncertainty. Statistical case law developed in the direction of tighter constraints on budgetary reporting to shore up the basic credibility of the excessive deficit procedure (Savage 2005). On the other hand, the SGP reform of 2005 gave more room for fiscal policy manoeuvre to new accession states with low debt and high growth potential. In addition, the attitudes and behaviour of existing member states like France, Germany, and Italy added to the sense of uncertainty. A new stress on exemptions and flexibility suggested a less constraining fiscal framework.

Informal Conditionality Informal conditionality has deeper and more pervasive effects on the room for manoeuvre of east central European states in defining fit. It functions at the deeper ideational level of background policy paradigms and through mechanisms of policy learning in transnational policy networks. These networks are most developed in central banking and amongst monetary economists. They are much less present in finance ministries and, even less, in economics and industry ministries, where post-communist legacies and domestic ‘clientelist’ networks of mutual dependency within sectors are more apparent. In particular, central bankers form a tight, cohesive transnational policy community, united around shared policy beliefs (a so-called ‘epistemic community’). Their shared beliefs give them a self-confidence, and sense of legitimacy that endows their policy proposals with a high degree of persuasiveness in domestic policy arguments. ‘Accession’ Europeanization privileges and empowers domestic central bankers and helps them to win arguments. However, the origins of this privilege and empowerment rest outside the EMU process in globally shared norms and in close exposure of central banks to global financial markets. Central bankers and some finance ministry officials had already been exposed to these norms during post-communist transition. This sense of a shared transnational epistemic community is much less developed within finance, economics, and industry ministries, where attitudes are more conservative and inward-looking and Europeanization effects shallower. Hence, informal conditionality is variable in its domestic effects.

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Informal conditionality takes the form of two complementary sets of policy beliefs—‘optimal currency area’ theory and ‘sound money and finance’. Currency area theory stresses that, in entering a single currency area, states abandon two key policy instruments of economic adjustment—the exchange rate and the interest rate. In consequence, they are forced to rely much more on other instruments to adjust to asymmetric shocks—labour market mobility, wage flexibility, and/or fiscal policy. Fiscal policy works optimally as a policy tool of adjustment as long as public debt levels permit the ‘automatic stabilizers’ to operate effectively. Hence, policy beliefs privilege an agenda of domestic reforms to strengthen fiscal discipline and to give more flexibility to collective bargaining and labour markets. The logic of this policy belief fundamentally challenges the ideological attachment to social solidarity amongst many east European social democrats and nationalist politicians of the centre–right. There is, in short, a problem of ideational fit with key actors within domestic political elites. This same problem is also apparent within current Euro Area member states, as the French and Dutch referenda of 2005 showed. The constraint of informal conditionality is further tightened, and the challenge of ideational misfit accentuated in some areas of the domestic political spectrum, by the underlying policy paradigm of ‘sound money and finance’. Euro Area monetary and fiscal arrangements are embedded within, and find coherence and legitimacy from this paradigm, which is anchored in Articles 3a(3) and 102a of the Maastricht Treaty (Dyson 1994, 2000; McNamara 1998). The revision of the ECB monetary policy strategy in 2003 and the reform of the Stability and Growth Pact in 2005 can be interpreted as loosening and greater flexibility (see later). Though, in the view of critics, these rule changes may have reduced its credibility, they do not fundamentally challenge the policy paradigm. It rests on a robust body of economic theory that is shared by monetarists (both fundamentalists and moderates) and neo-Keynesians (though not traditional Keynesians). Its two core beliefs are the neutrality of money and the centrality of credibility to policies to counter inflation (Dyson 1994). The first belief argues that in the long-term, growth and employment are independent of monetary policy, which should only be targeted on inflation; the second that inflation is a phenomenon of expectations so that effective anti-inflation policies depend on building credibility. They converge around the policy prescription that ‘binding hands’ in monetary and fiscal policies is essential for sustainable growth and employment. ‘Binding hands’ delivers credibility and reduces the costs of disinflation by

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ensuring that macroeconomic policies are insulated from the electoral and party incentives of politicians to create inflation. States can ‘bind hands’ and gain credibility by two mechanisms: importing discipline by fixing policy to a strong external anchor (classically, tying the domestic currency to a ‘hard’ currency, for instance, through membership of the Exchange Rate Mechanism (ERM)); and the domestic creation of discipline by giving independence to the national central bank, which has the single objective of price stability. Euro entry strategy combines these mechanisms in an especially tough combination of binding hands. Credibility is increased when an independent monetary policy is flanked and supported by clear, transparent fiscal policy rules. The institutional arrangements of the Euro Area are built around this policy paradigm of ‘sound money and finance’: notably the goal, instrument, and institutional independence of the ECB, and the ‘hard’ coordination of the SGP. EMU accession involves a commitment by east central European states to this policy paradigm of ‘enabling constraint’. Proponents of the paradigm believe that it is in the self-interest of states to voluntarily adopt euro entry. EMU locks in sustainable economic growth and employment, and thus avoids the domestic economic and political costs of ‘boom and bust’.

Conditionality, Transition and Domestic Transformation The EMU conditionality requirements that are linked to Euro Area accession are challenging for the east central European states. They represent systematic pressures and incentives for domestic transformation. However, the challenges are variable. They depend not just on how specific and prescriptive is the EMU template across sectors and over time but also on the particular character of post-communist transition and the nature of the institutional and policy choices made about transition, and how well they fit with these templates. Domestic transformation is an on-going process that reflects the legacies and problems from these past domestic choices about transition, as well as EMU conditionality. The domestic effects of EMU conditionality are mediated by relatively robust macroinstitutional and sector arrangements, which in turn reflect this earlier process of transition, in central banking, fiscal, corporate governance, financial market, industrial and employment policies. These core executive arrangements provide technical and political elites with bureaucratic interests to promote and defend and with platforms for this purpose. In short, EMU templates are not downloaded to fill institutional ‘voids’

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(financial market regulation is an exception); their effectiveness is not enhanced by domestic institutional ‘weakness’ (cf. Goetz 2001). The challenge from misfit in EMU accession is, accordingly, variable. In monetary, exchange-rate, fiscal, and structural reform policies it ranges from low (e.g. Estonia) through moderate (e.g. Hungary) to fundamental (e.g. Romania). Though moderate misfits trigger an agenda of domestic reform, they leave a range of discretion to domestic policymakers. More problematic is the possibility that fundamental misfits could produce domestic inertia and resistance. Domestic elites use the uncertainties surrounding these misfits in different ways. Some within the technical elites—notably in their central banks—argue for tighter, more specific EMU conditionality, especially to achieve more rapid and secure fiscal discipline. Other technical elites, for instance, in economics and industry ministries, seek to distance their sector domains from the effects of EMU conditionality. On the whole, the political elites and leaderships within the core executives welcome room for manoeuvre. Domestic political incentives from electoral and party competition point to retaining flexibility in economic policies in order to support accelerated real convergence with the rest of the EU, and thus increase living standards. Hence, political preferences tend to embrace retention of room for manoeuvre in adapting to the requirements of euro entry. Domestic challenges from misfit are moderated to the extent that east central European states have completed the process of transition to competitive market economies before EMU accession Europeanization begins to impinge (Mattli and Plumper 2004). Some had started in more favourable conditions: Hungary inherited an advantage in market liberalization. They also differed in the method and timing of transition, with Poland pioneering the ‘big bang’ approach. States like Romania that combined poor initial conditions with a preference for gradualism in transition were more likely to encounter serious problems of negotiating fit on EMU accession. However, across most of east central Europe transition was largely complete, though with some unfinished business, and hence accounted for much domestic transformation (European Bank for Reconstruction and Development (EBRD) 1995–2004; Gros and Steinherr 2004). These states were, by and large, pace-setters in post-communist transition, and hence better positioned to negotiate fit in EMU accession. Nevertheless, transition continued to cast economic, social, and political shadows over EMU accession. There was still a marked post-communist legacy of a higher share of employment in industry and a higher energy

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use than was to be expected on the basis of income per capita. Moreover, transition problems remained, notably in lack of professionalism in public administration and in financial sector regulation and development. There were, additionally, difficult transition-related legacies, above all in varying levels of welfare stress. Issues like ending indexation of wages and social benefits threatened to generate widespread domestic opposition from the losers of transition. Perhaps the most potent evidence that transition was over came from market liberalization. East central European states were in many respects more advanced in market liberalization than not just other countries with their level of income per capita but—more importantly—many existing EU and Euro Area members. This factor, combined with low production costs and skilled workforces, meant that they were well positioned to capture the benefits of closer European economic integration. Existing Euro Area members often faced more fundamental domestic challenges of misfit from the indirect effects of EMU (and the single European market) on their competitive positions. Their taxation, welfare state, labour market, and collective bargaining policies were under increasing pressures to promote greater flexibility in wages and working time and practices if they were to retain, as well as to attract, new investment (Sinn 2002). In areas like flat-rate taxation policies east European states, notably Estonia and Slovakia, emerged as policy ‘shapers’ rather than ‘takers’; states like Austria and Finland had to adapt to their behaviour. The moderate to fundamental challenges to many east European states from the direct effects of EMU compared with the potentially even more fundamental challenges to at least some existing members from EMU’s and the single European market’s indirect effects. At the same time this factor was offset by the continuing ‘agglomeration’ effects from which those traditional member states close to the EU’s ‘core’ benefited. The combination of offering to firms readier access to, or presence within large, rich markets along with high quality infrastructure gave states like France and Germany some leeway to levy higher corporate taxes and pay higher wage levels. By the time of EMU accession Europeanization, domestic processes of transition were sufficiently completed for east central European states to have consolidated their own distinctive executive institutional structures. These structures conditioned the context within which their political elites and technocratic elites—in central banks, and economics and finance ministries—defined and negotiated fit with EMU requirements. They could not be described as ‘weak’, let alone institutional ‘voids’, when interfacing with EU actors (cf. Goetz 2001). Technical elites in

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particular possessed significant institutional capacity to the extent that they had formal competences and resources, notably of economic, financial, and industrial expertise. They gained strength either from being integrated into larger global and increasingly EU institutional networks that were united by shared beliefs and knowledge (like central bankers) or from being part of dense domestic sectoral networks (like industry ministry officials). Finance ministries provided a third category of technical elite. They were integrated into global and EU networks (though to a lesser extent than central bankers). However, they were also embedded in the domestic institutional framework. In contrast to ‘line’ ministry officials, these frameworks were not at the sectoral level but on a central coordinating level, making them potentially more powerful players than sectoral ministries. Domestic transformation was caught up in, and conditioned by, how effective contending technical elites were in using EU requirements to strengthen or to protect their domestic positions. The institutional weaknesses of central banks and finance ministries derived from a degree of isolation that followed from being ‘islands of technical excellence on EMU’ within the wider executive structure. From the perspective of compliance with the Maastricht convergence criteria, these weaknesses were reinforced when one or both of two domestic conditions applied: . Central policy coordination and leadership on euro entry was frustrated by fragmentation within the core executive due to the lack of formal competences of the prime minister and/or finance minister (as, for instance, in the Czech Republic) . The policy preferences of the governing party or parties favoured priority to defence or even extension of the welfare state (as in Hungary where, despite a centralized institutional framework, the FIDESZ government (1998–2002) and the Socialist government (2002–) proved disinclined to pursue fiscal prudence). Consequent domestic difficulties of sustaining fiscal consolidation complicated EMU accession. This domestic paradox of institutional capacity and resilience, on the one hand, and institutional weakness to deliver on economic stability, on the other, blunted the cutting edge of EMU conditionality. In Bulgaria and Romania initial conditions were poorer, they had opted for a ‘laggard’ role in transition, and consequently transition was less complete. Here too EMU conditionality faced constraints. The lack of an early shock therapy—on Estonian and Polish lines—through radical market

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liberalization and privatization created opportunities for vested interests to form across the domestic economic and political structures. This state ‘capture’ strengthened resistance or inertia in the face of external conditionality, especially in retaining state subsidies that made for fiscal complications. Bulgaria differed from Romania in undergoing a traumatic economic and political crisis in 1997. The result was a delayed shock therapy: the International Monetary Fund (IMF) imposed tough conditionality requirements for its financial assistance. These IMF requirements were in many respects more detailed and specific than later EU conditionality requirements. They led Bulgarian policymakers to opt for a pacesetting role in transition within the Balkans. Romania found itself more exposed as a laggard, its credibility in negotiating fit limited by the legacy of earlier state capture on institutional capacity to prepare for euro entry. Second, the international dimension of transition changed as the IMF and the World Bank reframed their own concept of conditionality. From the late 1990s they shifted their policy paradigm from a ‘top-down’ approach to promoting transition, on the basis of a ‘one-best-way’ model, to a stress on supporting ‘country ownership’ of transition (Tumpel-Gugerell, Wolfe, and Mooslechner 2002). In this new perspective, IMF and World Bank conditionality was adapted to supporting individual, ‘country-owned’ strategies for transition. EMU conditionality was caught up in this larger international change in transition conditionality. This change involved a greater stress on domestic responsibility and on different national models of market economy.

Variation in Conditionality Across Policy Space Generalization about EMU conditionality is difficult because of variation in the specification and detail of requirements across policy sectors and over time; because EMU policy requirements represent a moving target as EMU evolves; and because of the important role of indirect effects of EMU, especially on existing Euro Area members. Each of these three factors introduces an element of uncertainty and offers room for manoeuvre to domestic policy. They highlight also the importance of careful analytical refinement in examining the effects of conditionality. At the same time this variation over sector and time, change in content, and indirect effects on existing members are embedded in the broad unifying framework of a ‘sound money and finance’ paradigm. The varying degree of flexibility that east European governments possess in negotiating fit with the Euro Area entry requirements—both over time and across policies—is bounded

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by this paradigm. In addition, the indirect effects of EMU on the Euro Area members potentially overshadow the direct effects of EMU conditionality on east central Europe.

MONETARY POLICY East European states face very different conditionality requirements in monetary, exchange-rate, fiscal, and competitiveness policies. On EU accession they are required to meet tough legal convergence requirements over national central bank independence. In particular, central banks have to be functionally independent: that is, domestic legislation must give them an exclusive mandate to secure price stability. The difficulties of operationalizing the complex details were evident in the critical ECB Convergence Report (2004), which judged eleven of the non-Euro Area states not compliant, especially on provisions relating to personal independence of board members. The ECB adopted a restrictive definition of the implications for who can appoint and dismiss board members and who can be members (central bank outsiders cannot be board members). The European Commission reinforced this strict view. Almost all states were required to make further amendments to domestic legislation on their central banks to make them compliant with the ESCB statute. This process involved a ‘pull’ as well as a ‘push’ factor. National central bank governors used the process of drafting the ECB Convergence Report to ‘upload’ a maximal interpretation of their independence, as well as to gain backing from an official EU critique of their government’s economic policies. They sought to define how precisely fit was applied at the EU level in order to strengthen their domestic position. Nevertheless, domestic discretion in monetary policy strategies is retained after EU accession (see Rollo, Chapter 2 below, Table 2.9). It is radically reduced with ERM II entry, when the scope for national central banks to pursue an activist monetary policy is sharply reduced. It is also radically reduced by domestic choice to adopt a currency board linked to the euro, as in the Baltic States and Bulgaria. Entry into the Euro Area means that the national central bank becomes a part of the ESCB and acceptance of a single, ‘one-size-fits-all’ monetary policy, set for the Euro Area as a whole. As the total economic weight of all the new east European accession states barely equates with the Netherlands, never mind France, Germany and Italy, data about their monetary and economic conditions is unlikely to be decisive in shaping ECB monetary policy. Moreover, the ECB represents

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an extreme variant of central bank independence, possessing goal as well as instrument and institutional independence. In short, the ECB—not ECOFIN or the Euro Group—defines what price stability means. The ECB’s revised definition of price stability in 2003 as ‘below but close to’ 2 per cent remains a tough constraint for states whose prolonged ‘catch up’ is likely to lead to difficulties in staying within this requirement (see Begg, Chapter 3 below). A symmetrical target for inflation of 2 per cent, perhaps a little higher, would allow more room for changes in relative prices that accompany ‘catch up’. However, the experience of existing Euro Area members suggests that in practice this constraint might prove less tight for east European states. Inflation convergence pre-entry—to comply with Maastricht Treaty convergence criteria—was followed by divergence after entry. Given the relatively low economic weight of the accession states, a divergence in their inflation rates would have limited impact on ECB monetary policy (though the ECB would not welcome it). Hence, monetary policy constraint could prove more a phenomenon of Euro Area accession (as they seek to comply with the strict inflation criterion of the Maastricht convergence criteria) than of membership.

EXCHANGE-RATE POLICY There is no pre-EU accession acquis governing exchange rates. Pre-accession states had a variety of exchange rate regimes, varying from the tight constraint of currency boards (Bulgaria and Estonia) to managed floating (Poland). Moreover, though EU accession involves an obligation to join ERM II as part of the process of Euro Area entry, no timetable is attached. The obligation to accept that exchange rates are ‘a matter of common interest’ amounts to little in the way of specific guidance. The ECB confined itself to clarifying that the only clear incompatibilities are with fully floating exchange rates, crawling pegs, and pegs against currencies other than the euro. Exchange-rate policy has to become more euro-focused. The severe policy choice comes later, after an accession state has negotiated a central rate for ERM II membership with the EU. ERM II is defined by the ECB and by ECOFIN as the crucial testing phase both for the viability of the final central rate of currency conversion on euro entry and for the sustainability of the overall convergence process. This policy choice can, however, be deferred. The exchange-rate criterion for entry is also complex and raises some uncertainties. In accession negotiations states gained clarification on one matter: the ECB and ECOFIN confirmed that they cannot seek to avert

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potentially destabilizing market testing of their determination to hold to the central rate by abiding by the Maastricht criterion on exchange rates, without entering ERM II. States have to participate in the ERM II for a period of two years ‘without severe tensions’ and ‘without devaluation on a country’s own initiative’. Particular stress was placed on ‘at least’ two years (see Solbes in Davies 2004: 762); while Christian Noyer (2001), vicepresident of the ECB, argued that some accession states would need the flexibility of longer in ERM II (on the model of Greece, Portugal, and Spain) in order to cope with the problems of ‘catch up’. Further clarification was provided on the question of whether entry is ruled out either by a mutually agreed devaluation or by appreciation (which has been a broad trend for these currencies consequent on the scale of direct foreign investment). ‘Severe tensions’ can be deemed to exist even if the currency stays within the band and is to be measured by the ECB, notably by reference to interest rates. FISCAL POLICY In contrast to the supra-national policy regime in monetary policy, fiscal policy represents a process of ‘hard’ (though ‘softening’) coordination of domestic policies. However, this ‘hardening’ does not begin till EU accession (see the earlier discussion of the PFSP) after which the excessive deficit procedure is governed by the SGP and EU statistical case law. East European states are then required to submit annual convergence programmes for peer review in ECOFIN. These programmes must clarify how they intend to meet the requirements of the SGP: a medium-term budgetary objective of ‘close to balance’ or in surplus; a deficit limit of 3 per cent of GDP; and a maximum debt-to-GDP ratio of 60 per cent. These rules are prima facie clear and specific. They are also ‘hard’ in that states can be ‘named and shamed’ for fiscal laxity; pre-euro entry, they can be sanctioned by the withholding of EU cohesion funds, on which they are highly dependent to reap the advantages of EU membership; and, after euro entry, heavily sanctioned for persistent laxity. In addition, Eurostat has the authority to make final national account rulings, deny certification to member-state budgetary data, and submit convergence reports The sharp edge of fiscal policy is, however, blunted by the behaviour of, and example set by, leading Euro Area states, notably France and Germany. Despite German leadership in designing the Pact, these two core Euro Area members evaded the excessive deficit procedure in November 2003, precipitating a crisis just before the first wave of eastern enlargement. They worked to reform the SGP, agreed in March 2005, to bring it into line with

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changed practice, especially by improving domestic ‘ownership’ (ECOFIN 2005). These reforms involve new ‘get-out’ clauses where breach of the pact is ‘exceptional and temporary’ (including a less restrictive definition of ‘a severe economic downturn’), where various ‘other relevant factors’ are to be taken into account (such as systemic pension reforms and financial contributions to ‘achieving European policy goals, notably the unification of Europe’), and where states—as in east central Europe—have low debt and high growth potential. Moreover, a longer period is specified between identifying a breach of the SGP limits and the start of talks about sanctions, and a new emphasis is placed on assisting rather than punishing states in this position. The new focus on debts rather than just deficits also represents a relaxation of the pressures on new accession states; their problems are greater with deficits than with debt. This relaxation of the fiscal framework means that euro entry takes place against a different context from the first wave of Euro Area entrants. Accession states face the new empowerment of the European Commission to issue early warnings to states failing to consolidate when economies are growing above trend. However, overall, the weakening of the binding on France, Germany, and Italy opens up the possibility of greater room for manoeuvre to accession state on EMU accession.

MACROECONOMIC POLICY COORDINATION AND COMPET IT IVENES S P OLICIES Conditionality is much less specific and detailed in macroeconomic policy coordination and structural reforms to boost competitiveness. Mechanisms of ‘soft’ coordination prevail: policy ‘guidelines’, peer review, benchmarking on the basis of best performance, and policy learning. The Broad Economic Policy Guidelines (BEPG) tighten the obligation to treat economic policies as a matter of common concern. They include specific policy recommendations to individual states and offer an opportunity to address issues of fiscal policy and structural reforms. Like the BEPG, the Luxembourg process for coordination of employment policies and the Lisbon process for coordination of policies to promote competitiveness lack any ‘binding’ quality. Governments have scope to evade specific and detailed policy commitments in structural reforms for which they could be held accountable; the ‘naming and shaming’ of states is not practised. Conditionality has an even blunter cutting edge than in fiscal discipline. Correspondingly, in the sequencing, timing, and tempo of structural

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reforms accession state governments retain considerable room for manoeuvre. They can accommodate to domestic ‘reform fatigue’.

Variation in Conditionality Over Time EMU as ‘accession’ Europeanization is a protracted process spread out over at least ten years. Broadly, four phases can be identified: . The pre-‘accession Europeanization’ period: till 1996–7 for the first wave, till 1999 for the second wave. Domestic transformation was shaped pre-eminently by domestic choices about transition (in part affected by communist legacies) and also pressures and incentives from international institutions like the IMF and the World Bank. There was some evidence of anticipatory EMU Europeanization (for instance, in central bank independence) but it was not structured around complying with an acquis (Agh 2003). The EU was part of a wider international assistance for transition to democracy and a functioning competitive market economy, notably through the Copenhagen criteria of 1993. To the extent that these states made early choices to comply with global norms, as with the Baltic States, their macroeconomic policy arrangements fitted closely with the EMU acquis. . The pre-EU accession period: from 1996–7 to 2002–3 for the first wave, and from 1999 to 2003 for the second. Accession negotiations were structured around the EMU acquis, and its related single European market acquis. Institutional links were intensified around PFSP, PEPs, and the Economic Dialogue. A few formal conditionality requirements for EMU accession, like central bank independence, came into play. This period is the main focus of this book. . The post-EU entry and pre-ERM II accession period: 2004–. Institutional links deepen. Accession states participate in ECOFIN, the Economic and Financial Committee, the CMFB, and the general council of the ESCB. Accession states submit convergence programmes under the SGP, and can be sanctioned for failure of compliance by the withholding of cohesion funds (see Jones, Chapter 4 below). They are faced with difficult choices about when and how to prepare for ERM II entry. . The post-ERM II and pre-Euro Area entry period (beginning in 2004 and 2005 for some states). Foreign exchange markets can test the sustainability of nominal convergence, especially in relation to fiscal policy. In this period of at least two years the constraints are tightest.

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The Role of EU Actors in Shaping EMU Templates and Entry Velocity The gate-keeping mechanism involves EU actors in seeking to control euro entry velocity of accession states by giving greater specificity to EMU templates. The relative ease with which they can do so derives from the coherence that is given to their interpretations by ‘informal’ conditionality and from the empowerment of the ECB and the EC by the ascendant policy paradigm. This process of specification by these actors seeks to reduce the uncertainty that surrounds formal conditionality and to constrain the room for manoeuvre of accession state governments in EMU accession. In the process it focuses and sharpens the pressures for domestic transformation. In the absence of specific and detailed formal conditionality, gate-keeping is the most powerful mechanism available to the ECB and the Commission for the encouragement of structural reforms. EU actors—led by the ECB and the European Commission—emphasize the principle of equality of treatment both with each other and with earlier euro entrants when it comes to assessing whether the criteria for entry have been met and whether nominal convergence is sustainable. However, the application of this principle is not easy against the background of lessons learnt from Greek and Italian entry and from nominal divergence within the Euro Area. Criticisms from Eurostat of the quality and reliability of fiscal statistics supplied by the Greek and Italian governments as part of the SGP framework mean that governance of the European statistical system places new requirements for transformation on EU states to ensure the independence, integrity, and accountability of national statistical offices (ECOFIN 2005: 8). Accession states can expect a more cautious and critical scrutiny of the statistics that they use to justify compliance with the Maastricht criteria. The application of the principle of equality of treatment is shaped by policy learning from past accessions. The European Commission and the ECB also use the sound money and finance paradigm to argue a policy logic in the sequencing of domestic reforms. They define intensified domestic structural reforms as the precondition for reconciling nominal and real convergence and for abandoning the exchange rate as a policy instrument. However, this logic becomes more difficult to apply when existing Euro Area members like France, Germany, and Italy display a greater reluctance than accession states to undertake the structural reforms necessary for their own competitiveness in the face of economic challenges from these states and other new global competitors. EU criticisms of ‘reform fatigue’ in east central Europe, consequent on the acute social pains from harsh transition and EU accession, lose credibility

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when contrasted with ‘reform blockage’ by powerful vested interests in the old and richer EU and the Euro Area, for instance, in liberalizing service provision. Against this background of the principle of equality of treatment and of an EU-defined policy logic that prioritizes structural reforms, the ECB and the European Commission argue for a diversity of approaches to euro entry that take account of national particularities. Above all, they warn against too early a timetable for entry (which could place fiscal policy under too tight a constraint). According to the European Commission and the ECB, each state is responsible for clarifying its own timetable and strategy for euro entry, based on its specific characteristics and challenges (Papademos 2004). In the words of Lucas Papademos (2004), vice-president of the ECB, the differences in economic conditions mean ‘ . . . that it is unlikely that we can define a unique path to the euro that would be appropriate for all. It is impossible to formulate a single strategy and a set of policies that can be applied uniformly across all the acceding countries.’ Overall, conditionality is complex in the incentives and constraints that it offers. The tightest constraints are provided by the informal conditionality of an ascendant policy paradigm of ‘sound money and finance’. Formal conditionality is at its tightest in monetary policy; combines a complex and shifting ‘loose/tight’ framework in fiscal policy; offers an increasingly tightening constraint in exchange-rate policy with successive phases of EMU ‘accession’ Europeanization; and is least specific and detailed in structural reforms. Critically, the EU makes no attempt to prescribe a ‘one-best-way’, assigns responsibility to accession states for defining a euro entry strategy, and places no timescale on ERM II and euro entry. Within this ideationally structured but formally varied conditionality, accession state governments have room for manoeuvre. In seeking out and using this room, their behaviour is conditioned by contagion processes and domestic political structures and dynamics.

Contagion: Indirect Europeanization The room for manoeuvre of east European governments is shaped not only just by formal and informal conditionality (direct Europeanization) but also by contagion processes of indirect Europeanization. Indirect Europeanization is mediated by the market effects of EMU and the single European market programme on firms, and by the policy behaviour of

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existing Euro Area members and of other east European accession states in response to EMU incentives and constraints. In short, EMU as ‘accession’ Europeanization exhibits contagious behaviour: small events can lead to radical changes, and these changes can happen very quickly. The mechanisms of contagion are the knowledge, status, and power of a very small number of pivotal domestic actors in transmitting certain ideas into economic policy; the properties of the Euro Area itself and whether it is associated with positive or negative economic and political developments; and the context within which euro entry strategies operate (cf. Gladwell 2000). The domestic transmission of ideas about euro entry is strongly influenced by central bankers, and to a lesser extent finance ministry officials, who are embedded within transnational policy communities that are bound together by a ‘sound money and finance’ policy paradigm. Their views have a disproportionate impact because of the prestige and the persuasiveness that they gain not just from this transnational linkage but also from the coherence and robustness of the shared policy paradigm on which it is founded. They are, in short, empowered by this structural privileging to press a domestic agenda of central bank independence, fiscal discipline, and structural reforms. In defining fit, they present EMU as an enabling constraint. As we see below, this structural privileging is counterbalanced by interests in the domestic economic structure, and by technical elites that seek to benefit from expansionary fiscal policies, developing the welfare state, and wage increases. These policies can be justified as accelerating convergence in living standards with the rest of the EU. The actors who represent these interests press a domestic agenda based on exploiting the room for manoeuvre created by deferral of euro entry. Both sets of domestic actors seek to use small windows of opportunities that are opened by the changes in the properties of the Euro Area or in the wider EU and global context to press their agendas. This domestic contest underpinning euro entry strategy in east central Europe highlights the extent of uncertainty and the potential for small events to translate into radical change. The properties of the Euro Area are bound up with the image that is associated with its larger role in relations between the EU and member states and with its policy performance. The association of the Euro Area with a relatively consensual process of political union strengthens the domestic credibility of euro entry in the accession states. In this respect, the protracted and difficult debates about reforming the SGP sent ambiguous signals. More serious was the process of ratification of the European

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Constitutional Treaty, especially in core Euro Area members like France and the Netherlands. Rejection of the Treaty in the name of defending the European social model was associated with an unwillingness to embrace the economic policy logic not just of EU enlargement but also of EMU itself. The policy behaviour of Euro Area member states—whether in subverting the excessive deficit procedure or the extension of the single European market to services or in rejecting the Constitutional Treaty that was designed to make enlargement work more effectively—has the potential to generate large changes in the euro entry policies of accession states. This phenomenon of contagion is not just limited to the behaviour of Euro Area members. Just as Greece showed how a derogation can soon be translated into very early Euro Area membership after 1999, Sweden illustrates that derogation can be treated as though it were an ‘opt-out’, with no timescale for entry and the domestic hurdle of a (failed) referendum adopted prior to entry. In a more subtle way, relative improvements in the economic performance of EU states with opt-outs (Britain and Denmark) as well as with derogations (Sweden), in comparison with Euro Area members, translates into reduced incentives to seek early euro entry. Economic life outside the Euro Area, in Britain and Sweden, could be viewed as better than within it. Similarly, the policy behaviour of other east central European governments—when judged as ‘significant others’—can produce large-scale effects. Early, relatively tension-free and successful euro entry by some states strengthens arguments for forcing the pace of domestic change in other states. There are perceived political and economic costs in being left behind as periphery. Conversely, the association of attempts at early entry with economic crisis—as the markets test the credibility of domestic policies—and the resulting high domestic economic and political costs create contagion effects in the opposite direction. A failed ERM accession could have powerful side effects. The context of euro entry strategy in east central Europe is distinctive because—unlike Britain—it forms part of the ‘euro time zone’ and a process of unofficial ‘euroization’ of their economies. The widespread use of the euro results from the high share of the Euro Area in exports and imports, the integration of domestic production in wider European structures, the number of private agents with cash deposits in euros, the relatively late and weak development of the domestic banking systems and financial markets and consequent inability to finance budget deficits or any large-scale corporate lending in domestic currencies, and the

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importance of Euro Area banks in the ownership and modernization of their banking sectors and financial intermediation. The result is potentially powerful in-built systemic pressures to pursue euro entry. These systemic pressures follow from the role of the euro as a parallel currency in the region (for figures below see European Central Bank 2005b: 35–6: also Barisitz 2004: 98–9). This role was illustrated in trade and bank deposits, though often with different rankings for states in each case. In 2003 the share of imports invoiced in euro extended from 84 per cent in Slovenia, through 72 per cent in Hungary, 66 per cent in the Czech Republic, 61 per cent in Estonia and 60 per cent in Poland, to 49 per cent in Latvia (cf. Denmark 30 per cent). The share of exports invoiced in euro was at its highest again in Slovenia (87 per cent) and Hungary (85 per cent), with 70 per cent in the Czech Republic and Estonia, and 65 per cent in Poland. Though the percentage of customers with cash deposits in euros was on an upward trend, it varied in 2004 from 45 per cent in Slovenia, to just under 30 per cent in the Czech Republic and Slovakia, and a low of 6 per cent in Hungary (ECB 2005b: 60–1). This diversity was also apparent in the share of the euro in bank deposits: 19.8 per cent in Latvia, 18.5 in Bulgaria, 11.7 in Estonia, but only just over 6 in the Czech Republic, Hungary, and Poland. These figures on the role of the euro in domestic financial transactions suggest a potential for Euro entry strategies to be caught up in evolving processes of unofficial ‘euroization’. On the other hand, there seems to be no clear correlation between high ‘unofficial’ euroization and a pacesetter role in Euro Area accession. Underlying structural factors of size and real convergence can prove more important, for instance, in explaining Hungary’s shift from pacesetter to laggard (see Begg, Chapter 3 below, and Jones, Chapter 4 below). On closer examination, the banking and financial market contexts are potentially unstable in their effects on euro entry strategy. Banking supervision remains problematic when banks are headquartered outside east central European states. Financial markets exhibit their own contagious behaviour once faced by inconsistencies in domestic economic policies. The actions of a very few market participants can produce herd-like reactions. A likely trigger is inconsistency between an exchange-rate policy commitment (like ERM II) on the one hand, and domestic fiscal policies or negative developments in growth and employment on the other. Market tests of policy credibility can turn small changes in economic indicators into full-scale crises that can radically transform domestic strategies for euro entry. Euro entry strategies are accordingly vulnerable.

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Domestic Consensus Building Negotiating fit in EMU accession is a dynamic process of reconciling formal and informal conditionality requirements and contagion in markets and in policy behaviour with domestic political problems of consensus building. This domestic context consists of three main elements: structures of economic interest, political party and electoral competition and public opinion, and executive configurations and bureaucratic politics. Each element conditions the room for manoeuvre of domestic political leaders on euro entry.

Economic Structure Euro entry strategies are shaped by the size and exposure of economies and by the extent of similarity of the domestic and the EU economies (see Begg, Chapter 3 below, and Jones, Chapter 4 below). The merits of early euro entry are likely to command broad assent in smaller accession states, in which monetary policy is likely to be less effective and the incentives of trade-related growth are stronger. Hence, the three Baltic States, Slovenia, Cyprus, and Malta, formed the pacesetters. Openness of the economy confirms this pattern. The greater the share of imports and exports in GDP, the more likely domestic elites are to pursue a pacesetter role in euro entry. Similarity of economic structures matters if accession states are to reduce risks of asymmetric shocks. These shocks are more difficult to handle once monetary policy autonomy is lost and fiscal policy autonomy constrained. Slovenia, for instance, is more convergent in economic structure than Poland (though it faces risk in the banking and financial sector). The incentives to opt for, or shift to, a laggard role are greater to the extent that there are problems of mediating conflicting domestic economic interests. These problems are accentuated when strong domestically focused sectors and transnational enterprises, concentrated in export-oriented, low-wage industries (and possibly, as in Hungary, an emerging interest in exporting capital), contend to shape euro entry policy. They are exposed in different ways to the potential shocks of euro entry. Their different policy preferences with respect to exchange-rate, fiscal, and wage policies complicate euro entry strategy (cf. Frieden 2002). Domestic governments are under pressure to mediate these conflicts in euro entry strategy, while opposition parties have an incentive to exploit them. The concluding chapter focuses on the different strategic

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choices available to governments to manage this conflict, in particular, extending the timetable for ERM II and for euro entry, as in Hungary.

Party and Electoral Competition and Public Opinion Domestic political parties have different forms of linkage to economic structures that, in various ways, circumscribe their policies, for instance, in privatization and fiscal consolidation. These constraints are tight when governing parties of the Right seek to define a nationalist appeal by protecting domestically oriented industries or governing parties of the Left rest on political support from managers and employees in traditional state-owned industries that represent communist-era legacies. The result is ‘capture’ of state economic policy, which becomes more constraining, the greater the economic weight of these industries. As in Romania, this capture is likely to constrain privatization, market liberalization, and welfare-state reforms, and hence create difficulties for euro entry strategy. Conversely, in general, accession state governments are less hemmed in by powerful domestic employer and trade-union organizations than most existing Euro Area members. Collective bargaining has not taken on a macroeconomic dimension that induces accession state governments— like earlier euro entrants in the 1990s—to pursue a strategy of relying on social pacts to tackle EMU accession issues. Euro entry strategy is also exposed to the incentives and constraints of domestic party and electoral competition. A key incentive to extend the timetable for entry comes from the unwillingness of governing parties to bind their fiscal hands for the next elections. A commitment to early entry and the resulting painful reforms would be politically costly for the governing parties and make it likely that the opposition parties could both capitalize on subsequent disaffection, and then preside over successful euro entry. EMU accession cannot evade the domestic political cycle. Party ideology also casts a spell over euro entry policies. Social democratic parties and nationalist (as opposed to liberal) parties of the Right seek to bind together their electoral clienteles by staking out claims to be, and competing on the basis of being, the best defenders of social solidarity through developing welfare-state provision. This factor impedes rapid fiscal consolidation to achieve early ERM II and euro entry in, for instance, Hungary and Poland. Moreover, delayed euro entry can be presented as ‘good’ European policy in ensuring that EMU is compatible with real convergence with other EU members in levels of social welfare, for

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Euro Entry as Defining and Negotiating Fit

instance, pensions. Procrastination on the euro may reflect Euro-populism, as opposed to Euro-scepticism. Nevertheless, fears of potential Euro-scepticism provide another incentive for delay. An ERM II crisis and forced exit creates an opportunity for populist politicians on the Left and the Right to create a climate of Euroscepticism. Poll evidence suggests that such a potential exists (Taggart and Szczcerbiak 2001). A Polish ERM II crisis could have similar effects to the British ERM crisis of 1992 (and might produce contagion). Failed ERM II entry could have major spillover effects into the behaviour of markets and of other east central European policymakers. Opinion poll surveys have documented a relatively low level of interest in euro entry across the new member states: 19 per cent were not interested at all (European Commission 2004a: 5). Moreover, those who thought that entry would be positive for their country had only a small relative majority over those who expected negative effects (European Commission 2004a: 7). When it came to effects on a personal level, those expecting a negative outcome were in a relative majority of 5 per cent (European Commission 2004a: 9). Only 19 per cent wanted to enter as soon as possible; 40 per cent as late as possible (European Commission 2004a: 15). The broad lack of enthusiasm and scepticism about effects offered little incentive for political elites to prioritize the issue. However, the incentives seemed to vary across countries. Hungary and Slovenia, followed by Slovakia, showed the highest levels of interest, expectations of positive effects and hurry to join. By contrast, Poland exhibited negative majorities on entry. The lowest scores were registered in the Baltic States, especially Latvia, where the currency issue was more strongly bound up with national identity. As Feldmann argues (Chapter 6 below), Euro Area entry poses a serious question about elite–mass relations for these countries, which have opted for a pacesetting role on this issue.

Core Executives and Bureaucratic Politics Domestic configurations of executive institutions and bureaucratic politics also play a prominent role in shaping how fit is negotiated. Executive structures in east central Europe display a variety of patterns, from centralized—as in Hungary—to decentralized—as in the Czech Republic (Goetz 2001; Dimitrov, Goetz, and Wollmann with Brusis, and Zubek 2006 ). Hence the capacity for central political leadership varies, especially in fiscal policy. In cases where the capacity is low, the problem can be addressed either by using ‘binding hands’ through an external discipline

38

Euro Entry as Defining and Negotiating Fit

like a currency board or by ERM II entry and commitment to an early date for euro entry. However, this strategy does not solve the problem of credibility; it may even cruelly expose it. Subsequent failure of domestic fiscal discipline to deliver may invite the financial markets to put credibility to the test. Another strategy is to defer ERM II entry and put back the date for euro entry till fiscal discipline has been achieved. Once again, this strategy begs the question of delivery, and without it there is a continuing strong incentive to continue deferral of EMU accession till the strategy loses credibility. Against this background of problems with external ‘binding of hands’ and with fiscal discipline, there are strong political inducements to negotiate fit by seeking greater flexibility in EU fiscal rules. The asymmetry of power (noted above) suggests a very limited scope for ‘uploading’ the domestic policy preferences of east central European states into the redesign of EMU institutions and rules. This asymmetry was apparent in the debate about reforming the SGP, where a multitude of ideas came almost exclusively from the EU15. Moreover, technical elites in east central Europe—especially in the central banks—who participated in this debate had, on the whole, little incentive to relax externally imposed domestic constraints. Hence, they were unlikely to attempt to play active uploading. Political elites in east central Europe were, nevertheless, relieved to be given a greater room for manoeuvre. Especially in those contexts in which executive fragmentation applies, and in which coalition government parties seek to keep open their electoral options, bureaucratic politics assumes a sharp profile. Ministries and agencies, other than finance ministries and central banks, seek to protect and enhance their competences and resources in ways that can frustrate fiscal discipline and structural reforms. They define their interests in terms of protecting a particular economic clientele and of fiscal stimulation rather than retrenchment. Conversely, central banks and finance ministries use EMU to empower themselves in domestic bureaucratic politics. ESA95 is a tool for consolidating public finances. Finance ministries are ambivalent about it. They welcome ESA95 as a tool for their own control of line ministries and independent agencies; they also fear that it may constrain their own autonomy of action. This intra-governmental bureaucratic politics is complemented by a contest for power between governing parties and national central banks. Central banks in east central Europe have tended to be caught up in the extension of party political competition to the extent that their presidents are identified with former governing (and now opposition) parties (often

39

Euro Entry as Defining and Negotiating Fit

as leading ministers). Their independence is then seen as a convenient technocratic cover for the continuation of former politically motivated policies by other means. In this arena most of all, EMU accession requirements (even in the early stage of pre-EU accession) have proved a tight constraint on attempts to reduce the independence of national central banks (see especially the chapters on Hungary and Poland).

Defining Fit: Domestic Narratives of EMU as Harsh Master or Good Servant How domestic political and technical elites negotiate fit between EMU conditionality requirements, contagion, and domestic politics is bound up with the narratives that they develop about EMU. These domestic narratives serve to legitimate euro entry policy positions and to communicate them in a meaningful way both to each other and to public opinion (Schmidt 2002). They are in part instruments of persuasion in the hands of elites and in part structure how elites themselves understand why they adopt particular positions. In short, ideas shape how fit is defined and the parameters in which it is negotiated. The question is whether and how ‘informal’ EMU conditionality, the sound money and finance paradigm, can be reconciled with domestically originated ideas about economic policy. In those east European states where post-communist legacies have proved most enduring, like Romania, the design of a persuasive policy narrative is more difficult than where early shock therapy and domestic transition have severed these legacies, as in the Baltic States. Broadly, two different types of domestic narrative—of harsh master and good servant—legitimate euro entry policy strategies. The ‘harsh master’ narrative comes in different variants, depending on whether its historical and ideological roots are in communist legacies in social democracy and the Left (which is most often the case) or in right-wing parties that prioritize issues of national identity over economic liberalism (which is less often the case). In these types of narrative EMU is defined in structural terms as a tight exogenous constraint. It prescribes what must be done, radically diminishes domestic policy autonomy and identity, and relies on mechanisms of conditionality and market discipline to punish domestic economic policy failures and weaknesses: by ‘naming and shaming’ states, denying euro entry, imposing financial sanctions, or downgrading credit ratings. Negotiating fit with euro entry presents east central European governments with a stark trade-off. An exchange rate pegged to the euro

40

Euro Entry as Defining and Negotiating Fit

in ERM II—a precondition of EMU entry—means a sharply reduced control of domestic policy. Euro entry depends on an acceleration in the scale and pace of domestic structural reforms to labour markets, welfare states and budgets, including increased privatization and liberalization. The result is heightened welfare stress. This ‘harsh master’ narrative argues that EMU mimics and reinforces globalization and compounds the pain of post-communist transition. It reflects an extreme asymmetry of power. By defining the policy requirements in precise terms, and inviting the market to judge states in these terms, EMU is potentially a harsher (and more visible) master than globalization. EMU accession is pictured as a cruel process, imposing domestic changes that are socially unjust in outcomes. It serves as a punishment mechanism for older and unskilled workers, breaks social contracts, and provides a potential breeding ground for resentment and alienation. Its political implications include opportunities for populist mobilization, growing Euro-scepticism, and continuing electoral defeats for incumbent governments that are merely seen as weakly ratifying externally imposed changes. The ‘good servant’ narrative stresses the fit between domestic strategic interests and EMU accession and the discretion that domestic elites have to use EMU for domestic purposes. EMU accession provides an ‘enabling’ constraint. For key actors in the technical elites of central banks, finance ministries, financial institutions, employer associations, and internationally oriented firms EMU enables the achievement of sustainable convergence, through lower interest rates, increased trade and higher foreign direct investment, and the relaxation of current account problems. Its discipline is understood not as top-down but as a complex, dialectical interaction in defining and negotiating fit between the domestic level and Euro Area actors. This ‘inside-out’ narrative focuses on turning EMU accession into a good servant of domestic priorities. EMU is instrumentalized by domestic elites—notably central bankers—to legitimate their own policy ideas and to gain domestic political leverage over the scope, timing, and pace of fiscal and structural reforms. Above all, it legitimates the strategic option of using EMU accession to anchor a pre-existing domestic discipline (see the chapters on the Baltic States and Bulgaria). Amongst political elites in east central Europe this type of ‘good servant’ narrative takes the form of the attempt to mobilize consent for early entry on the basis of the historic ‘return to Europe’ after the end of the Cold War. This historical form of legitimation attaches vital national interest to being at the centre and not the periphery of Europe and to making a

41

Euro Entry as Defining and Negotiating Fit

decisive historical break with the isolation of the communist period. The process of defining and negotiating fit is nested within larger historical and geostrategic arguments In contrast, domestic technical elites elaborate the ‘good servant’ narrative in technocratic terms. Small, open economies are seen as having no realistic policy alternative to the earliest possible euro entry, other than the prohibitive costs associated with continuingly high interest rates, speculative capital flows and exchange-rate instability. This narrative emphasizes major and urgent structural reforms in order to achieve greater fiscal discipline, a strengthened financial sector, and improved efficiency in the public sector. It stresses euro entry as a means to greater freedom of manoeuvre for policy over the longer term. Some central bankers have also linked this narrative to a critique of EMU for not providing a stronger emphasis on ‘fundamental adjustments’ in the domestic macroeconomic sphere and ‘clear and better structured’ prospects of entry ‘as a powerful incentive to the proper development of economic policy. It limits any propensity to engage in harmful policies . . .’ (Balcerowicz 2001). The ‘good servant’ narrative can, however, lead to different conclusions: that euro entry needs a patient, cautious, and long-term approach on an individual case-by-case basis. This view is shared by key actors in the Euro Area and by many in the technical elites of accession states, including some central bankers, many finance ministry officials, as well as by leading members of political elites. Its starting point is the technocratic argument that policy credibility takes a long time to construct and can be destroyed overnight by a crisis. Hence, it is important to avoid premature entry into ERM II. EMU accession should be seen as a flexible framework for domestic economic policies to promote both nominal and real convergence. Only when nominal convergence is becoming sustainable should it be exposed to the tests of the financial markets. This type of narrative supports the strategic option of using delay in negotiating EMY accession. In short, the ‘good servant’ narrative of EMU accession takes two technocratic forms. One narrative stresses importing economic credibility either by an early fixed peg to the euro (as with the currency boards of Bulgaria and Estonia) or by toughened EU requirements for fiscal balance and structural reforms (as with Balcerowicz, the Polish central bank governor). This narrative seems to find particular support in very small, open economies. The other narrative prefers managed exchange rates and a more active use of domestic monetary policy, notably inflation targeting. ERM II entry is ‘regarded merely as the gateway to eurozone participation

42

Euro Entry as Defining and Negotiating Fit

and not as an alternative to the existing monetary policy regime’ (Czech National Bank December 2002). The ‘good servant’ narrative provides scope for domestic economic policy choices about how and when to enter EMU. The key question is the domestic definition of a credible timetable for euro entry that will serve as the basis for individual economic decisions (Czech National Bank December 2002). EMU is understood to enable individual accession state governments to pursue flexible interpretations that reflect their particular historical and political contexts, economic conditions, and the vagaries of contagion. Each has some scope to define EMU as a good servant in its own way, whether by opting for a ‘fast-track’ or for a cautious approach (Tuma 2004b). Hence the president of the Polish National Bank, Balcerowicz (2001), argued that ‘. . . there is no prescribed monetary or exchange rate policy route to euro membership and . . . all alternatives deserve a profound debate.’ The ‘good servant’ narrative of EMU cannot, however, disguise an underlying asymmetry of power and an edifice of ‘informal’ conditionality that overshadows Euro Area entry. There is domestic room for manoeuvre over ‘how’ and ‘when’. This room for manoeuvre offers opportunity for domestic elites to negotiate fit with domestic politics and to construct narratives to legitimate this fit. However, the underlying definition of fit rests in a potent combination of formal and informal conditionality. In EMU accession, conditionality only becomes a myth when and if—perhaps as a consequence of an ERM II crisis and exit—east European political elites persuade themselves and their publics that EMU is a ‘harsh master’. Even in this case pervasive global norms will continue to tightly prescribe ‘credible’ domestic economic policies.

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Part I European and Global Contexts

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2 EMU and the New Member States: Strategic Choices in the Context of Global Norms Jim Rollo

The emergence of the countries of Central Europe and the Baltic from communism between 1989 and 1991 coincided with the beginnings of a wave of global economic integration and with shifts in the global economic governance paradigm. The shift in paradigm was towards rulesbound, open trade in goods and services and free capital movements. There was a parallel move towards the objective of a stability culture in domestic macroeconomic policy. This move represented an attempt to replace the apparent but lost certainties of the multilateral system of economic governance among capitalist countries that had prevailed between 1946 and 1973. Exchange-rate regimes are relevant both to the management of the macroeconomy and to the real economy. As a result they are an important gear for transmitting forces from one to the other. Attitudes to exchange-rate regimes in general, and to the appropriate regimes for emerging markets (of which the transition economies of central Europe were a special case), shifted in the 1990s as adjustable peg systems of exchange-rate management were perceived to be less defensible in the face of global capital markets. These global shifts in defining norms of economic policy—liberalizing markets, embracing stability culture, and away from ‘soft’ pegs in exchange rates—have important implications for the strategic choices of the new accession states in negotiating fit with Euro Area entry.

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EMU and the New Member States

Liberalizing Markets The European Union (EU) led trends to global market liberalization with its single European market initiative, which pursued completion of the common market, the objective of which was set out in the Rome Treaty of 1957. The objective of the ‘Four Freedoms’ of trade in goods and services, and of capital and labour, accompanied by European Monetary Union (EMU), added up to the deepest episode of international economic integration since the nineteenth century. Thus, the EU was at the leading edge of what came to be called the ‘Washington Consensus’ (Williamson 1990) as markets for goods, services and capital liberalized across the world. These changes in Europe and globally were paralleled by the beginnings of a retreat of the state in the USA but perhaps most obviously in the UK, where the privatization of state-held stakes in private companies and of nationalized utilities led a worldwide trend of privatization of state assets. Countries in East Asia had to a degree followed the Japanese model of development, most notably Korea and Taiwan (formally Chinese Taipei), but to a lesser degree the countries of South-East Asia and less so still, China. They too began to open their economies to foreign trade and capital. Two markers of this global move to a liberal approach to economic policy governance was the push by Mexico and by Korea to join the OECD, which required an explicit commitment to liberal markets for goods, services, and capital both internally and externally. The former communist countries of central Europe thus emerged into the world economy at a point at which the principles and practice of governance were moving decisively to a new global norm. Trade in goods was freeing rapidly; trade in services also, but less so; and, because foreign direct investment was a major element in development strategies, a move to more open capital markets reassured possible investors. The relevance of this new paradigm to the countries of central Europe was underlined since their nearest democratic neighbours were either members of the EU or contemplating membership. Austria and the Scandinavian members of European Free Trade Association (EFTA) were actually integrating into the EU single market via the European Economic Area. As well as engaging the International Monetary Fund (IMF) and the World Bank in the transition process in central Europe, the Western democracies moved quickly with two policy tools in response to the collapse of communism. First was the use of free-trade agreements to integrate the transition economies into Western systems of trade and payments quickly

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EMU and the New Member States

(the EU, the USA, and EFTA all offered these agreements). The EU went further with the Europe Agreements, which, in addition to simple preferential tariff dismantlement, included elements of freedom of movement of services and capital, regulatory harmonization (notably competition policy) and freedom of movement of natural persons to allow cross-border service provision. Second, the European Bank for Reconstruction and Development (EBRD), a new and specifically designed instrument to help fund transition, underlined the perceived role of FDI both in transition and in the global governance model. The EBRD was specifically tasked to help establish new enterprises, privatization, and to leverage private-sector investments, foreign and domestic. In this task it differed markedly from either the World Bank or the European Investment Bank, both of which give their main emphasis to funding structural adjustment and infrastructure. The opponents of communism in central Europe were keen observers and analysts of this global shift from a development model based on import substitution and state intervention to one based on economic liberalization, domestically and at the frontier, and export-led growth. A Hungarian academic was responsible for coining one of the most analytically perceptive critiques of state intervention in resource allocation—the ‘soft budget constraint’ (Kornai 1986) meaning that there was no incentive to find efficiency gains since the state simply validated any revenue shortfalls with more subsidy. Vaclav Klaus and other reformers in the then Czechoslovakia came to power with a programme of domestic and frontier liberalization that went further than practice in most, if not all, OECD members. In Poland, the Balcerowicz plan brought about a very rapid liberalization of domestic prices—notably for consumer goods, a regime of low and uniform tariffs (mainly for anti-inflation purposes), as well as a crash macroeconomic stabilization aimed at eliminating hyperinflation. No doubt, some of these policy prescriptions in the transition economies resulted from a reaction to what had gone before. At the same time, there was a general conviction among the first wave of democratic governments that these emerging global norms promised the quickest, most certain way to embed democracy and the market, anchor themselves to the west, and prevent any return to communism. Initially the post-communist states of central Europe were enthusiastic liberalizers, domestically and at the frontier. All joined or rejoined the GATT/WTO, the IMF, and the World Bank; the Visegrad countries joined the OECD (Table 2.1). Privatization, reduction in the role of the state and FDI were central to strategies of transition (Tables 2.2–2.5). There was some

49

EMU and the New Member States Table 2.1. Membership of IBRD, IMF, WTO, and OECD date of membership Country

IBRD

IMF

WTO

OECD

Bulgaria Czech Republic Estonia Hungary Latvia Lithuania Poland Romania Slovak Republic Slovenia

Sep 25, 1990 Jan 1, 1993 Jun 23, 1992 Jul 7, 1982 Aug 11, 1992 Jul 6, 1992 Jan 10, 1946 Dec 15, 1972 Jan 1, 1993 Feb 25, 1993

Sep 25, 1990 Jan 1, 1993 May 26, 1992 May 6, 1982 May 19, 1992 April 29, 1992 June 12, 1986 Dec 15, 1972 Jan 1, 1993 Dec 14, 1992

Dec 1, 1996 Jan 1, 1995 Nov 13, 1999 Jan 1, 1995 Feb 10, 1999 May 31, 2001 July 1, 1995 Jan 1, 1995 Jan 1, 1995 July 30, 1995

Dec 21 1995 May 7, 1996

Sept 22 1996 Dec 14 2000

Table 2.2. Private sector share of GDP in % Private sector share of GDP in % Year

Czech Slovak Bulgaria Republic Estonia Hungary Latvia Lithuania Poland Romania Republic Slovenia

1991 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

20 50 55 60 65 70 70 70 75 75 75 75

15 70 75 75 75 80 80 80 80 80 80 80

10 65 70 70 70 75 75 75 80 80 80 80

30 60 70 75 80 80 80 80 80 80 80 80

10 55 60 60 65 65 65 65 70 70 70 70

10 65 70 70 70 70 70 70 75 75 75 75

40 60 60 65 65 65 70 75 75 75 75 75

25 45 55 60 60 60 60 65 65 65 70 70

15 60 70 75 75 75 80 80 80 80 80 80

15 50 55 60 60 60 65 65 65 65 65 65

Source: EBRD (2005a).

rowing back in Poland on tariff reductions, but generally successive governments of Left and Right sustained the shift to the market in lines with global norms and the EU acquis. In short, there was a complex mutual interaction between transition, the EU acquis and global norms.

Stability Culture The approach to macroeconomic policy governance also began to shift to a focus on stability and credibility of institutions. This global shift was driven, in part, by economic theory, and in particular new classical macro-

50

EMU and the New Member States Table 2.3. General government expenditure (% of GDP)

Year

Czech Slovak Bulgaria Republic Estonia Hungary Latvia Lithuania Poland Romania Republic Slovenia

1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

45 48 46 41 42 33 37 40 40 39 37 38 37 38

50 41 44 40 40 39 38 43 42 45 47 53 44 43

na 38 39 39 38 35 38 40 36 35 35 35 37 40

60 60 60 53 49 50 50 50 47 48 52 50 50 51

na na 37 37 36 37 40 41 37 35 36 35 36 38

na 35 37 35 33 33 35 37 33 37 31 31 33 31

50 50 51 50 50 49 47 47 44 44 44 45 43 43

42 34 33 35 34 34 35 35 35 33 32 31 31 31

58 79 58 54 61 65 61 57 63 44 43 39 39 37

43 44 44 41 40 41 42 42 48 48 48 48 48 47

Source: EBRD (2005a).

Table 2.4. Foreign direct investment, net inflows (% of GDP)

Year

Czech Slovak Bulgaria Republic Estonia Hungary Latvia Lithuania Poland Romania Republic Slovenia

1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

.. .. 1 0 0 1 1 1 5 4 6 8 6 4 7

.. .. .. .. 2 2 5 2 2 6 11 10 10 13 3

.. .. .. 2 4 6 5 3 6 11 6 8 10 4 10

1 1 4 4 6 3 11 5 5 4 4 4 5 1 3

.. .. .. 1 1 5 4 7 9 6 5 6 2 5 3

.. .. .. 0 0 0 1 2 4 8 5 3 4 5 1

.. 0 0 1 2 2 3 3 3 4 5 6 3 2 2

0 0 0 0 0 1 1 1 3 5 3 3 3 3 3

.. .. .. .. 2 2 1 2 1 3 2 10 8 17 2

.. .. .. 1 1 1 1 1 2 1 1 1 3 8 1

Source: World Bank (2005).

economic theory and, in part, by empirical research. New classical macroeconomics, especially in its rational expectations form, reinforced the view that neither monetary policy nor permanent deficit financing of the budget have any long-term effect on output. This view does not undermine the case for the operation of the automatic fiscal stabilizers, but it certainly undermines the case for long-term public debt accumulation. The injection

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EMU and the New Member States Table 2.5. GDP (constant 1995 US$) 1990¼100 Czech Slovak Year Bulgaria Republic Estonia Hungary Latvia Lithuania Poland Romania Republic Slovenia* 1992 85 1993 84 1994 85 1995 88 1996 79 1997 75 1998 78 1999 80 2000 84 2001 87 2002 92 2003 96 2004 102 2005 107

88 88 90 95 99 99 98 98 101 104 106 109 114 121

73 67 65 68 71 78 81 81 87 92 98 105 113 124

85 85 87 89 90 94 99 103 108 112 116 120 125 130

58 50 50 50 51 56 58 60 64 69 73 78 85 94

74 62 56 58 61 65 70 68 71 76 81 89 96 103

95 99 104 111 118 126 132 138 143 145 147 153 161 166

79 81 84 90 93 88 83 82 83 87 91 96 104 108

80 77 81 86 91 96 100 101 103 107 112 117 123 131

.. 100 105 109 113 119 123 129 135 139 143 147 153 159

Source: World Bank (2004) and own calculations. Notes: Slovenia* 1993 ¼ 100.

of expectations into the analysis led to the issue of credibility as a key element of macroeconomic policy success. In a world of open capital markets, investors, businesses, consumers, and wage earners would adjust their behaviour to compensate if they found policy incredible. These theoretically based predictions had backing from studies that suggested that inflation was lower in countries where central banks were independent, and hence free of arbitrary political intervention.

Monetary Rules German performance was crucial in ensuring that the monetary aspects of this global stability culture were well established by the end of the 1970s. Germany had apparently survived successive oil shocks with lower inflation and more robust economic activity than its counterparts. The general acceptance among central banks that the Bundesbank, with its target and instrument independence, was the most successful central bank of the post-war period was crucial to the emerging shape of global monetary rules. This proposition is certainly borne out by a much better average inflation performance compared to its OECD peers. It is also probably true in terms of domestic political support. But it was not the only model for monetary policy. From 1946 until 1971 under the Bretton Woods system, inflation control was to a degree delegated to a monetary hegemon (the USA) via a fixed but adjustable exchange-rate regime. During the 1990s

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EMU and the New Member States

inflation targeting as an approach to monetary policy emerged mainly among Anglo-Saxon countries. The emergence of the Bundesbank as the most successful central bank after the demise of the Bretton Woods system in 1971 had historical roots. After two hyperinflations in a generation, the Bundesbank headlined price stability as its ultimate target. To implement this target, the Bundesbank used money supply as its intermediate target and interest rates as the instrument to control it. Previously, up to the 1970s at least, it was quite normal for there to be a range of quantitative restrictions on different types of credit to try to rein in monetary demand, while interest rates were kept low and relatively stable to encourage investment. The success of this model is demonstrated by the fact that the ECB at the heart of European Monetary Union (EMU) is a one-for-one institutional mapping of the Bundesbank except, arguably, that it is even more independent. ECB independence is guaranteed by treaty, whereas Bundesbank independence was guaranteed by an act of the German Parliament, and thus subject to the views of that body, at least until 1999. This context helps explain the low-key but astute political positions that the Bundesbank management undertook throughout its history (Kennedy 1991; Marsh 1992) to sustain its popularity with the German public. Early domestic central bank legislation in transition economies like the Czech Republic and Slovenia took the Bundesbank as its institutional model. However, the Bundesbank was not the only model of rules-based monetary governance. At the end of the 1980s, an alternative model of inflation targeting, accompanied by an accountable and transparent central bank, emerged. The task of the central bank was to deliver the inflation target set by government, and the bank management was held accountable for failure. The earliest explicit model of this approach was the Reserve Bank of New Zealand (Reserve Bank Act of 1989). The inflation target was agreed between the finance minister and the Reserve Bank Governor, and was hence under democratic control (in principle at least). The Reserve Bank Governor was free to deliver it in whatever way was effective. If, however, the Reserve Bank allowed inflation to move outside agreed bands, the Governor could be sacked (McCallum 1996). Accountability and political control is therefore quite explicit in this model. Since 1991 a number of countries have followed the New Zealand approach to one degree or another: notably, Australia, Canada, Sweden, and the United Kingdom, and in central Europe the Czech and Slovak Republics, Hungary, and Poland.

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EMU and the New Member States

Inflation targeting requires that the exchange rate should be left to float. This combination is driven by the so-called inconsistent triad of inflation rate, exchange rate, and interest rate. Interest rates can be used to set either the inflation rate or the exchange rate, but not both. For price stability models domestic prices per se can be the target: or, if the credibility of domestic institutions is in doubt, an exchange-rate fix to a credible lowinflation anchor currency may be possible. The Bundesbank followed the exchange-rate fix during the Bretton Woods period but thereafter either the D-Mark was floated or it was the anchor for the ‘snake in the tunnel’ or the ERM (themselves modelled on the Bretton Woods system). In either case monetary policy and interest rates were set for domestic German purposes, and the D-Mark floated against currencies outside the snake/ ERM. Thus, a third model for monetary policy is to make a commitment to fix exchange rates to some credible anchor currency. This is a particularly relevant approach to gaining monetary stability for transition economies, and emerging market economies more generally, where initial information and track record is lacking. Domestic policy then becomes a matter of setting the monetary and/or fiscal policy mix to sustain the chosen fixed rate. This policy model takes such forms as a variant on fixed but adjustable exchange rates through to harder fixes like currency boards or the adoption of a foreign currency (dollarization/euroization). These latter are usually adopted only where the credibility of domestic policy is very weak. Thus, new countries such as Estonia and Lithuania or countries emerging from a period of prolonged economic crisis such as Bulgaria in 1997–8 adopt these in an attempt to assert credibility by borrowing it from the target currency of the currency board. The central Europeans all chose to base monetary policy initially on exchange-rate pegging, mostly adjustable pegs, though Estonia introduced a currency board immediately and Lithuania within a few years of independence. This choice suggests that, initially at least, they saw asserting monetary policy credibility as a major difficulty. Bulgaria introduced a currency board in 1998 in response to a severe economic crisis, while others persevered with adjustable pegs on wider or narrower margins (Latvia and Slovenia). However, the Czechs, Hungarians, Poles, and Slovaks moved towards floating as they confronted competiveness problems on fixed rates and as inflation fell (Table 2.6) and as their domestic monetary policy became more credible (Poland and the Czech Republic in particular).

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EMU and the New Member States Table 2.6. Inflation, consumer prices (annual %)

Year

Czech Slovak Bulgaria Republic Estonia Hungary Latvia Lithuania Poland Romania Republic Slovenia

1989 6 1990 24 1991 338 1992 91 1993 73 1994 96 1995 62 1996 122 1997 1058 1998 19 1999 3 2000 10 2001 7 2002 6 2003 2 2004 6 2005 5

.. .. .. .. .. 10 9 9 9 11 2 4 5 2 0 3 2

.. .. .. .. 90 48 29 23 11 8 3 4 6 4 1 3 4

17 29 34 23 22 19 28 24 18 14 10 10 9 5 5 7 4

.. .. .. 243 109 36 25 18 8 5 2 3 2 2 3 6 6

.. .. .. .. 410 72 40 25 9 5 1 1 1 0 1 1 3

245 555 77 45 37 33 28 20 15 12 7 10 6 2 1 3 2

.. .. 231 211 255 137 32 39 155 59 46 46 34 23 15 12 9

.. .. .. .. .. 13 10 6 6 7 11 12 7 3 9 7 3

.. .. .. .. 33 21 13 10 8 8 6 9 8 7 6 4 2

Source: EBRD (2005a).

Fiscal Rules Prior to the Keynesian revolution, the norm was for governments to follow a balanced budget policy in times of peace. After Keynes the advantages of short-term borrowing to balance the economic cycle, and particularly when monetary policy had run out of room (‘pushing on a string’), were taken for granted. This approach allowed the automatic stabilizers to run as activity-related tax revenues and expenditures adjusted to boom and bust. The intensification of the welfare state increased the effect of the stabilizers, but the impact on the tax burden became increasingly heavy with an increasing share of public spending in GDP. The result was increased public deficits and public debt in a context of election-driven economic cycles. Incumbents attempted to sustain their positions by pre-election booms, followed by post-election busts, while oppositions tried to outdo incumbents (which might extend and intensify booms into the post-election period but lead inexorably to a deeper recession). These electorally driven fiscal policies were perhaps more prevalent in Anglo-Saxon economies in the 1960s and 1970s, but regional and interest-group politics led Italy and Belgium respectively to debt totals in excess of 100 per cent of GDP. The difficulty of financing increasing debt levels gave governments, and particularly those in control of monetary policy as well as fiscal policy, an incentive to cut the cost of debt by keeping inflation high and interest rates negative in real terms. Eventually, however, debt can only be sold at a

55

EMU and the New Member States

steep discount, pushing up real interest rates and reducing maturity dates sometimes steeply. In developing countries dependency on foreign savings to fund government spending led to a series of sovereign debt crises in the 1980s. The result was a drying up of debt-based credit for developing countries in the 1980s and a move towards the promotion of FDI and other equity-based instruments as a main source of foreign capital (and so links back to the development model that had emerged by 1989). Thus, in both the OECD countries and middle-income developing countries the focus became sustainable fiscal positions. It was not unreasonable that governments should borrow either to fund development in countries with high growth potential or to spread investments with inter-generational pay-offs. However, both strategies ran into the question of sustainability. The sustainability of public debt is relatively easy to conceptualize—the relationship between the growth rate of the economy and the real interest rate will give an immediate test of whether real debt is accumulating or not and whether debt service is likely to squeeze out other expenditure. But it does not answer the question of sustainability since it is subject to forecasting errors on future growth rates and real interest rates. Fiscal programmes were increasingly judged on a case-by-case basis by international institutions and the markets. If monetization of the debt is not possible, as a regime of independent central banks implies, short-run accumulation of debt might be sustainable if markets thought that growth would be higher in the medium term or if there was some external judgement, for instance, by the IMF, that medium-term policy was prudent. Thus, when the central European transition economies emerged on the global stage in 1989–90, there was no simple global fiscal rule to follow. Some had low debt levels; others had significant foreign debt. Their fiscal systems bore little relation to Western tax systems, and new taxes had to be introduced. The collapse of enterprises and the rise of the black economy restricted tax income, while rising unemployment and in some cases hyperinflation put real strain on the funding of social safety nets. All had IMF programmes, but they did not prevent budgetary crises even among the good performers, notably in Hungary and the Czech Republic in 1993 and 1996 respectively, and a slower motion crisis in Poland after 1998 as the central bank tightened monetary policy to bring down persistent inflation and, in consequence, put upwards pressure on budget deficits (Tables 2.7 and 2.8). Against this background, as the 1990s progressed, for the Central European transition states the de facto fiscal policy standards became the Maastricht convergence criteria and the SGP. This development mirrored an emerging global norm in the informal sense that during the 1990s

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EMU and the New Member States Table 2.7. General government balance (% of GDP)

Year

Czech Slovak Bulgaria Republic Estonia Hungary Latvia Lithuania Poland Romania Republic Slovenia

1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005

5 3 11 6 6 10 0 2 0 0 1 0 1 1 2

2 3 3 1 1 2 2 4 4 4 6 7 12 3 3

na na na 1 1 2 2 0 4 1 0 2 3 2 2

3 6 6 8 7 5 7 8 6 3 3 8 6 5 6

na na na 4 4 2 1 1 5 3 2 2 1 1 1

na na 5 5 4 4 1 3 6 3 2 1 1 1 2

2 5 3 3 3 3 4 4 3 2 4 3 5 4 3

na 5 0 2 3 4 5 4 2 4 3 2 2 1 1

na 12 6 1 0 1 5 5 7 12 6 8 4 3 3

3 0 1 0 0 0 2 2 2 3 3 3 3 2 2

Source: EBRD (2005a). 2005 Estimates

Table 2.8. General government debt (% of GDP) Country

1995

1999

2000

2001

2002

2003

2004

2005

Bulgaria Czech Republic Estonia Hungary Latvia Lithuania Poland Romania Slovak Republic Slovenia

115 15 9 86 16

99 15 8 61 13 23 40 24 47 25

89 17 6 58 13 24 37 23 50 27

70 19 6 52 15 23 37 23 49 28

56 18 6 55 14 22 40 23 43 30

48 22 6 57 15 21 44 21 44 29

41 24 5 57 15 20 42 19 44 30

32 26 5 58 11 19 43 19 35 29

50 21 23 18

Source: EBRD (2005a). 2005 Estimates.

whether any country’s fiscal performance was better than the Maastricht fiscal criteria for entry to EMU and avoided an excessive deficit was seen as a mark of success or at least prudence. This outcome is perhaps ironic since the Maastricht criteria were clearly set to be exclusionary (Dyson and Featherstone 1999). The Maastricht tests of a budget deficit not exceeding 3 per cent of GDP and a debt level not exceeding 60 per cent of GDP met two criteria. First, on standard assumptions in the late 1980s about trend growth and real interest rates, deficits below 3 per cent of GDP were consistent with a debt to GDP ratio that did not

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exceed 60 per cent. The second criterion is that they were levels that France and Germany had historically never exceeded but looked hard for Italy— seen as the problematic candidate for EMU—to meet. So, while there was a technical basis for the Maastricht criteria, the parameters had no general applicability as a global norm. Growth rates and real interest rates could vary, particularly in emerging markets experiencing rapid catch-up growth. The failures of fiscal discipline in France and Germany, which led to the March 2005 reform of the SGP, threw the whole notion of widely accepted, well-specified fiscal policy norms into question. These failures generated a wide range of alternatives proposed by both governments and academics (see Begg et al. (2004) for a snap shot of the debate). They ranged from the Pact’s abandonment (Enderlein 2004), via some sort of panel of wise persons (Eichengreen 2004), to some loosening of the Pact to allow balance over the cycle, borrowing where public infrastructure needed renewing particularly where debt levels were low (HM Treasury 2004), and to longer-term indicators of sustainability with a focus on debt levels (Buiter 2003). Nevertheless, there is a clear preference for fiscal stability and sustainable policy. The reaction to the burgeoning US fiscal deficit and the controversy around the failure of the SGP suggest an expectation of stability, if no clear agreement on a precise prescription. The central European states have found fiscal discipline the most difficult global norm with which to comply. The starting conditions were extremely difficult, as noted above, and the prevalence of the black economy and non-payment of taxes by the state-owned enterprises made sustaining revenue and social policies and transfers difficult without running deficits (Table 2.7).

Exchange-Rate Policy As noted above, exchange-rate policy lies at the intersection of macro- and microeconomic policy and of the domestic and the world economy. Hence the choice of policy is very complex. Perhaps the only truth is that there is no exchange-rate policy that is right for all places and all times (Frankel 1999). After the collapse of the Bretton Woods system the world did not move en masse towards a paradigm of floating rates, for various reasons. First, a number of European countries saw a need to retain fixed rates, at least at a regional level, to sustain open trade within the then European Community and to allow integrated policies to work. Hence, they opted for the

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EMU and the New Member States

(failed) ‘Snake in the Tunnel’, and then for the (successful) European Monetary System from 1978. Second, many developing countries, unable to achieve the domestic institutional and policy credibility required to sustain relatively stable floating rates, saw floating as a recipe for importing instability. Third, even where policy regimes were credible, a floating rate was likely to overshoot plausible equilibrium levels. Illustrative examples include sterling in the 1979–85 period, when it appreciated to a peak of $2.40 by mid-1980, and then depreciated to a level of $1.04 by early 1985, and the exchange-rate cycles between the USA and the rest of the world since 1971. The uncertainty about the correct approach to the exchange rate led to a range of regimes in use round the world. They ranged from: . More or less free floating (which would not preclude occasional intervention in the market) . Managed floating, where the central bank was active in trying to keep the exchange rate on a smooth path but would not stand in the way of trend movements . ‘Dirty’ floating, where there was an unannounced exchange-rate target . Crawling pegs, where there was a fixed exchange rate, usually with a fluctuation band, and a pre-announced path for the central rate, normally downwards to maintain competitiveness . Fixed but adjustable pegs, with a fixed rate and fluctuation band, and a commitment to sustain the central rate, but the possibility that it could be realigned if domestic conditions or international competitiveness demanded. . A currency board, which is an irrevocable fix against a chosen currency (or basket) and in which the domestic monetary base is related through the fix to available foreign-exchange reserves. . Dollarization/euroization, which involves the adoption of a foreign currency in place of your own. The initial monetary base is purchased with foreign-exchange reserves. . Monetary union. The history of the ERM illustrates the interaction of micro- and macroeconomic policy and how this interaction had an important bearing on the development of global norms of exchange-rate policy. As part of the single market programme, the EU abolished capital controls in 1990. It was forecast that this policy development would make the management of the ERM more difficult, if not impossible. This view is based on the so-called inconsistent quartet (see ECB 2003: 53 for a summary), which states that

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open trade, free capital movements, a fixed exchange rate, and domestic monetary autonomy are inconsistent. Monetary policy is set either to deliver the exchange-rate target or to deliver domestic inflation (in which case the exchange rate is left to float). Any attempt to run an inconsistent monetary and exchange-rate policy with open capital markets will lead to an uncontrolled inflow or outflow of capital, making the fixed exchange rate untenable. From this episode came the first stirrings of the ‘corner regimes’ analysis. Crudely this analysis argues that there are only two stable policy positions: floating with a credible domestic monetary policy or an irrevocable fix (monetary union being its most stable form). The experience of the 1997 Asian financial crisis, and the contagion that it released in Russia and in Latin America, seemed to reinforce this message. Argentina—with a currency board—survived the crisis in reasonably good order, whereas its biggest trading partner, Brazil, had a very difficult time. In perhaps the clearest statement of this analysis, Fischer (2001) noted the migration of IMF members from ‘soft’ pegs (any adjustable peg system) to ‘hard’ pegs after 1990. Though his analysis of the problems of soft pegs implicitly approves of this move, he is scrupulous in referring to alternative views, notably Frankel (1999). The ECB (2003) notes that the ‘corner regime’ analysis is still controversial. The collapse of the Argentinean currency board in 2000 suggests that the widely noted vulnerability of currency boards to weaknesses in the domestic banking system—along with the difficulty of exit, except when the exchange rate is under upwards pressure or into a monetary union—make them a risky choice other than in the most difficult of situations. Membership of a monetary union (Schadler et al. 2004) is a preferred choice or, in an emergency, dollarization or euroization (Nuti 2001), although the US Federal Reserve and the ECB do not welcome such arrangements.

The Implications of Global Norms for Strategic Choices of Accession States Starting with the signature of the first Europe Agreements in 1991, the central European transition economies have used accession to the EU as their main instrument in integrating into the world economy and global governance norms. As noted above, the EU has been at the heart of developing global norms via the single market programme, the develop-

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ment of monetary policy institutions, fiscal policy rules, and changes in exchange-rate regimes. In effect, Europeanization and globalization processes were simultaneous. In any case, the prospect of EU entry did not really become firm until the Luxembourg Council in 1998, and then only for five out of the ten countries under consideration. Given some difficulties along the way, entry could not be taken for granted. So, even if the countries concerned had not eventually entered the EU, they were patterning themselves on the EU as their nearest capitalist and democratic neighbour. There was, in short, an ‘anticipatory’ Europeanization at work in economic policy. But these states also took the other and more traditional routes to joining the world economy. They all joined the Bretton Woods institutions and the WTO. Four of them are members of OECD, exposing them to peergroup reviews across a wide range of economic and social policies as well as to the capital codes, which require freedom of capital movement. The Visegrad countries (Czech Republic, Hungary, Poland, and Slovakia) and Bulgaria and Romania were founding members of the EBRD, and the Baltic States and Slovenia joined during 1992.

Liberalization Agenda All these states have shown a strong tendency to privatize. The share of the private sector in GDP has grown steadily (Table 2.2), while government expenditure has fallen (Table 2.3). For all, except Romania, tariffs were reduced to relatively low levels, even before joining the EU; while for Estonia tariffs actually increased on entry to the EU. They also opened up to foreign investment and in some years showed exceptionally large inflows relative to GDP (Table 2.4), particularly among the smaller economies. There is some evidence that FDI increased as EU membership prospects became firmer (Bevan, Estrin, and Grabbe 2001). The overall effect of these liberalization policies is that, after initial setbacks, growth returned, if slowly in Romania and Bulgaria (Table 2.5). But it is only in Poland and Slovenia that GDP was significantly above pretransition levels by 2002, and in Poland unemployment remains very high. This outcome reflects interestingly on the debate over fast or slow adjustment in the early years of transition. Poland famously adopted shock therapy, while Slovenia went more slowly (though Slovenia was closer to a market economy initially than Poland). The fact that they have both performed strongly on growth suggests that the choice was a false one. The key question is whether the initial political conditions allow one to

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EMU and the New Member States

go slow or not. This—rather than the choice between shock therapy and phased adjustment—may be the real issue. If it is likely that phased reform will run into political barriers, then rapid adjustment might be the best way of embedding the reforms (cf. Papadimitriou, Chapter 11 on Romania).

Stability Culture Judged by outcomes, these states bought very directly into the stability culture. Inflation has come down significantly, despite periods of hyperinflation in Poland and Bulgaria (Table 2.6). By 2002 only Romania showed inflation in double figures; while the Czech Republic, Latvia, Poland, and Slovakia scored inflation rates consistent with the Euro Area. At the same time debt levels were all inside, and in some cases well inside, the Maastricht criteria by 2003 (Table 2.8). However, the Visegrad countries comprehensively failed the Maastricht fiscal deficit test in 2003 and subsequently. Fiscal stabilization is high on the agenda of all four countries so that this situation might change rapidly.

Exchange-Rate Regimes Table 2.9 on current exchange-rate regimes suggests that the transition countries in central Europe have followed the trend of moving to either ‘hard’ pegs (currency boards in Estonia, Lithuania, and Bulgaria and a relatively ‘hard’ peg in Latvia on 1 per cent margins) or free floats in Poland and the Czech Republic and managed floats in Romania and Slovakia. Only Slovenia in ERMII, and Hungary shadowing ERMII, seem to be on a ‘soft’ peg. However, both are on 15 per cent margins, and Hungary has an inflation target and so might effectively be put in the ‘floating’ category.

The Position on Entry to the EU Apart perhaps from Romania, the new member states and the candidates in central Europe have been pretty predictable emerging markets. For eight of the ten, membership of the EU has anchored market liberalization and property rights. All have followed the broad path of global economic governance norms. The result has increased output almost everywhere, eventually. In the context of EMU Estonia, Latvia, Lithuania, and Slovenia are in the ERM and en route to EMU, Bulgaria is in a currency board with

62

EMU and the New Member States Table 2.9. Monetary and exchange rate strategies in accession countries Exchange Rate Regime

Currency Features

Currency Board Bulgaria Estonia

Lithuania

Currency board to the euro Currency board to the euro & member of ERM II with 0% margins since 2004 Currency board to the euro and member of ERM II with 0% margins since 2004

Lev Kroon

Introduced in 1997 Introduced in 1992

Litas

Introduced in 1994; repegged from the US dollar to the euro in February 2002

Conventional Fixed Peg Latvia

Slovenia

Lats Peg to the Euro (earlier pegged to SDR) and member of ERM II with 1% margin Member of ERM II Tolar

Exchange Rate Band 1%

Monetary targeting; the euro is used as reference currency

Unilateral Shadowing of ERM II Peg to the euro, with 15% fluctuation bands

Forint

Exchange rate regime combined with inflation targeting 2.5%–4.5% by end-2005

Romania

Managed float

Leu

Currency basket (US dollar, euro) is used informally as reference

Slovakia

Managed float

Koruna

Czech Republic

Free Float

Koruna

Poland

Free Float

Zloty

Hungary

Managed Float

Independent/ Free Float Inflation targeting: 2%–4% by end-2005 Inflation targeting: 2.5%  1%

Source: ECB Bulletin July 2002 and national central banks.

the euro, and the remainder are arguably floating. Only Slovakia of the Visegrad 4 has a firm plan to join EMU, which posits joining ERMII no later than mid-2006 and EMU in 2008–9 (National Bank of Slovakia 2004). Others have stated intentions to join EMU. However, Poland has no timetable, and, while Hungary and the Czech Republic speak of 2008–09, there are no timetables for membership of ERMII. The adjustment that is necessary to meet the fiscal criteria in the timescales set looks challenging in all of the Visegrad 4.

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EMU and the New Member States

Fiscal policy has drifted away from EU norms in some places and may require some action to bring it back on track. However, arguably they are no further from EU and global best practice than some core members of the Euro Area. The challenge that they all face is to move to a sustained high-growth path that leads to convergence. As the core Euro Area illustrates, EMU accession and membership is no guarantee of growth. The test for the countries in this group that are currently floating is to find an entry rate to the euro which allows their traded-goods sector to flourish and deliver export-led growth and attract the investment and technology that will allow them to follow Ireland. As Eichengreen and Leblang (2003) show in their survey of exchange-rate regimes and convergence, there is no guarantee this decision will be got right.

The EU, Global Norms, and Transition in East Central Europe The EU was a generator of global norms on market liberalization and stability culture from 1957 onwards, but in particular from 1985 on the single market and from 1992 on stability culture. This largely coincided with the emergence of the transition economies onto the world market. They brought their own enthusiasm for economic reform, and they pursued it faster or slower through the years until the EU decided to set conditions for EU membership and then to open negotiations. This enthusiasm was encouraged by the terms of the Europe Agreements, which gave an FTA in manufacturing and some aspects of the single market notably competition policy and free movement of capital (subject to exclusions) There is no doubt that EU accession both shaped and embedded global norms in the central European states, particularly after the negotiations for membership began. Nonetheless, the original five central Europeans with whom negotiations were opened in 1998 were early adopters in any case (the Czech Republic, Estonia, Hungary, Poland, and Slovenia). In contrast, some of the countries that began accession negotiations later, notably Bulgaria and Romania, were late adopters, and even the incentive of early EU membership failed to accelerate their move to global norms. Indeed, Bulgaria moved to a currency board and fiscal stability only after severe economic crisis and under the tutelage of the IMF: that is, the Bulgarians did it for their own reasons. Only then was the incentive of EU candidature proffered. Of course, the Copenhagen criteria made it clear that the central Europeans had to be functioning market economies and

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EMU and the New Member States

capable of facing competition in the single market before accession. These criteria clearly gave an incentive to adopt global norms. It is equally true that the countries of the former Soviet Union have had much more difficulty embedding global norms but that may also owe more to the political economy of rent-seeking in resource-rich economies than to the lack of a perspective of EU membership. Undoubtedly, however, membership of the EU makes commitment to global norms as close to irrevocable as any polity can. The final step in this process of irrevocable commitment would be to join EMU.

What Will the New Members Have to Do to Qualify for EMU? To join EMU the new members must meet the convergence criteria (the Maastricht criteria). Once the criteria are met, membership of EMU is formally mandatory. The criteria are: . Not to be in an excessive deficit (budget deficit less than 3 per cent of GDP, public debt less than 60 per cent of GDP) . Inflation no more than 1.5 percentage points and long-term interest rates no more than 2 percentage points above levels in the 3 best performing states . Independent central bank . Membership of the ERMII on normal margins (meaning plus or minus 15 per cent round the central rate, which is not very constraining) for two years without severe tensions and in particular without devaluing the central rate against the euro. Membership of EMU is, however, largely voluntary. The fiscal convergence criteria are unavoidable because they depend on not being in excessive deficits, which is in the Treaty and mandatory, although member states can be in breach of their commitments for a time without attracting sanction. Similarly, the inflation and interest rate criteria can be missed as a result of policy. Above all, membership of ERMII is at the discretion of the member state, or at least the timing is discretionary. All member states are expected to join and conditions in countries with a derogation (those which do not qualify) should be reviewed every two years, at least, according to the Treaty (Article 122.2 Treaty of Nice). Hence, there may be peer pressure to join if it appears that the criteria are met. On the other hand, the ECB is not currently putting pressure on new members of the EU to join EMU. They are all small economically—they

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EMU and the New Member States

add up to little more than the Netherlands in terms of GDP. Having a further ten members with different structural challenges and a probable higher inflation rate (as growth drives up wages, especially in the nontraded sector) is not an attractive proposition for the Executive Board (especially given worries about divergence amongst current members). Indeed, neither the UK nor Denmark, which have opt-outs, is under any sustained pressure to join. As Sweden demonstrates, it is possible to remain outside EMU without coming under pressure to join, even when there would be no problem in meeting the fiscal and monetary convergence criteria. Once the fiscal and inflation and long-term interest rate criteria are within reach, the key decision is essentially when to join ERMII, which then gives a two-year time frame to fulfil all the other criteria. Because the fiscal convergence criteria are the same as the key fiscal sustainability variables in the Excessive Deficit Procedure (EDP) and in the SGP (all EU members are subject to it but only Euro Area members to its sanctions), the new member states have been under immediate pressure to meet them. The decisions on the timing of entry into ERMII, however, are not mandatory in the treaty and are in the hands of the national government. The soonest that full membership of EMU can take place is two years after joining the ERM. Membership of the ERM is therefore the key initial decision on moving towards membership of EMU.

The Global and Time Dimensions of Negotiating Fit: PaceSetters and Laggards Why is there an issue about when to join the Euro Area? As noted above, the exchange rate is a key variable and potential policy tool in managing the relationship between both the real economy and macroeconomic variables and the rest of the world. Equally, as noted above, there are two main global norms on which exchange-rate regime to follow: an irrevocable fix with a credible hegemon or floating with credible and stable domestic monetary and fiscal policy. So, what then are the elements in a cost–benefit calculation in negotiating Euro Area membership? The main advantage of negotiating early Euro Area entry would be the adoption of a stability-oriented macroeconomic framework that would bring with it the credibility of the ECB on inflation and of the EDP and the SGP on fiscal policy. Such stability should improve wage-setting behaviour, bring down long-term interest rates, and improve the climate

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EMU and the New Member States

for both domestic and foreign investors, with a consequent increase in the trend rate of growth. Recent, if contested, research (Rose 2004) also suggests trade gains of 40–90 per cent from membership of a monetary union. There is empirical evidence of such trade growth in the Euro Area after the start of EMU in 1999 (Micco et al. 2004). The British government suggests that membership of EMU could increase trade with partners by up to 50 per cent and Gross National Product by up to 9 per cent over the long term (HM Treasury 2003). Given these major advantages, what argues against negotiating immediate entry? The potential reasons for delay relate both to the real economy and to policy management problems that might come with Euro Area membership. The first reason might be summarized as the risk of joining at the wrong (too high) exchange rate. Entry to the EU could bring about a liberalization shock as new members adjust to full membership of the single market and the deep integration that follows. Keeping a flexible exchange rate could help the adjustment to the new conditions. There is evidence that joining at the ‘wrong rate’ can take a long time to recover from and that the result could be low growth (Eichengreen and Leblang 2003). This risk is reduced if labour markets, in particular nominal wages, are flexible. But, even in countries like the new members with a reserve of unskilled labour in agriculture and other low-productivity sectors, shortages of skilled labour in the traded sector could still lead to long lags in wage adjustment, and hence to uncompetiveness in the EU market. The second potential reason for caution in negotiating entry is that conditions in the new members will play a very small role in the setting of Euro Area monetary policy. Hence, coincidence apart, monetary policy will be wrong for the new members. The question is—will it be a little or a lot wrong? The answer might be that, for some time prior to entry, domestic short-term interest rates should be relatively closely aligned with Euro Area levels, if entry is not to be either inflationary or deflationary. It is likely that inflation in the new members will run above the level in the core of the Euro Area. This divergence is consequent on the new members’ position as emerging market economies in a process of rapid catch-up growth. In these circumstances the benefits of rapid increases in productivity in the traded sector are then spread to the non-traded sector in two ways. If the exchange rate is flexible, the nominal exchange rate appreciates, driving down prices and raising real wages across both traded and non-traded sectors. If, however, the exchange rate is fixed, increased productivity will be captured by higher wages in the traded sector, and hence

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spread via the labour markets to the non-traded sector, mainly services and the public sector, where productivity growth is much lower. The result is a structurally higher inflation rate than in mature economies. There is some controversy about how big this effect is (sometimes known as the Balassa–Samuelson effect), with estimates of inflation higher by up to 0 to 3 percentage points (Mihaljek and Klau 2004). If the higher inflation differentials were true for the new members, it would make it hard to join the Euro Area (inflation must be no higher than 1.5 percentage points above the best three performing member states in the reference period for the convergence criteria). Once members, inflation would consistently exceed the ECB target level, and the authorities would come under pressure to reduce domestic demand, via tighter fiscal policy. This policy response would increase unemployment and reduce wages, and hence inflationary pressures in the economy. In short, there is a case for caution over negotiating entry, until a significant element of catch-up with the core Euro Area has taken place. Third, the potential for increased capital flows, along with the certainty of significant net inflows from the EU budget after EU membership, will also add to potential policy management problems if the exchange rate is fixed. The experience of Poland shows that the prospect of EU membership leads to increased inflows of foreign direct investment. In recent years FDI to Poland has increased from negligible levels towards 5 per cent of GDP (Table 2.4). EMU membership might be expected to reinforce this trend. At the same time, Poland might expect to receive net inflows of up to 5 per cent of GDP from EU policies (up to 4 per cent of GDP from the structural funds and perhaps 1 per cent or more net from the CAP budget and higher agricultural prices for exports to the EU). Thus, annual foreignexchange inflows could reach 10 per cent of GDP in the new members after entry to the EU. These inflows will, other things being equal, put upward pressure on the exchange rate ahead of Euro Area membership. This upward pressure will both reduce the potential inflationary impact of these inflows by reducing import prices and perhaps help contain FDI inflows to a manageable rate. If the exchange rate is fixed early in membership, the impact of these inflows can only be managed by restrictive fiscal policy, perhaps including running significant budget surpluses. This fiscal stance could potentially hinder the ability of the government to invest in infrastructure or to fund redistributive policies to help those adversely affected by liberalization or left behind by rapid growth, such as older or less skilled workers or pensioners, with difficult political ramifications for governments in the new member states.

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EMU and the New Member States

These three reasons suggest that caution on negotiating the timing of entry and the entry rate to the Euro Area might be warranted, until the impact of EU membership on competitiveness and inflows across the exchanges is well understood, and the size of any Balassa–Samuelson effect is clear. If labour markets are flexible, and domestic markets for goods and services are competitive, none of these reasons are showstoppers for early membership of EMU, and realizing quickly the trade and growth benefits of a credible, long-term, stability-orientated macroeconomic policy framework with low inflation and prudent fiscal policy. Estonia, Lithuania, and Slovenia joined ERMII in June 2004 and Latvia (along with Cyprus and Malta) in April 2005, signalling their intentions to adopt the euro early. Poland, Hungary, the Czech Republic, and Slovakia all seem to be waiting. This pattern of pacesetters and laggards may suggest that the smaller countries among the new members are more intent on the immediate credibility gains of membership, while the bigger countries may be more worried about the loss of flexibility.

Conclusions As recent economic history in Europe and globally has demonstrated, macroeconomic stability is not a luxury, in or out of the EU and the Euro Area. Lax and incredible economic, fiscal, and monetary policies lead to external and internal disequilibrium and significant costs in lost output, unemployment and of servicing domestic and external debt as well as political crises. The international capital markets and the global policy community in the IMF demand prudent policy, as much as the EU or the ECB. Global policy norms create powerful incentives for prudent macroeconomic policies that are not dependent on, but are reinforced and anchored by, Euro Area membership. Members of the EU are expected to become members of the Euro Area when they qualify. The timing of membership is essentially in the hands of each national government, with entry into ERMII as the likely key decision. The benefits of early membership are very significant, especially for any country with a history of economic instability. Lower long-term interest rates and trade expansion following Euro Area entry could also help boost long-term growth potential. There may be reasons for caution, however, if early entry and loss of the exchange rate as a shock absorber would create problems of adjustment for the real economy or make the impact of capital and budgetary inflows hard to manage. Flexible labour

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EMU and the New Member States

markets would ease any adjustment problems in the real economy, but managing capital and budgetary inflows could still put significant pressures on the management of fiscal policy. Staying out of the Euro Area would not mean room for manoeuvre for national governments to ignore the strictures of prudent monetary and fiscal policy. Capital markets and the Excessive Deficit Procedure in the EU Treaty would require, and could penalize, loose fiscal or monetary policy. Membership of the Euro Area would give the new members both credibility and the support of other members in pursuing economic policy goals. Staying out for an extended period might incur political costs, if the Euro Group becomes the focus for enhanced cooperation within the EU, and economic costs, if some of the benefits of further economic integration within the single market are denied those outside EMU.

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3 Real Convergence and EMU Enlargement: The Time Dimension of Fit With the Euro Area Iain Begg

Constitutionally, the new member states from east central Europe, like Sweden, have no choice about becoming full members of the Euro Area. They did not do so on joining the EU in 2004 only because the standard Maastricht conditions have to be fulfilled before they are eligible. Formally, therefore, they have derogations, with a trajectory for becoming members that has effectively been translated into a minimum two year participation in ERM II and a clear procedure to be followed (see ECB 2004). In practice, as the Swedes have demonstrated, it is possible to postpone membership indefinitely if political or economic priorities dictate otherwise, and it is already evident that there are conflicting perspectives on the matter. Some new members, such as Slovenia (which will join in 2007) and Lithuania, want to accede at the earliest opportunity, while others—notably the Czechs—have signalled that they prefer to wait. Hungary initially seemed keen to join quickly, but has since back-tracked. Behind these positions lies a debate about the costs and benefits of early Euro Area accession, focusing especially on its implications for real convergence. Simply put, the question is whether switching prematurely to the euro would endanger real growth, even if it is regarded as axiomatic that Euro Area membership confers longer-term benefits. This question goes beyond the simple approach of asking whether the new members are suited to join the Euro Area on the basis of conventional optimum currency area criteria by the intrusion of the element of timing. Managing the

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relationship between nominal and real convergence highlights the time dimension in negotiating fit with EMU. There is no intrinsic reason to believe that countries with different levels of GDP per head will be less suited to form a monetary union, though in practice an excessive imbalance in level of development is likely to be problematic because it will bear on the feasibility of different adjustment strategies. Aglietta et al. (2003) note that the east central European states have successfully re-orientated their productive structures towards global markets and that a key factor in doing so has been the balance struck between maintaining export competitiveness and containing inflation. They also argue that attempting to accede too rapidly to the euro could, by tipping the scales too far towards nominal convergence, upset this delicate balancing act and have an adverse effect on real convergence. In contrast, Leszek Balcerowicz, the Governor of the National Bank of Poland, argued in a speech to the eleventh European Banking Congress in Frankfurt, 23 November 2001, that early ‘entry of the candidate countries into EMU would allow them to start reaping the related advantages (more price transparency, reduced transformation costs, stronger macroeconomic framework)’ as quickly as possible and would help to consolidate the momentum towards structural reforms. He also believes that setting a firm deadline is advantageous and has stated (quoted in Detken et al. 2005: 201) that use of language is important. He observes that the portrayal of monetary union as the ‘loss of an independent monetary policy’ conveys a misleading impression of something forgone, whereas the statement ‘shift from a domestic monetary policy to a common monetary policy’ sounds much better. Although he made his point in relation to the political economy of the choice, it can be interpreted to mean that the focus should be on a dispassionate assessment of costs and benefits, rather than more emotive language about national autonomy. In devising an optimal strategy for acceding to Stage 3 of EMU, the new member states face conflicting incentives. Full participation in EMU promises to entrench macroeconomic stability, to accelerate the integration of financial markets and help to assure financial stability, and to raise the volume of trade by eliminating currency risk as a form of barrier. For an economy that is not only competitive on entering EMU, but able to exploit the opportunities afforded by membership of the Euro Area, these attributes of full participation would be attractive. Having come through the process of transition, the allure of EMU for advocates of rapid accession is that stable macroeconomic policy would underpin a long-term development strategy.

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However, EMU imposes constraints on macroeconomic policy and can restrict flexibility by eliminating the exchange rate as a potential instrument of adjustment and shock absorber. These constraints could slow real convergence and may also give rise to difficulties such as how to contend with the Balassa–Samuelson effect. This effect arises where the price level in a country is substantially lower than in partner countries, but is expected to converge as the country increases its relative prosperity. As a result, measured inflation would be higher than elsewhere, potentially increasing the real exchange rate. In addition, adhering to even the reformed SGP (after the March 2005 deal) may be incompatible with the substantial public investment needed to upgrade economies. These latter considerations mean that the Maastricht glide-path to monetary union may be more demanding in the short-term for the new members—with fewer immediate compensating gains in the form of a desirable rebalancing of the macroeconomy—than they were for the current Euro Area members. The prospects for any of the new members under full EMU will depend on a range of variables and on the economic development trajectory that they choose. For the smallest and most open economies, monetary independence may well be implausible, implying that they have little choice but to fix their currencies to some external benchmark. If so, a euro peg would be the only realistic option as the country becomes more closely integrated into the EU. The leading example is Estonia which pegged its currency to the DM in 1992 and to the euro from 1999, forgoing any currency flexibility. Lithuania followed suit in 2000 and these two countries, together with Latvia, are now widely expected to join Slovenia as the next of the new members to move to Stage 3. For the larger economies the choices are more open and a longer period of prior adjustment is now being contemplated. As an analytic device for understanding the likely effects of acceding to, then participating fully in, monetary union, a useful concept is the ‘j-curve’, the essence of which is that there are short-term costs of a change that produce a dip in performance (however measured), followed by an up-turn. Figure 3.1 illustrates it, showing that there is an expected trajectory for the economy in the absence of full adoption of the euro. The introduction of the change to it initially causes a worsening of performance, but then induces a superior performance. The crucial issues, especially from a political economy standpoint, are the depth of the dip in the ‘j’ and the time it takes for performance to revert to an upward trend (shown on the horizontal axis as the gap from point A to point B), then

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Fully in EMU

GAINS

National currency

LOSSES

A

B

C

Figure 3.1. The euro membership ‘J’-curve (trajectory of the economy)

to return the economy to where it would have been in the absence of the shift to the euro (from point A to point C). This chapter examines the time dimension of negotiating fit with EMU in the light of economic arguments for and against rapid accession and of the circumstances of the different new member states from east central Europe. The next section briefly reviews some of the key economic policy issues that arise in negotiating fit with EMU. Section 3 looks at what might be called (Ardy et al. 2005) ‘Stage 2 adjustment’—what Euro Area candidates need to do to become fit for Euro Area entry. The subsequent section concentrates on how countries can be expected to deal with problems of managing fit within Stage 3. Concluding comments complete the chapter.

The Economic Aspects of Negotiating Fit With EMU: Optimum Currency Area Theory Formally, eligibility for Stage 3 of EMU calls for fulfilment of the Maastricht convergence criteria. Among the existing twelve Euro Area members, attaining this ambition was a struggle for many, but easy for others, reflecting the underlying performances of their economies, their recent economic history and the degree to which the ‘economic model’ of EMU was confluent with their own. For several of the new members, achieving the necessary values on the four nominal convergence criteria looks, similarly, as though it will not be terribly demanding, but others have seen the gap that will have to be overcome widen. As Table 3.1 shows, for most of the new members the outlook on the fiscal indicators is not too bad, with the

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Real Convergence and EMU Enlargement Table 3.1. The Maastricht fiscal criteria: recent values and prospects

Fiscal indicator

Trend from 2000–03

Ratio in 2004 % of GDP

Forecasts for next years

Outlook for EMU accession

Czech Republic

Deficit Debt

High and worsening Low but growing

2.6 30.5

Excessive deficit Stable

Comfortable

Estonia

Deficit Debt

In surplus Negligible

þ1.6 4.8

Staying in surplus Lower still

Very favourable

Latvia

Deficit Debt

Low and stable Low and stable

0.2 11.9

Slight worsening Stable

Favourable

Lithuania

Deficit Debt

Low and stable Low and stable

0.5 18.7

Steady Stable

Comfortable Favourable

Hungary

Deficit

Persistently high

6.1

Needs to fall

Debt

Approaching 60% limit

Remaining ‘excessive’ Stabilizing

Poland

Deficit

Creeping over 4%

Debt

Rising beyond 40%

43.6

Slight increase Slight increase

Slovenia

Deficit Debt

Shrinking Stable

1.8 29.1

Steady Stable

Comfortable

Slovakia

Deficit Debt

Falling Falling

2.9 34.5

Improving Steady

Reasonably comfortable

Cyprus

Deficit Debt

Increasing High and growing

2.4 70.3

Improving Coming down a little

Favourable Over limit

Malta

Deficit Debt

High, rising Going over 70%

3.3 74.7

Steady Stays high

In range Uncomfortably high

58.4 2.5

Too close to limit Under control Acceptable now

Note: The Maastricht criteria are 3 per cent of GDP for the deficit and 60 per cent for debt. Source: European Commission Spring 2006 Macroeconomic Forecasts.

recovery in economic growth in recent years enabling many of them to be close to the required values for the Maastricht convergence criteria. All bar Cyprus and Malta meet the debt criterion, and, although some countries exceed the deficit criterion, the slippage is far less pronounced that that of current Euro Area members during much of the 1990s. There are, though, signs of dwindling fiscal discipline: Berger et al (2004) note that the larger central European economies have all seen a deterioration in their fiscal position that cannot wholly be explained by what they call the usual suspects, namely, economic and electoral cycles and institutional factors. Consequently, the nominal adjustment needed to meet the criteria is less daunting for many than it was for several existing members of the

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Euro Area in the run up to the decisions taken in May 1998 about the first wave of membership. However, for those, such as Poland and Hungary, which had relatively high debts at the outset of transition, these trends in public finance exacerbated the fiscal problems that arose during the 1990s and have made it more difficult to attain the criteria. Regarding long-term interest rates, the three lowest member state rates in spring 2006 averaged 3.72 per cent. The Maastricht convergence threshold is to be within two percentage points of the three best, and according to data in the June 2006 issue of the ECB Statistics Pocketbook only Hungary, at 7 per cent, would fail to pass the test among the eight east central European states (a directly comparable figure for Estonia is not available, but a proxy computed by the ECB puts its rate just half a percentage point above the ‘three best’). In considering a country’s suitability for monetary union, some insights can be gleaned from the conventional theory of optimum currency areas, the underlying question being how compatible the structures of the candidate member are with its prospective partners. A paradox about the new members is that although, on the whole, they cannot be said to meet the criteria of optimality for joining the Euro Area, many commentators consider that they are closer to being a good fit than were several of the current members of the Euro Area prior to 1999. Using estimates of how well the new members accord with the Euro Area on optimum currency area criteria, von Hagen and Traistaru (2005) find not only that they do not fit that well overall, but also that there is considerable diversity, although they note that the same was true of the current Euro Area members (see also Kozluk 2004). However, as noted by Bayoumi and Eichengreen (1997), there is by no means agreement that optimum currency area criteria are the only, let alone the best criteria for assessing whether joining a monetary union will be economically attractive. The position confronting the new members is asymmetric in that the economic weight of any individual country is negligible compared with the Euro Area. Indeed, even as a bloc, the ten new members have an aggregate GNI that is around 7 per cent of the Euro Area and the largest economy—Poland—is just over 3 per cent. Consequently, ECB monetary policy decisions will pay little heed to the conditions in any of these countries. Instead, they will have to accommodate to the Euro Area rather than finding that Euro Area conditions are modified in their direction. Thus, where optimum currency area theory usually assumes that countries agreeing to form a monetary union will meet in the middle, the new members will have to accept existing Euro Area conditions.

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The main arguments in favour of early accession fall under five main headings . . . . .

Improving the credibility of macroeconomic policy Financial stability Reducing transactions costs Lowered risk and uncertainty, as perceived by investors Increased, mutually-beneficial trade and integration of financial markets

The main drawbacks of early participation in the euro concern . The costs of conforming to a one-size-fits-all monetary policy (implicitly, the degree of convergence of economic cycles, certain structural characteristics of economies and the behavioural responses to policy signals). . The scope for using alternative adjustment mechanisms to deal with either asymmetric shocks that affect the country or uneven effects of shocks affecting the whole Euro Area . The absence of EU level policy instruments to support stabilization Overall, these arguments are about the balance of risks, rather than whether exchange-rate flexibility or monetary union offers the best outlook for real convergence. Exchange-rate flexibility probably makes it easier to manage short-term adjustment, but without the anchor of external obligations imposed by EMU, governments may fail to take the necessary steps, resulting in a more profound adjustment problem if the economy suffers shocks. In other words, EMU offers a greater certainty that ‘sensible’ policies will be pursued and may, in turn, mean a more stable (and possibly better) trajectory of long-term convergence. In practice, it will be an empirical question, with the outcome dependent on relevant parameter values, policy decisions and on the intrinsic capacity of the new member state economies to adjust. Rostowski (2005) highlights a range of possible risks surrounding how quickly to join the euro. First, the risks associated with catch-up growth can be substantial, principally because of the tendency for the current account of the balance of payments to be in deficit. So long as inward investment offsets these deficits, macroeconomic balance can be maintained, but if there is any kind of shock to the equilibrium, an independent currency could rapidly come under pressure, especially if external debt is high. From a time inconsistency perspective, Rostowski also advocates membership as a means of tying the hands of policymakers, who will

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often face populist demands that will be difficult to resist. He argues, particularly, that EU accession has engendered an expectation of growing prosperity and that a failure by governments to assure rising living standards will be politically damaging. Calmfors (2004) recalls from Swedish experience that high unemployment and the risk that an asymmetric shock would aggravate it, and the fact that high debt and deficits precluded the use of fiscal policy for stabilization purposes, are reasons to hesitate. Only Poland and Slovakia on current indicators would appear to be much at risk on these tests. One of the most obvious tensions about rapid EMU accession concerns public investment. The new members have less well-developed infrastructure than the EU15 and also face commitments to improve, notably, environmental standards. Yet for many, because of the legacy of transition there is also a substantial need for social policy expenditure, so that room for manoeuvre in fiscal policy is limited. Higher public investment consequently implies fiscal deficits—which could be justified on ‘golden-rule’ argumentation—but which still need to be compatible with the treaty requirement of maintaining the deficit below 3 per cent. Von Hagen and Traistaru (2005) entitle a section on ERM II of their chapter ‘boot camp or purgatory’. The former epithet is intended to capture the role of the system in training the authorities in how to manage their economies effectively to be ready for full monetary union, while the latter refers to unnecessary impositions on candidate countries that cause pain for no discernible gain. Although it might be expected that ERM membership would be accompanied by good macroeconomic policies, these authors note that the empirical research does not support the boot camp view as there is no evidence that macroeconomic policy followed by countries under the ERM was better. A conclusion they draw is that to avoid any risk of purgatory, countries should aim to spend as little time as possible in ERM II, that is barely two years. An implication of their view is that the choice of when to enter ERM II has to form part of the strategy for Euro Area accession, and that there will be a premium on having other variables in line to forestall adjustment problems prior to entering the mechanism. By definition, large idiosyncratic or country-specific shocks are unusual, so that it makes sense not to consider entering a monetary union while one is in progress. Frenkel and Nickel (2002) analyse the congruence of shocks between Euro Area members and the east central European states, based on data from 1993 to 2001, and find that the east central European states as a whole react more slowly to a shock than the Euro Area members.

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Since the estimation period does not include the consolidation of transition and the relatively better recent performance of the east central European states, the outlook is likely to have improved. Closer integration, implying greater trade, as well as the impact of formal EU accession will reinforce these effects. Even writing in 2002, Frenkel and Nickel (2002: 23) conclude that their results ‘support an entry into EMU for more advanced east central European states at the earliest possible date’.

Negotiating Fit: Stage 2 Adjustment To be eligible for Stage 3, the minimum adjustment requirement for any country is to meet the nominal convergence criteria laid out in the Treaty. All the new member states have been, though a period of unprecedented reform since the end of the 1980s, starting with the initial transition from central planning, and then continuing with the further reforms required to conform to the acquis communautaire. Although many countries started with a fairly clear slate as regards fiscal indicators, problems in tax collection and control of public expenditure were widespread. Other factors also affected economic stability, such as the Russian crisis in 1998, which had significant repercussions for the Baltic States. Latterly, problems have been especially pronounced in containing social expenditures as expectations adjust and new expenditure needs have surfaced. A key issue in negotiating fit with euro entry is the choice of domestic monetary regime. During Stage 2, there is no explicit guidance on the monetary policy framework that would-be members of the Euro Area should adopt. However, the choice will have some implications for the prospects of meeting the Maastricht convergence criteria. A variety of exchange-rate arrangements can also be envisaged, some of which (such as a currency board) would anticipate membership of ERM II, while a floating rate regime would, at some point, have to be reconciled with ERM II membership. Those countries that opt for a fixed exchange-rate arrangement plainly have to orientate monetary policy towards the exchange rate, thereby risking volatility in inflation. By contrast, those that opt for a variant on inflation targeting could find exchange-rate volatility increasing. Since the Maastricht criteria encompass both exchange-rate and price-stability targets, the choice will never be clearcut, although the standard optimum currency area argument that small open economies gain most from fixing their exchange rates is relevant for many of the new members. Both the monetary framework and the

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exchange-rate regime will be subjugated to the demands of ERM II as the country enters the last two years of Stage 2. What may be critical is whether the stance of monetary policy is such that the central bank acquires sufficient credibility to forestall volatility on either indicator. Estonia, Lithuania, and Slovenia joined ERM II in June 2004, just weeks after acceding to the EU, while the other three small new members (Cyprus, Latvia, and Malta) waited until May 2005. In theory, because of the twoyear membership criterion, this means that the first three could enter Stage 3 in 2006, while the others become eligible in 2007 though only Slovenia has, so far, progressed. In contrast, the four Visegrad countries have retained a degree of exchange-rate flexibility via managed floats (or, in Hungary, a crawling peg). These exchange-rate arrangements have been associated with different forms of inflation target. In monetary policy, therefore, two groups of countries can be distinguished, and it is perhaps no coincidence that the first group (those that favour exchange-rate stability) are the presumed vanguard for euro accession, while the latter group has progressively been pushing back the accession date. Premature ERM II entry may have a number of adverse consequences. First, if the real economy is still undergoing substantial structural change (as arguably remains the case for most new members), it will be difficult to establish an equilibrium real or nominal exchange rate. However, because ERM II calls for a fixed central rate, the risk of selecting an inappropriate rate is heightened (Issing 2005). The rate also has to be consistent with what the market anticipates if the risk of destabilizing speculation is to be avoided. In addition, as Padoa-Schioppa (1982) explained in setting out his notion of the ‘inconsistent quartet’, simultaneous achievement of an exchange-rate target and a price-stability target will be problematic with open trade and financial flows without enough prior nominal convergence. EU membership may also lead to some short-term fiscal problems, even though the sizeable allocations expected from the cohesion budget will result in net fiscal transfers to the new members. In particular, co-financing rules may oblige the new members to devote more public spending to public investment. Provided the investment in question is productive, it should underpin growth, and thus generate greater fiscal resources in the medium-term, but here again a short-term cost arises. Six of the new members were found to have excessive deficits immediately following EU accession and Hungary was castigated again in the spring and autumn of 2005 for being slow to abate the deficit. Reform fatigue may also be a factor complicating adjustment, especially with EU accession being sold as an economic opportunity.

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A crucial question for the new members is the extent to which they are likely to be subject to the Balassa–Samuelson effect. Schadler et al. (2005) suggest that the effect will add in the range of 1–2 percentage points to consumer price inflation in new member states. The implication is that, to offset this effect, they will have to attain an underlying inflation rate in the traded sectors which is as low as the best performing Euro Area members to meet the Maastricht price inflation criterion. The Maastricht ratios of 3 per cent deficit and 60 per cent debt were selected largely to ensure that a steady state could be maintained in the convergence process, assuming a 5 per cent trend growth in nominal GDP, values that were around the EU12 average at the time the criteria were set. Nominal growth at that rate would, in turn, be approximately 2.5 per cent real growth with 2 per cent inflation, or a similar combination of the two components.1 A country growing at that rate with an initial debt of 60 per cent could sustain a 3 per cent deficit without increasing the debt ratio; if the deficit were held below 3 per cent, debt would decline. For the new members, however, the initial arithmetic is different. Real growth in recent years is well above the benchmark 2.5 per cent rate, as is inflation, while for several countries the debt ratio is well below 60 per cent. As a result, their deficits could remain some way above 3 per cent, without imperilling fiscal sustainability (as measured by indebtedness). The upshot is that several new members may have to rein in their deficits in a manner that would reduce aggregate demand and compromise public investment, yet not be necessary to contain public debt. Treaty change in this respect cannot be expected to happen, but it is evident that rapid fiscal consolidation could be damaging to real convergence. In practice, EMU is a profound regime change. Even without wholesale acceptance of the Lucas critique, the implication of which is that history will be a poor guide when a significant regime change occurs, it would be implausible not to expect some degree of adaptation from countries that embrace a switch as profound as shifting to EMU. However, the high degree of trade integration between the new members and the Euro Area, as well as their relatively more flexible labour markets, mean that they may find it easier to ‘live’ with the euro. An inference is that Stage 3 adjustment, part of which is the degree to which optimum currency area criteria are satisfied endogenously, will be more critical than Stage 2 adjustment. In short, key issues of negotiating fit will occur within the Euro Area after entry. 1

The calculation is multiplicative rather than additive.

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Negotiating Fit: Stage 3 Adjustment Optimum currency area reasoning suggests that small, open countries with broad sectoral mixes similar to the Euro Area will have fewer problems in negotiating fit with the Euro Area. Those that are less diversified could find the EMU environment less congenial and face more difficult problems. A growing body of literature has, however, sought to elucidate the conditions under which optimum currency area criteria may be endogenously achieved, rather than being a pre-condition for successful participation in a monetary union (Frankel and Rose 1997; De Grauwe and Mongelli 2005). Three overlapping, but distinct dimensions of negotiating fit and domestic adaptation are relevant.2 The first is macroeconomic acclimatization, which comprises a range of processes: . Re-balancing of the policy mix, given the switch to a firm monetary policy orientated to price stability, with fiscal policy expected to assume more of the burden of dealing with demand shocks. The macroeconomic re-balancing also includes learning to live with more constraints on fiscal flexibility. . Changes in the signals that guide the relationships between monetary and fiscal policy, and in how demand management interacts with the labour market. . Effects on nominal interest rates, and thus on the burden of debt service that lead to a rebalancing of tax and spending, and may have distributive consequences by shifting demand from lenders to borrowers, a change that may also be regional in its incidence. Second, there will be a shift in the dynamics of the labour market and how its different attributes affect the capacity for supply-side adjustment. An economy with a rigid labour market will find it more difficult to alter its competitiveness, because labour-market adaptation occurs only slowly, and, as countries such as Germany have found since entering EMU, is highly contested. On the whole, however, the east central European states start from a more propitious position in that the extensive transformations that they have already undergone during transition have resulted in relatively freer labour markets than in many current Euro Area members.

2

82

This analysis draws on Ardy et al. (2002).

Real Convergence and EMU Enlargement

Third, closer integration through monetary union induces longer-term effects. These include structural changes in the geography of economic activity caused by polarizing and agglomerating forces (see Neary 2001; and, for a perspective on policy issues, Baldwin et al. 2003). There will also be EMU-specific trends, such as a possible spatial concentration of financial services. One of the effects of EMU that was, arguably, underanticipated has been the relatively rapid growth of intra-Euro Area trade, even though Rose (2004), especially, had pointed to it as a probable effect. Trade data show that the new members are generally more open economies than most EU15 member states, and also that their trade is now very largely with EU partners. This sort of trade pattern implies little need for adjustment. A particular source of instability is capital inflows, which are likely to remain substantial in the new member states, even though the major waves of privatization are now passed. The experience of Ireland and Portugal also suggests that asset bubbles that could impinge on macroeconomic stability need to be anticipated, and that dealing with a public investment boom (especially with a gearing-up of transfers from the EU Structural Funds) may be an issue. The volatility of financial flows may also be linked to the probability of early euro adoption, pointing to another problem in negotiating fit with the Euro Area. Much has been written about the high level of employment in agriculture, notably in countries such as Poland. However, it is the share of primary activity (agriculture and fishing) in GDP that is, arguably, more revealing. In the Euro Area, the average in 2004, according to Eurostat data reported in the June 2005 issue of the ECB Statistics Pocketbook was 2.2 per cent, with a range from 6.4 per cent in Greece to 1.1 per cent in Germany and just 0.5 per cent in Luxembourg. In the new member states, the Baltic States have the highest ratios, peaking in Lithuania with 5.7 per cent, while most other countries are clustered around the 3 per cent mark (including Poland at 2.9 per cent). In general, manufacturing in the new member states accounts for a higher proportion of GDP than in the Euro Area: the highest share in 2004 was in the Czech Republic at 32 per cent and Slovenia at 30.2 per cent, with the median around 25 per cent compared with 20.8 per cent in the Euro Area. However, the Irish manufacturing share is marginally higher than the Czech one, and Germany, Slovakia, Poland, and Hungary have similar values around the 25–6 per cent mark. In construction, the data suggest that it is the EU15 ‘cohesion countries’ that have the highest GDP shares, implying that receipts from the Structural Funds may have played a part. Most of the new members have a

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construction share close to the Euro Area average of 5.9 per cent, but higher than the three largest economies. The one area of economic activity where the new members are most distant from the Euro Area is finance and business, which accounted for 27.8 per cent of economic activity in 2004 in the Euro Area, but a spread from 12.1 per cent in Lithuania and 16.4 per cent in Poland to just over 21 per cent in Slovakia and Hungary. These admittedly crude indicators suggest that, in terms of the broad structure of economic activity, the new member states do not present a serious problem of fit with the Euro Area. While the dependence on agriculture as a source of (plainly low-quality) employment is much greater in the new member states, it would not take many years of relatively higher growth for the structures to converge with the Euro Area, at least at this highly aggregated level. Indeed, in the various broad sectors, the range among the twelve current members of the Euro Area is such that, with the exception of finance and business, the new members would not appear to be out of place. More highly disaggregated data might tell a subtler story. However, to the extent that monetary policy tends to focus on the impact of interest-rate changes on broad sectors, and on the distinctive transmission channels that bear on different sectors, there is no immediate cause for concern. One likely trend is that the indebtedness of consumers and the corporate sector will increase. Zdeneˇk Tu`ma, the Governor of the Czech National Bank, noted that: ‘in the acceding countries, bank credit to the domestic private sector typically has a ratio of 30 to 40 per cent of GDP, while the EU average is around 100 per cent of GDP. This difference is to a large extent natural, reflecting the lower GDP levels of the acceding countries, their history, and the recent weaknesses in their legal and institutional environments’ (Tu`ma 2004: 2) He goes on to make the point that higher debt is likely to be associated with a greater risk of financial crises. Risk of financial crisis consequent on this scale and speed of change further complicate the negotiation of fit. Competitiveness also bears on the negotiation of fit since it will influence the trajectory of the economy in the short- to medium-run. In practice, this means entering at an appropriate real exchange rate, but it is also important to have regard to supply-side variables that bear on adjustment capacity. Arguably, one of the problems confronting the Italian economy is that its competitiveness declined progressively after acceding to the euro because of the twin effects of low productivity growth and rising real wage costs. Consequently, for the new members, ‘getting the parity right will be another key part of the strategy’, as Schadler et al. (2005: 9) note.

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Bulir and Smidkova (2005) present potentially worrying evidence that the nominal exchange rates of some new members risk being overvalued, even within ERM II. They find that the Czech, Hungarian, and Polish currencies were overvalued in 2003. Their simulation work suggests that, in contrast to the Slovenian Tolar, all three currencies would struggle to stay within the constraints of ERM II over the period 2004–10, based on their end-2004 exchange rates. Bulir and Smidkova also suggest that the competitiveness of these three economies could be harmed if they try to meet the Maastricht criteria too soon, while Slovenia may be better off revaluing before entering Stage 3. Longer-term, a key issue in the negotiation of fit will be how well the new members perform in boosting productivity and competitiveness. They start with the advantage that, largely as a result of the upheavals of the difficult period of transition since 1990, they now have relatively flexible product and labour markets. Various indicators of the competitiveness of the different economies have been compiled and are summarized in Table 3.2. They include the Dekabank DCEI indicator, which combines real, institutional, monetary, and fiscal criteria (although, because it refers to progress towards accession, it cannot be used beyond the 2004 accession date). Other indicators include the various measures calculated by the World Economic Forum (EFW) (of Davos fame), and the competing world competitiveness index published by the Swiss Institute for Management Development. Measures of the degree of liberalization of economies are provided in the EFW index, published by the Fraser

Table 3.2. Various indicators of competitiveness Global competitiveness World comEFW Index Report 2003–04 petitiveness yearbook 2004 2004 GCI BCI Cyprus Czech Republic Estonia Hungary Latvia Lithuania Malta Poland Slovakia Slovenia

— 6 2 4 5 7 1 9 8 3

— 4 1 5 2 6 7 9 8 3

— 4 1 3 — — — 6 2 5

7 4 1 2 3 6 5 9 8 10

DEKA Index of StandortEconomic DEKA Freedom DCEI Index Indikator 8/2004 7/2004 2004

2 5 1 8 4 3 7 10 6 9

— 3 1 6 8 6 — 4 4 2

— 5 4 6 3 2 — 7 1 8

Source: Lalinsky (2005).

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Institute, and the Index of Economic Freedom, calculated by the Heritage Foundation. These indices have to be interpreted with some care because they reflect a particular view of competitiveness and are also rather volatile (see Lalinsky 2005). The high ranking for Slovakia on the world competitiveness index, for example, could look anomalous. Nevertheless, they provide some useful comparative information: for example, Estonia is generally highly ranked, while Poland fares badly. However, the new members are well below the EU15, though the recent World Economic Forum reports suggest that change is afoot. Italy, for example, has slipped below all bar Poland and Slovakia in the ‘growth competitiveness index’ ranking, while Estonia has overtaken Hong Kong to be ranked twentieth in the world and sixth in the EU25. Italy, however, remains higher on the ‘business competitiveness index’. Clearly the east central European states, perhaps with the exceptions of Slovenia and the Czech Republic, are economically less developed than the Euro Area by an order of magnitude. This is especially true of their financial sectors; as Issing (2005: 193) notes, coinciding with a lower level of economic development is the lower degree of financial market development. Both the degree of intermediation through the banking sector and the level of stock market capitalization are below the average EU level. Issing argues that full participation in EMU also means being prepared for financial market integration. Uncertainty about economic development, especially for the east central European states, which have been through such an extensive regime change, further complicates the negotiation of fit. The banking and financial systems in the new member states consequently represent a further source of potential problems. They will have to be robust enough under EMU to contend with possible financial crises, and adaptable enough to respond to a different monetary policy and transmission mechanism. A report by the Bundesbank (2003) found that considerable progress has been made in reforming the financial sectors in most of the new member states, but nevertheless argues that the banking system in particular is an obstacle to Euro Area membership. Similarly, the ECB (2005) finds that the level of financial intermediation is low compared with the members of the Euro Area, and that bank finance plays a more dominant role than securities. A striking characteristic of the new members in banking and financial services is the very high degree of external ownership. Although this development might be expected to be favourable towards Euro Area membership by spreading risk, the ECB expresses concern that the new members may be vulnerable to shocks

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hitting the home countries of these foreign banks that cause them to reinin lending to a greater degree than if they were responding only to host country conditions. Non-performing loans, at a markedly higher proportion of assets than in the EU15, are also identified by the ECB as a risk factor. The ECB (2005) stresses the need for effective prudential controls as a crucial element in living with EMU.

Conclusions As the ECB (2004: 14) observes in the convergence report it published when the new members acceded to the EU, the ten new members (and Sweden) are ‘committed by the Treaty to adopt the euro, which implies that they have to strive to meet all the convergence criteria’. For the new members of the EU several overlapping issues arise in negotiating fit with EMU, posing difficult questions of timing. They have to decide how quickly to enter ERM II as part of a strategy for moving to Stage 3 and how best to organize the transition from current arrangements. They have to ensure that their economies are equipped for the challenges of living with a policy regime which, in some cases, will differ markedly from what came before. They have to distinguish between potential economic effects that emerge because of the prospect of Euro Area membership, and thus bear on the transition to the euro, and those that follow from its adoption and have longer-term impacts. In addition, in an echo of a well-known tension during the transition from communism over the 1990s, the new members have to balance real and nominal convergence. The ECB report notes that there has been some slippage in the last two years in what had previously been low inflation rates, partly because of what it calls EU entry-related prices rises, but also because of strong economic performance. The ECB is also critical of the lack of progress in fiscal consolidation. All the east central European states are, however, comfortably placed on the debt criterion and, although the ECB is duty bound to call for tougher action to assure the sustainability of public finances, none of them faces an insurmountable burden in bringing the nominal indicators towards the Maastricht thresholds. The ECB stresses the importance of conforming to the ‘close to balance’ norm of the SGP, and not the 3 per cent ceiling. An IMF study concludes (Schadler et al. 2005: 10) that ‘euro adoption is likely to bestow substantial net gains on the CECs over the long-term and make them stronger, more self-reliant members of the EU’. The eight east

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central European states can be split into two main groups with respect to problems of negotiating fit with, and hence to likely speed of entering, Stage 3. The four smallest (in population terms) seem set to proceed as early as possible and appear to face few problems in conforming to the formal convergence criteria. Despite worries about Balassa–Samuelson effects, there does not seem to be much evidence of rising inflation, except in Latvia, or of upward pressure on long-term interest rates. These same four countries have enjoyed relatively robust growth in recent years, suggesting that Stage 2 adjustment (insofar as much adjustment was necessary) has not had a damaging effect on real convergence. Among the other four, the picture is more mixed. Hungary has had difficulty in maintaining fiscal discipline and has opted to push back its target date for entering Stage 3. Poland and Slovakia appear to remain persuaded of the benefits of early entry, though they face perhaps the starkest real convergence challenges because of their high rates of unemployment. The Czech Republic has indicated a preference for a more relaxed pace, despite the fact that it has more favourable Maastricht indicators than its Visegrad peers. The ambivalence of the ECB and the EC about the desirability of relatively rapid Euro Area accession raises other problems for the new members in negotiating fit. If their support for rapid membership is only lukewarm, it risks playing badly domestically for aspirant members to the extent that sacrifices may be necessary to pave the way for euro accession. A related political problem is that joining at an inappropriate time and subsequently facing problems will discredit monetary integration with potentially long-lasting repercussions, a point made by Balcerowicz in a comment reproduced in Issing (2005) about the UK’s circumstances. For the small economies, notably those, such as Estonia, that have a currency board strategy, this may not matter. Indeed, it would be hard to argue that Estonia would have much to do either to meet the criteria or to ‘live’ with the Euro Area policy model. For others, a possible strategy advocated by Schadler et al. (2005) may be to aim to achieve the Maastricht criteria some way in advance of full Euro Area participation, then to maintain the discipline for a more extended period than some current members did. A strategy for Euro Area accession thus has to combine nominal and real targets, on the one hand, and the choice of instruments and preferred frameworks, on the other. How long to aim to be part of ERM II is a key choice. The minimum participation of two years sets a floor, but there

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could be arguments for a longer spell in the system to provide leeway for Stage 2 adjustment, offset by consideration of the risks involved in staying within a system that could be deemed to offer the advantages of neither a fully fixed nor of a flexible exchange rate. Equally, an inference from the boot-camp versus purgatory dichotomy suggested by von Hagen and Traistaru (2005) is that ERM II membership should be kept as brief as possible. The conclusion of von Hagen and Traistaru (2005: 166) is that Poland and the Czech Republic ‘are the only two new member states for which a late entry makes sense, given that they have demonstrated the potential for an autonomous, stability-oriented monetary policy based on inflation targets’. The danger with delay is, however, that it is far from obvious that retaining control of monetary policy aids stabilization, especially if time inconsistency considerations apply. Instead, the very fact of an external constraint can facilitate the pursuit of policies that have the better longterm pay-off. In the short-term, though, pressures on governments to favour real over nominal convergence and thus to avoid policies that have an immediate cost will be strong. A first political economy challenge, therefore, is to flatten and shorten the dip in the j-curve by a careful mix of policies. Second, the new members need to learn from the founding members of the Euro Area that Stage 3 adjustment matters and to prepare accordingly. Living with EMU means that endogenous change has to take place, and that it is not enough to meet the nominal criteria. In some cases, preparing the ground will be necessary, rather than rushing into the euro. The trick will be to optimize the timing of successive steps along the way in negotiating fit.

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4 Economic Adjustment and the Euro in New Member States: The Structural Dimension of Fit Erik Jones

The negative referenda outcomes on the European Constitutional Treaty in France and the Netherlands in May–June 2005 encouraged a wave of speculation about the future viability of the euro and the progress of EU enlargement. Some claimed that the Euro Area would fall apart, others that the EU would stop expanding. Speculation also touched on where the two issues intersect: the enlargement of that group of EU countries using the euro. Should the Euro Area continue to enlarge before it gets its own macroeconomic conditions in order? Should the new member states that joined on 1 May 2004—Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia, Slovenia—join the single currency? These two questions about Euro Area enlargement are closely linked. At least part of the blame for the EU constitutional crisis derives from the poor performance of the Euro Area economy and open bickering over the rules for macroeconomic policy coordination. Slow growth in the Euro Area also pulls down economic performance in the new member states and so makes it harder for them to join the single currency. In a different way, conflict over Euro Area macroeconomic governance makes it less attractive for the new member states to adopt the single currency. Meanwhile, the new member states need to strengthen their competitiveness if they are to contribute to a strengthening of the European economy and if they are to play an effective role in European macroeconomic policymaking. This combination of challenges is daunting. Nevertheless, political leaders across Central and Eastern Europe have pledged their intention to

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join the single currency. The purpose of this chapter is to consider whether this commitment makes sense either economically or politically. This analysis focuses attention on the structural dimension of what Kenneth Dyson (Chapter 1 above) argues is a complex process of defining and negotiating the fit between the new member states and Europe’s economic and monetary union. Dyson argues that this negotiation of fit is characterized by three features—an asymmetry of power between the new member states and the EU institutions; an emergent economic paradigm emphasizing the importance of price stability and sound public finances; and a growing structural and psychological dependence (which Dyson calls ‘contagion’) in the new member states on achieving ever deeper relations with Europe. The new member states do not have a complete freedom of action, and they face a growing imperative to do something in order not to be (or to be perceived to be) left behind. Nevertheless, they can negotiate fit only insofar as their domestic economic structures make it advantageous— and their domestic political structures make it possible—for them to do so. My argument is optimistic. The advantages accruing to the new member states from joining the single currency outweigh the costs. By implication, the rest of the Euro Area should encourage the new member states to adopt the euro: what is good for the parts is even better for the whole. Such claims are qualified. The calculations differ from one country to the next, and timing is also an important dimension of fit—a point underscored by Iain Begg (Chapter 3 above). Moreover, such variation derives from real structural differences across countries; differences in the types of reforms that must be undertaken and in the pace at which such reforms are possible. Defining and negotiating fit is no simple matter. Both the EU and the new member states seem to be taking such qualifications into account in their plans to enlarge the single currency. Hence, the prospects for continued expansion of the Euro Area are good. Of course, there are downside risks, and this optimism should not be confused with complacency. The rash of popular speculation about the future expansion of the single currency is, nevertheless, misplaced. Euro Area enlargement is one area where the pace of integration is just about right. This argument is developed in three sections: The first describes the pattern for Euro Area enlargement and links it to the need for market structural adjustment in the new member states. In doing so, the first section fleshes out the constraints faced by the new member states in negotiating fit—constraints that emanate primarily from the asymmetry in their relations with the EU and from the underlying importance of the macroeconomic stability paradigm promoted by EU institutions.

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The second compares the costs and benefits of accession to the Euro Area. Because such costs and benefits are largely structural in origin, this section highlights the growing dependence of the new member states on economic relations with the EU and the implications of this dependence for the willingness of politicians across the EU to encourage an expansion of the single currency (and to engage in a process of supportive market-structural reform). The third examines the implications of Euro Area enlargement both for the new member states and for the EU as a whole.

Accession and Adjustment The new member states are legally obliged to join the single currency once they demonstrate that they are able to do so. This obligation is similar to that accepted by the existing member states during the Maastricht Treaty negotiations in 1991. At that time, only Denmark and the UK negotiated the right to opt out of Europe’s monetary union. When Austria, Finland, and Sweden joined the EU in 1994, they accepted the obligation to join the euro as well. Nevertheless, Sweden chose not to participate in the euro when the monetary union was formed in 1999, and the Swedish people soundly rejected adopting the single currency in a September 2003 referendum. Soon thereafter, the Swedish government committed to postpone discussion of euro entry for the lifetime of two parliaments—effectively, 2010. Sweden remains legally obliged to join Europe’s monetary union. But the Swedish government, and the Swedish people, control the timing. The countries that joined the EU on 1 May 2004 have all accepted the obligation to participate in the euro. But, like Sweden, they can influence the timing. They cannot join whenever they choose. But they can remain outside the euro, should they choose not to participate. Both this influence and its limits arise from the criteria for membership. The new member states must meet these criteria before they can adopt the euro. And they can refuse to meet the criteria if they want to stay outside—most easily by refusing to join the current incarnation of the ERM II for the European Monetary System (EMS). The criteria come from the Maastricht Treaty and were used to select the countries that created the Euro Area in 1999. As elaborated both in the Treaty itself (articles 104c, 108, and 109j) and in two protocols attached, the Maastricht criteria state that a prospective participant in the single currency:

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. ‘has a price performance that is sustainable and an average rate of inflation, observed over a period of one year before the examination, that does not exceed by more than 1½ percentage points that of, at most, the three best performing member states in terms of price stability’; . ‘had an average nominal long-term interest rate that does not exceed by more than 2 percentage points that of, at most, the three best performing member states in terms of price stability’; . ‘has respected the normal fluctuation margins provided for by the ERM II of the EMS without severe tensions for at least the last two years before the examination’; . ‘has achieved a government budgetary position without a deficit that is excessive’—where ‘excessive’ means: –‘the ratio of the planned or actual government deficit to gross domestic product exceeds a reference value (3 per cent), unless either the ratio has declined substantially or continuously and reached a level that comes close to the reference value, or, alternatively, the excess over the reference value is only exceptional and temporary and the ratio remains close to the reference value’; –‘the ratio of government debt to gross domestic product exceeds a reference value (60 per cent), unless the ratio is sufficiently diminishing and approaching the references value at a satisfactory pace’; . has ensured that ‘its national legislation including the statutes of its national central bank is compatible with this Treaty and the Statute of the ESCB’. These criteria are well-known to students of European integration, but they are nevertheless worth citing in detail. Despite the passage of time, the original wording remains in force. But the implications of that wording have changed: first, because of the creation of the euro; and, second, because of the increasingly elaborate framework for macroeconomic policy coordination and market-structural reform that has evolved in the EU as a whole. The existence of the euro has altered the criteria for inflation, interest rates, and exchange-rate stability. Technically, the reference value for price stability remains the three best performing countries. Given that the ECB strives to hold Euro Area expected aggregate inflation ‘close to but below’ 2 per cent per annum, the three best performers are likely to be below 2 per cent. Since 1999, the average of averages for the three best performances is just between 1.3 and 1.4 percent inflation per annum—as calculated from

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data provided by the European Commission in its Annual Macroeconomic (AMECO) database (April 2005 release). Nevertheless, the standard for evaluating ‘best’ performance has changed. After the slowdown of the German economy in 2002 and 2003, both politicians and policymakers in the Euro Area became aware of the risks of deflation. As a result, they are unlikely to count a member state with falling prices as a best performer. If we omit countries with an inflation rate below 1 per cent from the calculations, then the average of averages rises to slightly above 1.5 per cent per annum. Finally, understanding of the implications of inflation convergence has changed. Originally, the expectation was that convergence would be enduring and inflation rates would be fairly consistent across the Euro Area. Experience has taught otherwise. The average of the best three performers in 2002 was just over 1.5 per cent, implying an upper bound for price stability of 3 per cent. By that standard, Greece, Spain, Ireland, the Netherlands, and Portugal would not have qualified for participation in the euro. The Netherlands would have qualified in 2003, but Italy would not. The test for price stability is only necessary to join the Euro Area, not to remain within it. The impact of the euro on the interest-rate criterion is exactly the opposite. Once the markets perceive that a country is committed to join the single currency, long-term interest rates begin to converge on the Euro Area average. Moreover, this convergence has endured despite the persistence of inflation differentials after countries have adopted the euro. Bond markets appear to be pricing in modest differences in national debt issues to reflect the very small possibility that some countries may either default on their debts or leave the single currency. But such differences do not reflect underlying inflation rates. In 2004, long-term interest rates were 4.0 per cent in Germany while they were 4.3 per cent in Greece. Inflation during the same year was 1.7 per cent in Germany and 3.1 per cent in Greece. By implication, real borrowing costs are lower in Greece than in Germany. The convergence of long-term interest rates is not an obstacle to membership, but an advantage of making a credible commitment to join. The euro also changed the criterion for exchange-rate stability. During the run-up to monetary union, countries had to worry about the performance of their currency relative to a grid of other currencies. This makes for a challenging environment because any one country’s appreciation becomes another’s depreciation, and the reverse. Now they need focus only on exchange rates with the euro. The movements of third-country currencies are no longer factored into the assessment. The question then becomes one of establishing the ‘normal fluctuation margins’. The old

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ERM had two different references for normal fluctuation margins: 2.25 per cent and 15 per cent. The smaller number applied before the 1993 exchange-rate crisis. The larger number applied afterwards. Nevertheless, the European Commission continued to use the 2.25 per cent number as a reference in assessing exchange-rate stability within the normal fluctuation margins during the selection of candidates to create the Euro Area in the late 1990s. Relatively large appreciations against the median currency in the ERM grid were tolerated, as in the case of Ireland. Relatively large depreciations were taken as a possible indication of ‘severe tensions’. In its 2000 report on convergence, the Commission indicated that it would apply the same standards to any enlargement of the Euro Area (European Commission 2000: 66–8). The 15 per cent number continues to define ‘normal fluctuation margins’ in the new ERM II, but variations of more than 2.25 per cent in a country’s exchange rate with the euro will inform any assessment of ‘severe tensions’ experienced within those margins. The performance of the new member states against these first three criteria is mixed. Some appear to do well across the board. Others have some distance to go in achieving Maastricht-style convergence. Moreover, the different choices of exchange-rate regime appear to reflect this variation in performance. Estonia, Lithuania, and Slovenia chose to join the ERM II almost immediately upon entering the EU, and all three are very close to qualifying even on the basis of 2004 data. Cyprus, Latvia, and Malta joined the ERM II in 2005, and they are very close as well. Meanwhile, the Czech Republic, Hungary, Poland, and Slovakia have chosen to peg or float their exchange rates outside the formal institutions of the EMS. With the exception of Slovakia, these larger countries tend to have more volatile euro exchange rates as a result. These assessments are supported by Table 4.1, which includes data for the inflation, interest-rate, and exchange-rate criteria including the choice of exchange-rate regime. Most of the data are straightforward, apart from the indicator for exchange-rate stability. The measure used is the standard deviation of euro exchange rates against an index where the average for the year is set at 100. Where the standard deviation is below 1.1, we can be confident that the currency has not moved more than 2.25 per cent from its average. A higher number indicates either a higher degree of volatility or (more likely) a trend in the euro exchange rate. The creation of the euro had little influence on the fiscal criteria. The development of a European framework for macroeconomic policy coordination and market-structural reform played a much greater role. Here it is useful to point out that the prohibition against excessive deficits appears

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Economic Adjustment and the Euro in New Member States Table 4.1. Nominal convergence indicators Country (2004)

Inflation

Interest Rates

Exchange Rates*

Exchange Rate regime

Date Joined ERM II

Cyprus Czech Republic Estonia Hungary

1.9 2.5 2.9 6.6

5.8 4.8 4.4 8.2

0.7 2.3 0.0 2.4

2 May 2005

Latvia Lithuania Malta Poland Slovakia Slovenia Euro Area

6.0 1.1 2.7 3.5 7.1 3.6 2.1

4.9 4.5 4.7 6.9 5.0 4.7 4.1

1.7 0.0 0.6 5.0 1.2 0.4

ERMII Float ERMII Managed Float ERMII ERMII ERMII Float Euro-peg ERMII

28 June 2004

2 May 2005 28 June 2004 2 May 2005

28 June 2004

Note: The indicator for exchange rate volatility is the standard deviation of daily euro exchange rates against an index where the average for the year is set at 100. Source: Data for harmonized index of consumer prices inflation and for nominal long-term interest rates is taken from the AMECO database published by the European Commission. Exchange rate data is calculated using daily exchange rate data downloaded from the on-line statistics of the Dutch National Bank.

in the Maastricht Treaty in the chapter on economic policy and not in the chapter on transitional provisions. By implication, all EU member states are prohibited from running excessive deficits, whether or not they participate in the single currency (just as all member states are required to regard their exchange rate as a matter of common interest whether or not they participate in the ERM II or the single currency). The UK is the only exception, insofar as its opt-out specifically releases it from the injunction to ‘avoid excessive government deficits’. Denmark’s opt-out from the single currency is not so encompassing. It cannot be sanctioned for running an excessive deficit, but it remains obliged not to do so. Sweden has no formal opt-out at all. Like Denmark and Sweden, the new member states are bound to avoid excessive deficits as part of their general obligation to ‘conduct their economic policies with a view to contributing to the achievement of the objectives of the Community’ (Article 98 of the Treaty Establishing the European Communities as amended at Amsterdam in June 1997). Another part of this general obligation is the commitment to achieve a mediumterm budgetary position that is close to balance or in surplus as set out in the June 1997 Resolution on the Stability and Growth Pact (SGP). This resolution was embraced by all member states, including the UK. And, while it is not legally binding, it does have force through the Broad Economic Policy Guidelines (BEPGs) that are negotiated annually in the

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Council of Ministers. The SGP also exerts influence through a pair of Council regulations (1466/97 and 1467/97) that streamline the procedures for handling excessive deficits and that introduce a new procedure for issuing early warnings to member states that are heading into difficulty. The Council has not enforced either the excessive deficit procedure or the SGP with vigour. Nevertheless, the new member states are more likely to pay attention to both commitments than their older counterparts. The reason has little to do with monetary union and much to do with the transfer of ‘cohesion’ funds from the EU to poorer member states, including all of the newer member states. During the 2004–6 period, the amounts that will be transferred to the new member states from this fund range from a low of 21 million euros for Malta to a high of 4.2 billion euros for Poland. These funds are conditional and not automatic. If the Council finds that a member state has failed to take action to correct an excessive deficit or ‘has not respected the Stability and Growth Pact’, then the Council may not provide funds for new projects in the member state concerned or even new stages of important projects (Council Regulations 1164/1994 and 1264/1999). For this reason, the standard procedures for enforcing the prohibition against excessive deficits matter less to the new member states than the procedures for evaluating performance with respect to the SGP or for finding that an excessive deficit exists. The significance of these procedures was immediately apparent. Only weeks after the EU’s historic enlargement, the Council of Economics and Finance Ministers (ECOFIN) found excessive deficits in six of the new member states—the Czech Republic, Cyprus, Hungary, Malta, Poland, and Slovakia. However, rather than calling for immediate and equivalent action from all parties, ECOFIN (2004: 8) adopted a differentiated approach. Given the different starting points and different budgetary plans of the member states concerned, the Recommendations set different target dates for bringing their deficits below 3 per cent of GDP: 2005 for Cyprus, 2006 for Malta, 2007 for Poland and Slovakia, and 2008 for the Czech Republic and Hungary. The progress made by the different member states was almost uniformly acceptable. In January 2005, only Hungary was singled out for having failed to take sufficient action. As a consequence, ECOFIN adopted a new set of recommendations for Hungary during its March 2005 meeting and called for a further review to be undertaken the following July. In the meantime, the European Council redefined its interpretation of excessive deficits and of the SGP. The language used in the Maastricht Treaty remains unchanged. But the European Council did change the

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meaning attached to the qualification that ‘the excess over the reference value is only exceptional and temporary and the ratio remains close to the reference value’. Under the new regime, the Council will consider ‘as exceptional an excess over the reference value which results from a negative growth rate or from the accumulated loss of output during a protracted period of very low growth’. The European Council then went on to enumerate ‘other relevant factors’ that might be used to explain a deficit which is ‘exceptional and temporary’, including ‘developments in the medium-term budgetary position’ and ‘a high level of financial contributions’ to the EU or to European objectives. Finally, the European Council established different medium-term budgetary objectives for member states that have low public debts and high growth potential, and member states that have high public debts and low growth potential. Low-debt, highgrowth countries can aim to run a modest deficit (1 per cent of GDP) over the medium term, while high-debt, low-growth countries should continue to strive for a medium-term fiscal balance that is close to zero or in surplus (European Council 2005: 28–9, 33–4). With the exceptions of Cyprus, Malta, and possibly Hungary, the new member states are almost all low-debt, high potential growth countries. Hence, under the new system, they will earn consideration for the more relaxed medium-term budgetary objective, and they will be given marginally greater leeway in assessments that an existing deficit is temporary and exceptional. These are not major concessions, but they constitute an improvement over the previous interpretation of the fiscal criteria. Table 4.2 summarizes the performance of the new member states in 2004. The same table also includes data for labour market participation, GDP per employee, and the adjusted wage share of value added. Such data reveal the potential for growth in terms of under-utilized labour resources, inadequate capital, and relative labour costs. By these measures, only Cyprus, Slovenia, and perhaps Malta have caught up to the average profile in the Euro Area. The effort required to qualify for membership in the single currency differs from country to country, and the time frame differs as well. Estonia, Latvia, and Slovenia could join by as early as 2007. The Czech Republic, Hungary, and Poland do not plan to join until the end of the decade or, if necessary, even later. This variation is due to differences in economic structures and to the different challenges implied by the process of market-structural reform. Table 4.2 also provides data for unemployment rates and current account performance. These data illustrate the substantial differences between the member states both in terms of the functioning of local factor markets and in terms of their net dependence upon foreign

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Economic Adjustment and the Euro in New Member States Table 4.2. Fiscal convergence indicators, growth potential, and the need for structural reform

Country (2004)

Current UnemReal GDP GDP per Adjusted Participa- ployment account balance Deficit Debts growth employee wage share tion rate rate

Cyprus Czech Republic Estonia Hungary Latvia Lithuania Malta Poland Slovakia Slovenia Euro Area

4.2 3.0 1.8 4.5 0.8 2.5 5.2 4.8 3.3 1.9 2.7

72 39 5 59 14 20 74 48 45 29 71

3.7 4.0 6.0 3.9 8.2 6.5 1.4 5.2 5.4 4.5 2.0

37.4 17.7 14.8 20.6 11.0 12.5 29.1 14.3 16.1 29.0 56.0

53 53 50 53 47 49 51 54 44 44 63

67 67 65 56 64 62 55 51 57 64 65

5.0 8.3 9.2 5.9 9.8 10.8 7.3 18.8 18.0 6.0 8.8

5.7 5.2 12.9 9.0 12.4 8.3 10.1 1.3 3.4 0.9 0.6

Note: Deficit and debt data are percent GDP; real growth is annual percentage change; GDP per employee is in euro thousands; adjusted wage share is percent value-added; participation rate is percent working-age population; unemployment rate is percent labor force; current account balance is percent GDP. Source: All data are taken from the AMECO database published by the European Commission.

trade and capital flows. Such aggregate measures tell only part of the story. They can explain, for example, why Slovenia is more confident about membership in the single currency than Slovakia. Below the aggregates, the structural differences become more subtle and the comparisons more complex. The point remains, however, that official attitudes towards participation in the euro are structurally determined. Even a cursory read through the literature made available by the central banks of the new member states reveals an un-blinkered assessment of the particular challenges involved for different countries. The strategies for the Czech Republic and Poland state explicitly that reforms must be made up front in order to ensure that time spent in the ERM II is kept to a minimum: ‘the Czech Republic should enter the ERM II only after conditions have been established which enable it to introduce the euro at the time of the assessment of the exchange rate criterion’ (Czech National Bank 2003: 6); ‘it is desirable to tighten fiscal policy in advance, prior to joining ERM II. This approach will require a comprehensive reform of public finances. The period of ERM II participation should be as short as possible and not exceed the two years required in the Treaty’ (National Bank of Poland 2004: 90). The concern in both cases is that financial markets will use participation in the ERM II as an excuse to speculate against their national currencies. By contrast, the Slovak Republic has adopted an integrated approach—building from inflation targeting to

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ERM II membership in order to support the process of nominal convergence (National Bank of Slovakia 2004). Despite the influence of structural differences, there is a clear and consistent prioritization of interests; market-structural reform is at the top and joining the single currency is further down. This prioritization is consistent with what Dyson describes as the ascendant European macroeconomic stability paradigm (see also Dyson 2000). And it is shared across the EU. The single most important lesson drawn from the first six years of monetary integration is that market-structural reform is vital to the success of the single currency. Efficient local market structures facilitate the implementation of the common monetary policy and also the consolidation of national fiscal accounts. They promote growth and competitiveness. They foster employment. And they underpin the European social model. This analysis is not universally celebrated. Some analysts regard the emphasis on efficient market structures to be an expression of class conflict (Moss 2005). Others suggest that it is the result of a dangerous political compromise (Jones 1998). Whatever the arguments, the need for efficient local factor markets is now recognized as an institutional fact of life. Moreover, this lesson is not lost on the new member states, all of whom are well aware of the competitive pressures implied by monetary integration, European integration, and globalization more generally. The consistent prioritization of market-structural reform manifests differently across countries for the simple reason that qualification for the single currency and market structural reform are not mutually exclusive activities. Governments can pursue Maastricht-style convergence and market liberalization at one and the same time. There is no necessary contradiction between joining the single currency and constructing a successful economy—one capable of delivering jobs and growth. Indeed, the real question is whether the two processes are, in fact, complementary. Can EMU membership contribute to the development of robust economic institutions in the new member states? Or is the single currency at best an unnecessary distraction from the real work at hand (and at worst an unintended obstacle to reform)?

Costs and Benefits This idea that EMU supports the economic reform process is contested. A front-page article in the Financial Times ran under the headline ‘ECB fears euro has hurt growth’ (Atkins and Jenkins 2005: 1). The article focuses on a

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speech made by ECB Vice President Lucas Papademos and on a paper presented by two economists from the Organization for Economic Cooperation and Development (OECD), Romain Duval and Jørgen Elmeskov, at an ECB conference on the impact of the single currency on its member states. Papademos (2005) noted that ‘adjustment mechanisms [in the Euro Area economies] are functioning slowly and that self-equilibrating forces are not sufficiently strong’. He then went on to point out that ‘the policy implication of this general diagnosis is that more economic reforms are needed to address the structural impediments to growth and the causes of growth and inflation divergences’. Structural reform is necessary to improve the functioning of the Euro Area economies, but does the existence of the Euro Area improve the process of structural reform? The answers suggested at the conference were mixed. In their paper, Duval and Elmeskov (2005: 30) find that, on the margin, large countries are less likely to undertake structural reforms after joining the Euro Area because they lose the macroeconomic flexibility necessary to mitigate the costs of such reforms. By contrast, Duval and Elmeskov suggest that smaller countries stand to gain so much in terms of increased trade with the rest of the monetary union, that they are even more likely to undertake structural reform after joining the Euro Area than they would be beforehand. The journalistic synthesis of these positions is straightforward. If market-structural reform is necessary for growth and competitiveness, and participation in the single currency slows the pace of market-structural reform in the larger Euro Area economies, then the euro hurts growth. This synthetic view of the relationship between Euro Area participation and market-structural reform helps to explain the major cleavage between different groups of new member states in their intention to join the Euro Area. The countries in the first two waves of participants in ERM II are all small, both demographically and economically. The country with the largest population, Lithuania, has fewer than 3.5 million inhabitants. The country with the largest economy, Slovenia, produces just under 26 billion euros. By contrast, the smallest country in the more reluctant group, Slovakia, has a population that is 45 per cent larger than Lithuania’s and an economy that is 25 per cent larger than Slovenia’s. The Czech Republic, Hungary, and Poland are significantly larger still. Nevertheless, it is important not to overestimate the direct impact of monetary integration on the incentives for market-structural reform in any of the new member states. Although the more reluctant countries are larger in terms of population and output than their more enthusiastic

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neighbours, all of the new member states are ‘small’ in the economic sense of being heavily dependent upon foreign trade and yet unable to influence international prices. Poland imports and exports roughly 40 per cent of its GDP, Hungary roughly 67 per cent, and the Czech Republic more than 70 per cent. Moreover these larger countries are heavily dependent on the export markets found in the older EU member states. By implication, they stand to gain significantly from any positive impact of monetary integration on trade. The relative size difference between the new member states may contribute to an explanation for why some countries are more eager than others, but it cannot provide the whole account. Table 4.3 reports the data for their size, openness, and trade dependence on the older EU member states. The challenge is to compare any direct impact of monetary integration on the incentives for market-structural reform with the indirect effects of monetary integration on economic performance more generally. The result is a much more complicated version of traditional arguments about the costs and benefits of monetary integration. Nevertheless, it is also more useful. The traditional arguments are grounded in the achievement of a monetary union in theory, and leave aside the pathologies of specific institutional arrangements. The Euro Area has moved well beyond such abstract considerations and, as the previous discussion has shown, is now embedded in a path-dependent institutional framework.

Table 4.3. Size, openness, and trade with Europe Trade share of GDP*

EU (15) share of total trade**

Country (2004)

Population (thousands)

GDP (* bln)

Exports

Imports

Exports

Imports

Cyprus Czech Republic Estonia Hungary Latvia Lithuania Malta Poland Slovakia Slovenia

741 10,218 1,349 10,110 2,315 3,440 400 38,361 5,368 1,996

12.4 86.3 8.8 80.3 11.1 17.9 4.3 195.2 33.1 25.9

46 71 81 65 43 53 76 39 77 60

51 72 88 69 59 59 84 41 79 61

49 69 57 75 60 48 39 69 61 59

42 61 54 56 53 43 56 62 50 68

Note: All trade shares are in percentages. Exports and imports as a share of GDP are for goods and services. GDP shares are calculated using current euro values. EU15 trade share data is for 2002 and not 2004. Source: All data are taken from the AMECO database published by the European Commission except for the EU trade shares, which are taken from the Direction of Trade Statistics annual yearbook of the IMF.

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The claim that participation in the Euro Area slows market structural reform in the larger member states starts with the assumption that marketstructural reform entails a trade-off over time. In the short term, economic actors have to adapt to new rules and institutions (and, perhaps, the inevitable uncertainty associated with institutional change). Over the longer term, the economy benefits from whatever increases in efficiency the new rules and institutions may bring. This is a problem because voters are impatient and politicians are risk averse. So long as the short-term costs result in popular political opposition, politicians will be reluctant to gamble their futures on the possibility of taking credit for the longer-term benefits of market-structural reform. Of course, when there is a full-blown crisis, voters may be willing to overlook the costs of adjustment and politicians may be empowered to undertake bold reforms. Such moments of ‘extraordinary politics’ are well known to the former transition countries of Central and Eastern Europe (Rose 1999). Nevertheless, they are more rare in advanced industrial democracies, where ‘crisis’ is more likely to manifest itself in less dramatic episodes of sclerosis or malaise. The difficulty of reform is to soften the costs of institutional change in the short-term in order to accrue the benefits of having more efficient institutions over time. Here the argument that monetary integration lowers the incentives for reform splits in three directions, each corresponding to a macroeconomic policy instrument that could be used to bolster economic performance in the short-term: monetary policy, fiscal policy, and exchange-rate policy. The monetary argument is that larger countries will be restrained from lowering interest rates because of the common monetary policy of the ECB. The fiscal argument is that they will be prevented from running intermittent or systematic deficits because of the injunctions set down in the SGP. And the exchange-rate argument is that they will be prevented from devaluing their currency due to the irrevocable fixity of exchange rates between participating countries in the monetary union. The monetary argument does not apply to the new member states. Although they too will be influenced by the common monetary policy of the ECB, the macroeconomic stimulus that they experience will be greater than the Euro Area average for the simple reason that their inflation rates are likely to be higher, implying a relatively low real interest rate. Since these new member states are small relative to the Euro Area as a whole, the excess stimulus is unlikely to influence the direction of the common monetary policy. Moreover, there is little chance that the new member states could engineer lower real interest rates outside the single

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currency than they can once having made a credible commitment to join the Euro Area. Thus, while it is technically true that the new member states will be unable to manipulate monetary policy instruments after joining the Euro Area, they will not suffer from a lack of monetary stimulus as a result. On the contrary, there is a danger that monetary conditions will be too loose for the new member states after joining the single currency, much as many analysts claim they are for Ireland, Greece, Spain, and Portugal in the Euro Area today. However, that is a separate problem from the impact of monetary integration on the incentives for marketstructural reform. For the moment, what matters is that participation in the single currency indirectly creates an opportunity for reform rather than a reason to delay undertaking reform measures. The fiscal argument also does not apply. As mentioned above, both the injunction to avoid excessive deficits and the medium-term budgetary targets set down in the SGP are binding on the new member states, whether or not they participate in the single currency. Moreover, the conditionality attached to the cohesion funds ensures that these policies will be observed without need for recourse to the various sanctions set down in the excessive deficit procedure. Therefore, the indirect effects of monetary integration on the incentives for market structural reform again predominate. The reduction in interest rates will lower the share of fiscal outlays allocated to debt servicing, and therefore free up resources that can be used to stimulate real economic activity. And any net increase in trade or investment will broaden the potential for government revenues, adding new resources into the fiscal mix. Such factors do not create a positive incentive for market structural reform. But they do create an opportunity for the new member states to implement market structural reforms without suffering from the political fall-out resulting from the short-run macroeconomic costs. Nevertheless, the exchange-rate argument has merit, particularly given the relatively high inflation rates that most economists expect to observe in the new member states as a result of the ‘Balassa–Samuelson’ effect of relatively fast productivity growth in manufacturing. The mechanism behind this effect is directly relevant, although it has little to do with the need to soften the negative economic consequences of market structural reform. On the contrary, the mechanism builds on the assumption that the impact of market structural reform is to increase the productive use of labour and capital, benefiting the manufacturing sector of the economy relatively more than the service sector. As a result, a new productivity differential emerges between manufacturing and services, enab-

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ling manufacturers to pay more for labour than service-sector employers. As service-sector workers struggle to maintain wage parity with their counterparts in manufacturing, they inadvertently drive up inflation across the economy as a whole. In turn, the relatively high rate of inflation begins to undercut the price competitiveness of manufacturing in foreign markets (by appreciating the real exchange rate). The Balassa–Samuelson argument has attracted considerable attention from economists, who estimate that the impact on inflation could be as high as 3–4 percentage points. In the case of Slovenia, for example, Jazbec (2002) finds that consumer price inflation increases by 1.7 per cent for every 1 per cent increase in the productivity differential between manufacturing and services. Nevertheless, it is difficult to conclude from such estimates that maintaining a national currency will solve the problem of lost competitiveness. To begin with, government policymakers would need to be able to adjust the exchange rate to compensate for relative inflation differentials, without encouraging speculative attacks and without inviting international financial markets to impose a premium on lending. The experience of the EMS suggests that this cannot be done. By the same token, the decision of Estonia and Lithuania to adopt hard currency pegs suggests that the effort may not be worth the cost. They are not alone in making that decision. When Jazbec joined the Governing Board of the Bank of Slovenia, he became a leading proponent of strengthening that country’s peg on the euro and accelerating efforts to join the single currency. The alternative to having the government manage a currency peg to compensate for the Balassa–Samuelson effect is to allow the national currency to float in the markets. However, this assumes that variations in exchange rates will reflect relative price differentials or other relevant economic fundamentals. And there is very little evidence that the markets work in line with that assumption. On the contrary, empirical work on exchange-rate movements in the new member states suggests that their movements have done more harm than good. Rather than cushioning real shocks to supply or demand, they tend to propagate shocks of a monetary or financial nature, leading analysts to suggest that ‘the costs of losing exchange-rate flexibility in the [Central and East European Countries] are limited, if even positive’ (Borghijs and Kuijs 2004: 15). The Balassa– Samuelson effect is a real problem with monetary integration (UNECE 2001: 227–39). But floating exchange rates are not the answer. Finally, it is important to recall that the Balassa–Samuelson effect follows the implementation of market-structural reforms with a considerable

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lag. First, the reforms have to be implemented, second productivity has to increase, and third, this increase has to translate into higher real wages in manufacturing. Lastly, service-sector employees have to incorporate the gains in manufacturing into their own wage bargains, and this has to increase inflation, and the increase in inflation has to undermine the trade competitiveness of manufacturing. Not only is the chain of events too long to factor into the cost–benefit calculus of those policymakers who advocate the market structural reforms in the first place; also, it is too complicated to play a role in any reasonable model for political attribution. Voters at the end of the chain have to recognize that the loss of competitiveness is due to the decisions made by politicians at the start. And they have to regard this loss of competitiveness as more important electorally than any of the real wage increases that have taken place along the way. This process of political attribution is difficult to imagine. The Balassa–Samuelson effect is a real economic problem. But it is not a plausible mechanism for reducing the incentives for politicians to undertake market-structural reforms. The marginal impact of monetary integration on the incentives for market structural reform in the new member states is neutral. The single monetary policy and the indirect effects of monetary integration on fiscal policy create opportunities for reform, but they do not provide incentives. The loss of the exchange rate as a policy instrument may prove beneficial despite the problem of real appreciation, but it does not provide an incentive for market-structural reform either. Nevertheless, there is one remaining incentive for market structural reform identified by Duval and Elmeskov—trade creation. During the original debates about monetary integration, the belief was that the impact of having a single currency on the flow of goods and services would be relatively small. By contrast, Rose (2000: 33) argues that ‘even after taking a host of other considerations into account, countries that share a common currency engage in substantially higher international trade.’ This argument sparked considerable debate among economists, much of it trying to deflate Rose’s claim. Even after all the corrections, however, the effect remains considerable. Baldwin (2005: 1) summarizes the estimates in the literature as an increase in ‘intra-Euro Area trade by something like 5–10 per cent on average’. If true, and given the data presented in Table 4.3, this would imply a potential increase in Polish exports worth somewhere between 1.3 and 2.6 per cent of GDP. For the Czech Republic, the increase is between 2.5 and 5 per cent of GDP. In economic terms, the range between the estimates is very large. The political incentive to engage

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in market-structural reforms that will push national performance to the high side of its potential is large as well. The growth in trade will have an impact on imports as well as exports. As a result, the whole of the Euro Area stands to gain from an enlargement of the single currency. The gain will not be nearly so dramatic for the existing members as for the new member states. But it will be cumulative over time.

The Implications for Negotiating Fit The new member states can join the single currency. Six of the ten are well on their way to doing so. The remaining four will take more time. But all those that choose to enter will be able to do so. And the trade-creation effects will be considerable, even at the low side of the estimates. Provided that the new member states commit to undertake the necessary marketstructural reforms, the enlargement of the Euro Area could turn out to be a big success. Such commitment will require political determination. Dyson suggests in his Introduction (above) that politicians may feel compelled to define and negotiate fit in the European single currency out of a fear of being left behind. Doubtless such fears have an impact. Nevertheless, as Dyson emphasizes, the negotiation of fits must take place within a domestic reality where there are likely to be real losers as well as winners from the process of structural adjustment and market reform. Hence, even with the incentive of trade creation, and the opportunity provided by low real interest rates and liberated fiscal resources, it is possible for politicians to ignore the necessity for change. Italy is a case in point. So is France. Hence, the fact that the larger new member states are willing to undertake reforms even before joining the single currency is a positive sign. The fact that Hungary has already shown some difficulty in doing so is less encouraging. The new member states are not the only countries in need of marketstructural reform, and Maastricht-style convergence is hardly the greatest economic challenge that the new member states must face. A far greater challenge is the slow growth in France and Germany that continues to pull down on the performance of all those smaller economies around them. No amount of reform in the new member states can repair the absence of a large and dynamic market at the centre of Europe. Euro Area enlargement is possible and is happening. Moreover, the economic and political effects are positive both for the new entrants and for existing member states. However, they would be even more positive if the larger countries of the Euro Area would match the reform efforts of the new member states.

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5 Optimal Economic Governance in an Enlarged European Union: Scenarios and Options Ingo Linsenmann and Wolfgang Wessels

A Weak Acquis and Problematic Compliance: The Legal Provisions The future of the European Union—and more generally of EU–Europe— depends on its economic performance. This view belongs both to the conventional wisdoms of European analysis and to the vocation and finalite´ of the EU construction. The ‘Treaty Establishing a Constitution for Europe’ (TCE; European Council 2004), even if not ratified, demonstrates the political aquis with respect to this view. It reconfirms long-held convictions that the Union shall—among other objectives—promote ‘the well-being of its peoples’ (Article I–3(1)), ‘economic, social and territorial cohesion’ (Article I–3(3)), and, more concretely: The Union shall work for the sustainable development of Europe based on balanced economic growth and price stability, a highly competitive social market economy, aiming at full employment and social progress, and a high level of protection and improvement of the quality of the environment. It shall promote scientific and technological advance.

Given the overall importance of the economic objective, and of the instruments in other areas of economic policies like monetary union and competition policy—to name just two—the role of the EU in economic governance looks rather vague and ambiguous. The Constitutional Treaty reflects this assessment: in the enumeration of competencies ‘the

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coordination of economic and employment policies’ (Article I–15) is not allocated into one of the three categories of ‘exclusive’, ‘shared’ or ‘supporting’ competencies (Article I–12) (cf. Wessels 2005a). Its wording on the coordination of economic and employment policies, which takes up articles 3, 4, 15, 99, and 128, illustrates that in this area of state activities member states confer competencies to the Union only reluctantly: 1. The member states shall coordinate their economic policies within the Union. To this end, the Council of Ministers shall adopt measures, in particular, broad guidelines for these policies. Specific provisions shall apply to those member states whose currency is the euro. 2. The Union shall take measures to ensure coordination of the employment policies of the member states, in particular, by defining guidelines for these policies. 3. The Union may take initiatives to ensure coordination of member states’ social policies. Also, in part three of the Constitutional Treaty (TEC), Article III–179— using the wording of Article 99—confirms that member states should simply regard their economic policies as a ‘matter of common concern’ and that they should coordinate these policies within the Council. For pursuing these objectives the treaty enumerates several instruments and procedures, which are essentially designed to support the coordination of member states policies. Policy coordination within the EU can be defined as an iterative, cyclical process by which member states submit themselves to a common set of policy objectives, timetables, and review, reporting and monitoring procedures in order to realize common gains and/or to safeguard the provision of collective goods. The institutional architecture looks quite complex and byzantine. Although quite detailed, the various provisions linked to economic governance show a high level of respect for the autonomy of the member states. For the Broad Economic Policy Guidelines (Article 99 TEC) (Linsenmann 2006) and the European Employment Strategy (Article 128 TEC) (Jacobson and Vifell 2006a), the major instruments are ‘guidelines’ linked to a procedure of multilateral surveillance (see below). The respective procedures of Articles 99 and 128 TEC might eventually lead to a loss of reputation for member-state governments that are ‘named, blamed

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and shamed’ by their peer group and, potentially, in the mind of the broader public. Several other instruments complement these two treatybased procedures, in particular ‘open methods of coordination’ (OMC) in the field of socioeconomic governance (e.g. pension reforms, social inclusion; cf. among many others, Zeitlin and Pochet 2005), the ‘Cardiff process’, that is the structural reform sub-cycle of the Broad Economic Policy Guidelines (BEPG) (Foden and Magnusson 2002), and the macroeconomic dialogue between the European Commission and the Council, social partners and the European Central Bank (ECB), which is somewhat misleadingly named the ‘Cologne process’ (Heise 2002; Koll 2005). We call these mechanisms ‘soft’ coordination to distinguish them from the ‘hard’ coordination in fiscal policies of member states. Article 104 TEC and the SGP (Council of the EU 1997a, 1997b) specify that member states might be fined for not respecting fixed thresholds for annual deficit spending. These forms are clearly different from supranational ‘traditional’ modes of governance, which dispose of a coherent and intensively used mechanism of enforcement, ultimately involving the European Court of Justice (Kohler-Koch 1999; Treib, Ba¨hr, and Falkner 2004; NEWGOV 2005; Wallace 2005). The amount and variety of these mechanisms already indicate a lack of functional coherence. At the same time in European economic governance the EU faces a major dilemma. On the one hand, EU actors and many member states acknowledge that the Union ‘has to deliver’. The 2005 halftime evaluation of the Lisbon strategy to make Europe the strongest economic entity in the world clearly demonstrated that most member states still have a long way to go to meet the targets set by themselves in the year 2000 (Kok Report 2004). The new European Commission and its president, Jose Manuel Barroso, have put ‘growth and jobs’ at the centre of their political programme (European Commission 2005a). More and more, citizens measure the ‘success’ of the EU by economic and social development and by fighting unemployment, poverty and social exclusion (European Commission 2005b: 30 f.). On the other hand, the EU has only a few competencies in the most critical policy fields, such as fiscal policy, labour-market regulation or social policy and the social security systems, and the EU is certainly not on the way to become a welfare state of its own, reflecting that there is nothing like a single ‘European social model’ but several (Esping–Andersen 1999; Scharpf 2002; Sapir et al. 2004).

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Optimal Economic Governance in an Enlarged European Union

Enlargement: The Search for an Optimal Area of Economic Governance An enlarged EU, with increasing heterogeneity and member states with different histories, raises both fundamental and operational issues. In a fundamental sense the Union’s role in this highly diversified and fragmented landscape becomes a central issue for debate. The acquis in these areas of EU activity is rather loose and not binding as in matters of the internal market. Even more, the new member states have already demonstrated during the enlargement process that, despite being open to processes of learning and socialization, the most effective instrument of the EU to encourage transformation remains explicit EU conditionality (Lippert 2004; Sedelmeier and Schimmelpfennig 2004; Pollack 2005). Given that most new members have a different past and present in view of their evolution as ‘welfare states’ (Schmidt 2002; Sapir et al. 2004) and their overall economic performance, what function should the surveillance procedure of ‘soft’ and eventually ‘hard’ coordination have (the normative question) and what impact can we expect (the positive question)? Does it make sense to hope for a renaissance of these efforts in a larger and more diversified Union—as ‘EMU’s second chance’ (Schelkle 2004)—when the success rate of the Union with fifteen member states already looks rather dismal? How should the institutional and procedural architecture be designed or used to optimize common efforts? Are there any criteria to identify an optimal area for economic governance? The issue of well-functioning European economic governance is even more important in the enlarged EU of twenty-five member states. The claim is that the old twelve—and from 1995 fifteen—member states displayed a greater convergence of key economic variables and of their welfare systems at the time of the Maastricht negotiations for EMU than is the situation today with most of the ten new member states. Economic governance at the European level should alleviate this heterogeneity in the long run. Even more, most of the new member states will demand support from the European level by means of effective economic governance. The search for an optimal set-up of instruments and procedures also raises the fundamental question of whether it makes sense to promote any kind of coordination of macroeconomic policies. If we look at inherent problems of political steering of economic processes—such as inevitable time lags between observation, analysis, decisions and impact, if we take the role of national parliaments in the budgetary process seriously, and if we take the heterogeneity of conditions and interests into account, then

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Optimal Economic Governance in an Enlarged European Union

the rationality of any kind of EU efforts might seem questionable. In addition, reasonable objectives cannot be achieved due to unavoidable procedural blockages. An elaborate system of binding decisions would risk producing solutions systematically out of touch with economic realities, leading to increasing compliance problems, and ultimately a loss of credibility for the EU. Due to inherent structural problems, the ‘output legitimacy’ (for the term, Scharpf 1999) would suffer negative returns. Hence, coordination exercises might be counterproductive for the EU system as a whole. In this sceptical view about EU capabilities, competition between different economic and social systems in a monetary union, with only a minimum amount of European political steering, would lead to better or even optimal results. An exchange of data and an open deliberation on the economic situation might then be the most appropriate form for the EU. This chapter examines these questions by using institutionalist approaches that are grounded in political science (cf. Bulmer 1994; Scharpf 1997; Aspinwall and Schneider 2000; Wessels, Maurer, and Mittag 2003; Wessels 2005a, 2005b; March and Olsen 2005). The aim is not to contribute to the economic analysis of what kind of economic policies is most adequate on the EU level, but to analyse and assess how actors can use the opportunities and constraints that are provided by the ‘legal constitution’ (Olsen 2000: 6) of the present treaties and how those actors might change their set of preferences by learning from collective deliberations. This approach must deal with methodological difficulties. First, in order to export or apply current schemes to a larger EU and a set of new members in different economic and political conditions, it is important to know about the mechanisms and dynamics of the emergence and the evolution of European economic governance in ‘soft’ and ‘hard’ coordination over the last decades. From the early days the EU institutions have discussed issues of economic governance. Not only has the European Council regularly taken position on macroeconomic issues since the 1970s; also, early versions of economic coordination instruments had been put in place at that time (Linsenmann 2006). However, the current type of European economic governance by legally binding procedures, laid down in detail in the treaty and Council regulations, is rather new. Most of the procedures now discussed in the context of an enlarged Union have evolved since the mid-1990s and have only been used for a few years. Even if the experiences remain limited, the performance of this type of governance looks rather poor, and, given the constant modifications implemented

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in recent years, they are not adequately developed even in the perception of the institutional actors. Though we can base our expectations on substantial empirical evidence (e.g. Govecor 2004; Linsenmann, Meyer, and Wessels 2006), these findings represent the trial and error process of what is still an early experimental phase. Second, what can we learn from past experience? Does it makes sense to continue with a set of instruments and methods which have had only a limited performance in the EU of fifteen more advanced and more experienced member states? This chapter remains speculative as it cannot start from the assumption that—except for accession—all other conditions remain the same (ceteris paribus). Care must be taken not just to extrapolate past trends along the beaten track of the EU’s evolution. To put this puzzle in a counterintuitive manner: the impact of new member states might lead to a different set of attitudes by earlier members and thus change the ‘living constitution’, without changing its legal form. The political culture underpinning ‘soft’ and ‘hard’ coordination measures in economic governance—as in other policy fields in which open methods of coordination are applied—might change. This prospect is, however, speculative, an educated guess that might serve to inform debate about how European economic governance might evolve. In addition, European economic governance might be characterized by different patterns of participation from those in policy areas where, since joining the EU in Spring 2004, the new member states are in principle on an equal footing with the old member states. The ultimate goal of many domestic political actors within the new member states is accession to the Euro Area, even if the timing of this accession might be different from country to country and the desired entry date might change over time. Nevertheless, it can be expected that this overarching interest will determine their political actions at the European level. While the diversity of interests articulated on the national level needs to be accommodated in the domestic policy decisions—the same way it has dominated the political arenas in those old member states that earlier joined the Euro Area— their particular situation as ‘pre-ins’ actually willing to join the Euro Area will have clear impact on the way that they will pursue their interests on the European level. This impact affects their political behaviour with the policy cycles of the Broad Economic Policy Guidelines and the European Employment Strategy, the deliberations within ECOFIN (see Figure 5.1), for example, on their convergence programmes in fiscal policy, and the road to adoption of the euro. In this context, the new member states are under different kinds of pressures from old members.

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Economic and employment policy European council

EC level

Employment and social policy council

European parliament Economic and social committee Commitee of the regions

European commission

ECOFIN Euro-group

Employment committee

Economic and financial committee

Macro-econ dialogue Social partners

European central bank

Media

Heads of government National level

Ministries for employment/social affairs

Economic and finance ministries

National parliaments

Figure 5.1. The Institutional Setting of European Economic and Employment Policy

Natioanl central banks

Economic policy committee

Optimal Economic Governance in an Enlarged European Union

Scenarios of Development Current Institutional Framework of European Economic Governance The institutional architecture signals a complex multi-level and multiactor structure of economic governance (Wessels and Linsenmann 2002). The inclusion of many actors from the EU and national levels is as much desired by the member states as is the weak role for both the European Parliament and the European Court of Justice and an unusual, though not a minor role for the European Commission. In the case of the European Employment Strategy and the SGP, the Treaty gives far-reaching mandates to two high-level committees: the Economic and Financial Committee (Article 114.2) (Linsenmann and Meyer 2003) and the Employment Committee (Article 130) (Jacobsson and Vifell 2006b). In addition, the Economic Policy Committee plays an important role in coordinating the input into the Broad Economic Policy Guidelines (BEPG). While policy coordination is the predominant mode of governance in economic policy, it has also ‘lingering elements of transgovernmentalism and European Council oversight’ (Wallace 2005: 89). From a procedural point of view, member states and EU institutions have demonstrated since the Amsterdam Treaty in 1997 that European economic governance through coordination does not follow static rules. There has been an almost continuous revision of, and amendments to, the existing rules of European socioeconomic governance and the introduction of several new procedures (e.g., the ‘Cardiff process’ on structural reform, the macro-economic dialogue named ‘Cologne process’, the ‘Lisbon Strategy’ with its ‘new’ instrument of the ‘OMC’, subsequently applied to a range of policy fields linked to the economic development of the member states) on the European level to enhance the deliberation and interaction process on economic policy. The result has been an increase in the number of political actors participating in these coordination procedures and a diversification of governance modes. Key actors have attempted to strengthen economic governance by going beyond the provisions of the legal constitution and merging (or fusing) existing policy areas (horizontal) and policy arenas (vertical) on the European level. For example, the Broad Economic Policy Guidelines procedure on the European level encompasses virtually all actors concerned by them, thus creating a kind of core network for socio-economic governance in nucleo. On the other hand, the more actors become involved in the coordination of policies, the less they can rely on ‘shared commitments’ and

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‘common doctrines’; the implementation record of commonly agreed guidelines on the domestic level is rather limited despite the procedural evolutions on the European level. In difficult economic situations, the cost of compliance increases and has led to an intensification of domestic debates by parties and especially by interest groups concerned by, for example, cuts in public spending. Arguably, tendencies for evasion and non-compliance were more pronounced in the run-up to national elections, as was the case in Portugal in 2001 and in Germany in 2002. The constraints of the Stability and Growth Pact (SGP) on the budgetary powers of member states have become an even more controversial issue, with member-state governments having a self-interest in reducing these constraints (Linsenmann, Meyer, and Wessels 2006). The first years of economic policy coordination after the introduction of the euro in 1999 can thus be described as a strengthening of an evolving core network of economic policy actors and a tightening or streamlining of ‘the coordination of coordination policies’ on the European level, however coupled with a loose coordination in terms of national implementation and commitment to commonly agreed guidelines. The trend towards softer coordination (cf. Meyer, Linsenmann, and Wessels 2006) in terms of constraints on member states can also be identified in the decision of the member states in early 2005, in agreement with the European Commission, to soften the sanctions and reform the surveillance mechanism of the SGP (for an overview and assessment, ECB 2005). The trend towards further rationalizing economic governance on the European level could equally be observed in Spring 2005, when the European Council, within its attempt to re-launch the Lisbon strategy at mid-term, further reformed the procedures of the Broad Economic Policy Guidelines and the European Employment Strategy by establishing ‘joint guidelines’ for both procedures, reducing the number of guidelines and recommendations, and requesting National Action Plans for all policy areas concerned (European Council 2005b: intent 10 and annex 2). These measures demonstrated the willingness of member-state governments to reconsider and perhaps advance European level coordination. However, they do not overcome the implementation problem at the domestic level. How does EU enlargement impact on this provisional balance sheet of European economic governance? In order to explore the implications, this chapter develops three scenarios as points of reference for describing and explaining empirical developments on the European level over the next years.

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Scenario I: Keeping the Status Quo—‘Soft’ Coordination as Ambiguous Governance Mode A first scenario assumes that the impact of enlargement will be negligible. The new member states easily accommodate themselves to the current institutional architecture and the procedures as amended in recent years. Having been exposed to trans-governmental deliberations during the accession negotiations, which included not only guidelines but also a ‘command and control’ type of interaction with the European level, they have no difficulties in following the administrative demands of the coordination procedures, for example, submitting national plans for the implementation of guidelines, or other reports required by the provisions. In addition, the new member states have taken part in open method of coordinationtype bilateral cooperation activities with the European Commission in employment policy since 1999, and later on in inclusion policy and pensions (de la Rosa 2005), as well as in the Pre-Accession Fiscal Surveillance Procedure (PFSP), which included the drafting of Pre-Accession (Convergence) Economic Programmes since 2001 (see Dyson, Chapter 1). At the same time, the ‘old’ member states do not perceive the need to amend either the procedures or the actual content of European economic coordination. As for ‘soft’ coordination efforts in the BEPG and in employment policies, as well as those along the lines of the open method of coordination, this scenario concludes that the ‘top-down’ approach to coordination has had and continues to have limited impact on the policies of the member states. The ‘insider’ discussions of administrative expert groups might extend the epistemological communities ever wider to colleagues in the new member states. However, little more is to be expected than an exchange of views leading to rather ambiguous plans along present lines. Since non-compliance does not lead to severe sanctions and, if at all, only to some critical remarks in implementation reports drafted by the European Commission, both new and old member states will continue to deliberate on the European level without expecting that any member state will unequivocally pursue this European agenda for economic reform. Moreover, given the rather common-sense guidelines both for economic and employment policy, they can be applied to all 25 member states alike (cf. the new 24 general ‘common’ guidelines adopted in June 2005, European Council 2005b). The machinery will run smoothly with a limited real world effect, and without, ultimately, constraining national choices in these policy fields. As regards the entry of new member states to the Euro Area, a flexible and non-dogmatic approach will be adopted. The Maastricht convergence

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criteria will have to be met by the new member states, on price stability, sustainable fiscal position, exchange-rate stability, and low interest rates. However, these criteria have already been interpreted by the member states in the run up to the decision on stage three of EMU in 1997 and 1998, when both Belgium and Italy could join the Euro Area despite the fact that their gross government debt level was far higher than the 60 per cent of GDP stipulated in the relevant protocol to the Maastricht Treaty. The same leniency was applied to Greece when it joined the Euro Area two years later.1 ‘Pre-ins’ will be encouraged to join the Euro Area in order to demonstrate the functioning of European economic governance and to further legitimize the move to EMU in the first place, and no new criteria such as ‘real economic convergence’ will be implicitly imposed on the new member states.

Scenario II: Reducing the Load: Softer Coordination towards Irrelevance An alternative scenario highlights the challenges of enlargement. It poses a fundamental issue of quantity. There are even more actors involved in each institution—some at first with limited experiences in this kind of trans-national coordination. Given an increase of heterogeneity, especially in domestic economic and social conditions, we can assume that the range of interests will also be broader. From the perspective of domestic politics, this scenario stresses that the load of adjustment will get larger and less acceptable. Though at a first glance the set of treaty rules have remained the same, this scenario expects that the use of some provisions will change with enlargement. The Commission has turned into a larger collegiate, coupled with a broader range of personal capacities and experiences; in the Council the conditions for majority voting have been reduced, and with it the probability of getting to a constructive majority (Baldwin and Widgre´n 2004). Moreover, the present members of the Euro Area do not have a qualified majority in the Council. Both sets of factors (increase in heterogeneity and changes in the Commission and Council) point to a scenario in which member-states can be expected to make less use of the opportunity structure. In terms of pursuing treaty objectives, the prospects for any kind of serious coordination worsen. 1 With hindsight, all three countries are still far away from the 60 per cent criterion, in Italy (and Greece) the situation has in fact deteriorated in recent years. In addition, the decision in favour of Greece’s entry into the Euro Area was based on grossly falsified information provided by the Greek government and, in fact, demonstrated a clear failure of multilateral surveillance (cf. European Commission 2005c: 32).

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This assessment is reinforced by the past and present records of European economic governance. Given that the ‘top-down’ strategy of the EU guidelines has had a very limited impact on domestic actors so far (Govecor 2004; Meyer and Umbach 2006), the less experienced administrations of the new members’ countries will be even less able (and perhaps willing) to take the Brussels guidelines seriously (Lippert and Umbach 2005). The ¨ rzel and Risse 2004; Falkner et al. 2004) between ‘misfit’ (for the term, Bo the EU’s declarations and national actions increases even further. With reference to the rules on ‘hard’ coordination of the SGP, this reading concludes that the institutional arrangements have led to a dismal performance of member states and that revisions have reinforced tendencies towards an ever softer interpretation. As the experimental phase of the last years has already led to a credibility gap, there is no hope that the accession process will turn the wheel around. If old and founding members with relatively strong economies have shown a poor record in compliance (four out of six founding members, plus Greece and Portugal), why should new members be expected to follow a failing economic strategy? The ultimate test of enforceability will come in the next years if and when Germany continues to violate the SGP and should therefore pay a substantial fine according to the Excessive Deficit Procedure. In this scenario, the path has been set towards a permissive (non–stability) culture, reducing the importance of former stability culture (Dyson 1994) and the Frankfurt/Brussels strategy (Sapir et al. 2004). A weakening of the doctrine of national fiscal discipline as laid down in the Maastricht criteria might be welcomed by new member states which, in pursuing high growth and real convergence, aim for higher public expenditures, for example on infrastructure or research and development (European Central Bank 2004). For six out of the ten new member states the Council declared the existence of an excessive deficit by the time they joined the EU (Council of the EU 2004), and for most of them the breach of the 3 per cent deficit criterion will continue at least until 2006 (European Commission 2005c: 21 ff.). Game and regime theory (see e.g. Scharpf 1997), as well as empirical findings, might provide some answers. Without a dominant doctrine for economic policies, highly sensitive distributive issues with a major impact on electoral politics like domestic fiscal policies cannot be tackled just by peer coordination. Hence, this scenario claims that the founding generation of these provisions in the 1990s committed serious mistakes in designing these objectives and procedures. Forced by the political pressures of the day, they overlooked that, without an institutional hierarchy or some kind of hegemonic power, coordination activities

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within these provisions will not produce the desired outcomes. As the treaty does not set up an independent body to take decisions outside the power games between a peer group of countries in the Council, some kind of leadership of one country or a group would be needed to create the necessary pressure and impetus. In the early days of the EMS the German Bundesbank might have taken up such a function, in the Euro Area the necessary reputation for this kind of leadership is missing due to the economic and political inability of Germany—and of the collective hegemony of France and Germany—to stick to their own rules. In adopting a sovereignty-led attitude, new members can be seen as imitating some founding members and can legitimate their inaction by the norms that the core group has already developed in the living practice of the legal procedures. In this view, accession does not really change the situation but again illustrates the fundamental limits of these coordination efforts. The Maastricht criteria for membership in the Euro Area are not a convincing ‘whip’ for the hopeful: after entry, the discipline can be relaxed. This effect might be even larger if the new interpretations of the SGP as concluded by the European Council (cf. European Council 2005a: annex 2) do not work either. If, after a trial-and-error period, performance remains weak, the EU will have a credibility gap in all areas of its economic governance. As economic governance is based on coordination, with apparently no mechanism enforcing compliance, this scenario would expect a growing ‘commitment-implementation gap’ (Meyer 2006) leading to a ‘rhetoric-inertia’ trap: the more official rules and statements create expectations that cannot be met, the more member-state governments will get locked in a constellation in which declarations replace concrete actions. Politicians and civil servants of new member states will learn in a short period how to live in this world of words without serious action. The accession of states with different backgrounds and performances would thus not create any major difference. It would highlight and reinforce a vicious spiral already set into motion by the old members. The deliberations on the provisions in the European Convention (Thiel 2003; Begg 2004) and the Intergovernmental Conference reinforce this interpretation. The deliberations in the European Convention demonstrated once more that there is no consensus on how much coordination is needed; while the outcome of the IGC—keeping most of the status quo—underlined the position of the member-state governments that political choices on vital policy fields of the European welfare states should remain in their hands. This approach has not been disputed by the ruling of the European Court of Justice on the Stability Pact. The judges have

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underlined that it is the member states that decide on the application of sanctions, even if the procedure applied in November 2003 was judged to be against the wording of the EC Treaty (Dutzler and Hable 2005). In this scenario, the acceptance of new member states into the Euro Area will be fairly automatic, as long as the ECB and the European Commission declare that convergence in the Maastricht sense has been achieved, and as long as the member states concerned actually want to join. They will not be forced. Despite the clear commitment expressed in the enlargement treaties to join the Euro Area, every member state still has the implicit right to stay outside. Legally speaking, the new member states will have to join EMU since there is no ‘opt-out’ clause as in the case of Denmark and the UK. At the same time, however, the new member states could follow Sweden, a country without an opt-out but deliberately not fulfilling the legal criteria with the implicit consent of the other member states. This kind of action cannot be brought in front of the European Court of Justice (Louis 2004: 605). Others will also argue (along long-established lines) that, if weak economies stay out, it would be for the benefit of the Euro Area itself, avoiding the impression that it was attractive only to less prosperous, that is ‘cohesion funds’, countries, while strong economies such as Denmark, Sweden, and the UK stay deliberately apart.

Scenario III: A Learning Process with an Open Outcome The third scenario expects that actors learn together in the complex institutional set up and construct a ‘communaute´ de vue’, from which sustainable doctrines will emerge and evolve. This scenario involves a downgrading of the procedures in favour of promoting learning processes, with potentially open results. If the apparently inadequate performance in both ‘soft’ and ‘hard’ coordination is due to weak analytic understanding of the opportunities by the founding generation of these provisions, more reflective reforms based on piece-meal engineering, as presently undertaken with respect to the Lisbon strategy and to the SGP, might lead to a more workable and effective set of rules. Lessons learned from a trial-and-error period will improve the opportunity structure for more effective compliance with the objectives laid down in the EU treaty and reconfirmed in the Constitutional Treaty. This scenario has implications for a larger and more differentiated Union. What is good for a set of well-developed members might not be suitable for countries in a different situation. However, in a constructivist view (e.g. Risse 2004), the scenario expects that the actors and respective

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Optimal Economic Governance in an Enlarged European Union

circles in the institutional governance network would prepare and introduce some kind of EU doctrine for the future economic policy outlook for the whole of the Union. Widening might prove a helpful exercise with a long-time effect for all members of the EU. Arguing in a peer group will lead to shared analyses and common strategies in an ‘epistemic community’ (cf. Haas 1992). The effects are at first not clearly visible, but after some time the convergence of views will create the basis for national actions that fit EU guidelines. Within a larger group with no dominant power structure, deliberations will work better among equals who might all be ‘sinners’ (Habermas 1996; Joerges and Neyer 1997). The mutual understanding for each others’ weaknesses might open the gates for some concerted actions affecting other instruments of the EU, perhaps even a more extensive use of the EU budget. With this growing convergence of viewpoints, a new consensus on what needs to be done will evolve. This process could also lead to a further increase in the involvement of non-governmental actors in the coordination cycles at the domestic and the European levels and an intensification of interactions and coordination attempts across policy areas at the same level of governance as well as across levels of governance. New provisions on the Euro Group have the potential to increase this type of deliberation. They seem to acknowledge the necessity to ensure that a coherent economic framework for Euro Area countries is provided for the setting of monetary policy by the ECB. This concept seems to have guided the drafters of the constitution and can be understood as some exceptional form of ‘enhanced cooperation’ (Deubner 2004: 281). Nevertheless, ‘enhanced cooperation’ does not exclude divergent views amongst member states. When it comes to deciding on country-specific recommendations, hard performance indicators, and particularly salient issues of fiscal, employment, or economic policy positions could still be locked-in, leading to bargaining rather than arguing in the relevant committees and, at a later stage, in the Council (for the terms, Risse 2000). In this scenario, the acceptance of new members to the Euro Area will be as automatic as in the late 1990s, but shared economic considerations will be taken into account. In order to ensure that a political decision will not water down the stability course of the Euro Area, even in light of the low overall share of GDP that the new member states contribute to the EU, issues such as ‘real convergence’ will be evaluated, and decisions based on individual economic rationales will be taken. Different economic policy strategies for a period defined by the member states concerned will be accepted, such as higher inflation rates and higher public investments

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leading to temporarily higher public debt. Thus, longer adjustments paths will be acknowledged, based on the understanding that joining the Euro Area is the ‘default option’ for all member states.

Conclusions: Towards an Optimal Economic Governance in the Enlarged Union? The EU of twenty-five member states displays a greater divergence of key economic variables and of welfare state systems than the twelve countries at the time of the Maastricht negotiations for EMU. Economic governance at the European level should reduce this heterogeneity in the long run, thereby fulfilling the Treaty objectives. Yet specific types of welfare states will continue to coexist in the enlarged EU, and convergence will be limited by the persistence of the specificities of national systems. Looking back at the evolution of European economic governance since the mid-1990s and extrapolating to the future, member states cannot be expected to move towards some kind of supra-national economic governance or government (gouvernement e´conomique) in the near future. National preferences in these vital policy fields will not be subordinated to any European economic guidelines that run counter to them. The fate of the SGP since 2000 proves the case. More hierarchical decisions of a commandand-control type, a fiscal agency or Stability Council on the supra-national lines of the European Central Bank, or more room for fiscal transfers within a substantially enlarged budget of the EU, are policy proposals that are not in line with the strategic interests of the majority of member states. The Constitutional Treaty has not formulated major changes in this direction, and the debate on the financial framework for the years 2007–13 exemplifies that a ‘federal solution’ with a highly redistributive EU budget in order to reduce economic diversity will not emerge (for a recent debate, McKay 2005). As a result, European economic governance will continue to be pursued by coordination. Since the ‘soft’ character of policy coordination will remain, it will be more important to secure a better vertical integration of economic policymaking at the national level. As previous studies have shown (Govecor 2004; Linsenmann, Meyer, and Wessels 2006), European policy coordination may have contributed to the strengthening of administrative linkages between departments and agencies involved in socio-economic policymaking on the national level. However, it has left out the key political actors involved in domestic policymaking. Thus, if European economic governance should have a greater impact on the actual decision-making and subsequent

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implementation of policies on the domestic level, a greater involvement of domestic policymakers, above all, parliaments will be necessary. Nevertheless, the efficiency and effectiveness of European economic governance will largely depend on the success of the Euro Area and, therefore, on the interaction of Euro Area member states within the Community institutions. The ECB has amended its provisions to accommodate a larger number of central bankers in its decision-making structures. While the new reformed voting rules in the ECB-Council might be functionally sound, they are extremely complicated, clearly not transparent (Louis 2004; Allemand 2005), and they cannot be transposed to the Euro Group or voting rules in the Council. The proposed provisions for the Euro Group in the Constitutional Treaty—though not likely to be ratified in the near future—are closer to reality. They could serve the purpose of establishing a coherent policy-mix with monetary policy within the Euro Area, and at the same time of keeping the ‘soft’ character of coordination with those outside. Apart from a clearer role assignment in the field of the external representation of the Euro Area in international organizations and exchange-rate mechanisms vis-a`-vis other currencies, the constitution would allow for a closer coordination of economic policy in the Euro Area member countries (for an overview, Smits 2005). This coordination involves both possibly stricter rules in the field of fiscal policy and also the adoption of special Euro Area BEPG, as long as these are in line with those for the EU as a whole. The result would be to reinforce the trend by which the Euro Group is emerging as the main deliberation body for finance ministers and the discussions in the full ECOFIN are much less important (Puetter 2004: 865). However, provisions have to be found for the next few years, given that the Constitutional Treaty is unlikely to enter into force in this decade. In addition, European economic governance, as outlined in all three scenarios above, will have to take account of the likelihood that a number of member states will stay out of the Euro Area for a number of years. The Euro Area will not have a qualified majority in ECOFIN for the time being. Procedural adaptations such as the recent streamlining exercise and the reduction of guidelines are already an appropriate answer to increased diversity, although it is doubtful that they will narrow the ‘commitment–implementation gap’ and lead to some kind of political leadership by the Euro Group which was not in place in the years prior to accession. Ultimately, the question remains of whether there is a way to accommodate different views on the future development of European states. Even if the Lisbon goals are shared, the way to achieve them so far is not.

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Part II Domestic Political and Policy Contexts

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6 The Baltic States: Pacesetting on EMU Accession and the Consolidation of Domestic Stability Culture Magnus Feldmann

In contrast to the Czech Republic, Hungary, and Poland, the three Baltic States of Estonia, Latvia, and Lithuania chose to pursue a euro entry strategy that made them EMU accession leaders, targeting full membership by 2007–08, and shortly after Slovenia. This status as pacesetters and the prospect of accelerated euro entry would have seemed highly unlikely in the early 1990s when they were attempting to break loose from the Soviet Union and when EU membership itself seemed utopian. The frontrunner status derives from policies pursued since the early 1990s that represent a remarkable goodness of fit with the EMU acquis, both formally and informally (see Dyson, Chapter 1 above). This chapter argues that EMU membership is relatively unproblematic for the Baltic States because it represents policy continuity and the ‘lock-in’ of pre-existing macroeconomic policy arrangements. Their macroeconomic policy regimes since the early 1990s can be viewed as examples of a stability culture with relatively strong domestic support. All three Baltic States adopted monetary policy regimes based on fixed exchange rates early in the transition period. Estonia (since 1992) and Lithuania (since 1994) have currency boards, and Latvia (since 1994) has a very similar monetary policy regime based on a hard peg. The Baltic States have not practised activist monetary policy, as the money supply has been determined by external factors. This continuity between EMU and domestic policy choices makes the adoption of the euro technically easier than in most other EU accession states. EMU is a form of ‘lock-in’ of

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the monetary policy regimes of the 1990s. The requisite fiscal prudence for EMU accession is also not a real break with earlier experience, as the commitment to the monetary order has imposed severe constraints on public budgets. EMU accession is also facilitated by labour markets that are relatively flexible by regional standards. The domestic elite consensus in favour of EMU accession and the stability culture more generally is also very strong compared to other accession states. Although popular support is high and there is little genuine euro-scepticism, there is some Euro-populism, which could grow in strength, especially in times of recession. This chapter places the EMU accession strategy of the Baltic States in context and highlights some of its unique features. It then analyses macroeconomic policies and the largely home-grown stability culture that has been well-established since early transition. Some differences between the three Baltic States are highlighted. The chapter also examines various explanations for the Baltic policy regimes and the role of Europeanization in shaping EMU accession. The conclusion considers whether the domestic stability culture can be sustained in the light of new challenges and possibly greater domestic opposition in the future.

Transition in the Baltic States At the beginning of the 1990s the three Baltic States were constituent republics of the Soviet Union. The dream of reinstating their independence, which Estonia, Latvia, and Lithuania had lost during the Second World War as a result of the Molotov–Ribbentrop Pact and foreign occupations, was beginning to look more realistic. However, many observers questioned their viability as potential independent states and cautioned against a complete break with the Soviet Union, for both political and economic reasons. Even after they had regained their independence, the International Monetary Fund (IMF) was sceptical about the prospect of Baltic currencies (Lainela and Sutela 1994). Doubts about the viability of these states dissipated rather quickly. They successfully re-established their political independence, introduced market economies, and reoriented both political and economic relations to the West. A testimony to their success is that international organizations, such as the European Bank for Reconstruction and Development (EBRD), no longer treat the Baltic States as part of the post-Soviet block, but rather compare Estonia, Latvia and Lithuania to central and east European states. The Baltic States’ stable

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democratic systems, geopolitical position and economic success have moved them out of the post-Soviet orbit and back to a position in east central Europe, an area to which they were widely seen to belong in the inter-war period (Rothschild 1974). Since 2004 Estonia, Latvia, and Lithuania have been member states of NATO and the European Union—a prospect that most people would have viewed as utopian at the beginning of the 1990s. Membership in these organizations marks the culmination of the Baltic States’ ‘return to Europe’. The initial conditions of reform were particularly complicated for both economic and geopolitical reasons (for individual Baltic States, see Dreifelds 1995; Raun 1997; Vardys and Sedaitis 1997; Nissinen 1999; Lane 2001; Pabriks and Purs 2001; Smith 2001). The onset of transition coincided with deep economic crisis, shortages, hyperinflation and the collapse of the Soviet market—the key outlet for their production. The Baltic States are the only new EU (and NATO) members that were part of the Soviet Union. They were fully integrated into Soviet economic planning, and trade relations with the rest of the world were negligible. Their relationship with Russia was problematic, and security was a key concern, perhaps not least given their small size. The position of the large Russian minorities in Estonia and Latvia, border disputes, the presence of Soviet/ Russian troops, and Russian access to Kaliningrad via Lithuania were four major challenges. All this led Russia to take a keen interest in the Baltic states and consolidated the view of them as part of her sphere of influence. Additionally, unlike most central and east European states, Estonia, Latvia, and Lithuania had to re-establish all the institutions of an independent state. This process of domestic institution building had important implications for how they experienced Europeanization of their economic and monetary policies. EU integration has constituted the main focus of political activity in recent years. There has been near unanimity about the importance of EU integration among the Baltic elites. It was believed that full integration into the EU would provide a host of economic benefits for these small and trade-dependent countries, including structural funds and also increasing trade and investment flows. Nevertheless, the importance of the security dilemma faced by the Baltic States and of the EU as a promoter of ‘soft security’ in bringing about this consensus can hardly be overstated. In the Estonian case, this security role of the EU was consciously acknowledged in 1996, when NATO accession looked unlikely; correspondingly, policymaking was focused more sharply on EU accession (Mikkel and Kasekamp 2002: 12). Since there were Russian troops in the three Baltic States—in

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Lithuania until 1993 and Estonia and Latvia until 1994—the potential for Russian influence in early transition also had a military dimension. The integration process started somewhat later in the Baltic States than in the central European countries, and key agreements were signed later. Major milestones include the Trade and Cooperation Agreements signed in 1992 (in force since 1993) and further agreements on trade signed in 1994 (in force since 1995). This was four years after the Europe Agreements were signed with Hungary and Poland, and two years after Bulgaria, the Czech Republic, Romania, and Slovakia. All three Baltic States submitted formal applications to become members of the EU in the late autumn of 1995—a few months after the Association Agreements (also known as the Europe Agreements) with the EU had been signed (Pettai 2003: 7). This elite consensus on the merits of European integration has been so strong that it is hard to find genuinely Euro-sceptic platforms among mainstream political parties in the region. In Latvia there has been some moderate Euro-scepticism, on both the Left and the Right, but this has largely dissipated among major parties. The conservative For Fatherland and Freedom/Latvian National Conservative Party (TB/LNNK) adopted a pro-EU stance in March 2003 after previously having a ‘soft Euro-sceptic position’, and a month later the Equal Rights party on the Left made a similar policy change (Mikkel and Pridham 2004: 719 f.). Virtually all the other Latvian political parties—including National Harmony Party on the Left (which draws much of its support from the Russian minority)—have been in favour of EU integration, with the rather weak Latvian Socialist Party on the far Left as the only major exception (Mikkel and Pridham 2004: 719 f.). A similar situation prevails in Estonia and Lithuania. In Estonia no genuinely Euro-sceptic party was represented in the parliament elected in 2003 (in the previous parliament, elected in 1999, only one party, the Social Democratic Workers’ Party, with only one out of 101 deputies, had a genuinely anti-EU platform). Outside parliament small parties of the far Right have developed an anti-EU agenda. These parties differ from their precursors in the early 1990s, which had a narrowly ethnic agenda based on citizenship concerns (Kasekamp 2003). Opposition parties have at times been critical of aspects of the integration process, for example the People’s Union and the Centre Party in Estonia. These are instances of Euro-populism, when opposition parties have attacked governments for failing effectively to represent the national interest in accession negotiations. When in government, however, these parties have supported EU integration and been instrumental in advancing it (though some disagree-

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ments remained in the Centre Party). In Lithuania, the most pro-European of the three Baltic States, the picture is similar with the Union of Farmers’ Party, New Democracy (ND), and the Labour Party representing soft Euroscepticism (Paas et al. 2003: 97). The Baltic States stand out not only because of their exposed geopolitical situation but also because of the rapid and radical market-oriented reforms that they pursued, even compared to most central and east European states. All three states quickly dismantled the institutions of the command economy and developed into competitive market economies. Price liberalization, trade liberalization, and privatization proceeded swiftly. Baltic economic policies can be broadly characterized as marketliberal and very different from French-style dirigiste or organized capitalist models akin to Germany and the Scandinavian states (Feldmann 2006). For instance, all three states introduced a flat-rate income tax early in transition (Lainela 2000). Unilateral policies, like the establishment of current and capital account convertibility as well as liberal trade regimes, served to reorient economic relations to the West. Western and Northern Europe quickly became very important trading partners. In the Estonian case Finland and Sweden played the dominant role as trading partners and sources of foreign direct investment (FDI). After a very deep initial recession the three Baltic States achieved a strong recovery. Despite some problems, such as the recession in the aftermath of the Russian crisis and fairly high unemployment, the Baltic States are generally viewed as successful economic reformers. They made rapid progress in market-oriented transition, compared not just to other former Soviet republics but also to many other post-communist states (Raun 2000–1; European Bank for Reconstruction and Development 2003). The radicalism of market-oriented reform in Estonia, Latvia and Lithuania constitutes a ‘Baltic puzzle’ (Feldmann 2001). The roots of these exceptional policy choices can be found in the depth of the initial crisis, geopolitics, weak interest groups, and the institutional vacuum at the outset of transition. Under these circumstances radical market reform was seen as the most viable policy strategy. An important role was played by e´migre´s as policy advisers, like Ardo Hansson in Estonia and George Viksnins in Latvia. While market liberal ideas existed in these states, these external advisers played a central role in spreading them and translating these visions into policy. In addition, multilateral economic institutions, such as the IMF, provided some technical support to the Baltic States (e.g. Nissinen 1999: 68 f.).

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The three Baltic States differed in both speed of economic reforms and reform strategy. The general consensus among analysts is that Estonia’s reforms were most rapid, with Latvia following close behind, and Lithuania opting for a somewhat more gradualist approach (Lane 2001). Estonia chose the most radical—classical liberal—approach to economic policy reform, including unilateral free trade (Feldmann and Sally 2002). Latvia and Lithuania also introduced relatively open trade regimes, though interest groups were stronger in these countries, and there was protection in specific sectors like agriculture. There were differences in other policy areas as well, like privatization. Many of these differences can be explained by political factors and interest group configurations (Feldmann 2001). These factors include the centrality of citizenship and minority issues in Estonia and Latvia, which focused the political debate on high politics for longer than in Lithuania (Mygind 1998). Many industrial workers in these two countries were ethnic Russians and non-citizens, especially in the early part of the transition period. The Centre-Right has been predominant in Estonia and (almost to the same degree) in Latvia throughout the transition period, which has led to a relatively consistent pursuit of market liberal policies. By contrast, Lithuania quickly resolved the citizenship issues and border disputes with Russia, in large part because of the much smaller minority population in this country. Power has shifted between the Left and the Right in Lithuania, where there has been more debate about the speed and substance of reform.

Macroeconomic Policy and EMU Macroeconomic policy, especially the introduction of stable national currencies, has been among the headline reforms in the Baltic States. Estonia, Latvia, and Lithuania moved quickly and successfully to establish fully convertible national currencies and combat inflation. Despite adverse initial conditions, such as inherited hyperinflation, they were remarkably successful in stabilizing their currencies. As Table 6.1 shows, their inflation rates are among the lowest in east central Europe. The main premise of the sound money and finance policy paradigm—the desirability of stable and low inflation—was fully endorsed by all three states. They all chose fixed exchange rate regimes—Estonia and Lithuania even chose currency boards. This choice resulted in part from their small size and resulting trade dependence. More importantly, it was a means of establishing credibility

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for their new currencies in the absence of an inherited domestic central banking capacity and very limited monetary policy expertise. Estonia was the first mover in rapidly establishing a national currency, the kroon, in June 1992. Initially this initiative was against the recommendations of the IMF, which was sceptical about the prospects of Baltic currencies and for a while suggested that the three Baltic States remain in the rouble zone (Lainela and Sutela 1994). The monetary policy regime was a currency board, with the kroon pegged to the D-Mark at the rate EEK 8: DM 1. The currency board was seen as a very radical policy choice— unique in the transition world (albeit later to be adopted by other states like Lithuania, Bulgaria, and Bosnia–Herzegovina). The exchange rate was at first substantially undervalued in order to shield domestic producers from a sudden influx of imports and to accommodate the expected real appreciation during the process of macroeconomic stabilization. Under a currency board the national currency in circulation is fully backed by foreign exchange reserves. This monetary policy arrangement minimizes the scope for discretionary monetary policy. The Estonian central bank, Eesti Pank, has been highly independent throughout the 1990s. Moreover, Article 116 of the Estonian Constitution requires the government to maintain balanced budgets, which has effectively ruled out activist fiscal policy as well (Korhonen 2003). The currency board proved to be credible and remained in place at the original parity—though with the euro as the new anchor currency. When Estonia entered ERMII along with Lithuania and Slovenia in June 2004, it continued with its currency board arrangement as a unilateral commitment. In effect, Estonia had embraced a stability culture (Dyson 2002), very similar to that entailed by EMU, since the introduction of the kroon. Latvia introduced the national currency, the lats, in March 1993, but the currency reform was implemented more gradually. A transitional currency (the Latvian rouble) was introduced in May 1992 and was not fully withdrawn until October 1993 so that, for a period, it co-existed with the lats. In March 1994, the exchange rate shifted from floating to a hard peg. The lats was fixed to the IMF’s Special Drawing Rights (SDR) at the rate SDR 1: LVL 0.7997. The Latvian central bank, Latvijas Banka, was highly independent and ensured that money in circulation was fully backed by foreign exchange holdings, thereby making the system operate in similar fashion to a currency board. The high degree of independence of the Bank of Latvia in the early years of transition under its governor Einars Repsˇe enabled it to resist government demands to use seignorage to finance budget deficits, especially in periods of cabinet instability (Lainela

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The Baltic States: Pacesetting on EMU Accession Table 6.1. Annual inflation rates in Baltic states, in %, measured by CPI

Estonia Latvia Lithuania

1996

1997

1998

1999

2000

2001

2002

23.1 17.6 24.6

11.2 8.4 8.9

8.2 4.7 5.1

3.3 2.4 0.8

4.0 2.7 1.0

5.8 2.6 1.3

3.6 1.9 0.3

2003 1.3 2.9 1.2

Source: ECB (2004).

and Sutela 1994). In May 2005, Latvia followed Estonia and Lithuania into ERMII with a narrow fluctuation band. The first stages of Lithuania’s currency reform bear some resemblance to the Latvian experience. An interim currency, known as the talonas (literally coupon), was introduced in May 1992, and the rouble was withdrawn from circulation in September. The Lithuanian currency, the litas, was introduced in June 1993, and the talonas withdrawn in August. Like Latvia, Lithuania initially adopted a floating exchange rate. In April 1994, the Lithuanian authorities decided to introduce a currency board to increase the credibility of monetary policy and to lock in a falling inflation rate, with the US dollar as the anchor currency at the rate US dollar 1 ¼ LTL 4 (Kukk 1997). However, Lithuania announced in 1997 that it would abolish the currency board in early 1999, a sign that there was not as strong a consensus on the stability culture as in the other two Baltic States. Financial market instability, in large part related to the Russian crisis, prompted the authorities to reverse this decision. The currency board was retained, and in February 2002, Lithuania adopted the euro as the new anchor at the rate EUR1 ¼ LTL 3.45 (Korhonen 2003). Inflation rates in Lithuania have been exceptionally low in recent years (see Table 6.1). Like Estonia, Lithuania entered ERMII in June 2004 and continued with its currency board as a unilateral commitment. Despite these variations in the details of policy instruments, all three Baltic States have been committed to rapid stabilization and sustained low inflation by means of a monetary policy environment based on hard pegged exchange rates. Instead of seeking monetary policy autonomy, they attempted to ‘import’ credibility to compensate for a weak domestic institutional capacity in monetary policy after introducing the national currencies. The result was an experience of exchange-rate discipline that constituted a good fit with EMU accession requirements and enabled them to be pacesetters in ERMII entry.

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The Baltic States: Pacesetting on EMU Accession Table 6.2. General government budget balance in Baltic states, in % of GDP

Estonia Latvia Lithuania

1996

1997

1998

1999

2000

2001

2002

2003

1.7 0.5 3.6

1.7 1.5 1.2

0.3 0.6 3.0

3.7 4.9 5.6

0.6 2.8 2.5

0.3 2.1 2.0

1.4 2.7 1.5

3.1 1.5 1.9

Source: ECB (2004).

In all three states this monetary policy regime has been complemented by prudent fiscal policy. Since 1997 they have met the Maastricht criterion of maintaining budget deficits below 3 per cent, except for 1999, when the repercussions of the Russian crisis adversely and unexpectedly affected government revenue (see Table 6.2). There was more variation in the early years of transition. Most notably, Lithuania recorded substantial budget deficits (often exceeding 4 per cent). Latvia’s deficits were quite modest, while Estonia recorded small deficits or even surpluses (Lainela 2000). Fiscal discipline was ensured by the firm commitment to a hard peg or a currency board, which constrained deficit financing by seigniorage. Since bond markets were underdeveloped, especially in the early period of transition, the governments’ ability to borrow was also limited. In short, throughout the 1990s the commitment to a stability culture was strong in the Baltic States, especially in Estonia but also in Latvia. The adoption of radical macroeconomic reform policies and the endorsement of a stability culture at the outset of transition can in large part be attributed to the dire initial conditions of the three states. Weak, even nonexistent institutional capacity in macroeconomic policy, hyperinflation, the small size of the economies, and the need to reorient trade towards the West in the face of the economic crisis in the former Soviet Union created a window of opportunity for large-scale reform (Balcerowicz 1995). Given the lack of confidence in the new currencies, not least by the IMF, the choice of a fixed exchange rate—and even a currency board—had a lot of appeal. It would induce credibility by binding policymakers’ hands, thereby largely removing the scope for discretionary fiscal and monetary policies (cf. Dimitrov’s chapter on Bulgaria). However, few observers would have believed that these exchange rate pegs would remain in place beyond a transition period, let alone at the original parities. The domestic consensus in favour of the stability culture was strong. Importantly, domestic resistance was reduced by the sizeable undervaluation of the currencies at the beginning of the currency reforms

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(Lainela and Sutela 1994). Hence, most businesses, political parties, and the largest part of the central executive and public bureaucracy endorsed this stability-oriented strategy. This policy choice for hard pegged exchange rates can be related to the openness and trade dependence of the economy (Frieden 2002). On occasion, there has been some resistance, with a few politicians, farmers, and small businesses lobbying for devaluations, though without success (Nissinen 1999: 70). Proposals for devaluing the kroon were discussed in Estonia in 1997, but did not gain large political support beyond some ministers and civil servants (notably in the Agriculture Ministry). Similar proposals were made by representatives of Saimnieks in Latvia in 1995 (Nissinen 1999: 185). In Lithuania the proposal to abandon the currency board in 1999 was reversed in the aftermath of the Russian crisis. It is a widespread view that the currency board helped stabilize financial markets and foster confidence in Lithuania during this period (Korhonen 1999). Pressures for looser fiscal policy have been somewhat stronger. However, they have generally not been successful in Estonia and Latvia, except in the aftermath of unanticipated shocks, such as the Russian crisis, or adverse developments in the banking sector. Even though there has been some cabinet instability (see Tables 6.3–5), Centre-Right parties with a commitment to fiscal discipline dominated for most of the transition period. In Estonia, the constitutional requirement of balanced budgets imposed an additional institutional barrier to protect fiscal prudence. Finally, central bank independence has meant that the monetary authorities have not been able to finance budget deficits (Lainela and Sutela 1994). The position of the central banks has also been bolstered by the continuity in their leadership in both Estonia and Latvia and, after a few years of somewhat greater turnover, in Lithuania too (see Tables 6.3–5; ¨ ima¨ 1998). The independence of the central banks has been a relatively A uncontroversial part of the stability culture, and there has only been very occasional lobbying against it by producers advocating a looser monetary policy (e.g. some agricultural interests). An indication of the high popular standing of the central banks in these countries is that two former central bank governors (Siim Kallas in Estonia and Einars Repsˇe in Latvia) subsequently embarked on successful political careers, leading to the position of prime minister. The domestic consensus has been somewhat less strong in Lithuania, especially in the early years. In this case the party system is quite different, with a clear divide between parties of the Right and the Left (Lane 2001). Fiscal deficits were initially higher. Despite a very high degree of legal

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The Baltic States: Pacesetting on EMU Accession Table 6.3. Estonia: prime ministers, finance ministers, and central bank governors Prime ministers

Term in office

Ministers of finance

Term in office

Central Bank governors

Edgar Savisaar Tiit Va¨hi

Jan. 1990– Jan. 1992 Jan. 1992– Oct. 1992 Oct. 1992– Nov. 1994 Nov. 1994– Apr. 1995 Apr. 1995– Nov. 1995 Nov. 1995– Mar. 1997 Mar. 1997– Mar. 1999 Mar. 1999– Jan. 2002 Jan. 2002– Apr. 2003 Apr. 2003– Apr. 2005 Apr. 2005–

Rein Miller

May 1990– Jan. 1992 Jan. 1992– Jan. 1994 Jan. 1994– June 1994 June 1994– Apr. 1995 Apr. 1995– Mar. 1999 Mar. 1999– Jan. 2002 Jan. 2002– Apr. 2003 Apr. 2003– Oct. 2003 Oct. 2003– Apr. 2005 Apr. 2005–

Rein Otsason

Mart Laar Andres Tarand Tiit Va¨hi Tiit Va¨hi Mart Siimann Mart Laar Siim Kallas Juhan Parts Andrus Ansip

¨ u¨rike Madis U Heiki Kranich Andres Lipstok Mart Opmann Siim Kallas ˜ unapuu Harri O ˜ nis Palts To Taavi Veskima¨gi ˜ erd Aivar So

Siim Kallas Vahur Kraft

Term in office Jan. 1990– Sept. 1991 Sept. 1991– Apr. 1995 Apr. 1995–

independence, there has been some debate about the degree of real independence of the central bank, Lietuvos Bankas, from political influence in ¨ ima¨ 1998). External influence, initially from the early years of transition (A the IMF but increasingly from Europeanization, acted as an important source of top-down pressure (Lainela 2000). This pressure was apparent in tough ECB opinions on Lithuanian central bank independence and the need to comply with the Maastricht criteria on fiscal discipline. Europeanization has ensured that, since accession negotiations began, the actual policy differences between Lithuania and the other two Baltic States have become less pronounced, as all three countries have set their eyes on full EMU membership. In short, Europeanization has contributed to legal and institutional convergence and a lock-in of fiscal discipline. Not least, no Baltic State wants to lag behind the others. In this sense contagion in policy behaviour was an additional powerful factor at work. Estonia’s inclusion in the initial Luxembourg group to start EU accession negotiations in 1997 was a powerful wake-up call to Latvia and Lithuania to engage in anticipatory Europeanization so that they did not end up as Baltic laggards (Lainela 2000). In the light of this experience, the Baltic States can all be viewed as pacesetters in EMU accession, if progress towards meeting the five

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The Baltic States: Pacesetting on EMU Accession Table 6.4. Latvia: prime ministers, finance ministers, and central bank governors Prime ministers

Term in office

Ivars Godmanis May 1990– Aug. 1993 Valdis Birkavs Aug.1993– Sept. 1994 Ma¯ris Gailis Sept. 1994– Dec. 1995 Andris Skele Dec. 1995– Feb. 1997 Andris Skele Feb. 1997– Aug. 1997 Guntars Krasts Aug. 1997– Nov. 1998 Vilis Kristopans Nov. 1998– July 1999 Andris Skele July 1999– May 2000 Andris Berzins May 2000– Nov. 2002 Einars Repse Nov. 2002– Mar. 2004 Indulis Emsis Mar. 2004– Dec. 2004 Aigars Kalvitis Dec. 2004–

Ministers of finance

Term in office

Central bank governors

Term in office

Elmars Silins

May 1990– Einars Repse Sept. 1991– March 1993 Dec. 2001 Uldis Osis Mar.1993– Ilmars Rimsevics Dec. 2001– Sept. 1994 Andris Piebalgs Sept. 1994– May 1995 Indra Samite May 1995– Dec. 1995 Aivars Kreituss Dec. 1995– Feb. 1996 Andris Skele Feb. 1996– Jan. 1997 Vasilijs Melniks Jan. 1997– Jan. 1997 Andris Skele Jan. 1997– Feb. 1997 Roberts Zile Feb. 1997– Nov. 1998 Ivars Godmanis Nov. 1998– July 1999 Edmunds Krastins July 1999– May 2000 Gundars Berzins May 2000– July 2002 Valdis Dombrovskis July 2002– Sept. 2004 Oskars Spurdzins Sept. 2004–

Maastricht convergence criteria is used as the baseline. Estonia and Lithuania joined ERMII, along with Slovenia, on 28 June 2004, and were joined by Latvia on 2 May 2005 (along with Cyprus and Malta). Both Estonia and Lithuania retained their currency boards, which suggests that the exchange rate is very likely be stable at the centre of the þ/ 15 per cent fluctuation band over to the two-year period that is required for the exchange rate criterion to be satisfied. If current trends continue, they will be amongst the first accession states to enter the Euro Area after Slovenia. Their euro entry strategies aim to meet all the Maastricht criteria in mid-2006 and to adopt the euro at the beginning of 2007. The adoption of the euro has been delayed, because Estonia and Lithuania (in the latter case narrowly) failed to meet the inflation criterion, in large part due to high energy prices on world markets. Slovenia, which has pursued a very different economic policy in the 1990s (Feldmann 2006), was admitted to the Euro Area in the summer of 2006 and will introduce the euro in early 2007.

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The Baltic States: Pacesetting on EMU Accession Table 6.5. Lithuania: prime ministers, finance ministers, and central bank governors

Prime ministers

Term in office

Ministers of finance

Term in office

Kazimiera Prunskiene Albertas Simenas Gediminas Vagnorius Aleksandras Abisala

Mar. 1990– Jan. 1991 Jan. 1991– Jan. 1991 Jan. 1991– July 1992 July 1992– Nov. 1992

Romualdas Sikorskis Elvyra Kuneviciene Audrius Misevicius Eduardas Vilkelis

Mar. 1990– Jan. 1991 Jan. 1991– July 1992 July 1992– Nov. 1992 Dec. 1992– Feb. 1995

Bronislovas Lubys Adolfas Slezevicius Laurynas Stankevicius Gediminas Vagnorius Rolandas Paksas Andrius Kubilius Rolandas Paksas Algirdas Brazauskas Algirdas Brazauskas

Dec. 1992– Mar. 1993 Mar. 1993– Feb. 1996 Feb. 1996– Nov. 1996 Dec. 1996– May 1999 June 1999– Oct. 1999 Nov. 1999– Nov. 2000 Oct. 2000– June 2001 July 2001– Dec. 2004 Dec. 2004–

Reinoldijus Sarkinas Algimantas Krizinauskas Rolandas Matiliauskas Algirdas Semeta Jonas Lionginas Vytautas Dudenas Jonas Lionginas Dalia Grybauskaite Algirdas Butkevicius Zigmantas Balcytis

Feb. 1995– Feb. 1996 Feb. 1996– Nov. 1996 Dec. 1996– Feb. 1997 Feb. 1997– May 1999 June 1999– Oct. 1999 Nov. 1999– Nov. 2000 Oct. 2000– June 2001 July 2001– May 2004 May 2004– April 2005 May 2005–

Central Bank Governors Bronius Povilaitis Vilius Baldisis Romualdas Visokavicius Jouzas Sinkevicius (acting) Kazys Ratkevicius Jonas Niaura (acting) Reinoldius Sarkinas

Term in office Mar. 1990– July 1990 July 1990– Mar. 1993 Mar. 1993– Oct. 1993 Oct. 1993– Nov. 1993 Nov. 1993– Jan. 1996 Jan. 1996– Feb. 1996 Feb. 1996–

Latvia does not lag far behind her two neighbours. It changed the anchor of its fixed exchange rate regime from the IMF’s special drawing rights to the euro on 1 January 2005, unilaterally decided to maintain a narrower fluctuation band of þ/ 1 per cent vis-a`-vis the euro, and joined ERMII in May 2005. Latvia has also made good progress in satisfying the other convergence criteria except for inflation. Its euro entry strategy aims both to bring inflation under control over the next two years and to achieve Euro Area membership at the beginning of 2008 (Rimsevics 2004). By mid-2006, all three Baltic States were in a good position to meet the technical requirements for Euro Area membership by 2007–08 if inflation falls back to levels experienced in recent years before the increase in energy prices (Viksnins 2004). The requirement of a continued emphasis

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on fiscal discipline represents continuity and a lock-in of the macroeconomic policy environment of the 1990s. This combination of continuity with goodness of fit with the EMU acquis is also one of the main reasons why the Baltic States require relatively few domestic adjustments to join the Euro Area and why they are among the pacesetters. Since there is no real misfit between their policy regimes and EMU requirements, ‘topdown’ Europeanization played a smaller role than in most other new accession states. However, it has been more important in Lithuania than Estonia or Latvia. The openness of their economies and the domestic weakness of interest groups opposed to the stability culture buttressed the national consensus in the area of macroeconomic policy. ‘Top-down’ Europeanization may, however, take on a new importance if growing domestic pressures from public opinion lead to a misfit with an EMU accession process that locks-in the pre-existing policy regime. While the structural preconditions for EMU membership, such as flexible labour markets, are favourable, there may be growing domestic demands for welfare spending. Many opinion formers argue that it is time to reward the losers of reform in the 1990s. The need for a new ‘social contract’, more public debate about policy priorities, and more attention to the losers of transition was expressed in Estonia in an article by a group of well-known social scientists (Aarelaid et al. 2001). This article triggered a lively debate about the existence of ‘two Estonias’. A strengthening of this kind of feeling could potentially lead to greater pressures for more spending programmes (cf. Rhodes and Keune, Chapter 14, which argues that there is relatively high welfare stress in the Baltic States). In short, accelerated EMU accession can come into conflict with domestic political pressures to tackle high, accumulated levels of welfare stress. The imperative of adopting the euro as soon as possible is whole-heartedly embraced by the political and the administrative elites in the three Baltic States, unlike in Hungary and Poland, which are in less of a hurry. This domestic elite consensus provides policymakers wedded to the stability culture with a useful tool to resist domestic pressure groups that would like governments to abandon fiscal discipline and to move towards a more activist macroeconomic policy. Notably some losers from transition, including pensioners, have had reservations about the stability culture and lobbied for more welfare spending. In this sense, EMU accession facilitates a lock-in of the policies pursued in the 1990s. However, the onus is on structural reforms, wage flexibility, and measures for upgrading skills and avoiding labour market mismatches to facilitate adjustment ensure

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high growth and bring down unemployment from relatively high levels (European Central Bank 2004).

Conclusion: Locking-In Domestic Policies through EMU Accession EMU accession has been associated with low to moderate rather than significant misfits between Baltic State and the acquis. Hence the ‘topdown’ Europeanization effects on policy adjustments have been relatively small, and they are pacesetters in EMU accession. The informal conditionality of the stability culture (see Dyson, Chapter 1 above) has essentially been enshrined in the Baltic economies for many years. Domestic support for early, accelerated euro entry from political as well as administrative elites is strong, especially in Estonia and Latvia. The Baltic political elites have made rapid adoption of the euro a central plank of their domestic agenda. Given the overwhelming consensus across party lines on this issue, EMU accession seems to be moving ahead rapidly. Europeanization through EMU accession has primarily served as a lock-in of existing domestic policies. Hence, negotiating fit with the EMU acquis was relatively free of political difficulties. There has been remarkably little debate about EMU entry in the three Baltic States, and there is a strong consensus on the desirability of rapid accession. The key question is whether the political and societal forces sustaining this policy strategy can be sustained in the run-up to Euro Area entry and beyond. Public as well as political and technical elite opinions in the Baltic States widely acknowledge that their stable national currencies and the monetary policy regimes based on fixed exchange rates have been a key to their relative economic success in the 1990s. Much like West Germany after the Second World War, the Baltic States have taken great pride in the stabilization of their currencies and viewed them as a symbol of their success. Though some Euro-sceptics have questioned the desirability of abandoning the national currencies, there are at least two prominent aspects of the EMU discourse that serve to mitigate these concerns. First, the emphasis on continuity—the fact that EMU in fact means a consolidation of a similar kind of arrangement—served as an important reason for endorsing early Euro Area entry. Monetary policy has been relatively uncontroversial because of its symbolic value as a headline reform (with Russian experience as an implicit critical reference point), its role as a general anchor, and the appreciation of the general benefits of stable

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exchange rates for small and open economies. All three Baltic States are typical small open economies with high trade-to-GDP ratios, where there are generally large business constituencies in favour of stable exchange rates. Foreign investment in these economies is substantial, and many firms are integrated in cross-border production networks (e.g. in the Estonian case with telecommunication and IT companies in Finland and Sweden). Such links make exchange rate stability a key priority for these actors (Frieden 2002). Second, the rapid adoption of the euro is often viewed as a way of making sure that these small states are ‘put on the map’ by outperforming other new accession states (Raik 2004). The importance of perceived external recognition for the EU discourse more generally should not be underestimated. Most notably, the Estonian victory in the Eurovision Song Contest immediately boosted support for EU accession—despite the fact that the connection between these two issues is tenuous and symbolic at best (Mikkel and Kasekamp 2002). Small states are also especially sensitive to contagion processes of the kind outlined by Dyson, (Chapter 1 above): not just the policy behaviour of significant Baltic ‘others’, led by Estonia, and the Finnish model of an early move from EU accession in 1995 to Euro Area entry in 1999, but also market contagion from the role of the euro in underpinning a wide range of economic transactions. In the light of these elements of EMU discourse and the strong elite consensus, negotiating fit on Euro Area entry has been a relatively smooth political process. Overall, there is remarkably little debate about the adoption of the euro in the Baltic States. Now that EU membership is a fact, EMU accession seems less controversial than EU accession had been, again as in the Finnish case. The question is whether, if the adoption of the euro is relatively uncontested among elites at the level of discourse, EMU accession will necessarily follow easily. Can the domestic stability cultures of the Baltic States be sustained both before and after Euro Area entry? One of the main rationales for radical market-based reform, European integration and the stability culture, namely the geo-strategic and historical imperatives of high politics and return to the West, is likely to lose some of its appeal for two reasons. First and foremost, now that formal membership of both NATO and the EU has been achieved, public opinion may be less inclined to accept restraint for a greater national purpose. The ‘inevitability’ rhetoric based on necessary adjustment to EU rules and technocratic management may no longer convince doubters in the way that it did in the run-up to

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the referenda on EU accession (Raik 2004). During the EU accession process the concern with not remaining in a political power vacuum meant that public opinion in the Baltic States was willing to accept very rapid adjustment to EU policies and the adoption of the acquis. ‘Membership’ Europeanization may be a less effective lock-in than ‘accession’ Europeanization, as the recent experience surrounding the SGP in the older member states suggests. Second, both EU membership and the stability culture embodied in EMU more specifically may become more controversial with painful economic adjustment and recession. EMU could become a convenient scapegoat for people who perceive themselves as faring less well. Heightened controversy would be particularly likely if economic performance deteriorates. Whether this development would dent the elite consensus in favour of the stability culture is less clear. The Baltic party systems have been quite volatile, and trust in politicians is low. Not only has there been a clear anti-incumbency bias in all the Baltic elections, but also the shifts have tended to be quite dramatic and to involve new players (Pettai and Kreuzer 1999). In the recent Baltic elections many of the biggest parties that entered government were new creations and had been founded shortly before the campaigns—notably New Era in Latvia, Res Publica in Estonia, and the Labour Party in Lithuania. These parties differ on many dimensions, most notably on economic policy (unlike the other two, the Labour Party is on the political Left). However, all of them campaigned on anti-establishment agendas and promised a new start in politics, a crackdown on corruption, and higher standards in public life. The role of individual leaders, perhaps especially in Latvia and Lithuania, has been important to their appeal. The Labour Party has also embraced Europopulist rhetoric and argued in favour of higher welfare spending, even though no major policy shifts have occurred. ‘Accession’ Europeanization and the consensus in favour of rapid EMU accession effectively rule out such changes. The possibility that populations become disillusioned again—and that political entrepreneurs and interest groups capitalize on dissatisfaction with the nexus of fiscal discipline, tight monetary policy, and perhaps the EU more generally—cannot be ruled out. This kind of shift in public opinion, exploited by members of the political elites, could dent the strong elite consensus in favour of the stability culture. So far new parties have been quite successfully integrated in governing coalitions with preexisting parties, and major policy shifts have been avoided. Future economic performance and the potential for mobilization of economic losers

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will be important in determining pressures on the economic policy regime and the continuing strength of the home-grown stability culture. In the meantime negotiating fit with the EMU acquis has proved politically unproblematic.

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7 From Laggard to Pacesetter: Bulgaria’s Road to EMU Vesselin Dimitrov

Binding Hands and the Negotiation of Fit Bulgaria’s road to EMU provides one of the clearest and most successful instances in east central Europe of one form of the two-level game of ‘negotiation of fit’ between the EU and the domestic levels (see Dyson’s introductory chapter above), the strategy of ‘binding hands’. In this variant, domestic actors, both political and technocratic, use European integration in order to limit their policy discretion, with the aim of enhancing their credibility at both the domestic and the EU level. This is a variation on a theme that is rather common in countries belonging to the southern and eastern periphery of Europe (Dyson and Featherstone 1999; Featherstone and Kazamias 2001; Radaelli 2002). However, the Bulgarian case is distinguished by the consistency and effectiveness of the framework enforcing ‘discipline’ on national actors, particularly in the area of fiscal policy, which is of critical importance for EMU accession. Bulgaria is also of interest because, in contrast to southern European countries such as Italy and Greece, in which the ‘binding of hands’ involved the use of the ERM as an instrument of ‘external discipline’ (Dyson and Featherstone 1996), in Bulgaria, the ‘binding’ took place before the impact of Europeanization could be felt, and preparations for ERM II entry have been used to reinforce and justify an already existing domestic institutional constraint, much as in the Baltic States (see Feldmann chapter). The case of Bulgaria demonstrates how previous negative experience in domestic institutional transformation, and the radical measures taken to overcome it, in the form of the creation of ‘non-majoritarian’ institutions (Thatcher and Stone Sweet

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2002), can give a country an advantage in dealing with the challenges of supranational integration at a later stage. Bulgaria’s trajectory can be seen, to paraphrase Greskovits’ reference to Hungary in this volume, as a case of ‘the last becoming the first’ (or at least catching up with the pacesetters). The main intellectual basis of the ‘binding hands’ strategy is the ‘credibility’ approach to inflation, which views expectations as a key variable in shaping inflation. By limiting their own policy discretion, decisionmakers can gain credibility in fighting inflation by reducing public expectations (Dyson 1994). While both political and technocratic decision-makers ‘bind their hands’, such an act favours technocratic actors in central banks and finance ministries to a much greater extent, in both institutional and ideational terms. In most cases, these technocratic actors would therefore find it in their interest to take part in the ‘binding of hands’; the more interesting question is why political actors would undertake such an act, which, while it may be beneficial in the long run, in the short run can impose serious costs on them, by limiting their ability to respond to electoral pressures, particularly in the context of the politicalbusiness cycle. Political actors do not resort to ‘binding of hands’ easily; they are only likely to do so in response to a severe crisis which can break the political-business cycle by demonstrating dramatically the destabilizing effects of high inflation. In such cases, political actors can attempt to restore their credibility by creating restrictions on their policy discretion by resorting to ‘non-majoritarian’ institutions at the national level and/or supra-national institutions at the European level. Such cases have tended to occur in countries suffering from a combination of structural backwardness in relation to the core of Europe, a legacy of policy failure, and instability induced by recent fundamental institution transformation (usually in the context of regime change). Some of these elements have been present in the countries in the southern periphery of Europe, but they can be found in a much more intensive form in the post-communist countries of east central Europe. There are, however, important differences among the latter, with some countries suffering from these problems to a much greater extent than others. This variation in problem loads, and the occurrence of crises, has important effects on the readiness of domestic political actors to restrict their own discretion. In analysing the ‘binding of hands’ involving the use of European integration, the ‘negotiation of fit’ approach to Europeanization (see Dyson’s introductory chapter) has a number of advantages compared to the more traditional ‘top-down’ and ‘bottom-up’ approaches. The latter

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approaches have been central to the debate on Europeanization and are based on the assumption that domestic actors attempt to maximize or, at least, defend their policy discretion, in the context either of resisting or adapting to ‘top-down’ pressures stemming from institutional and policy ‘misfits’ between the European and the national levels, or of operating within the domestic opportunity structures shaped by the impact of European integration (Kallestrup 2002; Knill and Lehmkuhl 2002; Dyson and Goetz 2003). The strategy of ‘binding hands’ does not fit easily with either of these two approaches. This strategy can be analysed from the perspective of ‘top-down’ Europeanization, as it is based on ‘misfits’ between the European and the national level. In contrast, however, to the assumption in standard ‘top-down’ analysis that the greater the misfit between the European and the national level, the greater the resistance of domestic actors is likely to be (Knill 2001), in the case of ‘binding hands’ the opposite is true. The ‘binding of hands’ can also be viewed through the prism of ‘bottom-up’ Europeanization, as it involves the strategic use of European integration by domestic actors in order to achieve their preferred outcomes at the national level. In contrast, however, to the assumption that domestic actors aim to use the opportunity structures shaped by Europeanization to expand their policy discretion, in the case of ‘binding hands’, domestic actors use these opportunity structures to limit their own discretion. By embracing both the ‘top-down’ and the ‘bottom-up’ perspectives and overcoming their limitations, the ‘negotiation of fit’ approach to Europeanization can provide a more refined instrument for analysing the strategy of ‘binding hands’. This approach sees Europeanization as a part of a ‘two-level’ game, in which national policymakers try to shape the fit between the EU and the domestic level, by acting on both levels. One of the ways in which the shaping of fit can occur is for domestic actors to use pressures emanating from the EU level to change the configuration of national institutions. This institutional change can involve the attempt to enhance or reduce policymakers’ discretion at the domestic level. Due to the fact that the game is played on two levels, a limitation in the actors’ discretion at the domestic level, as in the case of ‘binding hands’, can be compensated by an enhanced influence at the EU level. By proving to be ‘model pupils’ of the EU, national policymakers can enhance their influence at the EU level. This strategy is particularly appealing for small countries, which have limited political and economic weight, but can hope to win influence by doing as well as, or hopefully better than, their ‘significant others’, which could be other comparable small countries or

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large member states which have played a pivotal role in setting the standards for the entire Union. This rationale also applies, in a more complex way, in a case in which the reduction of policymakers’ discretion is undertaken initially for domestic reasons, for instance, in order to restore their credibility with voters following a crisis. While the initial decision to reduce discretion is the product of a one-level game, the transfer of the game to two levels at a subsequent stage can provide policymakers with an incentive to preserve and entrench the reduction at the domestic level, as it can give them advantages at the EU level. From the point of view of domestic actors, perhaps the most critical policy area likely to be affected by EMU accession is fiscal policy. While countries wishing to join EMU have to fulfil a number of conditions on inflation, interest rates and exchange rates, these monetary targets have had a relatively low political salience, partly due to the domestically driven shift towards ‘sound money’ policies in many European countries in the course of the 1980s and the 1990s, and partly to the fact that monetary policy has tended to become isolated from the political process, becoming the preserve of a small network of central bankers and finance ministry officials, whose decision-making is (or at least is presented as) based on an ‘objective’ assessment of the state of the economy rather than on the consideration of relative political priorities. Fiscal policy, by contrast, is central to the work of national governments. In institutional terms, the budgetary process is perhaps the most powerful coordinating mechanism binding members of the domestic executive to each other. In policy terms, fiscal policy involves making vital choices about both taxation and spending, which lie at the heart of political competition in modern democracies and provide vital legitimating mechanisms for political parties representing the often-conflicting interests of different constituencies. Hence, the restrictions on fiscal policy that are imposed by the Maastricht convergence criteria affect some of the core competencies of national governments. Given the inherent difficulty of the Maastricht fiscal criteria for domestic actors, it is not surprizing that their fulfilment has become the main factor considered by European institutions, such as the Commission and ECOFIN, in deciding a country’s fitness for EMU membership. Of the two fiscal criteria, public debt at or below 60 per cent of GDP and a fiscal deficit at or below 3 per cent of GDP, the deficit criterion has been by far the more significant. While numerous compromises have been made in relation to the debt criterion, by admitting into EMU countries such as Belgium, Italy, and Greece, whose debt/GDP ratio was far above

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60 per cent (in the case of the first two countries, nearly twice above the threshold), European institutions have taken a rather hard line on the fiscal deficit and have insisted on at least nominal compliance with the 3 per cent target. In view of the central importance of the fiscal deficit criterion, both for domestic policymakers and for European institutions, the preparation of the east central European countries for EMU membership has focused primarily on fiscal policy. Building on previous work by the author (Brusis and Dimitrov 2001; Dimitrov 2005; Dimitrov, Goetz, Wollmann et al. 2006), this chapter concentrates primarily on Bulgaria’s efforts, some more successful than others, to achieve fiscal rectitude. In order to investigate the negotiation of fit between EMU requirements and the domestic level in the area of fiscal policy, it analyses systematically the factors shaping national fiscal institutions. For the analysis of these factors, the chapter employs a historical institutionalist approach, which recognizes the capacity of institutions to mould the behaviour and even the preferences of political actors, but also emphases the importance of crises, in which actors have an opportunity to shape institutional structures (Hay and Wincott 1998; Checkel 1999; Featherstone and Kazamias 2001). The approach used in this chapter builds on Mark Hallerberg’s recent book, Domestic Budgets in a United Europe (2004). Hallerberg develops an actorcentred theoretical explanation of institutional change, focusing on the impact of party systems and party composition of government. In contrast to the historical-institutionalist approach that is adopted in this chapter, his explanation pays relatively little attention to the importance of institutions and critical junctures.

Domestic Institutions and the Negotiation of Fit This section examines the factors that have influenced the development of fiscal institutions in Bulgaria from the transition to democracy to the early 2000s, and assesses the way in which these institutions and the resulting policy outcomes have shaped the negotiation of fit between EMU requirements and the domestic level. The analysis focuses on factors such as institutional continuities, fiscal crises, the development of the party system, and the changing party composition of government. The section also examines the challenges posed by the negotiation of fit in the areas of monetary and structural policies.

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Decentralized Fiscal Institutions, 1989–97 Democratic transition in Bulgaria was initiated by reformers within the Communist Party Politburo, who removed the ageing leader Zhivkov in November 1989. Their ambitions of retaining the dominant role of the Communist Party (which underwent a nominal change of name in April 1990 to the Bulgarian Socialist Party (BSP) soon ran aground, despite the fact that the party narrowly won the first democratic elections in June 1990. The anti-communist opposition, grouped around the Union of Democratic Forces (UDF), was able to bring the BSP government down in November 1990 through street demonstrations, force the creation of a nominally non-political (‘expert’) cabinet in December, and gain the largest number of votes in the parliamentary elections in October 1991, falling short, however, of parliamentary majority. The UDF was able to form a minority government, but its unwillingness to consider the policy preferences of the Turkish minority party, the Movement for Rights and Freedoms (MRF), on whose support in parliament the cabinet depended, led to the government’s fall in October 1992 (Dimitrov 2001). It was followed by yet another ‘expert’ government, which managed to survive until October 1994 (see Table 7.1). The succession of different types of government led, in line with Hallerberg’s expectations (2004), to the preservation of the decentralized fiscal institutions inherited from communism. As in other East Central European countries, the communist-era executive in Bulgaria was relatively decentralized. Coordination was provided by communist party institutions acting outside the government, and the prime minister and finance minister had only limited coordinating powers. The position of the Bulgarian finance minister in the last years of communism was so weak that in 1987 Zhivkov went so far as to abolish the ministry altogether. While, following Zhivkov’s removal, the finance ministry was re-established, the position of the finance minister within the government remained rather weak. Each minister was able to largely determine her or his own level of spending, with little regard to the consequences for the fiscal position. The finance ministry proved unable to control not only the preparation but also the implementation of the budget. Not surprisingly, the fiscal deficit reached 4.9 per cent of GDP in 1990 (Dimitrov 2001). A Balcerowicz-style ‘big bang’ liberalization in February 1991 under a ‘non-political’ government led to a dramatic reduction in production subsidies, direct public investments, and operational expenses of publicsector organizations. The savings involved were quite substantial. The removal of subsidies to the industrial sector alone led to a cut of over 35

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From Laggard to Pacesetter Table 7.1. Bulgarian governments, prime ministers, finance ministers and governors of the Bulgarian National Bank (1990–2005)

Government term

Party composition of government

Bulgarian Communist (since April 1990 Socialist) Party 22.9.1990– Bulgarian Socialist 19.12.1990 Party 20.12.1990– Non-party govern7.11.1991 ment 8.2.1990– 22.9.1990

8.11.1991– 29.12.1992 30.12.1992– 17.10.1994

Union of Democratic Forces Non-party government (nominally under the auspices of Movement for Rights and Freedoms) 17.10.1994– Caretaker 25.1.1995 government 25.1.1995– Bulgarian Socialist 11.2.1997 Party and allies 12.2.1997– 20.5.1997 21.5.1997– 24.7.2001

Caretaker government Union of Democratic Forces and allies

24.7.2001– 17.8.2005

National Movement for Simeon II and Movement for Rights and Freedoms

Governor of Finance minister Prime minister (term the same as (term the same as Bulgarian the government) the government) National Bank Andrei Lukanov

Belcho Belchev

Ivan Dragnevski, 20.12.1989–9.1. 1991

Andrei Lukanov

Belcho Belchev

Ibid.

Dimitur Popov

Ivan Kostov

Philip Dimitrov

Ivan Kostov

Ibid. Todor Vulchev, 9.1.1991–24.1. 1996 Ibid.

Liuben Berov

Stoyan Alexandrov

Ibid.

Reneta Indzhova

Hristina Vucheva

Ibid.

Zhan Videnov

Dimitar Kostov

Stefan Sofianski

Ibid. Liubomir Filipov, 24.1. 1996–11.6.1997 Svetoslav Gavriiski Ibid.

Ivan Kostov

Muravei Radev

Simeon SaxeCoburg-Gotha

Milen Velchev

Ibid. Svetoslav Gavriiski, 11.6.1997– 9.10. 2003 Ibid. Ivan Iskrov, 9.10.2003–

per cent in total budget expenditures. Once the effects from the abolition of subsidies had faded away, however, the fiscal deficit rose to alarming proportions, reaching 12.1 per cent of GDP in 1993 (World Bank 2000). The victory of the BSP in the parliamentary elections in December 1994 and the creation of an effectively one-party BSP cabinet (the government was formally a coalition, but all the minor parties were entirely dependent on the BSP) was the culmination of a concerted attempt to restore the party’s dominant position within the Bulgarian party system. A new party leadership, headed by the 35-year-old Zhan Videnov, blamed party reformers in 1990 and 1991 for conceding power to the UDF, and called for a return to an idealized late communist past. The BSP’s success in

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reasserting its dominant position was facilitated by the seemingly irreversible implosion of the UDF. The UDF had reacted to the fall of its government in October 1992 by engaging in a seemingly endless series of internal purges. By December 1994, this process had brought the UDF to the brink of political irrelevance. It managed to gain only slightly more than half of the BSP’s share of the vote, and was unable to offer effective opposition to the Socialist government. The reassertion of the BSP’s dominant role in the Bulgarian party system resulted, in line with Hallerberg’s predictions (2004), in the preservation of decentralized fiscal institutions. Spending ministers, no longer concerned about effective political competition from the UDF, saw no reason to exercise restraint. The finance minister was confined to the position of ‘equal amongst equals’ in the cabinet and could be easily outvoted by his spending colleagues. The decentralized institutions resulted in an increase in the fiscal deficit in 1995 to 5.2 per cent of GDP, in spite of the rather favourable macroeconomic situation. In 1996–7, the economy went out of control. The long-standing distortions in the banking system led to a devastating crisis in 1996, resulting in the closure of fifteen banks within twelve months. In a snowball effect, the crisis led to the withdrawal of money from the banking system, its conversion into foreign currency, and a drastic fall in the Bulgarian Lev’s (BGL) exchange rate. Against a planned exchange rate of BGL 77 for USD 1 for 1996, the rate actually reached BGL 535 for USD 1. The credibility of the national currency collapsed. The result was runaway inflation (311 per cent in 1996) and a dramatic increase in interest rates from 42 per cent at the beginning of February, to 108 per cent in May, and 300 per cent in September 1996. The collapsing exchange rate, uncontrollable inflation and record interest rates brought about a drastic fall in output and exports, with GDP dropping by almost 11 per cent in 1996 and by nearly 13 per cent in the first two months of 1997. The financial crisis not only brought about a severe economic recession but also exacerbated the already difficult budgetary situation. The fall in the exchange rate and the high interest rates led to a substantial growth of expenditures devoted to servicing the government’s foreign and internal debts. Almost 20 per cent of GDP was used for debt repayment in 1996. The increasing share of budget expenditures devoted to debt repayment led to drastic cuts in expenditure on health, education, and social security. The fiscal deficit reached 15.4 per cent of GDP in 1996, its highest-ever level (World Bank 2000). The BSP government, having lost confidence in its ability to control the economy and faced with street demonstrations organized by the UDF,

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surrendered power in February 1997 to a caretaker government led by Stefan Sofianski. The apparent collapse of the fiscal system set the stage for a fundamental institutional transformation. The centre-piece of the new institutional framework was the creation of a ‘currency board’. The board meant that the Bulgarian Lev was linked to a foreign currency unit (first the German D-Mark, and subsequently the euro) at a fixed exchange rate, and the amount of Leva in circulation could not exceed the foreign currency reserve held by the Bulgarian National Bank (BNB). With the introduction of the currency board, governments could no longer finance the fiscal deficit by printing money. In addition, the BNB was prohibited from lending to the government. The IMF first proposed the idea of a currency board in the autumn of 1996. This proposal can be seen as an extreme form of the ‘sound money’ paradigm and, as such, emanating from the same intellectual framework that gave rise to EMU, although it has to be noted that the idea of the board encountered significant resistance within the IMF. While the IMF proposed the board to the Bulgarian government, and, given the country’s desperate financial straits, could exercise significant pressure on the government to persuade it to adopt the board, it was Bulgarian domestic actors, in particular, the core executive and the political parties, that made the ultimate decision to introduce this institutional arrangement. Technocratic actors, such as senior BNB and finance ministry officials, who were eventually to derive considerable benefits from the new institutional framework, played a relatively subordinate role in its creation. After some resistance, all the major political parties committed themselves to the board in March 1997. While fully aware of the fact that the introduction of the board would limit their policy discretion, the depth of the crisis and their legacy of policy failure left them with little choice other than binding their hands, in order to restore their credibility with the voters.

Currency Board, 1997–2005 The creation of the currency board brought about a major change in the domestic institutional framework governing monetary and fiscal policy. Its introduction as a ‘non-majoritarian’ institution was driven by the aim of isolating monetary policy completely, and fiscal policy to a considerable degree, from government and political influence. The impossibility of financing the budget deficit by printing money or by borrowing from the central bank made it considerably more difficult for governments to run deficits. In principle, governments could still finance deficits by

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borrowing on the international financial markets. However, Bulgaria’s credit history meant that this was not a realistic option in 1997 and for a number of years subsequently. Even when this option became more viable, Bulgarian governments were reluctant to use it on a significant scale. The currency board has largely worked as intended, and the broad parameters of fiscal policy in Bulgaria, in particular, the level of the fiscal deficit, have become largely independent of the party composition of government. It has to be noted, however, that the two governments which have ruled since 1997—the effectively one-party UDF government in 1997–2001, and the coalition between the National Movement for Simeon II (NMSII), a party set up by the former Bulgarian monarch, Simeon Saxe-CoburgGotha, and the MRF, in 2001–5, had a centre-right profile and were ideologically committed to fiscal discipline, thus making it difficult to disentangle the effects of the currency board from those of the governments’ own policy preferences. The policy outcomes were, however, unambiguous: under both governments, the budget was either in surplus or had a deficit considerably below 3 per cent of GDP. While the creation of the currency board was not a case of anticipatory Europeanization—it was established in response to a domestic crisis and at a time when not only the prospect of Euro Area membership, but even of EU membership for Bulgaria seemed almost hypothetical—its existence has major implications for Bulgaria’s capacity to join EMU. The effectiveness of the board in constraining fiscal deficit means that it can enable Bulgaria to meet the Maastricht deficit criterion, which has usually proved to be the most difficult obstacle for aspiring members. The apparent compatibility between the fiscal institutions and policy outcomes in Bulgaria with EMU requirements means that the negotiation of fit can take the form of preserving the already existing constraining domestic arrangement. Bulgarian domestic actors have thus sought to use preparation for EMU accession to reinforce the board and advance further their institutional interests. In particular, senior BNB and finance ministry officials have been actively exploiting EMU accession as a means of entrenching the board. They have been largely successful in shaping the agenda of the rather limited debates on preparation for EMU that have so far taken place in Bulgaria. A recently published BNB strategy for 2004–09 envisages the preservation of the currency board until the country’s full membership of the Euro Area. The strategy maintains that Bulgaria should become a member of ERM II as soon as possible following its accession to the EU (Bulgarian National Bank 2004), which is expected to take place in 2007 or 2008. As the examples of Estonia and Lithuania demonstrate, joining ERM II with a currency board

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soon after EU accession is a feasible option (see Feldmann chapter). The BNB expects full Euro Area membership for Bulgaria in 2009 or 2010. Senior central bank and finance ministry officials have also been far more effective than their counterparts in other institutions in playing a ‘two-level’ game, not only at the domestic, but also at the EU level. They have been successful in establishing linkages not only with supra-national institutions, such as the ECB, but also with transnational European networks. In particular, the BNB has developed extensive cooperation with the central banks of France and the Netherlands (Kabakchiev 2004). By contrast, officials in the spending ministries, in particular, those concerned with social welfare, have been disadvantaged by the relative weakness of supra-national institutions and transnational networks in their policy areas. While Bulgarian parties after 1997 have sometimes (usually when in opposition) criticized the restrictions imposed by the currency board, no government has seriously considered its abolition. The fear of a return to the hyperinflation of 1996–7 remains an important factor influencing voter behaviour, and no major political party could run the risk of destroying its economic credibility by appearing to undermine the board. This applies with particular force to the BSP, the party which, given its left-of-centre ideology, could be expected to be especially reluctant to support the board. The fact, however, that it was under BSP stewardship that the 1996–7 hyperinflation occurred, means that the party has had to make special efforts to demonstrate to the voters that it has abandoned its old ways. The Socialist leaders have therefore sought (with occasional slip-ups) to demonstrate their commitment to the board. The negotiation of fit, in the form of the preservation of the currency board, has been reinforced by a ‘contagion’ effect from the international financial markets. Bulgaria’s slow return to the markets after the catastrophic financial crisis of 1996–7 has been highly dependent on market expectations about the country’s entry into the EU and, in the longer term, into the Euro Area. Anything that could delay EU and Euro Area accession would make Bulgaria a less attractive prospect and, given the wide range of alternative emerging markets available, could have disproportionate impact on the country’s ability to attract finance. While Bulgarian governments have not resorted to borrowing from the international markets to any large degree, they have been eager to raise the country’s credit ratings. The NMSII-MRF government, in particular, has presented the attainment of a credit grade rating as one of its central achievements. The very composition of the government has made it particularly sensitive to the signals of the international financial markets. When constructing his cabinet in 2001, Simeon ensured that virtually all

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the key economic ministries were occupied by Bulgarian investment bankers working in West European financial centres. Partly because of the unusual character of the NMSII, which is mainly a collection of individuals around Simeon rather than a normal political party, the raison d’etre of the government has been defined primarily in terms of technocratic efficiency, along the lines of the ‘sound money and finance’ paradigm. The government’s priorities have been clearly demonstrated by the emphasis on debt reduction, rather than on increasing welfare expenditure. The government has been remarkably successful in achieving its objectives, with public debt as a proportion of GDP declining from 77.1 per cent at the end of 2000 to 40.9 per cent at the end of 2004, thus falling below the Maastricht threshold (EIU Country Data 2005). With the forthcoming general election in June 2005 and the return to normal party competition, future governments may not put quite as much emphasis on debt reduction, but they are unlikely to wish to jeopardize the country’s hard-won reputation for fiscal prudence. As in fiscal policy, the process of negotiating fit in the area of monetary policy can largely take the form of maintaining existing domestic institutional arrangements. A potential problem for Bulgaria could arise due to the fact that, under the currency board, the BNB is deprived of many of the functions of a central bank. If the BNB is to be able to play the role expected of it in the European System of Central Banks and to implement ECB interest-rate policies in Bulgaria, its competencies will have to be expanded (Kostov and Kostova 2002). There is little resistance in Bulgaria to such a change, as it is seen as purely technical. The amendments of the BNB statute intended to bring it fully into line with EMU requirements (Kabakchiev 2004) are likely to pass smoothly through parliament. Bulgaria’s success in achieving macroeconomic stability since 1997 has become the basis for some impressive, though still far from sufficient, progress in structural reform. According to the European Commission’s 2004 regular report, there has been good progress in privatization, with 86 per cent of state-owned assets transferred to private hands by the end of June 2004. Private sector employment has increased from 46 per cent in 1999 to 64 per cent in March 2004. The financial sector is almost entirely privately owned, and more than 75 per cent of commercial banks’ total assets is foreign-owned, thus strengthening Bulgaria’s integration in the Euro time–zone. There has also been good progress in reducing state intervention. Hidden subsidies to enterprises such as tax and social security arrears fell from 2.3 per cent of GDP at the end of 2001 to about 1 per cent of GDP at the end of 2003. Industries such as coal mining and steel

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still receive state aid, but according to the Pre-Accession Economic Programmes (PEP), subsidies fell from 2.4 per cent of GDP in 2001 to 2.2 per cent of GDP in 2003. State-owned enterprises with financial problems are subject to strict monitoring and ongoing restructuring (European Commission 2004c). It seems, therefore, that as in other east central European countries such as Estonia, the creation of a stability culture in Bulgaria has been accompanied by cutting the links between vested economic interests, state institutions and political actors, in contrast to the situation in Romania (see Papadimitriou chapter), which shared with Bulgaria the experience of lacklustre reform in the early- and mid-1990s. The main problems on which the negotiation of fit is likely to focus in the case of Bulgaria are the efficiency of the administrative and judicial system, labour market rigidities, and the efficiency and quality of the education system (European Commission 2004). In the longer term, the accumulating problems in the welfare system, partly due to high levels of social deprivation and partly to ineffective government policies, may put pressure on Bulgarian governments’ capacity to maintain fiscal discipline. In contrast to their West European counterparts, however, though in line with most other east central European executives, Bulgarian governments have a largely a free hand in imposing social reform, without having to contend with powerful social interest organizations. Trade unions are divided between two major confederations and suffer from rather weak links between the central leadership and workplace organizations. Employers’ associations are even weaker in organizational terms. Bulgarian governments are, therefore, likely to face little resistance from interest organizations in the pursuit of EMU-oriented welfare reforms. Resistance could come mainly from political parties facing electoral pressures to safeguard or extend the welfare state. But, as noted above, even the major left-wing party, the BSP, has tended to prioritize fiscal stability and an early entry into the EU and Euro Area.

Conclusion This chapter demonstrates that the negotiation of fit between EMU requirements and the domestic level is shaped to a large extent by the evolution of domestic institutions. The analysis of the factors shaping the development of Bulgaria’s fiscal institutions and policies over the last fifteen years demonstrates the significance of crises as a window of opportunity for institutional transformation, as well as the influence, largely in line with

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Hallerberg’s expectations (2004), of the evolving domestic party system and the changing party composition of national government. The instability of the Bulgarian party system in 1989–94 and the rapid changes in the type of government meant that it was difficult to change the decentralized budgetary mechanisms inherited from communism. The return to an uncompetitive party system with the BSP’s overwhelming electoral victory in 1994 also served to preserve decentralized institutions, as the spending ministers were able to pursue their expansionary ambitions without fearing serious electoral competition. The devastating fiscal crisis of 1996–7 led political parties to accept the creation of a currency board, which deprived them of significant policy discretion. While the creation of the currency board was not a case of anticipatory Europeanization, it did have the consequence of establishing an institutional framework that produced fiscal policy outcomes compatible with the Maastricht deficit criterion. Consequently, the negotiation of fit between EMU requirements and the domestic level in the area of fiscal policy has primarily taken the form of Bulgarian actors using EMU accession as means of preserving the domestic currency board and creating even greater obstacles to any future attempt to change its fundamental features. The same is largely true of monetary policy. Technocratic actors such as BNB and finance ministry officials have used EMU accession as an instrument for maintaining and enhancing the privileged positions that they have acquired in the policymaking process with the introduction of the currency board. They have proved much more successful than their rivals in the spending ministries at playing the game at the EU level, by establishing links to supra-national institutions and transnational European networks, benefiting from the ‘ECB-centric’ nature of the Euro Area (Dyson 2000). Bulgaria’s road to EMU shows clearly the importance of ‘binding hands’ as a strategy for ‘negotiating fit’ between the EU and the domestic level. The ‘binding of hands’ has been remarkably successful in accelerating Bulgaria’s accession to EMU and could give it advantages compared to ‘significant others’, such as other east central European countries, not to mention its Balkan neighbours. The fiscal stability created by the currency board should enable Bulgaria to join ERM II soon after it accedes to the EU in 2007 or 2008, and achieve full membership of the Euro Area by 2009 or 2010. Interestingly, this timescale is consistent with that of countries like the Czech Republic and Hungary, which experienced a much more rapid and successful transition in the early- and mid-1990s. However, Bulgaria’s ‘success’ has come at a high price. The ‘binding of hands’ has meant that domestic political actors have deprived themselves

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of considerable policy discretion. The fact that the currency board has made it more difficult for governments to run fiscal deficits (the option of financing deficits by borrowing on the international financial markets has been used by Bulgaria only to a very limited extent) has created an important constraint on party competition. Parties could still compete on the allocation of resources within the budget ‘envelope’. But, as Dyson (2003: 228) noted with respect to the Stability and Growth Pact (SGP), constraints on the fiscal deficit have a highly restrictive effect on the ability of domestic politicians ‘to make a distinct party political difference’. Given the limiting effect of the currency board on party competition, and thus on the ability of parties to represent the interests of their constituencies, it is not surprising that currency boards cannot be found in West European democracies and can be encountered in only a few east central European countries. The only countries in east central Europe, other than Bulgaria, to have adopted a currency board are Estonia, Lithuania, and Bosnia–Herzegovina, while Latvia has an arrangement that operates in a similar fashion (see Feldmann, Chapter 6). In each case, the adoption of the board was a result of a far-reaching crisis that suspended the normal operation of party politics, such as separation from a larger state formation and the (re-)establishment of national independence, and/or a deep financial crisis. While countries with currency boards have enjoyed advantages compared to their east central European neighbours on the road to EMU, Euro Area accession represents only one aspect of Europeanization (albeit perhaps a crucial one). Bulgaria’s success in that relatively narrow area, resting as it does on the ‘binding of hands’ of domestic political actors and a pacesetter role, may well make the process of Europeanization less sustainable in the long-term.

Acknowledgements This chapter is based on a research project on ‘Executive Capacity in PostCommunist Europe’, funded by the Volkswagen Foundation (1999–2001). The project was led by the author, Klaus H. Goetz (both at the London School of Economics and Political Science) and Hellmut Wollmann (Humboldt Universita¨t). Other researchers included Martin Brusis and Radoslaw Zubek. The project was assisted by the Economic Policy Institute in Bulgaria.

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8 From Pacesetter to Laggard: The Political Economy of Negotiating Fit in the Czech Republic Frank Bo¨nker

By the mid-1990s most observers regarded the Czech Republic as the pacesetter amongst east central East European states in progress towards adopting the euro. At that time, the country was widely perceived as a paragon of ‘sound money and finance’ in the region. Va´clav Klaus, the selfconfident architect of Czech economic reform in the first half of the 1990s, did not stand alone in arguing that the Czech Republic was closer to meeting the Maastricht convergence criteria than many traditional EU members. By 2005, however, the Czech Republic belonged, amongst the laggards, to those new member states that have postponed the adoption of the euro. The country’s official ‘Euro-Area Accession Strategy’, which was adopted by the centre-left government of Vladimir Sˇpidla and the Czech National Bank in 2003, envisages Euro Area entry in 2009–2010. This strategy offers one of the least ambitious timetables for EMU accession in the region. Why has the Czech centre-left government taken such a cautious approach and postponed entry into the Euro Area? How does the Czech Republic compare with Hungary and Poland, two other laggards covered in this volume? And what does the Czech case tell us about the ‘EMUization’ of economic policy in the accession states? In order to answer these questions, this chapter examines how Czech policymakers have perceived and dealt with the obligations, challenges, and opportunities associated with EMU accession and negotiated ‘fit’ between external pressures and domestic constraints.

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The first section of this chapter outlines the economic and political context of EMU accession in the Czech Republic by sketching the challenges associated with Euro Area entry, the positions of the main domestic actors on EMU accession, and the reform capacity of the post-1998 governments. The second section reconstructs how these economic and political conditions have shaped the Czech approach towards Euro Area entry and have limited the effects of EMU accession on Czech economic policy. The chapter concludes by summarizing the findings and by putting them into a broader perspective.

The Economic and Political Context of EMU Accession The economic and political context of EMU accession in the Czech Republic has been characterized by a combination of strong reform challenges with low enthusiasm about EMU accession among the elites and with weak governments.

Economic Challenges of EMU Accession The costs and benefits of EMU accession differ amongst the accession states. In the Czech case, the picture looks mixed. On a number of counts, the country is well prepared for EMU accession. Trade integration with the EU is high (Backe´ et al. 2004: 32 f.). With more than 60 per cent in 2002, the share of trade with the EU15 in total trade was slightly above the average of the EU and the accession states. In 2002, the Czech Republic was the only accession state in which the share of intra-industry trade in total EU15 trade exceeded the EU average of 60 per cent. Moreover, the Czech Republic has become the country with the highest stock of FDI per capita in the region. Cumulative FDI inflows from 1989 to 2003 amounted to 3,710 US dollars per capita, more than twice that in Latvia, Lithuania, Poland, and Slovenia and substantially higher than in Estonia and the Slovak Republic as well (EBRD 2004: Table A.2.8). Additionally, unlike a number of other accession states, the Czech Republic has met the Maastricht criteria on price stability and long-term interest rates for some time (Ministry of Finance of the Czech Republic et al. 2005: 45–50). On other counts, however, the Czech Republic has found itself in a much less favourable situation. First, compliance with the deficit criterion has required a substantial fiscal adjustment with the associated

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political and economic risks. Second, meeting the exchange-rate criterion has implied a shift in the exchange-rate and monetary policy regime, which increases the risk of a currency crisis. Finally, notwithstanding the high trade integration and FDI penetration, the synchronization of GDP growth with the Euro Area has been weaker than in a number of other accession states. For these three reasons, similar to Hungary and Poland, the Czech Republic has belonged to those accession states for which EMU accession has implied rather strong challenges. The result has been serious problems of negotiating ‘fit’ with EMU accession requirements. During most of the 1990s, the Czech Republic was envied for its ¨ nker 2006). Ever since the late 1990s, howfavourable fiscal record (Bo ever, fiscal deficits have been among the highest in the new member states and have clearly exceeded the ceilings set by the Maastricht criteria and the Stability and Growth Pact (Table 8.1). Part of the deficits has reflected the costs of recapitalizing the banking sector and of restructuring the enterprise sector after the 1997 currency crisis. However, the main reason for the high deficits has been high, and rising, social spending caused by the post-1997 increase in unemployment, strong entitlements and some improvements in benefits. Deficits have been largely structural and have remained high, despite the post-1999 economic recovery (Bezdeˇk et al. 2003). Compared to other accession states, three factors have aggravated the challenge of fiscal adjustment in the Czech Republic and the problems of negotiating ‘fit’. First, the low interest rates and the low stock of public debt in the Czech Republic imply that bond yield convergence in the

Table 8.1. Czech general government balances, 2000–6 (ESA 95 definitions)* Country

2000

2001

2002

Czech Republic Estonia Hungary Latvia Lithuania Poland Slovak Republic Slovenia

4.0 0.3 na 2.7 2.6 2.9 12.3 na

5.6 0.2 4.4 1.6 2.1 2.9 6.0 na

6.7 1.8 9.3 3.0 1.6 3.9 5.7 1.9

2003 11.7 3.1 6.2 1.5 1.9 4.5 3.7 2.0

* Figures for 2005 and 2006 are Spring 2005 forecasts. Source: European Commission, Public Finances in EMU, various issues.

162

2004

2005

2006

3.0 1.8 4.5 0.8 2.5 4.8 3.3 1.9

4.5 0.9 3.9 1.6 2.4 4.4 3.8 2.2

4.0 0.5 4.1 1.5 1.9 3.8 4.0 2.1

From Pacesetter to Laggard

run-up to EMU accession will not result in as strong a reduction of interest payments as in Hungary and Poland (Orba´n and Szapa´ry 2004). Second, the net fiscal costs of EU accession are the highest in the region, mainly because of smaller gains from the phase-out of agricultural production subsidies (Antzcak 2003). Finally, the Czech Republic will face one of the most dramatic increases in the old-age dependency ratio, but has made relatively little progress with pension reform so far because of relatively weak short-term reform pressures and a limited influence of the International Monetary Fund (IMF) and the World Bank in the 1990s (Bezdeˇk et al. 2003; cf. Rhodes and Keunen, Chapter 14 below). The second challenge has arisen from the exchange-rate criterion. The Maastricht Treaty makes the adoption of the euro dependent on a successful two-year participation in ERM II. This requirement is highly controversial among economists (Backe´ et al. 2004). Critics loath the ERM II as a ‘soft peg’ prone to speculative attacks (Begg et al. 2002; Buiter 2004). For the Czech Republic, the challenge is especially daunting. It moved from a pegged exchange rate to an inflation-targeting framework after the 1997 currency crisis and has followed a free float ever since 1998. Participation in ERM II thus requires a far-reaching shift in monetary and exchange-rate policy, which can further increase the risk of a currency crisis by destabilizing the expectations of investors. The challenge that is associated with the exchange-rate criterion is highlighted by the relatively high volatility of the Czech exchange rate. The past five years saw an appreciation of the Czech crown against the euro by about one-third from January 1999 to mid-2002, followed by a depreciation of about 15 per cent from mid-2002 to the beginning of 2004, and then an appreciation of about 7 per cent from Spring 2004 to Summer 2005. These ups and downs raised strong concerns about the volatility of capital flows and the risks of entering ERM II. A final challenge has resulted from the relatively weak alignment of the Czech economy with the Euro Area (Koma´rek et al. 2003; Ministry of Finance et al. 2005: 51 f.). While trade integration and FDI penetration have been high, the Czech Republic has featured a relatively weak correlation of supply shocks and a relatively limited synchronization of GDP growth with the Euro Area. Part of the explanation lies in persistent differences in economic structure, most notably the outstanding size of the industrial sector in the Czech Republic (Backe´ et al. 2004: 30 f.). The limited alignment of the Czech economy with the Euro Area has raised concerns about the economic costs that might arise from the loss of an independent monetary policy.

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Sharp Controversy and Low Enthusiasm about EMU Given the scale of these challenges, it is not surprizing that the Czech Republic has seen sharp domestic controversies about EMU accession. Broadly speaking, three main camps can be distinguished. They frame domestic debate about negotiating ‘fit’ with EMU accession. A first camp consists of the Czech National Bank, the Ministry of Finance, the bulk of the business sector, especially its more internationally oriented parts, as well as economists who are close to the centre-left parties, the liberal wing of the social democratic CSSD and the EU-friendly wing of the centre-Right ODS. These actors emphasize the advantages of EMU membership and argue for making a quick Euro Area entry possible by fiscal consolidation and structural reforms. In line with the ‘sound money and finance’ paradigm, they claim that fiscal reform is necessary anyway and does not necessarily have deflationary effects. Against this background, they welcome the Maastricht deficit criterion as a means to induce fiscal discipline. At the same time, the members of the first camp criticize the exchange-rate criterion and, to some extent, the inflation criterion. Echoing the critique by outside observers (Begg et al. 2002; Buiter 2004), they point to the vulnerability of the ERM II to speculative attacks, question the rationale behind the exchange-rate criterion and warn against a premature participation in ERM II. As for the inflation criterion, they argue that the Maastricht threshold does not take structural peculiarities of the accession states, most notably the Balassa–Samuelson effect (see Rollo, Chapter 2 above), into account. A second camp consists of economists with more Keynesian leanings, close to the trade unions and to the left wing of the Social Democrats, as well as some parts of the business sector. Similar to the first camp, its members welcome EMU accession as such, at least in public, but warn against a premature entry. However, they do so with quite different arguments. Their main concern is the trade-off between nominal and real convergence and the loss of policy independence. For one thing, the members of the second camp argue that the Maastricht criteria are likely to dampen economic growth and prolong the period of economic ‘catchup’ by calling for too tight a fiscal and monetary policy. For another, they emphasize the crucial role of the exchange rate as an instrument for safeguarding the competitiveness of the national economy. Unlike the members of the first and the second camps, the third camp openly questions the rationale behind EMU. The most prominent member of this camp is Va´clav Klaus, the long-serving chairman of the centre-right

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ODS, Czech Prime Minister from 1992 to 1997, and Czech President since 2003. Klaus has been an outspoken critic of EMU from the early 1990s. According to him, neither the current nor an enlarged Euro Area are optimum currency areas, and thus come with high economic costs (Klaus 2003). In line with his general rejection of a ‘deepening’ of European integration, Klaus has also criticized EMU for being ‘the Trojan horse for overall harmonization of economic rules, policies and laws in the EU’ (Klaus 2003). Klaus’s position is shared by some fellow economists and part of the ODS. More recently, the weak economic performance of the Euro Area has strengthened the third camp. Moreover, in February 2005 Va´clav Klaus used his presidential powers regarding the central bank to make two well-known opponents of euro entry members of the board of the Czech National Bank. The three positions on EMU and EMU accession can be found in other new member states as well. From a comparative perspective, however, it seems that that elite-level enthusiasm for Euro Area entry has been weaker in the Czech Republic than in almost all other accession states. This lack of enthusiasm can partly be explained by the strong challenges of EMU accession for the Czech Republic. However, this is only part of the story. In addition, the Czech scepticism towards EMU is deeply rooted in the country’s recent history. This point applies to all three camps. In the case of the first camp, the scepticism with regard to ERM II entry has been strengthened by the memory of the 1997 currency crisis. In May 1997, speculative attacks forced the authorities to give up the exchange-rate peg that had been introduced at the outset of transition (Begg 1998; Horva´th 1999). Similar only to the UK, the painful experience of being ejected out of a soft-peg system has remained unforgotten among Czech economists. In the case of the second camp, a particular reading of the slow post-1997 recovery has played a similar role. The members of this group tend to blame the tight monetary policy of the Czech National Bank for delaying the economic recovery in the late 1990s and view this episode as a precedent for the negative effects of macroeconomic tightening on economic growth. Finally, the third camp could not exist without Va´clav Klaus’s prominent role during the first half of the 1990s and the connections and contacts that he and the ODS forged with the British Tories and EU- and EMU-sceptic economists (Bugge 2003; Kopecky ˇ 2003; Hanley 2004a). and Ucˇen

Weak Reform Capacity Negotiating fit in EMU accession has been further complicated by domestic political-institutional constraints. While the Czech Republic had a

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strong government during the first half of the 1990s, the post-1998 governments have demonstrated a limited reform capacity (Williams 2003; ¨ nker 2006, Chapter 6). This weak reform capacity applies both to the Bo 1998–2002 Social Democratic minority government and to the post-2002 centre-left governments (cf. Table 8.2). Table 8.2. Czech prime ministers, finance ministers, central bank governors and party composition of cabinets

Parliaments January 1993– June 1996*

Parties in government ODS, KDS, KDU–CSL, ODA

Prime Minister

Finance Minister

Central Bank Governor**

Va´clav Klaus (ODS)

Ivan Kocarnik

Josef Tosˇovsky´

January 1993– November 1997 July 1996– June 1998

ODS, KDU– CSL, ODA

Va´clav Klaus (ODS)

Ivan Kocarnik July 1996–May 1997 Ivan Pilip

July 1996– November 1997

June 1997– November 1997 Josef Tosˇovsky´ caretaker government

July 1998– June 2002

December 1997–July 1998 CSSD (minority government)

Milosˇ Zeman (CSSD)

Ivan Pilip December 1997– July 1998 Ivo Svoboda July 1998– July 1999 Pavel Mertlı´k July 1999– April 2001 Jirˇ´ı Rusnok

July 2002– present

CSSD, KDU–CSL, US-DEU

Vladimı´r Sˇpidla (CSSD)

Josef Tosˇovsky´ July 1998– November 2000 Zdenek Tu˚ma November 2000-present

April 2001–June 2002 Bohuslav Sobotka

July 2002–July 2004 Stanislav Gross (CSSD) July 2004–April 2005 Jirı´ Paroubek (CSSD) April 2005–present

July 2002–present

* While the Czech Republic became an independent state on 1 January 1993, its first parliament had already been elected in July 2002. ** From December 1997 to July 1998, when the former and later Central Bank Governor Josef Tosˇovsky´ headed a caretaker government, the position of the Central Bank Governor remained vacant.

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The Social Democratic CSSD, which has dominated both post-1998 governments, has suffered from strong internal rifts and weak party discipline. The existence of strong factions within the party and the limited authority of the party leadership have made it quite difficult for Social Democratic party leaders and prime ministers to bring the party and its parliamentary group ‘in line’ and to commit them to controversial policies such as fiscal reform. While being the strongest party in parliamentary, the CSSD has not commanded a parliamentary majority on its own. From 1998 to 2002, Prime Minister Milosˇ Zeman led a minority government. Although an agreement with the centre-Right ODS, the so-called ‘Opposition Agreement’, provided for some degree of stability, the government was forced to find outside support for most of its policies (Roberts 2003). After 2002, the CSSD formed a centre-left coalition with the Christian Democratic KDUCSL and the Liberal US-DEU but enjoyed a mere one-vote majority in parliament. This narrow majority has made the government vulnerable to threats of defection by individual deputies, thus limiting its room for manoeuvre. The institutional position of the Czech Prime Minister and the Finance Minister has been rather weak. The Prime Minister has been constrained by the collegial nature of the Czech cabinet and the lack of a strong Prime ¨ ller-Rommel and Minister’s office (Goetz and Wollmann 2001: 869–71; Mu Mansfeldova´ 2001). The Finance Minister has suffered from the institutional fragmentation of the public sector and his limited control over the preparation and implementation of the budget (Gleich 2003; cf. Dimitrov, Chapter 13 below). Unlike in the early 1990s, when Klaus dominated the cabinet, Prime Minister Milosˇ Zeman, and his successors have not been able to compensate for the weak institutional position by their informal authority. The weakness of the core executive has complicated the initiation and consolidation of unpopular reforms. Finally, the Czech Republic has been characterized by a high level of EUˇ 2003; scepticism on the mass and the elite levels (Kopecky and Ucˇen Taggart and Szczerbiak 2004; Beichelt 2004). As evidenced by Eurobarometer surveys and the results of the EU referendum, the Czech population has been relatively EU-sceptic (Table 8.3). This scepticism has extended to the euro. A recent survey suggests that the Czech Republic belongs to the new member states with a relatively weak support for the euro (Figure 8.1). The political relevance of EU-scepticism has been aggravated by the fact that the two opposition parties—the communist KSCM and the centreright ODS—have catered for EU-sceptic voters. For this reason, the parties

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From Pacesetter to Laggard Table 8.3. Euro-scepticism in EU-accession states (percentages) Country

2001*

2002*

2003*

Bulgaria Czech Republic Estonia Hungary Latvia Lithuania Poland Romania Slovakia Slovenia

2 9 14 7 17 11 11 2 5 11

5 14 16 5 21 12 11 2 5 14

3 15 16 10 16 9 11 2 8 8

‘No’ in referendum

22.17 33.00 16.16 32.33 8.85 22.39 6.20 10.34

* % of the population that see EU membership as ‘a bad thing’. Source: Beichelt 2004: Table 3.

Q4. Generally speaking, are most people you personally know more in favour or against the idea of introducing the euro in (YOUR COUNTRY)? In favour NMS

Against

39%

22%

22%

55%

17%

38%

45%

SK

21%

22%

57%

HU

20%

41%

SI

CZ

[DK/NA]

12%

48%

40%

26%

36%

CY

38%

EE

38%

41%

21%

LT

38%

40%

21%

PL

34%

45%

22%

MT

33%

46%

21%

LV 0%

20%

25%

44%

31% 40%

60%

80%

100%

Figure 8.1. Support for EMU accession Source: European Commission and EOS Gallup Europe 2004: 11.

in the centre-left government have faced a rather high risk of losing popular support by launching unpopular reforms in the name of Europe. This particularly applies to the CSSD with its relatively volatile and Eurosceptic electorate.

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Czech Economic Policy and Euro Entry How have these conditions shaped the Czech approach to, and the domestic effects of, EMU accession? The formulation of a ‘Euro-Area Accession Strategy’ in 2002–03 was a watershed that highlighted the effects of these conditioning factors.

EU Accession and the Empowerment of the Czech National Bank At least since the mid-1990s, a future EMU accession has served as a point of reference for policymakers in the Czech Republic (Backe´ 1999: 131; Deˇdek 1999). However, it was not till mid-2002 that the Czech National Bank and the Czech government started to develop an explicit strategy for Euro Area entry. EMU shaped domestic economic policy earlier. ‘EMUization’ took different forms which ranged from the implementation of the EMU chapter of the acquis, through the gradual integration of the prospective new member states into formal and informal EU-level policycoordination, to the spread of the ideas and policy beliefs underlying EMU (cf. Dyson, Chapter 1 above). Formal EU accession conditionality has arguably been strongest in the field of central bank legislation. In many new member states, accession conditionality played an important role in strengthening the role of central banks by shielding them against political pressure (cf. the chapters on Hungary and Poland). The Czech case is broadly in line with these observations (for the following see Myant 2003: 71–113). Similar to most other east central European states, the Czech National Bank has enjoyed a high degree of independence, almost since the beginning of transition (Hochreiter and Kowalski 2000; Maliszewski 2000; Cukierman et al. 2002). The original legislation on the Czech central bank, which goes back to the Czechoslovak central bank law of December 1991, was largely patterned upon German law. This early decision for an independent central bank represented the strong professional consensus on the economic benefits of an independent central bank, as it had emerged in the course of the 1980s. While it was not explicitly intended as an ‘anticipatory Europeanization’, it substantially reduced the ‘misfit’ between the acquis and the existing central bank legislation. In the Czech Republic, government-central bank relations were tense in the second half of the 1990s. Both the Klaus and the Zeman governments criticized the Czech National Bank and its long-standing governor Josef Tosˇovsky´ for pursuing too tight a monetary policy. Whereas Klaus and the

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ODS blamed the central bank for having caused the 1997 currency crisis, which put an end to their rule, Zeman and many CSSD politicians believed that the Czech National Bank had delayed the post-1997 economic recovery by putting too much emphasis on price stability. In this vein, the Zeman government’s report on the state of Czech society, published early in 1999, criticized the Czech National Bank’s commitment to monetary restriction as ‘the principal short-term cause of the deepening of the current economic crisis’ (cited in Myant 2003: 92). The tensions between Klaus, the Social-Democratic government and the Czech National Bank culminated in 2000 when the ODS and the CSSD tried to amend central bank legislation with a view to strengthening the competencies of the parliament and the cabinet vis-a`-vis President Va´clav Havel and the central bank. These attempts were in part driven by the strong dissatisfaction with the Czech National Bank. They were also part of a broader power struggle between the two big parties and President Va´clav Havel, who had strongly criticized the cooperation between the ODS and the CSSD from the beginning and had been at odds with Va´clav Klaus since the early 1990s. A major element of the ‘Opposition Agreement’ between the ODS and the CSSD was the commitment to curtail the constitutional competencies of the Czech President. However, President Havel rejected these plans. Ironically, the opportunity to limit central bank independence was provided by the need for harmonizing Czech central bank legislation with the acquis as part of EU accession. When this harmonization requirement entered the domestic agenda in early 2000, the ODS seized the opportunity and used the legislative process for bringing in its own proposals. The ODS aimed at limiting central bank independence by obliging the Czech National Bank to set its inflation target and the exchange-rate regime in agreement with the government and by subjecting its operational budget to parliamentary approval. It also sought to alter the appointment process by obliging the President to appoint board members who had been recommended by the government. The Zeman government accepted these proposals in June 2000. The envisaged amendments met strong resistance from the Czech National Bank, President Havel, the centre-right parliamentary opposition, and a number of individual CSSD and ODS members of parliament. These actors tried to capitalize on the concerns of the European Commission, which was quick to point out that the proposed amendments were not in line with the acquis and were thus putting the Czech Republic’s EU accession at risk. Interestingly, however, the involvement of the EU could

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not prevent the majority of ODS and CSSD parliamentarians from passing the law in the first place, and from overriding Havel’s veto and the rejection by the second chamber. The conflicts between the ODS and the CSSD, on the one hand, and the Czech National Bank and President Havel, on the other, further heightened when Havel appointed a new central bank governor in November 2000. The resignation of governor Tosˇovsky´, who had accepted a new position at the Bank for International Settlements, gave Havel the chance to appoint a new governor before the enactment of the new law, that is, under the old rules of appointment. Havel seized this opportunity and made the Czech National Bank’s deputy-governor Zdenek Tu˚ma the new governor. While the ODS and the CSSD did not question the chosen candidate, they criticized Havel’s decision on procedural grounds. By taking the appointment of Tuma to the Constitutional Court, they provoked ‘the most serious constitutional conflict in the Czech Republic’s short existence’ (Myant 2003: 112). The conflict over the Czech National Bank was eventually solved by the Constitutional Court, which declared the controversial amendments unconstitutional and confirmed the appointment of Tu˚ma. The controversies over Czech central bank legislation in 2000–01 appear to offer a good example of ‘bottom-up’ Europeanization, showing how domestic actors can use EU conditionality as an argumentative weapon. In contrast, the Czech case is less clear with regard to ‘top-down’ Europeanization. Signals and interventions by the EU could not prevent the parliamentary approval of a central bank law that was not in line with the acquis. It is not clear what would have happened if the Constitutional Court had not killed the law. It seems, however, that the quick petering out of the controversies over central bank independence after the Court’s decision was partly due to the awareness that EU accession would in any case have required abandoning those parts of the central bank law that the Court had overruled. Moreover, there have been no serious subsequent attempts at questioning the independence of the Czech National Bank. Taking this change in debate into account, the Czech case thus also points to the power of ‘top-down’ Europeanization when there is a clear and specific EU template to download, as with monetary policy.

The Formulation of an EMU Accession Strategy Starting in 2001, the pressure on the Czech government to specify its plans for EMU accession increased. Interestingly, this pressure did not come so much from the EU. More important were the requests by international

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investors, most notably investment funds and banks, and by other international organizations such as the OECD, the World Bank and the IMF. As EU accession was approaching and other new member states were coming up with dates and strategies for Euro Area entry, these actors increasingly began to call for a clear EMU accession strategy. In this sense, Czech policy was caught up both in the global dimension of negotiating fit (see Rollo, Chapter 2 above), and in a contagion process (see Dyson, Chapter 1 above). However, before the 2002 parliamentary elections the Czech government refrained from formulating a strategy for Euro Area entry. In contrast to some other accession states, the Czech Republic’s 2001 Pre-Accession Economic Programme (PEP) did not mention a target date for EMU accession. The government’s reluctance was partly due to the lack of consensus on Euro Area entry within the government and between the CSSD and the ODS. Moreover, the forthcoming elections worked against any clear commitment to fiscal reform, a condition sine qua non for any credible strategy for EMU accession. In the run-up to the parliamentary elections in June 2002, the positions of major political actors on EMU accession remained relatively vague. The Christian Democratic KDU-CSL and the Liberal US-DEU committed themselves most strongly to a quick adoption of the euro. The CSSD also backed EMU accession but spoke of an accession in 2010–11. The ODS, which ran a EU-sceptic campaign, left it open how it would deal with the obligation to enter the Euro Area. After the 2002 elections, the formulation of a Euro Area accession strategy became a major political issue. The eventual presentation of a strategy took more than a year. It was preceded by complex negotiations within the newly formed centre-left government and between the government and the Czech National Bank. For different reasons, both the government and the central bank were interested in the formulation of a joint strategy. From the point of view of the government, the involvement of the Czech National Bank was a chance to benefit from the international reputation of the central bank and to enhance the credibility of the strategy in the eyes of investors. Moreover, the involvement of the Czech National Bank played an important role in the strategy of the new Prime Minister Vladimı´r Sˇpidla and the new Finance Minister Bohuslav Sobotka. Confronted with the double challenge of fiscal reform and EMU accession, they sought to turn EMU accession from a problem into a solution. Backed by the CSSD’s smaller coalition partners, the Christian Democratic KDU-CSL and the Liberal US-DEU, they began to use EU membership and EMU accession as a justification for the much-needed fiscal adjustment. By

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bringing in the Czech National Bank, with its insistence on fiscal reform, Sˇpidla and Sobotka hoped to strengthen their position within the government. The Czech National Bank had an interest in the formulation of a joint strategy as well. It hoped to get some concessions and guarantees in exchange for its cooperation with the government, most notably a clear commitment to fiscal reform and involvement in the major decisions regarding EMU accession. Given its strong fear of a currency crisis, the central bank was keen on ruling out any premature commitments, notably on ERM II entry, and ill-designed measures by the government. The fact that the Czech National Bank opted for a more cooperative approach than the Hungarian and Polish central banks can also be partly explained by the fact that its governor Zdenek Tu˚ma, a former academic, had a much weaker political background than Leszek Balcerowicz in Poland and Zsigmond Ja´rai in Hungary (cf. the chapters on Hungary and Poland). The forging of an agreement between the government and the Czech National Bank was delayed by fierce controversies within the government over fiscal reform. In their attempt at committing the government to fiscal reform, Prime Minister Sˇpidla and Finance Minister Sobotka faced strong obstacles, which highlight the tight constraints on the government’s reform capacity. A first obstacle was the strong opposition to fiscal reform from the trade unions and from within the CSSD. Echoing the concerns about a trade-off between nominal and real convergence, the reform opponents questioned the need for cuts in social spending and publicsector wages and warned against the negative effects of fiscal adjustment on economic growth. The opposition to fiscal reform manifested itself in different forms. The trade unions took to the streets. In the CSSD, reform opponents threatened to vote for a new party leader. Most importantly, part of the CSSD parliamentary party threatened to vote against some of the proposed measures. One of them even temporarily defected from the parliamentary group, thus ending the governing coalition’s formal onevote majority. A second obstacle to the passage of fiscal reform was the referendum on EU membership on 15 June, 2003. Given the strong Euro-scepticism in the Czech Republic, a rejection of EU membership was a real option. Against this background, the government feared to alienate voters by unpopular reforms and shied away from unveiling its final plans for fiscal reform before the referendum. The eventual approval of Czech membership in the referendum made it easier to announce unpopular reforms. With 77.3 per cent of the voters in favour of the Czech Republic’s EU accession, the

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referendum signalled a much higher support for the EU than expected (Hanley 2004b). By reducing the need to please voters, and by strengthening the authority of Prime Minister Sˇpidla within the CSSD, the referendum paved the way for the eventual move to fiscal reform. On 23 June, 2003, about a week after the referendum and almost a year after the installation of the new government, the government eventually adopted a programme for fiscal reform, which provided for a gradual fiscal adjustment and targeted a fiscal deficit of 4 per cent of GDP in 2006. More than two-thirds of the envisaged adjustment was to fall on the expenditure side and was to be achieved by cuts in spending, including public-sector wages and social outlays. The key elements of the programme went through parliament in the second half of 2003 (Ministry of Finance 2003; OECD 2005: 49–57). The programme provided for a substantial fiscal adjustment. Given the 2003 estimates, it reduced the fiscal deficit in 2006 by about 4 percentage points. At the same time, the adopted measures did not envisage a deficit below 3 per cent before 2008, thus effectively postponing Euro Area entry to the end of the decade. Given the resistance to reforms and the limited reform capacity of the centre-Left government, the government was not able to push through more ambitious measures. Moreover, it feared that a stronger fiscal tightening might dampen economic growth. The adoption of fiscal reform opened the way for an agreement with the central bank during the second half of 2003 (Czech Government and Czech National Bank 2003). The ‘Euro-Area Accession Strategy’ drew heavily on a paper presented by the Czech National Bank in December 2002 (Czech National Bank 2002). It emphasized the advantages of EMU accession and contained a clear commitment to Euro Area entry. Building on the government’s plans for fiscal reform, it targeted an entry ‘around 2009–10’ (Czech Government and Czech National Bank 2003: 7). The joint strategy also contained a number of concessions to the Czech National Bank. Echoing the central bank’s strong concerns about the risks of a premature participation in ERM II, it contained a clear commitment to the continuation of the bank’s inflation-targeting strategy and the minimization of the time spent in ERM II. In addition, it gave the Czech National Bank a strong voice in future decisions on EMU accession by involving it in a regular annual assessment of the state of convergence and the readiness of the Czech economy for EMU and ERM II. The formulation of the Czech EMU accession strategy highlights a number of interesting points. The fact that the pressure to formulate a

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strategy for Euro Area entry has come from international investors rather than from EU conditionality draws attention to the importance of both the global dimension and processes of contagion in negotiating fit. Furthermore, the strong involvement of the Czech National Bank and the concessions made to it by the government testify to the empowerment of central banks through EU and EMU accession. In addition, the attempts to instrumentalize EMU accession for the justification of fiscal reform illustrate the role of ‘bottom-up’ Europeanization. Finally, the struggles over fiscal reform and the formulation of an Euro-Area entry strategy show that the economic and political conditions have been unfavourable to quick EMU accession and have limited the effects of Euro Area entry on Czech domestic economic policy.

The Implementation of the EMU Accession Strategy The obstacles to a quick euro entry and the limited effects of EMU on Czech economic policy are also evident in the implementation of the EMU accession strategy. This applies to monetary and exchange-rate policies, fiscal reform, and structural reforms, although for different reasons. In monetary and exchange-rate policies EMU effects have been limited by the simple fact that EMU accession has not required major changes so far. The Czech entry strategy has allowed the central bank to stick to inflation targeting and to defer the move to a fixed exchange rate. In order to prepare for euro entry, however, the Czech National Bank announced a slight change in the inflation target in Spring 2004. From the beginning of 2006, the current inflation band, with a declining range from 3 to 5 per cent in January 2002 to 2 to 4 per cent in December 2005, will be replaced with a point target of 3 per cent with a þ/ 1 per cent tolerance band. The new target, which will apply until Euro Area entry, is supposed to help meet the inflation criterion. However, by taking Balassa– Samuelson effects into account, the new target is well above the inflation rate that is likely to be required by the Maastricht inflation criterion. As a result, it might lead to irritations about monetary policy in the run-up to EMU entry (OECD 2005: 92–4). In fiscal reform EMU accession strategy and the underlying programme of fiscal reform have required more substantial policy changes. Upon EU accession, the Czech Republic became subject to the provisions of the Stability and Growth Pact. Immediately, in May 2004, the European Commission launched the excessive deficit procedure against the Czech

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Republic and forced the Czech government to specify its plans for fiscal reform. This action provoked controversy in the Czech Republic. Whereas the government took the launching of the procedure and the quick agreement with the EU as a confirmation of its reform measures, the critics of EMU and a quick Euro Area entry attacked the EU ‘straitjacket’. Since the passage of the EMU accession strategy, the impact of EMU on fiscal policy has been weakened by stronger than expected economic growth. The acceleration of economic growth in 2004 allowed the government to meet its fiscal targets without fully implementing the 2003 reform programme. This fiscal over-performance, symbolized by the unexpected temporary fulfilment of the Maastricht deficit criterion in 2004, reduced the incentives to continue reforms. Incentives to slow down fiscal reform were strengthened by the political situation. The elections to the European Parliament in June 2004 and the forthcoming parliamentary elections in June 2006 reduced the incentives to tackle controversial issues. Moreover, the political turbulences in 2004–5 reduced the government’s capacity to act. Following the bad showing of the CSSD in the elections to the European Parliament, Prime Minister Sˇpidla was ousted by his own party. Less than one year later, his successor, Stanislav Gross, after some dithering, fell victim to a financial scandal. Given the incentives produced by these favourable economic and unfavourable political conditions, the government slowed down fiscal reform. Despite the acceleration of economic growth, it confined itself to minor changes in the fiscal targets. Reacting to the initiation of the excessive deficit procedure in May 2004, the government reduced the fiscal target for 2006 by a mere 0.2 percentage points. Instead of seizing the opportunity to tackle the country’s medium-term fiscal problems and to speed up fiscal convergence, it postponed part of the originally envisaged reforms, most notably in the fields of pensions and health care. In structural reforms, the Czech EMU accession strategy has been relatively vague. While the strategy emphasized the need for increasing labour-market flexibility in order to compensate for the future constraints on economic policy in EMU (Czech Government and Czech National Bank 2003: 7), it did not specify any particular reform measures. For this reason, the direct effects of EMU accession on structural reform have been limited. The indirect effects have been relatively weak as well. Compared to other points of reference such as the EU Lisbon Strategy or international trends, the prospect of EMU accession and the resulting constraints on macroeconomic policy have played a relatively subordinate role in public ¨ ttpelz 2004). debates on labour-market reform (Schu

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Conclusions This chapter has examined how Czech policymakers have dealt with the obligations, challenges, and opportunities associated with EMU accession and negotiated fit between external pressures and domestic constraints. In line with the findings in other contributions to this volume, the chapter has identified a number of effects of EMU accession on the making of economic policy and on economic policy itself. These effects include the empowerment of the Czech National Bank and a strengthening of certain reform-orientated actors, most notably the Finance Minister. Part of the effects has stemmed from formal accession conditionality; part from market pressures and peer group effects (see Dyson, Chapter 1 above). What is interesting in the Czech case are the limits to ‘EMUization’. The choice of the strategic option of postponement of EMU accession has strongly reduced the domestic adaptational pressures, and thus the effects of EMU on economic policy. As the analysis has shown, three domestic factors lie behind the choice of this strategic option and explain why the willingness and the ability of major political actors to go for a quick Euro Area entry has proved limited—the strong economic challenges associated with EMU accession in the Czech case, the prevailing pessimism about the costs and risk of EMU accession among the elites, and the limited reform capacity of the post-1998 governments. From a comparative perspective, the Czech case shows some similarities with the Hungarian and the Polish cases. This similarity involves the size of economic challenges and the domestic constraints on the governments’ reform capacity. Unlike the Baltic States, these three accession states have faced the strong challenges of cracking down on fiscal deficits and of overhauling exchange-rate policy in the run-up to EMU accession. Moreover, political conditions in all three countries have been rather unfavourable to the launching of fiscal reform, the key precondition for a speeding up of EMU accession. However, political conditions have been unfavourable for different reasons. In Poland and the Czech Republic, the capacity of governments to engage in unpopular reforms has been limited by unstable majorities, a weak core executive, and a high degree of EU scepticism on both the mass and the elite levels. In contrast, the main problem in Hungary has been the strong political polarization between the two main political camps.

177

9 The First Shall Be the Last? Hungary’s Road to EMU Be´la Greskovits

In 2004, the Hungarian government announced that it might not introduce the euro before 2010. This development was surprizing given that professional observers had predicted, and the National Bank of Hungary planned, a much more ambitious entry date, 2006. Why has the former pacesetter, Hungary, become a laggard? Why did Hungary fall so far short of compliance with most of the macroeconomic convergence criteria for euro entry? Analysts point either to the government’s unwillingness or incapacity to tighten fiscal policy or to the lack of coordinated fiscal and monetary policies as the direct causes of failure. In turn, they tend to identify the cause of the incoherent policies in the absence of political consensus behind a credible national strategy for euro entry. The explanation that is developed in this chapter also underlines the importance of absent political consensus. However, it shows that the Hungarian case does not confirm standard expectations about the identity, strategy, and rhetoric of the opponents of a radical euro entry strategy. Comparative studies of the politics of EMU in post-communist accession states tend to blame defensive business lobbies inherited from state-socialism, contentious trade-union movements, and Euro-sceptic populist parties for missed opportunities of early EMU membership (EIROnline 2004). None of these actors seems to be prominent in Hungary. The high level of Western integration of the Hungarian economy undercuts the influence of traditional protectionist lobbies. Trade unions rarely engage in confrontation. All major Hungarian political parties consider euro entry as a national priority. Open Euro-scepticism is virtually absent, except in

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The First Shall Be the Last? Hungary’s Road to EMU

marginal radical Right and Left parties. Given that these key conditions seem to predestine Hungary for early Euro Area membership, the opposite outcome seems puzzling. If, as is commonly assumed in Hungary, joining EMU as early as possible is beneficial for economic development, and the usual pattern of opposition does not apply, why has the Hungarian political system failed to generate support for a rapid entry? The chapter argues that this fiasco stems from the contradictory preferences of government and opposition about the sequencing and the timing of the Hungarian entry strategy. A second related argument is that, although Euro-sceptic discourses were disqualified, a specific kind of populist rhetoric, characterized here as ‘Euro-populism’, proved to be an effective weapon in the hands of opposition. Third, the trench warfare between the two equally strong political groups did not emerge in a social vacuum. Their contradictory positions capitalized on, and further deepened and politicized, existing cleavages between economic interest groups, top policymaking institutions, opinion-forming intellectuals, and the society at large. In effect, the politics of euro entry was shaped by two domestic advocacy coalitions, competing for power over policy (Sabatier 1991). Finally, the struggles around the politics of euro entry intensified at a time when Hungary’s development reached a crossroads, defined by the exhaustion of its earlier labour-intensive export path and a new path that requires industrial upgrading. Economic restructuring constituted a deeper problem at work in Hungary’s euro entry strategy: namely the compatibility of a radical entry strategy with the tasks of a shift to a more promising trajectory of economic development. Section 1 sketches the political economy of the major economic groups whose views about the details of preparation for EMU have shaped the policy debate significantly. It investigates how, around the 2002 elections, their demands interacted with the political agendas of main political actors, the conservative Alliance of Young Democrats–Hungarian Civic Alliance (FIDESZ–MPSZ) and the Hungarian Socialist Party (MSZP). Section 2 demonstrates how the political parties, business associations, financial institutions, and public intellectuals took sides in the intensifying conflict around core issues and events. These included the appropriate interest rate and exchange rate of the Hungarian Forint (HUF), the scope, speed and direction of fiscal reforms, and the relationship between the government and the central bank (National Bank of Hungary). The section discusses the accompanying political processes: the ensuing reversal of fortune of rival political forces, and the crisis of the old government, and the tactics of its successor in 2004.

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Rival Interest Groups and Polarized Politics How far were key Hungarian economic actors prepared to absorb the shocks associated with a fast entry to the Euro Area? For an answer, it is critical to understand how the earlier stabilization policies of the SocialistLiberal government (the Bokros package) and the later Conservative (FIDESZ–MPSZ) programme of fiscal expansion shaped the Hungarian political economy.

Legacies of the ‘Bokros Package’ and of the ‘Hungarian Model’ In March 1995, faced with mounting current account and budget deficits, Gyula Horn’s MSZP-Alliance of Free Democrats (SZDSZ) coalition government launched a stabilization programme named after its architect, Minister of Finance Lajos Bokros. The Bokros package included a 9 per cent devaluation, a temporary 8 per cent surcharge on imports, and a crawling peg exchange-rate regime with pre-announced depreciation rates for the forint. These policies were accompanied by measures of fiscal austerity cutting real wages and consumption, and by plans for the comprehensive restructuring of the public sector. Public sector reforms were partly abandoned later. However, the package enforced a significant redistribution of incomes from labour to capital, from consumption to investment, and from producers for the domestic market to exporters. The Bokros package was linked to impressive results in stimulating exports and restructuring. The share of labour-intensive manufacturing exports in GDP grew significantly. In the most dynamic electrical and electronics industries a division of labour emerged between major transnational corporations and domestic businesses. Attracted by low labour costs and generous subsidies, transnational corporations relocated labourintensive production to Hungary, while many domestic firms became their subcontractors. This boom lasted only as long as three conditions were met: a prosperous world economy, a depreciating forint, and low wages. Usually Hungarian suppliers’ contracts with the transnational corporations were set in euro, while they had to pay wages and other costs in forint. For this reason, they became staunch defenders of the crawling peg instituted by Bokros. Furthermore, by a one-off sharp increase in inflation the Bokros package achieved a deep cut in real wages. Otherwise, inflation—albeit at a falling rate—persisted over the second half of the 1990s, and in this inflationary environment wage setting followed a pattern of negotiated wage index-

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ation. Nominal wage increases were relatively easily achieved, but real wage growth was slow (He´thy 2000: 19). Thus, in the export sector, business and labour were not interested in rapid disinflation; they aligned around policies that reproduced inertial inflation and that minimized their conflicts. In this context neither practices of wage moderation nor a tradition of negotiating social pacts, implying long-term strategic thinking, could fully develop. In short, the Bokros package gave birth, shape, and strength to the labour-intensive export interests that, after 2001, vigorously opposed policies of currency appreciation and disinflation. Another of its legacies proved a political obstacle to future attempts at fiscal reform and austerity. The welfare shock of the Bokros package represented a lasting nightmare for Hungarian society, and produced an enduring loss of trust in Socialists’ and Liberals’ sensitivity on issues of social welfare. This public mistrust contributed to the Conservative (FIDESZ–MPSZ) electoral victory in 1998, and lent some credibility to Prime Minister Viktor Orba´n’s claim in 2001 that his ‘Hungarian model’ was superior to the Left alternative, even in social welfare. What was the Hungarian model? In Orba´n’s interpretation it combined growing output and employment with improving macroeconomic fundamentals, despite unfavourable external conditions. More specifically, Orba´n identified it with a set of policies designed partly to counter the negative impact of world recession, partly to pave Hungary’s road to EU accession, and partly to secure a next term for FIDESZ–MPSZ in the 2002 elections. The problem that his Conservative government had to face after 2000 was that the recession increasingly undermined the viability of Hungary’s labour-intensive export path. Cut-throat competition forced many transnational corporations to close their local operations and move further to the east. The policies of the Hungarian model did not offer much relief to local export businesses. On the contrary, the Orba´n government raised minimum wages twice, by altogether 80 per cent, leading to an economy-wide wage drift. Second, with EU-accession in 2004 (and planned Euro Area membership in 2006) creating new time pressures, in Spring 2001 Orba´n appointed his minister of finance, Zsigmond Ja´rai, as president of the National Bank of Hungary. Ja´rai replaced the crawling peg with a system of flexible exchange rates. The forint was allowed to float within a 30 per cent band around its central parity against the euro. The National Bank of Hungary also introduced a policy of inflation targeting and used the exchange rate as a tool of disinflation. It had three instruments at its disposal: verbal warnings to policymakers to pursue disinflation, the

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interest rate, and open market intervention. Due to expectations of EU accession and the new policy, the forint appreciated by 9 per cent between May 2001 and April 2002. Shocked by the combined effects of recession, increasing wages, and the shift in exchange-rate and interest-rate policy direction, exporters were sharply critical. However, the Orba´n government no longer considered that the labour-intensive export economy was the main engine of growth. Instead, it boosted domestic output and consumption by fiscal measures. Large-scale development programmes for transport infrastructure, tourism facilities, and public construction were launched. Additional growth stimuli came from generously subsidized loans for residential construction and renovation for middle and uppermiddle class home builders and from the ‘Sze´chenyi plan’, which combined existing with new incentives for domestic small and medium-sized businesses, local communities, and individuals. Like the Bokros package, the Hungarian model gave birth to its own beneficiaries. Its ‘offspring’ included property and construction businesses, and other producers of ‘non-tradeables’. Similarly, the petrol mon´ NIT, the telecommunications opoly MOL, the property developer TRIGRA ´ monopoly MATAV, and the top savings bank OTP benefited from a strong forint either as large-scale importers or, increasingly, as transnational investors in neighbouring countries. While the appreciating forint did not pose any problem for these economic interests, they pressed for fiscal consolidation by large-scale structural reforms, notably cuts in public administration, education, and the social welfare system that would allow them to pay lower taxes and social security contributions. Even before Hungary joined the EU in 2004, increasing sensitivity to the distributional impact of preparation for euro entry divided Hungarian society. The cleavages were not idiosyncratic features of the Hungarian economy. Rather, they are consistent with theoretical expectations about the socio-economic bases of support and opposition to preparations for Euro Area entry (Frieden, Gros, and Jones 1998; Frieden 2002). However, what seems to be specific is the early articulation of these interests and (especially after the 2002 elections) the intensity of resulting conflicts. They indicate that the stakes in policy choice might have been higher in Hungary than other accession states. This idea gains support from evidence about the pioneering role of Hungarian businesses as specialists in transnational, labour-intensive export industries as well as early capital exporters (Table 9.1). The political problem was how to reconcile conflicting interests in a weak versus strong Hungarian forint, in low versus high interest rates, and

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The First Shall Be the Last? Hungary’s Road to EMU Table 9.1. Transnationalization of selected ex-socialist economies Cumulative FDI-inflows per capita (1989–99, USD) Czech Republic Estonia Hungary Poland Slovak Republic

Outward FDI flows (1997–9, mn USD)

Selected labour intensive goods’ share in total exports (1997–9, per cent)

1447

301

17.8

1115 1764 518 391

217 1096 326 259

27.6 39.3 26.1 17.2

Sources: Column 1: Transition Report 2000. European Bank for Reconstruction and Development: 74. Column 2: Transition Report 2000. European Bank for Reconstruction and Development: 92. Column 3: Author’s own calculation based on the COMTRADE database of the United Nations Statistics Division. http://intracen.org/tradestat/sitc3-3d. Labour-intensive goods considered are electronics and electrical (SITC 75,76,77), furniture, garment, and footwear products (SITC 82, 84, 85).

in low wages versus expanding domestic consumption. Given the fact that actors with considerable influence on future development expressed both sets of preferences, the crucial question was the ability of the Hungarian political system to balance these demands. It also became an issue in which the National Bank of Hungary became embroiled. In short, Europeanization of Hungarian economic and monetary policies through EMU became intensely political.

Euro-Populism and the Programme of ‘Transformation with Welfare’ How much were key Hungarian political actors ready to create an atmosphere in which acceptable compromises regarding the details of EMU entry strategy could be achieved, and a deadlock avoided? After the 1990s, the Hungarian political system began to consolidate as an essentially two-party democracy, in which both FIDESZ–MPSZ and MSZP have been capable of mobilizing large electoral blocks. Two minor parties, the conservative Hungarian Democratic Forum (MDF), and the liberal Alliance of Free Democrats (SZDSZ), could gain seats in the Parliament only in coalitions with the dominant parties. In this context both major parties were aware that, in order to win the 2002 elections, they had to compete for the centre vote and supporters from the opposite camp (Downs 1957). Therefore, in the campaign they tried to appear credible on the two issues that seemed important for the majority: social welfare and the issue of EU membership.

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The marginal loss of the 2002 elections to the Left-liberal coalition led by MSZP caused FIDESZ–MPSZ to learn some important lessons. First, the poor showing of the nationalist Party of Hungarian Justice and Life (MIE´P) taught them that Euro-sceptic nationalism was a non-starter. Given the sentiments of centre-Right and centre-Left voters alike, opposition rhetoric had to be pro-European in order to be attractive. Second, the popularity of the MSZP’s new prime minister Pe´ter Medgyessy’s ‘government of the national centre’—which after the electoral victory implemented large salary increases in the public sector—led FIDESZ–MPSZ to recognize the importance of welfare issues and the potential of social demagoguery. Their post-election strategy of ‘Euro-populism’ drew on both these lessons. On the one hand, it was populist in the sense that it supported Medgyessy’s programme of ‘transformation with welfare’ but vehemently opposed any attempt to secure its financing by accelerated privatization, increased taxes or public spending cuts. Opposition rhetoric stigmatized these attempts as preparations for a new Bokros package. On the other hand, this populism was disguised as a demand for Europeanization. FIDESZ–MPSZ urged an accelerated catching up with European wage and pension levels, and argued that the government’s privatization ‘overdose’ ran counter to the European pattern of a mixed economy. The political debate on the appropriate strategy for euro entry opened up a domestic opportunity for the conservative-led opposition to simultaneously demonstrate the administration’s incompetence in ‘Europeanizing’ Hungary and in mitigating the temporary adverse welfare consequences of euro entry. Polarized preferences pitted the opposition against the government on both the desirable policy sequence and the desirable timing of euro entry. On policy sequence, the Medgyessy government made fiscal adjustment conditional on relaxed monetary policies. It argued that lower interest rates, a weaker forint, somewhat higher inflation, and less depressed growth could reduce the magnitude of shocks to competitiveness and to welfare, and enhance actors’ capacity to gradually adjust. In contrast, FIDESZ–MPSZ backed the president of the National Bank of Hungary, who insisted on the opposite conditionality. Ja´rai made the relaxation of monetary policy conditional on convincing results in fiscal tightening. Otherwise, the central bank’s disinflation target would be threatened. For political reasons of domestic electoral and party competition, the opposition was eager to see the Medgyessy government trapped between unpopular fiscal adjustment and a failure to comply with the macroeconomic convergence criteria, allowing them to

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simultaneously attack it for lack of sensitivity to social welfare considerations and for incompetence in leading the country to euro entry. On the issue of timing of euro entry, similar considerations of domestic electoral and party competition prevailed. FIDESZ–MPSZ’s original plan for entering the Euro Area as early as 2006 created a straitjacket for the new Left-led coalition government in 2002. In committing to ERMII entry in 2004, the plan required fiscal adjustment soon after the election victory but without the consoling perspective of being able to pacify aggrieved voters by pre-election spending in 2005–6. The early entry date meant that the coalition was compelled to do the ‘dirty job’ of complying with the Maastricht convergence criteria, and as a consequence risked defeat in the next elections. In this case FIDESZ–MPSZ, the ‘free rider’ in the hard times of preparation, was going to reap the rewards from the coalition’s efforts and introduce the euro in 2006. In short, FIDESZ–MPSZ had a domestic electoral and party interest in urging early entry, and the government in delaying entry, to the Euro Area. Given a combination of conflicting economic and social interests with polarized political interests and strategies, by 2002 the stage was set for protracted trench warfare between two major advocacy coalitions and for an ensuing volatility, incoherence, and drift of policies. Hungary’s euro entry strategy was caught up in a divisive process of ‘bottom-up’ Europeanization, in which different domestic actors used Euro Area accession to open up new opportunities in electoral and party competition (Dyson 2002, Dyson and Goetz 2003). The result was a politics of Euro-populism, deadlock and drift. The FIDESZ–MPSZ opposition tried to achieve domestic political gains by highlighting and criticizing ‘misfits’ between Hungarian government policies and the requirements of adapting to the EU. Specifically, it contrasted the goal of rapid nominal convergence that was being pursued by the National Bank of Hungary— which it presented as the sole guardian of the ‘European stability culture’ in Hungary—with the government’s inability to disinflate the economy. At the same time, the government’s attempts at fiscal austerity were attacked on the basis of their incompatibility with the requirement of real convergence towards the ‘European social model’ in wages and social policies. Both policy sequencing and timing became politicized.

The Politics of Policy Drift in 2002–4 The period 2002–4 brought about intense mobilization by both advocacy coalitions, into which an increasing range of important Hungarian

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business associations, core technical elites, opinion-forming intellectuals, and even holders of non-partisan public offices were drawn.

Taking Sides: The Controversy over Central Bank Independence Disregarding Medgyessy, who in the 2002 election campaign asked the National Bank of Hungary to devalue the forint by narrowing the flotation band, Ja´rai raised the interest rate right after the election. The new government saw this as political provocation, and the export sector as utterly harmful. Interestingly, the biggest transnational corporate players like Philips, Audi, Nokia, Suzuki, and General Electric remained remarkably silent and neutral in the intensifying policy debate. Their behaviour might be explained by their relative independence from domestic policy contexts and their impact. Hungarian interest rates did not really affect their strategic calculations since they financed their operations primarily from international markets. Neither was the high exchange rate a crucial concern for them. They competed less on the basis of price than of quality, product differentiation, and consumer services. Second, as major importers of intermediate goods, machinery and equipment, their gains from the strong forint mostly compensated for their losses as exporters of final products. In contrast, strong criticism was voiced by Ga´bor Sze´les, VIDEOTON’s owner, and the president of the National Alliance of Employers and Industrialists (MGYOSZ), the top association of exporting and importcompeting domestic businesses. In his view, Ja´rai’s policy undermined the competitiveness of exporters and favoured nobody but speculators. Sze´les demanded a tripartite negotiation of government, the National Bank of Hungary, and MGYOSZ to determine a more appropriate exchange rate (NOL 2002: June 7). While the government refused to mention any concrete entry date in its medium-term strategy paper, Ja´rai continued making policy with the year 2006 in mind. In July 2002 he warned about the inflationary consequences of the promised 50 per cent salary rise for public employees and raised the interest rate again. During the summer the Parliament amended the National Bank of Hungary Act, despite FIDESZ–MPSZ’s allegations that this was a violation of EU standards on central bank independence. The amendment extended government authority to all of the key aspects of exchange-rate policy: the determination of the forint’s central parity, the content of the currency basket, and the width of the band. Moreover, the National Bank of Hungary was to be controlled by creating an extra supervisory board. The role of ‘top-down’ compliance with EU law and

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norms in differentially empowering Hungarian policymakers is revealed by the way in which Ja´rai could recruit the European Central Bank to buttress his own position and back his ideas on central bank independence and domestic policy reform. The ECB publicly criticized the intervention as inconsistent with the legal convergence in central bank independence required for EU accession (HVG 20 July, 2002). Subsequently, the conflict between the Medgyessy government and the National Bank of Hungary over the sequencing of policy reforms for euro entry, namely whether fiscal tightening or monetary relaxation came first, escalated. This issue became more pressing as a combined result of increased public spending before and after the elections, the introduction of EU-consistent public accounting practices (ESA95), and a growing budget deficit. While the government overspent, the FIDESZ–MPSZ opposition behaved as a staunch defender of the social groups neglected by the coalition. At the same time the opposition failed to clarify how it would finance its own extra spending proposals. In late autumn, at the anniversary conference of one of the policy research institutes, a wide array of conflicting views were voiced. Csaba La´szlo´, the minister of finance, predicted that the budget deficit would not exceed 4.5 per cent in 2003, and asked the National Bank of Hungary to ¨ rgy lower the interest rate. Former National Bank of Hungary president Gyo Sura´nyi argued that there was no need to rush to euro entry. He believed that it would be a mistake to hurriedly dress the Hungarian economy in the straitjacket of the Stability and Growth Pact. The pressures of real economic processes were going to reveal the shortcomings of this artificial framework anyway, and sooner or later the EU itself would be forced to alter it. However, the National Bank of Hungary’s vice-president Riecke Werner rejected these views and insisted on the urgency of disinflation and early euro entry (NOL November 14, 2002). Ja´rai defended his policy no less stubbornly at a meeting with the largest exporters. In early December 2002, Hungarian economic interests organized a frontal attack on the National Bank of Hungary. In a coordinated move that was unprecedented in the history of the Hungarian transition MGYOSZ and four other business associations signed a petition demanding Ja´rai’s resignation, a 5–10 per cent depreciation, and a representation for actors of the ‘real economy’ in the central bank’s monetary council. Sze´les claimed to represent the view of many entrepreneurs when he asserted that the central bank’s policy was harming output, profits, and employment without successfully taming inflation. Two ministers publicly shared these concerns. However, two major associations, including the National Federation of

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Entrepreneurs and Employers (VOSZ), did not take part in the protest action. Similarly, the president of the State Supervisory Board of Financial Organ´ F), appointed under the Orba´n administration, criticized izations (PSZA MGYOSZ for undermining the independence of the National Bank of Hungary. The FIDESZ–MPSZ parliamentary party leader also defended Ja´rai on the grounds that a strong forint and early euro entry were in the interest of all Hungarians, whereas incoherent government policy damaged the economy. The conflict peaked at a debate before the Parliament’s economic committee, which was richer in political blame-shifting than in professional arguments. Sze´les criticized Ja´rai for appointing his own intimates to the monetary policy council. Ja´rai stressed the inflationary impact of an ‘outrageous’ budget deficit. He rejected the accusation that the high interest rate facilitated speculative ‘hot-money’ inflows and explained Hungary’s increasing attraction for short-term investors solely motivated by the prospect of EU membership (NOL 5, 6, 7, 10, 13 December, 2002). In the early years of transition such grave discontent would have most likely ended Ja´rai’s career as president of the National Bank of Hungary. However, in 2002, the policy deadlock could not be resolved by Ja´rai’s resignation or removal, despite continuing political allegations of his abuse of institutional independence for partisan decisions. Earlier Hungarian prime ministers dismissed central bankers or readily accepted their ‘voluntary’ resignation if they appeared not loyal or cooperative enough. Indeed, appointments of new National Bank presidents and efforts to strengthen central bank independence occurred in a revealing sequence. ‘Unreliable’ presidents were not allowed to enjoy the longer terms in office, legally better protected jobs, and enhanced policymaking authority guaranteed by the more and more Europeanized central bank laws. Rather, advances to stronger central bank independence typically favoured and empowered their ‘party-loyalist’ successors. Hence, the re´ kos Bod of MDF in 1991 ¨ rgy Sura´nyi by Pe´ter A placement of president Gyo coincided with the passing of the first National Bank of Hungary Act, which limited (though without entirely abolishing) the bank’s role in financing fiscal deficits. Similarly, Gyula Horn’s Left-led coalition started its term in 1994 by replacing Bod with Sura´nyi, whose authority was not questioned as long as the Horn government was in power. Although Sura´nyi served his term, by its end, he was vehemently attacked by Orba´n’s minister of finance, Ja´rai. While Sura´nyi helped to prepare the new act of June 2001 that further strengthened central bank independence, and declared direct financing of the public deficit by the National Bank no longer possible, the new EU-compliant law empowered his successor Ja´rai.

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All in all, since the Europeanization of Hungarian policymaking made its effect felt in enhanced central bank independence, firing became less feasible, and central bankers tended to outlive not just ministers of finance but even prime ministers. ‘Top-down’ compliance—in peculiar interaction with domestic partisan considerations—was at work in central bank independence and in the longer ‘life-span’ of central bankers (Table 9.2). National Bank of Hungary presidents also became increasingly influential in appointing members to the central body for strategic monetary decisions. According to the first National Bank of Hungary Act of 1991, the monetary council included the president (appointed for six years), five vice-presidents, and ten additional members (appointed for three years) of which five were nominated by the president and five by the prime minister. However, the new central bank act of 2001 empowered Ja´rai to nominate all eight members of the monetary council for six years,

Table 9.2. Hungarian prime ministers, ministers of finance and central bank presidents (1990–2005)

Premiers

Term in office MoF

Jo´zsef Antall

May 1990– Nov. 1993 Dec. 1993– June 1994 July 1994– June 1998 July 1998– May 2002 June 2002– Aug. 2004 Sept. 2004–

Pe´ter Boross Gyula Horn Viktor Orba´n Pe´ter Medgyessy Ferenc Gyurcsa´ny

30 Months in office (average)

Ferenc Raba´r

National Bank of Hungary Term in office president

May 1990– Dec. 1990 Miha´ly Kupa Jan. 1991– jan. 1993 Iva´n Szabo´ Feb. 1993– June 1994 La´szlo´ Be´kesi July 1994– Feb. 1995 Lajos Bokros March 1995– Feb. 1996 Pe´ter Medgyessy March 1996– June 1998 Zsigmond Ja´rai July 1998– Dec. 2000 Miha´ly Varga Jan. 2001– May 2002 Csaba La´szlo´ June 2002– Feb. 2004 Tibor Draskovics March 2004– April 2005 Ja´nos Veres May 2005– 18

Term in office

Gyo¨rgy Sura´nyi May 1990– Dec. 1991 Pe´ter A´kos Bod Jan. 1992– Dec. 1994 Gyo¨rgy Sura´nyi Jan. 1995– Dec. 2000 Zsigmond Ja´rai Jan. 2001–

45

Sources: Magyarorsza´g Politikai E´vko¨nyve (Yearbook of Hungarian Politics) Budapest: Demokra´cia Kutata´sok Magyar Ko¨zpontja Alapitva´ny. Various volumes. Heti Vila´ggazdasa´g April 23, 2005: 8.

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while the prime minister retained a right of veto (Gyenis 2004; Va´rhegyi 2004).

Policy Controversy in the Shadow of Speculative Attacks ‘Hot-money’ inflows magnified by January 2003, and the exchange rate of the forint closely approached the top end of its trading band. Ja´rai resisted any significant lowering of the interest rate until it was too late. Government technocrats, and even independent experts and some monetary council members, criticized his intransigence as unnecessary and harmful. However, speculators interpreted Ja´rai’s stubbornness as a signal of his acceptance of further appreciation beyond the limit of the band. When finally the National Bank of Hungary started to buy euros at the intervention rate, speculators tested the seriousness of its commitment for two consecutive days, and forced it to purchase more than 5 billion euros. If a decision were taken to widen the band and with further appreciation, this sum could have been bought back at an even higher forint rate: this was the logic of speculation. However, the financial markets overlooked an important factor. According to the amended National Bank of Hungary Act of July 2002, Ja´rai could not alter the band at will, without the prime minister’s approval. As nothing was more against the government’s vital interest than an even stronger forint, it apparently rejected changing the exchange-rate regime. The speculative attack could only be stopped by coordinated government– National Bank of Hungary measures to lower the interest rate by 2 per cent and to restrict by various administrative means the flow of ‘hot money’ (Csabai 2003a, 2003b; Va´rhegyi 2003). Until June 2003 the National Bank of Hungary regularly intervened, even within the fluctuation band, and gradually got rid of its accumulated euro balances. Just half a year later a second, equally threatening crisis situation emerged. However, the government, the National Bank of Hungary, domestic pressure groups, and foreign speculators acted in different roles and aligned in different configurations. This time, the initiative lay with the Medgyessy government. In early June 2003 minister of finance La´szlo´, referring to a consensus between the government and the monetary council, announced a band shift, practically a 2 per cent devaluation, as well as a fiscal austerity package that included a 2.5 per cent cut in ministry budgets across the board, stricter eligibility criteria for housing loan subsidies, and wage policy constraints in the public sector. These measures were meant to achieve improvements both in export competitiveness and in the budget-

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ary position against the background of deteriorating economic performance. The National Bank of Hungary agreed with the fiscal correction, but was less enthusiastic about the negative implications of the weakening of the forint for its policy of inflation targeting (NOL June 5, June 28, 2003). Once again the government and the National Bank of Hungary were not speaking the same language, and their lack of consensus shook financial markets’ trust in the Hungarian economy. It took time and a drastic rise in the interest rate before the forint was stabilized against speculative attacks that, on this occasion, probed the lower end of its band. The return of financial market speculation was not the only challenge that the Medgyessy government had to face. In a much debated interview in Summer 2003 Sa´ndor Demja´n, executive president of VOSZ, a lobby group of many businesses in tourism, commerce, construction and real estate, attacked the government for fiscal laxity and delaying large-scale structural reforms to the budget. ‘It is bitter to realize that the first shall be the last, but precisely this has happened to Hungary. In the past six months FDI inflows declined to African levels’. As a remedy Demja´n proposed a return to the basic idea of the Bokros package, namely radical cuts in public spending, and attacked the system of education as a large pocket of waste. ‘Hungarian higher education increasingly over-educates, while skilled workers are in short supply. . . there is a need for radical steps in education, narrowing the range of specialization of higher studies, and fast advances in vocational training.’ (interview, NOL 8 July, 2003) Demja´n’s ideas were further concretized by Ferenc Parragh, president of the Chamber of Commerce and Industry (MKIK). He urged the government to cut public expenditure by 200–300 billion forint (about 3–4 times the amount foreseen in the ministry of finance’s package) and to axe 50,000–70,000 public-sector jobs (NOL 9 July, 2003). Apparently, by 2003 the developmental vision of the ‘offspring’ of the Hungarian model revealed much less sensitivity for social welfare issues than the left-leaning rhetoric of FIDESZ–MPSZ. Parallel to the above suggestions some scholars and policymakers identified a European template of negotiated industrial relations (‘new corporatism’) and advocated a European-type social pact to pave the way towards EMU. Borrowing from Dutch and Irish experience, they argued that unionized public-sector workers should accept short-term wage restraint in exchange for longer-term gains in employment and wages. They characterized this solution as preferable to its alternative: ‘if financial market actors consider the Hungarian economy too risky. . . they will refrain from investment. Disinvestment might provoke sharp depreciation, accelerated

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inflation, and erode previously achieved real wage gains’ (Bruszt, Obla´th and To´th 2003).

An Old Government Toppled by New Problems, and a New Government Struggling with the Old Problems Faced with so many pressures and so much advice the government was inclined to postpone decisive action. Essentially, Medgyessy gave up both the programme of ‘transformation with welfare’ and comprehensive fiscal and structural reforms. The pension reform, which after a promising early start under the Horn government was partly reversed by Orba´n’s policymakers, did not return to the fast track under Medgyessy. There was no decisive advance in the reform of the health care system either. The reasons may include reform fatigue, resistance from interest groups, and perhaps the fiscal burden that such reforms, in the short term, imply. However, according to the EBRD’s transition indicators, Hungary is not a laggard but a leader in most other aspects of market institution-building and labour market flexibility. Medgyessy’s attempts at piecemeal reforms—cutting spending on welfare and public services and increasing revenues from taxes and privatization—met passionate opposition protests. Indeed, in 2004 FIDELITAS (a youth organization close to FIDESZ–MPSZ) went as far as initiating a referendum to block the coalition’s privatization plans. Furthermore, in December 2004 the conservative opposition supported (and lost) another referendum initiated by the radical left-wing Workers Party in order to stop private capital inflows into Hungarian hospitals. A ‘social pact’ solution was ruled out by the lack of experience with voluntary wage restraint, a tradition of eroding nominal wage gains by inflation and taxation, the government’s evaporating credibility, and the public-sector union’s failure to internalize the idea that real convergence with EU wages could not be a short-term goal. Under the pressure of deteriorating macroeconomic performance and an adverse change in the political climate, and consistent with its original aversion to a fast-track strategy, the Medgyessy government finally declared a postponement of the euro entry date to 2008. While Medgyessy might have put his faith in muddling through the rest of his term, reality soon forced him to face up to the rapidly accumulating external and domestic costs of Hungary’s volatile and drifting policies. Externally, Hungary’s reputation as a pacesetter for EMU entry was on the wane. In this new situation the National Bank of Hungary’s justification of the high interest rate by the need to compensate for the weaknesses of the

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Hungarian economy, and of an early EMU membership by the need to minimize the likelihood of speculative attacks, sounded more credible than in 2002. At the same time, the record level of interest rates magnified the cost of deficit financing and dwarfed the gains from ad hoc fiscal corrections. Domestically, the conservative opposition’s Euro-populism began to pay: from Summer 2003 it was much more popular than the governing coalition. The shock came in June 2004, in the first Hungarian elections to the European Parliament, when FIDESZ–MPSZ defeated MSZP. Shortly afterwards both MSZP president La´szlo´ Kova´cs and Medgyessy had to resign. In Autumn 2004, Ferenc Gyurcsa´ny, Medgyessy’s former Minister for Sports and Youth, took over his post and legacy. The new prime minister found his restructured government exposed to old struggles with experienced adversaries. On EMU-related issues Gyurcsa´ny acted much like his predecessor. On the one hand, he further postponed the date of euro entry to 2010. On the other, he launched a new campaign to alter the balance of power between the National Bank of Hungary and the government. The coalition again amended the National Bank of Hungary act, focusing this time on extending the prime minister’s authority to appoint members to the monetary council. Nothing is more telling of the persistence of earlier divisions in Hungarian politics than the conflict provoked by the new amendment of the central bank law. The verbal duel that took place between Orba´n and Gyurcsa´ny in late 2004 reflects both the lack of any significant advance towards reconciliation since 2002 and the increasing costs of the deadlock. Orba´n’s claim that ‘a weaker forint clearly contradicts the interests of people, means a weak state, and is desired only by weak statesmen’ was countered by Gyurcsa´ny: ‘The interest rate must decline . . . because we perish with the strong forint . . . those who nowadays defend the forint, opt for closing down businesses, losing jobs, and making Hungarian economic development impossible’ (Csabai 2004: 6). Predictably, while Gyurcsa´ny gave weight to his concerns by a joint public declaration signed with MGYOSZ, Orba´n sided with Ja´rai’s concerns that the intervention violated the National Bank of Hungary’s independence and undermined the stability of the forint. Ja´rai threatened to take the legal amendment to the Hungarian Constitutional Court and the European Court of Justice. New economic developments indicated the increasing stakes and risks involved in the debate. By late 2004 both Hungarian firms and households had accumulated significant debts in the form of low-interest euro and Swiss franc loans. In this context, National Bank of Hungary officials and

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independent experts warned that a drop in the interest rate and speculative attacks might shortly lead to the collapse of the forint, in which case euro-indebted firms and households were going to witness increases of 15–20 per cent in their debt service costs (MN 11 December, 2004).

Conclusion Since the time that EMU membership became a realistic (and indeed unavoidable) perspective for Hungary, domestic economic and political actors returned to the same kind of battles about the proper entry strategy, notwithstanding the increasing international and domestic costs of their conflicts. What is it in the Hungarian political economy that has made for so little social learning and such a stubborn persistence of this trench warfare? This chapter identifies the answer in the specifics of the Hungarian political economy and their role in mediating the effects of EMU on domestic economic and monetary policies. The first important factor is the character of the political system. Uniquely among the new east European accession states, by the late 1990s Hungarian democracy came close to a two-party system, where both dominant parties could mobilize large and equally strong electoral blocks. Especially during and after the 2002 elections, party rivalry intensified at the centre of the ideological spectrum as both sides tried to get access to voters of the opposite camp. Given the popularity of the EU in the political centre ground, Euro-scepticism became a losing option. However, because the available choices with respect to euro entry were limited to variants within a pro-EMU agenda, and narratives that focused on EMU as a ‘good servant’, intense clashes formed around the precise details of the proper domestic strategy. In this context existing conflicts between the policy preferences of export industries and producers of non-tradable goods, as well as various consumer and employee groups, politicized euro entry. Even before EU accession Hungary’s road to EMU became part and parcel of fierce domestic political struggles. Opposition and government increasingly capitalized on the socio-economic cleavages rooted in the distributional impact of exchange-rate policy, disinflation, and fiscal austerity. They tried to utilize, for their own purposes, key economic and political institutions, such as the National Bank of Hungary, business associations, the electoral calendar, and referenda. Last but not least, the opposition adopted a new Euro-populist rhetoric within a discursive space defined and tightly compressed by Europeanization.

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The strategies and arguments used by the rival advocacy coalitions have been thoroughly shaped both by ‘top-down’ and by ‘bottom-up’ processes of Europeanization. As this chapter demonstrates, mainly ‘top-down’ compliance requirements affected the competition for power over monetary policy, since they empowered the president of the National Bank of Hungary and allowed him to use the increasingly critical Convergence Reports of the European Central Bank and the European Commission to buttress his own position. In contrast, struggles over the fiscal and exchange-rate policies have been more strongly affected by a divisive process of ‘bottom-up’ Europeanization, in which domestic actors instrumentalized a variety of European models, such as the European ‘mixed economy’ or ‘Social Model’, to strengthen their positions in electoral and party competition. Is polarized domestic politics the only explanation? Are we faced with just one more variation on the theme of ‘negative politics’ undermining ‘positive economics’ (Grindle 1989)? The Hungarian case also highlights deeper problems, which are rooted in the specificities of this country’s economic development. The first problem is structural. After the collapse of the socialist system, the Hungarian economy soon embarked on an export-led development path. Due to the early start, as well as to later policy choices, Hungary became a preferred location for foreign transnational corporations, whose operations rapidly turned the country into one of the most transnationalized and most thoroughly Western integrated economies of the region. Thus, structurally, Hungary exhibits some of the features of an advanced European economy. Why is it then that, in the race for EMU entry, Hungary became a laggard? Are there, to extend Alexander Gerschenkron’s logic (1978), specific disadvantages for euro entry associated with the position of an early starter and a front-runner of post-communist development? First, precisely because Hungary is more thoroughly integrated in the European economy than many other post-communist states, it is also more dependent on the EU business cycle. In consequence, protracted stagnation in the traditional leading EU economies cut earlier and deeper into output, profits, and employment and resulted in sharper distributional struggles and stronger resistance to certain policies than in some other East European countries. In this sense, Hungary shares older members’ apparent problems with the EMU straitjacket. Second, because of Hungary’s early start and rapid advance on a labourintensive manufacturing export path, a relatively powerful transnationally

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integrated and politically vocal domestic export-bourgeoisie could emerge. However, the exhaustion of this kind of export opportunity also affected Hungarian businesses earlier than businesses in other countries of the region. By the early 2000s Hungary faced not just a challenge from foreign transnational corporations, which started to relocate their most labourintensive operations to lower-wage countries, but also the accelerating outmigration of its largest and most successful domestic businesses, which rapidly transformed themselves into the first transnational corporations of east European origin. The question of whether to keep these firms at home or encourage their eastward expansion became central for development strategists earlier in Hungary than elsewhere. Third, the acceleration of these processes of transnational restructuring confronted actors with the high stakes and difficulties associated with either staying on the previous exhausted trajectory or entering a more promising new one. The latter option has been conditional upon significant industrial upgrading. Hungarian businesses needed time and policy support to successfully meet this challenge. This explains their sensitivity to the shifts in policy priorities required by the preparations for euro entry. Fourth, however, Hungarian businesses and policymakers discovered in recent years that stretching out the period of preparation for EMU membership has its own heavy costs too. One important cost is a longer period of exposure to speculative attacks (Csermely 2004). These attacks become even more threatening if domestic policies are drifting and uncoordinated, and tend to further undermine government’s capacity to help the economy to cope with the disadvantages of an early starter. The second problem is institutional and is most clearly revealed by the permanent conflict between the legal and personal aspects of central bank independence. Ironically, while over the past one and a half decades Hungary succeeded in creating the legal institution of an independent central bank, so far it has not had the opportunity to have a central bank president whose personal independence and non-partisanship appeared credible to, and could be accepted by, the whole political community. More generally then, the Hungarian case highlights the extent to which the unevenness of Europeanization and the contradiction between its various aspects, as well as ‘top-down’ and ‘bottom-up’ processes, can itself severely distort policy interaction and produce results that fall short of ‘European’ standards.

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10 Poland: Unbalanced Domestic Leadership in Negotiating Fit Radoslaw Zubek

This chapter considers the way in which the national central bankers and finance ministers in Poland dealt with the challenges of Europeanization through EMU.1 In doing so, it analyses national and international factors that determined how Polish monetary and fiscal leaders negotiated fit with Euro Area entry between 1999 and 2004. It finds that, throughout the period, the central bank pursued a policy conducive to fast-track monetary convergence. This choice had been determined not only by its own push for EMU membership but also by a combination of macroeconomic conditions, policy legacies and party political considerations. The stability of the Polish central bank’s policy choice was reinforced by accession conditionality and by a domestic elite consensus. In fiscal policy, by contrast, Polish finance ministers largely failed to match the central bank’s pro-EMU stance. Paradoxically, the economic situation, which facilitated EMU convergence in monetary policy, made the adoption of a similar strategy more difficult in fiscal policy. Perhaps more importantly, the choices in budgetary policy were decisively shaped by short-term domestic exigencies of party and electoral competition, the ascendancy of the economics ministry within the core executive, and limited external empowerment from the European Union. This constellation of monetary and fiscal

1 ¨ nker, Kenneth Dyson, Vesselin Dimitrov, Bela The author would like to thank Frank Bo Greskovits, Klaus Goetz, Jim Rollo, and other participants of the British Academy workshop on ‘Enlarging the Euro-zone: the Euro and the Transformation of East Central Europe’ for their useful comments and suggestions on an earlier version of this chapter. The author also thanks Bartlomiej Osieka for research assistance.

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Unbalanced Domestic Leadership in Negotiating Fit Table 10.1. Poland: fiscal and monetary convergence with the Maastricht criteria 1997–2004

Government deficit Public debt Long-term interest rate Inflation (HICP)

1997

1998

1999

2000

2001

2002

2003

2004

4.0 44.0 n/a 15.0

2.1 39.1 n/a 11.8

1.4 40.3 9.53 7.2

0.7 36.8 11.79 10.1

3.8 36.7 10.68 5.3

3.6 41.1 7.32 1.9

3.9 45.4 5.78 0.7

5.6 47.2 6.9 2.5

Source: Own compilation based on data from Eurostat (http://europa.eu.int/comm/eurostat).

leadership resulted in an unbalanced pattern of domestic convergence with EMU. Although, in late 2004, Poland did not meet any of the nominal criteria for EMU membership, it clearly missed the monetary criteria by a narrow margin, while divergence in fiscal policy was more pronounced (Table 10.1) (European Commission 2004). The result of an unbalanced domestic fiscal and monetary leadership was a prolongation of the timescale for Euro Area entry. By studying the factors that influenced Poland’s strategic choices in monetary and fiscal policy, this chapter makes three principal observations about the modalities of EMU as Europeanization. First, it underscores the significance of ‘inside-out’ or ‘bottom-up’ approaches in the analysis of domestic adaptation to Europe (see Dyson and Goetz 2003; Radaelli 2003). The analysis demonstrates how Polish central bankers and finance ministers used EMU strategically to pursue their own policy preferences in the domestic arena. Second, the chapter points to the importance of external power resources for facilitating and impeding domestic adaptation to EMU. Significantly, it identifies accession conditionalities as a major resource empowering domestic leaders (see Dyson 2002; Featherstone 2003; Schimmelfenning and Sedelmeier 2005). It also reveals a crucial role played by the domestically embedded norms of ‘sound finance and money’ whose origins transcend the EMU process (Dyson 1994; Epstein 2002). Third and finally, the chapter emphasizes the critical shaping effect of domestic contexts for the process of Europeanization (see Hallerberg 2004; Dimitrov, Goetz, and Wolmann, with Brudis, and Zubek 2006; Zubek 2005). The Polish case study provides a good illustration of how short-term domestic party and electoral calculations and the disintegration of the largest governing parties seriously undermined the national government’s capacity to maintain fiscal rectitude.

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Negotiating Fit in Monetary Policy The Central Bank’s Leadership in Monetary Convergence Since the late 1990s the Polish central bank (National Bank of Poland) and its monetary policy council (RPP) have maintained a policy conducive to fast-track convergence with the EMU monetary criteria, based on a strategic preference for using external discipline to secure domestic macroeconomic stability (Dyson, Chapter 15; Lutkowski 2004; Orlowski 2004). Using direct inflation targeting, the bank managed to lower inflation from 15 per cent in 1997 to an all-time low of 0.7 per cent in 2003. The long-term interest rate also followed a declining trend, falling from 11.79 in 2000 to 6.9 in 2004. In 2004–5, the National Bank of Poland was successful in dealing with a slight divergence in monetary policy when—after Poland’s accession in May 2004—a higher demand for food products, changes in indirect taxes, and a natural price convergence contributed to higher inflation (cf. European Commission 2004; RPP 2004). Responding to such developments, the central bank managed to reign in rising inflation by rapid increases of interest rates, and thus revived hopes of monetary convergence. The ambition to secure speedy EMU membership played a key role in determining the Polish central bank’s monetary policy. In its strategy of 1998, the monetary policy council declared that ‘the EMU’s price stability criterion requires that Poland must relatively quickly reduce inflation to a level not exceeding 3–5 per cent a year’ (RPP 1998: 4). As Poland approached EU accession, EMU moved to the top of the central bank’s agenda. Speaking in 2002, Leszek Balcerowicz, its governor, said: ‘Poland will be better-off adopting the single currency as quickly as possible, that is, in 2006 or 2007’ (Slojewska 2002b). Consequently, in 2003, the monetary policy council identified monetary convergence as a key priority for its future policy and declared that it wanted Poland to join the euro at the earliest possible date after accession, that is, in 2007 (RPP 2003). The monetary policy strategy was thus based on the expectation that Poland would apply to join the ERM II as soon as late 2004 and would allow the exchange rate to fluctuate within the þ/ 15 per cent band for the following two years before locking it permanently on 1 January 2007 (Slojewska 2003a). The rationale behind the Polish central bank’s pro-Euro stance was twofold. First, the bank saw fast-track EMU membership, and the external discipline that it provided, as an ultimate safeguard against macroeconomic risks to which Poland’s floating exchange rate regime was exposed

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(cf. Lutkowski 2002). The key policy dilemma was that, under free capital movements, any increases in interest rates led to short-term capital inflows and nominal appreciation of the Polish currency, which in the longer run translated into imbalances in the trade and current accounts; at the same time any decreases in interest rates resulted in short-term capital outflows and depreciation of the currency which, in turn, led to higher inflation (Kawalec and Krzak 2001; Rostowski 2003). The central bank thus advocated prompt EMU entry to address the domestic risks of exchange-rate crisis and high inflation. Analysts close to the National Bank of Poland even advocated a unilateral euro-ization to import credibility and minimize adaptation costs (see Bratkowski and Rostowski 1999, 2001). The second motive behind the bank’s enthusiasm for EMU entry was its perception of the EMU agenda as an enabling constraint capable of inducing the political executive to undertake necessary structural reforms (cf. Zielinski 2001; Niklewicz 2002). This logic was perhaps most pronounced after Leszek Balcerowicz became governor of the central bank. Before appointment, Balcerowicz had been leader of the economically liberal Freedom Union (UW) and finance minister in the AWS-UW government, led by Jerzy Buzek of the AWS (Solidarity Electoral Action). When in government, he had failed to win sufficient support from the more social-policy-inclined, internally fragmented, and weakly-led AWS party to undertake the structural reforms that he deemed necessary (see Zubek 2001). Thus, once at the helm of the central bank, he had a strong penchant for using monetary policy to pursue his preferred policies by other means. The bank’s restrictive monetary stance may, for example, be interpreted as a way of imposing fiscal prudence on an otherwise reluctant AWS cabinet. The bank adopted a similar strategy vis-a`-vis the SLD-UP-PSL (Social Democratic, Labour Union, and Polish Peasant parties) government under Leszek Miller that came to power in autumn 2001 (cf. Greskovits’s chapter on the Hungarian central bank). In particular, the National Bank of Poland made the relaxation of monetary policy conditional on a firm commitment to fiscal stabilization by the Social Democrat-led government and reserved the right to tailor its approach to how credible it thought the government’s fiscal stance was. Table 10.2 contains information on Polish cabinets and their party composition between 1997 and 2004. The central bank’s leadership in monetary convergence was to some extent inhibited by the EU’s reluctance to recognize fast-track EMU membership as a viable option for Poland. Neither the European Commission nor European Central Bank endorsed the Polish central bank’s ambition of fast-track EMU entry, cautioning against what they saw as an unnecessary

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Unbalanced Domestic Leadership in Negotiating Fit Table 10.2. Polish prime ministers, finance ministers, central bank governors, and party composition of cabinets Prime ministers

Finance ministers

Parties

NBP governors

Jerzy Buzek (1997–2000) Jerzy Buzek (2000–1) Leszek Miller (2001–3)

Leszek Balcerowicz

AWS, UW

Hanna Gronkiewicz– Waltz (1992–2000)

Jaroslaw Bauc (2000–1) Marek Belka (2001–2) Grzegorz Kolodko (2002–3) Grzegorz Kolodko (2003) Andrzej Raczko (2003–4) Miroslaw Gronicki (2004–5)

AWS

Leszek Miller (2003–4)

Marek Belka (2004–2005)

SLD, UP, PSL

Leszek Balcerowicz (2000—present)

SLD, UP

SLD, UP

Source: Own compilation.

haste (Slojewska 2002b). The lack of external empowerment was, however, compensated by the bank’s domestic autonomy, which allowed it to pursue its preferred policy. The central bank had had its independence ensured in the constitution of 1997 as part of the ‘anticipatory’ Europeanization of the Polish polity before the start of the accession negotiations (cf. Sobczynski 2002). Modelled on the EU acquis, the constitutional framework granted the National Bank of Poland the right to formulate and implement monetary policy. It identified price stability as the primary goal of monetary policy, though the bank was to support the government’s economic policies insofar as this did not affect inflation. Under the Constitution, the central bank’s governor is appointed by the parliament for a fixed term of six years and may not be removed from office. The members of the monetary policy council also enjoy independence after appointment. The deep institutionalization of the National Bank of Poland’s and its monetary policy council’s independence reinforced the bank’s bargaining position vis-a`-vis the government and allowed it to maintain a policy aimed at rapid disinflation. The bank’s choice of monetary policy was further reinforced by economic conditions. Significantly, a key rationale behind the 1999 decision to adopt a restrictive monetary policy was the threat of an impending currency crisis, as the large and fast-growing current account deficit approached 8 per cent of GDP. The current account imbalances originated from a combination of low domestic savings and high demand for credit, which led to substantial net inflows of foreign capital (cf. Belka 2001; Rostowski 2003). By tightening

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its policy, the central bank also sought to put paid to a creeping rise in inflation, which became evident in the first half of 1999. When, in August 1999, higher inflation turned out to be all but transitory, the central bank decided to raise interest rates (Slojewska 2002d). Whereas the adoption of a restrictive monetary policy was in large part induced by macroeconomic conditions, the decision to maintain this policy in the face of a deepening economic slowdown was influenced by the experience of the 1999 inflation upsurge. The monetary policy council realized that, by sharply reducing interest rates in early 1999 to restore economic growth, it had committed a serious blunder that contributed to the subsequent rise in inflation (Slojewska 2002d). Thus, when responding to declining inflation in 2000–1, the council preferred to err on the side of caution. It waited until February 2001 to carry out the first reduction in interest rates and, even then, lowered them in a series of small steps rather than sweeping cuts. This strategy contributed to a sharp decline in inflation.

Monetary Convergence Under Challenge The central bank’s restrictive policy was challenged in 2001–02, when the incoming SLD-UP-PSL cabinet under Miller publicly blamed the monetary policy council for the sharp economic slowdown and weak recovery (Belka 2001; Orlowski 2004). The government called on the council to substantially reduce interest rates to support its attempts to stimulate economic growth (Rzeczpospolita 2002c). It also asked the central bank to counteract the strong appreciation of the Polish currency, which hurt Polish exports (Tarnowski 2002). Hoping to induce the bank to adopt a more relaxed stance, the Miller cabinet made a written commitment to pursue a restrictive fiscal policy in 2002–6 (see below). When, unimpressed by these promises, the monetary policy council declined to cooperate, the government threatened to limit its independence (Zdort 2002). In December 2001, the deputies of the two junior coalition parties—the Polish Peasants’ Party (PSL) and the Labour Union (UP)—proposed a private-member bill changing the bank’s mandate by requiring it to support economic growth and employment and by increasing the monetary council’s membership from nine to 15. In March 2002, the lower chamber of the parliament passed a resolution stating that, under the conditions of low growth, high unemployment and rapid disinflation, the bank is obliged to support the government’s policy by reducing interest rates (Sejm RP 2002). However, the Miller government did not succeed in inducing the central bank to change its monetary policy as the proposed changes were rejected in

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mid–2002. A key factor that reinforced the status quo was the Polish constitution. Any substantial change to the bank’s mandate through an ordinary parliamentary law carried a high risk of being ruled unconstitutional. But the constitutional hurdle was perhaps less important for preventing the proposed change to the size of the monetary policy council’s membership. The proposed amendment was widely perceived to be allowable under the 1997 Constitution. The monetary policy council seems to have been salvaged by a strategic domestic coalition of high-level technocrats and political actors who opposed any tampering with the central bank’s mandate. Unlike in previous disputes between the central bank and the government in the mid-1990s, these protective elites were not limited to the technical elites but extended to the core of the largest majority party and included finance ministers (Marek Belka and Grzegorz Kolodko) and President Aleksander Kwasniewski (cf. Epstein 2002). Not without significance was also the fact that the amendment bill became bound up with the dynamics of EU accession. In March 2002, the European Central Bank warned that tampering with National Bank of Poland’s position would ‘ . . . make Poland’s road to the EU and the euro more difficult’ (Slojewska 2002c). More significantly, in June 2002, the European Commission took the unprecedented step of declaring that the draft amendment was not compatible with the EU acquis and threatened to reopen accession talks on economic and monetary union if the law was adopted (Bielecki 2002). Empowered by external accession conditionality, the monetary policy council did not agree to the government’s demands for a relaxation of monetary policy. These external constraints were also used strategically by President Kwasniewski, who lent further support to the central bank’s position. Fearing to impede the EU accession process, the Miller cabinet backed down, deciding not to support the legislative initiative to change the central bank’s mandate.

Negotiating Fit in Fiscal Policy The Impact of Economic and Political Conditions During the entire period under examination Polish finance ministers found it very difficult to match the central bank’s pro-EMU stance. For one thing, the economic conditions that facilitated EMU convergence in monetary policy from 1999 made the adoption of a similar strategy relatively more difficult in fiscal policy. In mid-2000, an economic slowdown

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in the EU translated into lower growth in Poland, which was further depressed by the central bank’s restrictive monetary policy. The slowing economic activity placed a natural squeeze on the Polish budget, pushing it deeply into deficit. The fiscal imbalance grew from 0.7 per cent in 2000 to 3.8 in 2001. Although these budgetary problems were largely cyclical in nature, the Buzek government’s capacity to keep the deficit under control was complicated by serious structural problems of the Polish public finances. The key problem is that budgetary expenditures are characterized by high rigidity, which makes it difficult to respond quickly to changes in macroeconomic conditions (Orlowski 2004: 94–6). The inflexibility stems from the allocation of a major share of the budget to legislation-mandated social transfers and a relatively low proportion of capital investments and expenditures on public-sector wages. Besides structural legacies, the failure to keep the fiscal position under control was due to short-term domestic electoral concerns that dominated the political agenda in 2001. The budgetary problems coincided with the final year of the electoral cycle. The next parliamentary election, scheduled for September 2001, loomed large in political debates. The opposition SLD topped all opinion polls, with more than 40 per cent, while the AWS trailed with a mere 15 per cent of the vote. Hence, the AWS party wished to avoid a painful fiscal rationalization, fearing a further decline in its electoral fortunes. The prospect of fiscal stabilization was further undermined by the disintegration of the AWS party in late 2000. Its demise was accelerated in January 2001 after a split within the UW party had prompted many of the AWS members to join a newly established party, the Civic Platform (PO). The collapse of the AWS cabinet reinforced the status quo in fiscal policy. It undermined the executive’s position in parliament, in which the cabinet lost crucial votes and was not able to avert the adoption of private-member bills that increased future expenditure. The intraparty rivalries prevented finance minister Jaroslaw Bauc from setting the agenda for a controlled increase in government deficit after, in Spring 2001, lower growth caused a dramatic deterioration in the condition of the government budget. In May, in response to the crisis, Bauc proposed spending cuts totalling 6–8 billion zloty or 1 per cent of GDP (Rzeczpospolita 2001). But the cabinet rejected his proposal, hoping to postpone the amendment of the budget beyond the election date (Tarnowski 2001). It was only the size of the revenue shortage, which in July reached 17.5 billion zloty, that eventually persuaded the Buzek cabinet to address the issue (Tarnowski 2001). But, even then, the finance minister failed to

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persuade the cabinet to write a substantial part of the planned reduction into the new budget bill. Thus, he had a limited legal basis to demand these expenditure reductions from his ministerial colleagues (Bien and Lesniak 2001).

The Rise and Fall of a Fiscal Contract The prospect of fiscal convergence improved in late 2001 when the new Miller cabinet managed to carry out a reduction in public expenditure and adopt a budget with a lower deficit than that proposed by the outgoing Buzek administration. The cabinet pushed through parliament legislation that provided for a freeze on salaries in the administration and in education, more stringent criteria for awarding many social and pre-retirement benefits, and lower government-subsidized discounts on railway tickets. These spending cuts were combined with moderate income tax increases and the introduction of a capital gains tax (Solska 2001a; Solska and Tarnowski 2002a). In effect, the overall government deficit was reduced slightly to 3.6 per cent of GDP. Most significantly, the SLD-UP-PSL cabinet negotiated a fiscal contract that committed it to fiscal prudence in the medium term (cf. Dimitrov, Chapter 13). The coalition agreed in writing that the annual growth of public spending would not exceed 1 per cent above inflation. The government’s economic programme, adopted in January 2002, went as far as to lay down definite amounts of aggregate expenditure for the years 2002–6. Though the level of government deficit was not agreed, the government hoped that a combination of the spending caps and an expected pick-up in economic growth would allow the public finances to naturally ‘grow out’ of the revenue shortage (Solska 2001a). Although the preliminary fiscal stabilization and the commitment to further reforms in the medium term improved the outlook for EMU accession, they were not strictly speaking driven by EMU-related concerns. A deficit below 3 per cent was not part of the accession conditionality, and Poland merely informed the EU about its budgetary positions within the framework of its Pre-Accession Economic Programme (see Dyson, Chapter 1 above). Much more important for fiscal consolidation was the domestic budgetary crisis of 2001, which opened opportunities for finance minister Belka to persuade prime minister Miller and other ministers to support spending cuts and enter into a fiscal contract. A government official said: ‘nobody was more grateful to Bauc for revealing the true scale of the fiscal imbalances than Miller and Belka, who used this to justify the painful decisions that had to be made at the start of the term’ (interview January

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2005, Warsaw). Besides using the budgetary crisis, Belka was able to justify his proposals by arguing that some evidence of fiscal tightening was necessary if the government wanted the central bank’s monetary policy council to effect deeper and quicker reductions in interest rates. The finance minister’s success in improving fiscal discipline also stemmed from the SLD’s supremacy within the governing coalition and its close alliance with one of its coalition partners, the Labour Union (UP). Finally, the SLD’s ability to impose terms within the coalition was reinforced by the strong position of Miller, who combined his post as prime minister with the leadership of the party. The improved outlook for convergence with the EMU fiscal criteria, which emerged in late 2001, depended to a large extent on whether the finance minister could use the fiscal contract to induce ministers to rationalize spending. During the adoption of the guidelines for the 2003 budget, however, finance minister Belka lost his bid for further rationalization of public spending. The informal cabinet meeting in early July 2002 demonstrated that line ministers were unwilling to reassign expenditures within their budget heads to find resources for new policy projects. The cabinet adopted budget guidelines that provided for a total expenditure of 192.5 billion zloty, approximately 2.5 billion zloty more than allowed under the fiscal contract. As a result, Belka resigned in protest. The finance minister failed to avert the breakdown of fiscal stabilization in mid-2002 because his policies ran into opposition from the core of the SLD party. The contestation of Belka’s policies originated from a growing division between President-supported ministers and the rest of the cabinet. The prime minister had built the SLD’s electoral success by relying heavily on the loyalty of regional party leaders. But, when constructing his cabinet, Miller offered them mainly deputy ministerial posts, leaving most senior positions for Presidential nominees. This rebuff became a source of frustration for regional party governors and a strong incentive for contesting the policies of senior economic ministers, including Belka (Subotic and Stankiewicz 2002; Paradowska 2002b). The internal division within the core executive deepened after President Kwasniewski had not supported Miller in the latter’s attack on the independence of the monetary policy council (Paradowska 2002a). Perhaps more importantly, Belka’s commitment to budgetary prudence was widely perceived within the SLD as one of the reasons for the party’s declining popularity. Between October 2001 and June 2002, the SLD’s ratings dropped from 44 to 23 per cent, a predicament that was blamed on the spending cuts administered by Belka in late 2001 (Paradowska

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2002c). The key concern was that the actual shape of economic and budgetary policies stood in stark contrast to the SLD’s pre-election pledges. Moreover, the implementation of many structural reforms, such as labourmarket liberalization, provoked strong protests from the trade unions (Paradowska 2002b). Worse still, by mid-2002, there were few signs that Belka’s plan would deliver a rapid economic turnaround and lower unemployment (Raciborski 2002; Olczyk 2002a). Meanwhile, electoral considerations became a top priority for the SLD due to the approaching local government elections scheduled for September. A poor electoral performance would have meant a loss not only of power but also state resources on which Polish parties depend for their survival (cf. Szczerbiak 2001). More significantly, it would also have undermined Miller’s position within the SLD and the cabinet. The prevalence of domestic electoral concerns in the cabinet’s cost– benefit calculations was reinforced by limited external incentives for fiscal discipline. As the EU did not make accession conditional on fiscal convergence, neither the finance minister nor the prime minister could rely on external constraints to justify painful reforms. Also the opportunities for domestic policy entrepreneurship narrowed because by mid-2002 the sense of the budgetary crisis so prevalent in late 2001 had all but gone. Hence, when faced with the choice between long-term fiscal stabilization and short-term electoral considerations, Miller withdrew his support for the finance minister and sided with the spending ministers during the budget debate (Olczyk 2002b).

Kolodko’s Bid for Fast-Track Entry in 2007 By forcing Belka’s resignation, the prime minister released the tensions within his party, sent a positive signal to his electorate, and strengthened his position within the SLD. To emphasize the shift in policy, Miller appointed Grzegorz Kolodko, former finance minister, who—a few months earlier—had claimed in a well-publicized article that, unlike Belka, he would accept looser fiscal policy to achieve a higher growth in the short-term. Among the SLD’s voters, Kolodko was widely associated with the era of high growth in the mid-1990s and his appointment helped to boost political confidence. But, although the new finance minister agreed to higher spending in the 2003 budget—and hence to a breach of the 2001–02 fiscal contract—he managed to secure two important promises from Miller. The first assurance was that the threat of any increase in deficit would be averted by the introduction of new tax

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measures to plug the revenue gap. Accordingly, in July and August, Kolodko proposed to generate new revenues from a rise in income tax, a lower reduction in corporation tax, a tax amnesty bill, tougher discipline in collection, and incentives for companies to restructure tax debts (Lesniak 2002a, 2002b). The other promise was Miller’s support for a fast-track entry to EMU in 2007 and, hence, a substantial reduction in deficit in 2004 and 2005 (Rzeczpospolita 2002b). If achieved, such reforms would allow Poland to join the single currency in 2007. Kolodko managed to persuade Miller that early EMU membership would be politically beneficial because it would solve the problem of restrictive monetary policy maintained by the central bank’s monetary policy council. This prospect proved attractive for the prime minister, who had spent the previous nine months pressing the council to relax its interest-rate policy. The Miller–Kolodko accord on EMU triggered important preparatory work. The meetings of a joint working group, established by the finance ministry and the Polish central bank in June 2002, were intensified to develop a convergence programme. In October, the group announced that: ‘It is a joint intention of the government and the central bank to conduct macroeconomic policy in such a way as to ensure that Poland meets the nominal convergence criteria of the Maastricht Treaty in 2005’ (Ministerstwo Finansow 2002). In its medium-term monetary policy strategy, unveiled in February 2003, the central bank’s monetary policy council listed accession to EMU in 2007 as one of its key priorities (RPP 2003). In press interviews, Kolodko confirmed that the cabinet wanted quick EMU membership, though the feasibility of the plan depended mainly on fiscal reforms (Slojewska 2002a; Rzeczpospolita 2002b). Accordingly, in March 2003, the finance minister presented a comprehensive stabilization package that lowered the public finance deficit through a combination of restrictive tax policy, spending cuts, and extraordinary revenues (Bien and Lesniak 2003). However, the finance minister’s strategy for a fast-track EMU entry collapsed when, in May 2003, the prime minister and the cabinet rejected his stabilization programme and decided to delay spending cuts and to lower taxes. The fiasco of Kolodko’s convergence plan was, in large part, due to unfavourable external and domestic conditions, which made it difficult for the finance minister to justify a radical fiscal tightening. In response to Kolodko’s plans for quick convergence, both the European Commission and the European Central Bank discouraged the Polish government from seeking rapid membership in EMU. Both these institutions were concerned

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that, once EMU members, Polish decision-makers would not show sufficient commitment to lower inflation, and in particular that Poland needed higher growth to catch up with the old member states (Slojewska 2002b). The lack of EU pressures for early EMU entry meant that the finance minister did not find external allies in his push for fiscal convergence. Moreover, he received little support from domestic business associations and trade unions, which preferred lower taxation and higher deficits, even if that meant a delayed entry into the Euro Area (Jablonski, Lesniak et al. 2003). Also, the finance minister was not fully backed by the central bank which, although keen in principle on early EMU entry, criticized Kolodko’s plan to plug the budget shortage with extraordinary revenues from the dissolution of the bank’s revaluation reserve (Slojewska 2003b). In addition to lacking external empowerment, finance minister Kolodko was isolated within the cabinet and its supporting parties. Ministers and parliamentarians were concerned that spending cuts would reduce the already low approval ratings of the government. The economics and labour minister, Jerzy Hausner, led the internal cabinet opposition to Kolodko’s plans. Between March and April 2003, he emerged as a competitive agenda-setter. Hausner proposed an alternative economic programme that found the support of cabinet members (Bien and Lesniak 2003). He criticized Kolodko for suppressing nascent growth with a restrictive tax policy and for his desire to lower the deficit at a time when employment, anti-poverty policies and support for the absorption of EU funds should have been the government’s top priorities (Solska 2003). In April, Hausner presented a programme which, on its revenue side, was clearly contrary to Kolodko’s and, in its spending side, proposed only selective cuts to be undertaken when the economy reached a higher growth rate (Jablonski, Lesniak et al. 2003). Significantly, Hausner’s plans received strong endorsement from trade unions and the business community. The finance minister’s last hope was support from the prime minister. However, in May 2003, Miller sided with the rest of the cabinet, deprived Kolodko of the deputy premiership, and appointed Hausner as deputy prime minister with a coordination brief in economic affairs. In effect, Kolodko had no alternative but to resign.

Hausner’s Promise of Fiscal Convergence in 2009 Miller’s decision to support Hausner instead of Kolodko was tantamount to delaying Poland’s entry to EMU (Dabrowski 2003). Fiscal convergence in 2005 and EMU entry in 2007 became untenable, as taxes were slashed,

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public expenditure increased, and the government deficit shot up to 5.6 per cent in the 2004 budget. The change of policy on EMU marked the ascendancy of a new political discourse, which stressed the importance of achieving real convergence through structural reforms before Poland joined the Euro Area. Unlike governor Balcerowicz and finance minister Kolodko, economics minister Hausner believed that ‘Poland should not rush its EMU entry. Nominal convergence (including convergence with fiscal criteria) may make it difficult to implement structural adaptations in the Polish economy that are more important for delivering lasting economic growth’ (Gazeta Wyborcza 2003). Prime Minister Miller concurred: ‘A higher public deficit is a must. Without it, we would not be able to promote entrepreneurship through tax cuts or to absorb EU funds’ (Lesniak 2003). But, on the eve of Poland’s EU accession, the room for manoeuvre in domestic fiscal policy already began to diminish. In late 2003, the European Commission warned that, once Poland joined the EU in May 2004, it would be required to present a credible plan for achieving fiscal convergence: otherwise it risked the loss of its share of cohesion funds (Bielecki and Jablonski 2003). Responding to these external pressures, as well as seeking to allay the fears of financial markets, the cabinet adopted a medium-term fiscal strategy, in which it proposed to stabilize the public finance over the next four years so as to meet the EMU fiscal criteria in 2007 (Ministerstwo Finansow 2003). This medium-term fiscal strategy formed the basis for a convergence plan, which was later accepted by the ECOFIN Council in mid-2004 (Rada Ministrow 2004). Moreover, fiscal expansion was constrained by the norms of sound finance that had been deeply embedded in the Polish constitution, which places a limit of 60 per cent of GDP on the level of public debt. This limit had been introduced into the Constitution in 1997 as part of ‘anticipatory’ Europeanization. Due to delayed fiscal reforms in 2001–3 and fiscal expansion in 2004, the overall debt rose from 41 per cent of GDP in 2000 to 47 per cent in 2002 and was expected to reach 51 per cent in 2003. Many analysts pointed out that, if this dynamics continued, the public debt would exceed 60 per cent of GDP in 2005, violate the Polish constitution and require the government to prepare a balanced budget (Rzeczpospolita 2003). Responding to these external and domestic opportunity structures, economics and labour minister Hausner prepared a public finance stabilization plan which, after public consultation and some minor revisions, was adopted by the Miller cabinet in January 2004. Hausner’s plan envisaged a reduction in overall social spending of some 30 billion zloty or almost 4

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per cent of GDP over four years between 2004 and 2007 (Blajer 2004a). Yet, despite favourable external and domestic conditions and staunch support from the prime minister, Hausner’s stabilization plan faltered on implementation, thereby placing a new question mark over Poland’s plan for EMU entry in 2009. Between January and November 2004 alone, the government backed away from one-third of the expected reductions in overall social spending (Blajer and Sadlowska 2004). Hausner’s mixed success was, in large part, caused by a major crisis that enveloped the SLD party and culminated in its break-up in March 2004. By supporting Hausner, Miller came into conflict with the core of the SLD party (Olczyk and Ordynski 2003). A regional party leader put it bluntly: ‘The Hausner plan is good for Poland but disastrous for the SLD’ (Olczyk 2003). Rationalization of public expenditure was likely to be painful for many voters of the SLD, stood in stark contrast to the party’s election pledges, and brought the SLD into conflict with the trade unions. It was also certain to hurt the SLD in the European Parliament elections scheduled for June 2004. The SLD began to suspect that, in the face of plummeting popularity, Miller was fighting for his place in history, without consideration for the fate of the party. This mood quickly translated into calls for Miller to step down as leader and prime minister (Smilowicz 2004). The internal opposition to the Hausner plan within the SLD undermined party discipline within parliament and forced the formally minority coalition to make concessions on issues such as the reduction of sickness pay and pre-pension benefits (Binczak and Blajer 2004). Besides the tensions resulting from the Hausner plan, the SLD party was labouring under the strain of major corruption scandals that involved senior SLD ministers and party leaders and that the Polish media exposed in 2003–4. Miller’s refusal to acknowledge responsibility for these irregularities hurt the approval ratings of the government and eventually led to a split in the SLD party, when a group of party members set up a new party, Polish Social Democrats (SdPL) (Paradowska 2004). The fragmentation of the SLD forced Miller’s resignation as prime minister and the formation of a new cabinet under a former finance minister, Marek Belka. However, to be voted into office, Belka had to make further concessions on the Hausner plan, promising to withdraw proposals for new rules on disability benefits, which accounted for about one-tenth of the expected savings (Gottesman 2004; Blajer 2004b). Faced with volatile and fragmentary support in parliament, the Belka cabinet was not able to push through important rationalization measures. Perhaps more importantly, Hausner’s position in cabinet weakened. He had to compete with a new UP-nominated

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deputy prime minister for social affairs, who opposed further spending cuts (Blajer 2005). Last but not least, changes in external and domestic opportunity structures during 2004 further undermined Hausner’s ability to act as an agent for fiscal stabilization. Despite ominous predictions of analysts, the public debt in 2004 did not reach the 55 per cent threshold and was expected to remain well below 60 per cent in 2005. The lower debt was mainly due to higher than expected budgetary revenues in 2004, resulting from robust economic growth. As the prospect of an impending crisis receded, the momentum for reform dissipated, shutting the window of opportunity for entrepreneurship by the economics minister. The change in internal incentives coincided with the alteration of the external situation. Once Poland became a full EU member, the government sought to manipulate the degree of adaptational pressure by pushing for a change to the rules of the game at the EU level. This attempt to upload domestic preferences was most evident in Poland’s recent attempt to use the renegotiation of the SGP to change the way in which funded pension schemes were classified in the budget. In late 2004, finance minister Miroslaw Gronicki made deliberate efforts to secure a majority in ECOFIN for the idea of introducing special provisions for pension reforms with a measurable impact on the short-term deficit in the calculation of the budget deficit (Bielecki and Ostrowska 2004; Karpinski 2004).

Conclusion This Polish case study makes three principal contributions to the study of EMU as Europeanization. First and foremost, it emphasizes the importance of patterns of domestic leadership for shaping negotiation of fit with EMU and national strategic choices. Polish monetary convergence in 1999– 2003 would have been hardly possible if it had not been for the strong leadership of the central bank and its governor. Similarly, the outlook for fiscal convergence was inextricably linked to the ability of the Polish prime minister and finance minister to act as leaders for fiscal stabilization within the cabinet. The shaping power of domestic leadership should not come as a surprise. Convergence with EMU brings benefits that are largely long-term and diffuse, while domestic political competition rewards policies that produce immediate and concentrated effects. The challenge of Europeanization thus locks domestic actors in a collective dilemma. The presence of domestic policy entrepreneurs is a key condition that increases

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the likelihood that such dilemmas are solved and EMU adaptation takes place. This result is in line with recent findings from political economy research on the dynamics of EMU as Europeanization in the old member states (cf. Hallerberg 2004; Dimitrov, see Chapter 13 below). The second lesson is that opportunities for domestic leadership are closely linked to external incentives. EU accession conditionality was a crucial factor that helped to salvage the central bank’s autonomy in monetary policy and, by extension, its ability to maintain a pro-EMU stance. Similarly, EU membership conditionality limited the timeline available to the Polish government for the fiscal expansion launched in 2003 and contributed to the development of the Hausner plan. Moreover, the threat of losing cohesion funds provided an important lever to Miller and Hausner in pushing for fiscal reforms. Perhaps more importantly, the chapter also demonstrates the crucial role played by what Dyson (Chapter 1 above) calls ‘informal conditionality’ in facilitating or impeding policy entrepreneurship. In 2001–2, when the central bank’s independence came under challenge, it was able to rely on a strong ideational consensus among key domestic political and administrative actors, a result of almost a decade’s worth of learning within transnational networks. In a similar fashion, minister Hausner’s entrepreneurship was reinforced by the constitutional limit on the public debt, which represents another example of how the EMU policy paradigm has been institutionalized through policy learning. The provisions in the Polish constitution of 1997 on central bank independence and public deficit represent ‘anticipatory’ Europeanization. Third, and most significantly, this chapter emphasizes the importance of domestic variables in shaping negotiation of fit in Euro Area accession and its effects on Polish economic policies. The Polish case demonstrates how domestic crises have empowered monetary and fiscal leaders. In 1999, the central bank used serious current account imbalances as a justification for switching to a restrictive monetary policy. The fiscal crises of 2001 and 2003 provided windows of opportunity for the prime minister and the finance minister to persuade the cabinet to adopt otherwise unacceptable reforms. The chapter further illustrates the pervasive impact of domestic party political configurations on the negotiation of fit and patterns of Europeanization. The cohesiveness of the SLD-UP-PSL coalition government greatly facilitated the commitment to a fiscal contract in 2001, whereas the weak and disintegrating AWS and later SLD-UP governments proved unable to provide political leadership in fiscal policy. Political party competition also extended to the Polish central bank, whose governor had been closely identified with the opposition parties and was

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often accused of imposing deliberate constraints on the work of the governing coalitions. Finally, the Polish story identifies the electoral timetable as a major factor limiting the room of manoeuvre for domestic leaders in negotiating fit. All the three elections held between 1999 and 2004 had a critical impact on the cost–benefit calculations of Polish governments and stymied finance ministers in their role as agents of fiscal stabilization.

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11 Persistent Laggard: Romania as Eastern Europe’s Sisyphus Dimitris Papadimitriou

If Estonia has been a long-standing pacesetter, and Hungary has fallen behind, Romania has been a persistent laggard both on EU and on EMU accession. Moreover, unlike in Bulgaria, its governments have not been prepared to ‘bind hands’ by adopting a currency board. The explanation is to be found in the specificities of the Romanian political economy: a persisting reluctance to break with the legacy of the communist past, especially a large inefficient state-owned industrial sector; the role of political parties as breeding grounds of clientelism and corruption, the inability of complex coalition governments to make credible long-term commitments to economic stability and structural reform, a weak but ever-present state, and a highly politicized public administration. The National Bank of Romania stood out as a lonely island of technical excellence in a sea of low institutional capacity to deliver on the formal and informal conditionality attached to euro entry. Of all the ten East European candidates, Romania’s domestic context offered arguably the poorest ¨ rzel 1999) with the letter and the spirit of the EMU ‘goodness of fit’ (Bo acquis. Its post-communist political elite failed to produce and sustain a strong agenda for domestic economic reform. Against this background of domestic weaknesses, Europeanization of economic and monetary policies was slow and partial, often driven by changes in the timing and content of the EU’s ‘gate-keeping’ strategy and opportunistic behaviour of domestic elites rather than a genuine domestic commitment to economic reform and the informal conditionality that underpins this commitment.

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Romania’s laggard role was summed up when it was the last of the initial ten Central and Eastern European applicants1 to conclude accession negotiations with the European Commission on 9 December 2004. Despite the festivities and the government’s reiteration of its confidence that Romania was firmly on course for EU membership (alongside Bulgaria) on 1 January 2007, Romania’s ability to adhere to the provisions of the EU acquis, particularly in areas related to the Single European Market, was seriously questioned. As late as November 2003, the European Commission (2003: 121) granted Romania only a qualified recognition as ‘a functioning market economy’. The chapters on Competition and on Justice and Home Affairs (especially anti-corruption measures and judicial reform) were the last and most difficult ones to resolve. In consequence, the European Commission made Romania’s entry into the EU conditional on the implementation of eleven additional measures in these fields, envisaging a oneyear delay in the timeframe of accession in the case of non-compliance. While a similar safeguard clause was introduced for all 2004 entrants (and later Bulgaria), the Romanian one is widely regarded to be the most stringent. Its activation requires a qualified majority rather than unanimity as in the case of other applicants. The enhanced conditionalities attached to the final stages of Romania’s path towards EU membership reflect a wider pattern of hesitation and suspicion in its turbulent relations with the EU. Successive Romanian governments have found it hard to convince their EU counterparts of the merits of the country’s candidacy. Romania’s post-1989 political development has been characterized as an ‘unfinished revolution’ (Roper 2000; Light and Phinnemore 2001). The process of economic reform has also been compromised by inconsistencies and confusion. Relative political stability and a much improved economic performance under Nastase’s government (2000–4) partially restored Romania’s credibility and boosted its European ambitions. The election of the new Alliance government, in December 2004, also generated a degree of optimism over the acceleration of economic reform. However, questions about the sustainability of recent success remain. In the short term, dispersing these doubts will be crucial if the target for EU accession in 2007 is to be met. In the longer term, maintaining a reputation for economic stability and fiscal discipline will be a key condition for fulfilling Romania’s self-declared ambition for joining the Euro Area by 2014 (Table 11.1). 1 Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slovakia, and Slovenia.

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Romania as Eastern Europe’s Sisyphus Table 11.1. Prime ministers, finance ministers, government coalitions, and central bank governors in Romania, 1989–2004 Prime minister

Finance minister

Supported by

26.12.89–20.6.90

Petre Roman (FSN)

FSN

20.6.90–26.9.91

Petre Roman (FSN)

1.10. 91–4.11.92

Teodor Stolojan (non-affiliated)

Victor Stanculescu (military) Teodor Stolojan (non-affialted) Teodor Stolojan (non-affiiated) Eugen Dijmarescu (FSN) Gheorghe Ion Danielescu (PNL)

4.11.92–6.3.94

Nicolae Vacaroiu (non-affiliated) Nicolae Vacaroiu (non affiliated; PDSR) Nicolae Vacaroiu (PDSR) Victor Ciorbea (PNTCD)

6.3.94–3.9.96

3.9.96–12.12.96 12.12.96–30.3.98

Florin Georgescu (non-affiliated) Florin Georgescu (non-affiliated) Florin Georgescu (non-affiliated) Mircea Ciumara (PNTCD) Daniel Daianu (non-affiliated) Traian Decebal Remes (PNL)

2.4.98–14.12.99

Radu Vasile (PNTCD)

22.12.99– 28.12.00

Mugur Isarescu (non affiliated)

Traian Decebal Remes (PNL)

28.12.00– 21.12.04

Adrian Nastase (PDSR/PSD)

29.12.04 - present

Calin PopescuTariceanu (PNL)

Mihai Nicolae Tanasescu (PDSR/PSD) Ionut Popescu (PNL)

Central Bank Governor

FSN

Mugur Isarescu1

FSN/FDSN þ PNL þ MER þ PDAR FDSN/PDSR

Mugur Isarescu

Mugur Isarescu 2

PDSR þ PUNR

Mugur Isarescu

PDSR

Mugur Isarescu

CDR (PNTCD, PNL, PAR) þ PD3 þ UDMR

Mugur Isarescu

CDR (PNTCD, PNL, PAR4) þ PD þ PSDR þ UDMR CDR (PNTCD, PNL) þ PD þ PSDR5 þ UDMR PDSR/PSD

Mugur Isarescu

DA (PNL, PD) þ UDMR þ PUR

Mugur Isarescu

Mugur Isarescu

Mugur Isarescu

(1) Central Bank (National Bank of Romania) established in December1990 (2) PUNR left the Government on 2.9.96. (3) PD left the Government on 28.1.98. (4) PAR left the Government on 29.10.98. (5) PSDR left the Government on 8.9.00. CDR: Democratic Convention of Romania (multi-party alliance) DA: Justice and Truth (two-party alliance) FDSN: Democratic National Salvation Front (> PDSR 10 Jul 1993) FSN: National Salvation Front (FDSN > from 7 Apr 1992) MER: Romanian Ecologist Movement PAR: Alternative Party of Romania PD: Democratic Party PDAR: Agrarian Democratic Party of Romania PDSR: Party of Social Democracy in Romania (PSD > 16 Jun 2001) PSD: Social Democratic Party PNL: National Liberal Party PNTCD: National Peasant Party Christian Democratic PUNR: Party of Romanian National Unity PUR: Humanist Party of Romania UDMR: Hungarian Democratic Federation of Romania Source: Author’s own calculations.

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The recently completed accession negotiations offer a useful insight into the Europeanizing effects of the EU enlargement process on domestic economic and monetary policies. The underlying assumption of the Europeanization literature has been that the non-negotiable content of the EU acquis, coupled with the strong conditionalities and the huge power asymmetries associated with the enlargement process, produce strong adaptational pressures on accession states (Papadimitriou and Phinnemore 2003). Yet the impact of Europeanization over time, and across different sectors and countries, in Eastern Europe varies significantly. As both the EU ‘gate-keeping’ strategy on enlargement (Grabbe 2001) and the EMU acquis have evolved over the past decade, and given the phases of EMU accession, different East European states have been exposed to the ‘top-down’ pressures of Europeanization at different times and with various degrees of intensity. The impact of Europeanization on domestic opportunity structures has also been diverse and changing, reflecting the fluid political and institutional contexts of Eastern Europe’s young democracies. As a result, Europeanization-driven adaptation has generated different and sometimes changing groups of ‘leaders’ and ‘laggards’ in euro entry. Ultimately, the diverse outcomes of Europeanization of economic and monetary policies in Eastern Europe can be best understood by reference to the domestic constellations that mediate the impact of the EMU acquis (Papadimitriou and Phinnemore 2004).

Romania’s Troubled and Incomplete Transition: Domestic Blockage and Elusive Europeanization The violent overthrow and subsequent execution of Romania’s communist dictator was one of the most enduring images of the revolutions that swept through Eastern Europe in late 1989. Nicolae Ceausescu’s dictatorial credentials and the political repression associated with his regime are well documented (Deletant 1996). In comparison, the economic strategies of Romania’s communist regime have received less attention, despite the fact that the last decade of Ceausescu’s rule produced some of the most extreme and brutally implemented socioeconomic experiments ever seen in the former Soviet block. The single most important initiative was the decision to repay the country’s foreign debt, which in the early 1980s had exceeded 10 billion US dollars. By the end of the decade the debt repayment target had been met with ruthless efficiency. In 1989, Romania enjoyed the best debt-to-GDP ratio in Eastern Europe, and its foreign

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reserves exceeded 1.7 billion US dollars (Daianu 1997: 97). In the process the Romanian people suffered unimaginable hardship. The draconian restrictions on imports resulted in major shortages of basic goods, and household energy consumption was severely rationed (Ronna˚s 1991). By the end of the decade the economic implosion caused by the debt-repayment programme reduced GDP per capita by almost one-third, making Romanians the second poorest nation in Eastern Europe (ahead of Albania), with a yearly income of 1,571 US dollars in 1989 (OECD 1993: 12). By the time of Ceausescu’s fall Romania had virtually no experience of the limited free market operations that had been introduced by more ‘reform-minded’ communist regimes in Eastern Europe (e.g. in Czechoslovakia and Hungary). Immersed in a climate of fear that punished private initiative, Romania lacked even the most basic human capital on which it might have drawn to lead the economic reform process. The country was also unable to count on a sizeable Diaspora (like, e.g. the Baltic States), able to offer economic assistance and capitalist know-how during the early years of post-communist transition. The prospects for genuine economic and political reform were further undermined by the peculiarities of Romania’s 1989 ‘revolution’. The emergence of the National Salvation Front (FSN) as the dominant political force following the overthrow of Ceausescu in December 1989 pointed to a continuum, rather than a clean break, from the previous communist order. In ideological terms, the outlook of the FSN was blurred, reflecting the diverse origins of its supporters and the conflicting personal ambitions of its leading members. Overall the party engaged in a heavily patriotic and populist rhetoric, constantly emphasizing the virtues of national unity and social cohesion. This rhetoric disguised the absence of a clear strategy for economic and political reform and an increasing preoccupation of the FSN with consolidating its position in Romania’s confused and fragile early post-communist scene. The national populist outlook of the FSN left a deep mark on Romania’s strategy for economic transition and shaped the weak Europeanization of economic and monetary policies. Ion Iliescu and his close associates made it clear that Romania would not follow the aggressive agenda for economic reform pursued in other post-communist countries in Eastern Europe. Instead, they supported the paradigm of ‘economic gradualism’, encapsulated by the FSN’s electoral slogan ‘therapy, not shock’. In effect, the commitment to ‘economic gradualism’ reflected the unwillingness of Romania’s post-communist rulers to dismantle the huge apparatus of state-run firms. These firms provided the FSN (and its successors the Democratic National Salvation Front—FDSN—and the Romanian Social

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Democratic Party—PDSR) with a powerful network of electoral support and a rich source of political financing. The heavy shadow of an increasingly partisan state over the economy bred corruption and provided powerful domestic veto points against economic reform. Consequently, the various stabilization programmes during the first half of the 1990s failed to produce their anticipated results. Along the way, much of Romania’s potential for economic recovery was lost, and with it the promise of keeping the social costs of transition low. Eventually those who were supposed to benefit from the paternalism of the Romanian state would be asked to pay a heavy price for the persistent underperformance of the Romanian economy as a whole. The arrival of the centre-right Democratic Convention for Romania (CDR) into power after the November 1996 election was meant to put an end to this strategy of economic gradualism. The CDR had fought the election on a programme of radical economic reform based on price liberalization, fiscal discipline, and the aggressive pursuit of ambitious privatizations. The ability of the new government to deliver on its promises, however, was fatally undermined by internal conflicts and major inconsistencies in the design and implementation of its reform strategy. As the Romanian economy declined rapidly in 1997–8, the ruling coalition withered away and was followed by a quick succession of governments till, in December 1999, the Romanian President called in the president of the National Bank of Romania, Mugur Isarescu, to head the government for a year till the elections. By 2000 the failure of Romania’s post-communist elites to manage the transition to a market economy had become evident. GDP had not yet recovered to its pre-1989 level. Romania had suffered two major recessions during 1991–3 and 1997–8. In the intervening periods export-led economic growth had produced some short-term benefits, but eventually resulted in an overheating crisis and an explosion of inflation during 1997 (Daianu 2001). Strong inflationary pressures remained a constant feature of Romania’s transition, registering three digit figures during the first half of the 1990s and ending the decade at a level of 50 per cent. In 1999 one-third of Romanian citizens lived below the IMF’s poverty rate (World Bank 2004b: 2). Throughout the 1990s fiscal discipline remained lax, with budget deficits averaging well over 4 per cent of GDP. Fiscal imbalances were further exacerbated by the existence of substantial quasi-fiscal deficits that were fuelled by bad debts between state-owned enterprises and tax arrears, as well as government subsidies on fuel for both industrial and domestic consumption.

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The extent of Romania’s quasi-fiscal deficit in 1991 was estimated at well over 50 per cent of GDP. Much of the pressure on public finances was sustained by the continuing operation of a large number of loss-making public enterprises that were neither restructured nor privatized. By the end of the 1990s Romania enjoyed the worst privatization record of all ten east European candidates. Both voucher-based privatization programmes of 1991 and 1995 ended in failure due to lack of transparency and poor administration (Stan 1997), while accusations of mismanaged privatizations under the Adrian Nastase government (2000–4) threatened major compensation claims and an additional fiscal burden. The mismanagement of the privatization process, coupled with macroeconomic instability and legal uncertainties, also had a detrimental effect on Romania’s ability to attract foreign investment. Despite the advantages of size and low production costs, FDI inflows during the first half of the 1990s averaged less than 1 per cent of GDP; a figure well below those registered in other East European applicants over this period. Monetary and exchange-rate policies were fatally undermined by fiscal indiscipline and continuous government interference over the operations and policy objectives of the National Bank of Romania. As a result confidence in the Romanian currency remained low, and the country experienced frequent external vulnerabilities caused by depleting foreign currency reserves and high current account deficits. On two occasions, in 1991 and 1999, a payment default was averted at the eleventh hour. Starting from minimal levels in 1989, Romania’s external debt had reached over 25 per cent of GDP by 1999. Although small compared with foreign debt levels in other east European applicants, the rise of Romania’s foreign indebtedness was amongst the fastest in the region. Romania’s turbulent path towards democratic consolidation and economic transition during the 1990s highlights a weak adaptive and anticipatory Europeanization of economic and monetary policies compared to other east European states. For many central European and Baltic applicants the ‘return to Europe’ paradigm (of which EU membership was a central feature) had unleashed powerful domestic pressures for reform that swept away the previous communist order and, within a decade, had propelled them to the doorstep of the EU. In the case of laggards like Romania the transformative effects of EU accession were mediated by a domestic context that proved much more resilient to change. In Romania this domestic context was shaped by the catastrophic legacies of the Ceausescu era, powerful veto players in the state-owned sectors, the absence of a post-communist elite knowledgeable about market economies,

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a fragmented and fluid party political system, and lack of institutional capacity in the executive branch. Although these factors featured in the transition processes of other east European applicants, their cumulative effects in the Romanian case conspired to produce a domestic constellation that failed to respond adequately to the adaptational pressures associated with EU and with EMU accession. In July 1997, the Commission’s Opinion on the Romanian EU membership application listed the shortcomings of its transition process in painful detail. Romania had failed to meet the Copenhagen criterion on a functioning market economy, whereas it was judged to be ‘on its way’ towards fulfilling the political criterion for membership (European Commission 1997: 114). Consequently, Romania (alongside Bulgaria, Latvia, Lithuania, and Slovakia) was not amongst the countries invited to start fast-track accession negotiations with the EU in March 1998. This followed an earlier pattern in the EU’s gate-keeping strategy (Grabbe 2001) in which Romania (grouped with Bulgaria) had always lagged behind central European applicants in their ascent of the EU ladder of contractual relations with postcommunist Eastern Europe (Papadimitriou 2002). In the minds of EU policymakers, this ‘relegation’ was the result of an objective assessment of the applicants’ progress in meeting various EU conditionalities and provided those excluded with additional incentives to accelerate the pace of domestic reform. However, in practice, this strategy of relegation had a rather disruptive effect on the reform discourse in laggard applicants like Romania as it raised questions about the EU commitment to assisting their transition process and deprived domestic modernizers of a powerful leverage in defeating well-entrenched veto points at home. The next section discusses how changes in the EU gate-keeping strategy at the end of the 1990s assisted Romania’s efforts to develop a more virtuous economic strategy structured around a strong commitment to complete EU accession negotiations by the end of 2004.

Post-Helsinki Romania: External Empowerment and Unlikely Domestic Reformers The economic difficulties and political instability in Romania during 1999 coincided with major geopolitical changes in the Balkans and a radical rethink of EU enlargement strategy in Eastern Europe. The end of the war in Kosovo intensified calls for greater international engagement with the region and for rewards for those states like Romania and Bulgaria that

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supported the NATO-led operations against Serbia. The new European ¨ nter Verheugen, argued for an end to Commissioner for Enlargement, Gu the Commission’s two-speed enlargement strategy agreed in Luxemburg in 1997 in favour of fast-track accession negotiations with all ten east European applicants. The timing of the endorsement of Verheugen’s proposals by the Helsinki European Council in December 1999 coincided with a new Romanian government under the bi-partisan president of the National Bank of Romania, Isarescu, with a commitment to restore economic stability and kick-start the process of structural reform. In the parliamentary and presidential elections of late 2000 the centre-right Democratic Convention was swept way. Iliescu returned victorious to the Cotroceni presidential palace, and a new PDSR government under Nastase was installed. The return of the PDSR (in 2001 renamed the Social Democratic Party, PSD) to power was initially greeted with suspicion by Romania’s European and international partners. The poor economic record of the first half of the 1990s offered little promise that the new government would be able and willing to pursue economic stability and structural reforms. However, the PDSR was a much-changed party. During its time in opposition, it had tried hard to modernize its structures and place itself more firmly within mainstream European social democracy. While the strength of traditionalists within the PDSR remained considerable, the Nastase government tried to project a more competent managerial image, and the new prime minister made no secret of his appetite for radical economic reforms. While Iliescu concentrated on carving a more consensual profile during his second Presidency, Nastase was able to pursue his agenda relatively free from day-to-day interference from the Cotroceni. This privilege had been mostly denied to all of his predecessors. Above all, the rethink of EU gate-keeping strategy at Helsinki opened up an unexpected window of opportunity for the PDSR/PSD to redeem its past failures and reinvent itself as the party responsible for bringing Romania into the EU. At the same time, the combination of new opportunities opened by Helsinki with memories of being in the slow track delivered a powerful message to Romanian policymakers—that, if past failures continued, Romania risked real and imminent international isolation. Against this background, the Nastase government’s target for completing accession negotiations by the end of 2004 introduced a renewed sense of urgency and a clear timeframe for reform that had been missing in previous years. The highly structured nature of the accession negotiations (built around the thirty-one chapters relating to the EU acquis) helped Romania’s weak public

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administration to identify specific reform agendas for each policy area under discussion. The Commission’s close scrutiny over the design and implementation of these agendas left little room for complacency and inertia. More importantly, the fast pace of accession negotiations unleashed unprecedented pressures for executive reform and, particularly, the improvement of executive coordination. In previous years the fragmentation of Romania’s party political scene had been a major contributing factor to the inconsistencies surrounding economic (and wider public) policymaking. All but one of the country’s elections since 1990 failed to produce a single-party majority in the Parliament. The intense bargaining between coalition partners over the allocation of ministerial posts contributed to a turnover of seven prime ministers and more than a dozen government reshuffles, bringing about frequent changes in the names, structures, and competencies of individual ministries. Against this background no single executive institution was able to emerge as a recognized ‘leader’ in the design and implementation of economic reform. In addition, the constant struggle to accommodate intra-coalition politics and reconcile personal rivalries left most Romanian prime ministers unable to control their cabinet fully and to coordinate its work effectively. Unlike most of his predecessors, Nastase was able to address this problem with some success, mainly through the strengthening of the General Secretariat of the government and the powerful coordinating role assumed by the Ministry of European Integration. Encouraged and constrained by its intensifying elite interaction with the EU, the PSD government was able to accelerate the pace of domestic reform. Simultaneously, during the period 2000–4 the progress of Romania’s macroeconomic indicators was remarkable (European Commission 2004e: 22). Annual GDP growth averaged over 5 per cent, driven predominantly by investment and exports. Inflation, which in 2000 stood at a yearly average of 45.7 per cent, declined steadily to around 11 per cent in 2004, with single digit figures predicted for 2005. Fiscal discipline also improved. In 2003, the deficit of the general government was 2 per cent of GDP, a marked improvement from the 1999 figure of 4.5 per cent. Despite an increasing foreign debt (30.2 per cent of GDP in 2003) and a substantial current account deficit (5.8 per cent of GDP in 2003), the external vulnerabilities of the Romanian economy decreased as the result of record levels of foreign reserves (8 billion US dollars by the end of 2003). The overall economic improvement was confirmed in October 2003, when Romania successfully concluded its 2001 arrangement with the IMF, for the first time after five consecutive failures during the 1990s.

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In structural reforms the record of the Nastase government was mixed. By the end of 2003 Romania continued to have the worst privatization record of the east European accession states. While the share of the private sector in GDP had increased steadily to 69.1 per cent, only 40 per cent of Romania’s large enterprises and about two-thirds of its medium-sized enterprises were privatized by the end of 2003 (World Bank 2004b: 18). Despite this slow progress, a number of high-profile privatizations were concluded during 2003–4. Building on earlier attempts by the Radu Vasile and, particularly, the Isarescu governments to restructure the financial sector in the aftermath of the 1998–9 banking crisis, the Nastase government privatized Bank Agricola in 2001. This was followed by the sale of a majority stake in Romania’s largest state-owned bank, Bank Commerciala Romana, to foreign investors in 2003–4. In the energy sector the government proceeded with the breaking up of the electricity (CONEL) and gas (ROMGAS) monopolies, while the 2.2 billion euro sale of 51 per cent of Petrom in July 2004 was the largest-ever privatization deal in South-east Europe. The continuing restructuring of the banking system and the privatization of some of Romania’s loss-making industrial mammoths partially eased the pressure for direct government subsidies. However, the government’s implicit subsidies to the enterprise sector were much higher and continued to rise. The World Bank (2004b: 21) estimated that implicit government subsidies accounted, in 2002, for 7.2 per cent of GDP, whereas tax arrears for the same year were in excess of 12.5 per cent of GDP. Both the European Commission (2004e: 28) and the World Bank (2004b: 40–3) identified price subsidies and gross inefficiencies in the energy sector as the principal cause of Romania’s quasi-fiscal deficit. In response, the Romanian government speeded up energy privatizations and significantly raised prices of energy products in 2003–4. However, the lack of investment and the considerable distortions that still plague this sector cast a heavy burden on the whole of the Romanian economy and generated serious environmental problems. The Nastase government left a legacy that bore little resemblance to his party’s failures during the 1990s. Within the context of Romania’s turbulent democratic consolidation the distinction between pro-European modernizers and unreconstructed communist sympathisers had become increasingly blurred and highly interchangeable. The prospect of claiming the prized conclusion of EU accession negotiations during their tenure in office galvanized the Social Democrats to support a reform agenda that ran against the ideological grain of many of their leading members. Had the prospect of EU membership not been so credible and tied to a timetable, it is highly

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unlikely that the impetus for reform would have able to overcome powerful domestic veto points. In short, EU gate-keeping strategy was a crucial factor in shaping the domestic discourse of reform and in altering domestic opportunity structures, and thereby capable of transforming even the most reactionary political forces into torchbearers of Europeanization. However, neither the fruits of fast economic growth nor the political rewards of successful EU accession negotiations insulated the Social Democrats from the harsh judgement of the Romanian electorate during the presidential and parliamentary elections of November–December 2004. Nastase’s bid for the Presidency was defeated by Traian Basescu, the candidate of the centre-right coalition Justice and Truth Alliance (a successor of the Democratic Convention). Despite being the largest party in the new parliament, the PSD was forced into opposition, and a new four-party coalition government was formed under the prime-ministerial candidate of the Alliance, Calin Popescu-Tariceanu. The electoral outcome confirmed the extent to which the reforms of the Nastase government had alienated many of the traditional PSD supporters, particularly in rural areas and in the state-controlled sectors of the economy. For the urban population, however, and for those anxious to see a more dynamic economic development, the PSD reforms did not go far enough. Despite macroeconomic improvement, many still resented the clientelism and arrogance often associated with the PSD government’s practices. Public confidence in the civil service, the judiciary, and the market was also corroded by widespread corruption and a perception of a party-state that was suffocating the healthy segments of Romania’s society and economy. The PSD’s inability to respond to growing demands for more transparent and accountable public policymaking contributed to its electoral downfall in 2004. How best to deal with this complex problem will also be a major challenge for the new government of Popescu-Tariceanu, if one of the key pre-election pledges of the Alliance is to be met.

Romania’s Membership of EMU: Policy Legacies and Future Challenges As Romania edges closer towards its objective of EU membership by 2007, its later entry into the Euro Area becomes an increasing preoccupation for its policymakers. In November 2004, the president of the National Bank of Romania, Mugur Isarescu, set a target date of 2014 for Romanian membership of EMU. First and foremost, the EMU acquis for EU entry required

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legal compliance with ECB and European Commission opinions on central bank independence. In June 2004, the Nastase government introduced a new law (No. 312/2004) amending the statute of the National Bank of Romania in response to Commission criticisms that the previous legislative framework (enshrined in law No. 101/1998) ‘ . . . fell short of granting the National Bank of Romania full independence’ (European Commission 1999). Under its new statute the National Bank of Romania is recognized as ‘an independent public institution’ (Article 1) which ‘ . . . shall not seek or take instructions from public authorities or from any other institution or authority’ (Article 3). In addition to its new statute, the independence of the National Bank of Romania has been further strengthened by the amendment, in 2004, of Romania’s public debt law which closed a number of loopholes that had been used in the past to allow the direct financing of budget deficits from the National Bank of Romania’s reserves and restricted the government’s privileged access to financial institutions. The strengthening of the central bank’s independence in 2004 did not generate a great deal of political controversy similar to that witnessed in other east European candidates such as Poland and Hungary. Yet the central bank’s new role was viewed with suspicion by many traditionalists within the PSD who, during the course of the 1990s, had grown accustomed to the idea of the National Bank of Romania being asked to foot the bill for the miscalculations of their ‘gradualist’ economic reform agenda. On the other end of the political spectrum, the National Bank of Romania also faced critics who argued that it had failed to assert its authority against the government’s fiscal irresponsibility and was far too willing to sacrifice its inflation targets in order to compensate (through its monetary and exchange-rate policies) for Romania’s wider macroeconomic imbalances. These criticisms, however, never really seriously challenged the prospect of the National Bank of Romania’s empowerment within the context of Romania’s legal convergence with the EMU acquis. The timing of the reform of the National Bank of Romania’s statute—6 months prior to the scheduled conclusion of Romania’s accession negotiations—also made it difficult for domestic opponents to put in question the credibility of the country’s leading financial institution. Against this background, the National Bank of Romania’s reputation as an island of economic stability and expertise, which moderated (rather than exacerbated) the inconsistencies of Romania’s economic transition, was not threatened. The Commission, in its 1999 Regular Report, also recognized the strength of the National Bank of Romania’s institutional capacity, arguing that it was ‘ . . . one of the

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institutions best equipped to perform its tasks, with regard both to the quantity and qualification of staff’ (European Commission 1999). The National Bank of Romania’s domestic strength was also reinforced by its relative institutional stability and its bipartisan credentials. Ever since the overthrow of Ceausescu, Romania’s economic and political transition had been adversely affected by the excessive politicization of the public administration, which resulted in widespread institutional fluidity and a very high turnover of personnel. The National Bank of Romania, which assumed the responsibilities of a central bank in December 1990, stood as a sharp contrast to the prevailing pattern of post-communist Romanian politics. The bank’s governor, Isarescu, remained in his post since 1990 and served under both the Iliescu and the Constantinescu presidencies.2 This made him by far the longest-serving public official in Romania, and he was by 2005 the third longest-serving central banker in the world. The other eight members of the National Bank of Romania’s Board also had a powerful claim to independence, having been appointed (like Isarescu) for a renewable five-year term through consensual procedures involving both chambers of the Romanian Parliament (where no single party had an absolute majority). The amendment of the National Bank of Romania’s statute received a positive welcome from the European Commission, which, in its 2004 Regular Report, recognized that Romania had made ‘major’ progress towards meeting the EMU acquis (European Commission 2004e: 87). The Commission’s praise, however, was not unqualified. The Report stated that further safeguards ‘ . . . might be needed . . . ’ regarding possible ‘lending of last resort’ operations and the government’s ‘privileged access’ to financial institutions. More tellingly, the Commission also demanded that decisions regarding the dismissal of the National Bank of Romania’s Governor ‘ . . . should be exclusively referred to the European Court of Justice’ (European Commission 2004e: 88) and not to Romania’s High Court of Cassation and Justice as was originally envisaged by Law 312/2004. This position was an indication of the Commission’s anxiety over how the formal transposition of the EMU acquis would square with the politicization and unpredictability that has dogged Romania’s economic policymaking in the past. In addition to stronger guarantees of institutional independence, the 2004 amendment of the National Bank of Romania’s statute also 2 During his term as prime minister (December 1999–December 2000), Isarescu retained his role as president of the National Bank of Romania.

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introduced a sharper focus of its policy objectives, with price stability now recognized as the bank’s ‘primary’ responsibility (Article 2). This redefinition was a significant departure from its previous statute, which referred to the more ambiguous target of ensuring ‘. . . stability of the domestic currency with a view to maintaining price stability’ (Law 101/1998). The country’s improved macroeconomic performance allowed more scope for the National Bank of Romania to concentrate on its disinflation target. The shift towards inflation targeting—due to become operational in 2005—is a reflection of the central bank’s enhanced confidence and responsibility in this respect. Yet its new priorities carry with them significant risks. At a technical level, the development of the statistical capacity to anticipate and forecast economic developments in the country will be a crucial element of its success. As the National Bank of Romania’s policy objectives become more precise, its ability to deliver on low inflation will also come under closer scrutiny, with profound implications for its reputation and accountability to the Romanian public. Above all, however, its biggest test will be its ability to exercise its responsibilities with the significant degree of independence awarded to it by the EMU acquis. In previous years the National Bank of Romania’s inflation targets have been severely compromised either by direct political interference (particularly during the first half of the 1990s) or by the inability of successive Romanian governments to adhere to fiscal discipline and pursue structural reform. While in recent years coordination between government and the National Bank of Romania has improved, both the European Commission and the World Bank have warned of the dangers of returning to the inconsistencies witnessed during the 1990s. In exchange-rate policy, the National Bank of Romania is also likely to face key challenges to its credibility and independence from the government. While the elaboration of exchange-rate policy has been officially a prerogative of the National Bank of Romania since the early years of transition, its scope for independent action has been fatally undermined by continuous government interference and pressure. Confidence in the Romanian currency, the leu, was shattered during 1991 when the government introduced a compulsory conversion of foreign exchange deposits held by enterprises into lei deposits at the official, highly overvalued, rate fixed by the central bank. Soon afterwards, a full retention regime was introduced to prevent the ensuing capital flight (Daianu and Vranceanu, 2000). While an embryonic foreign exchange market was introduced in 1992, the government’s strategy of keeping the leu overvalued continued through a series of administrative measures. This led to the de facto

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existence of multiple exchange rates for the leu, with the government’s official rate bearing little resemblance to the rate accepted by the market (Dragulin and Radulescu 1999). This de facto fragmentation ended in 1997 when a fully fledged foreign exchange market was introduced, and multiple exchange rates were unified. Soon afterwards most of the restrictions on capital inflows were abolished, while a number of controls remained with regards to capital outflows. Despite official protestations that the ‘strong leu’ strategy was an integral part of the effort to curb inflation, the pressure to sustain an overvalued currency during the period 1991–7 was also inextricably linked to the domestic political agenda of FSN/FDSN/PDSR. In particular, cheap energy imports that resulted from an overvalued leu were used to subsidize a huge network of state-owned, energy-intensive, enterprises which remained the backbone of domestic support for Iliescu’s party. While, in the short-term, this strategy helped the state-controlled economy to survive, its impact on the current account deficit and the competitiveness of ‘independent’ private exporters was devastating. However, within the context of a liberalized foreign exchange market, upholding a strategy of appreciation for the leu became an increasingly difficult target to meet. When both the domestic economy and the international financial markets took a turn for the worse in 1998, the leu came under strong pressure, leaving the National Bank of Romania struggling to contain its depreciation against the euro and, particularly, the US dollar. With the foreign reserves of the National Bank of Romania dangerously depleted and an ever growing current account deficit, Romania come close to declaring an external payment default in the Summer of 1999. The apparent failure of monetary and exchange-rate policies to bring inflation under control and protect the country against external vulnerabilities opened up a debate on whether Romania should follow Bulgaria’s example and introduce a currency board as a means of providing an anchor for macroeconomic stabilization. However, Bulgaria’s impressive record of curbing inflation during 1998 did not provide a powerful enough incentive for policy contagion to its Balkan neighbour. Both senior officials in the government and influential economic commentators in Romania (Dragulin and Radulescu 1999; Daianu and Vranceanu 2000) argued against the introduction of a currency board on the basis that it would not insulate the Romanian economy from external shocks and would deprive the authorities of the use of monetary policy as a means of steering the economy towards further reform. An important argument of the opponents of a currency board was the need to use the National Bank of

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Romania’s role as a lender of last resort in order to close down insolvent banks, without triggering panic. The fact that Romania had not faced a banking melt down, similar to the one experienced by Bulgaria in the mid1990s, seems to have been a major factor in the decision not to emulate the Bulgarian model. Since 1999, the National Bank of Romania’s main objective centred on the need to maintain a controlled depreciation of the Romanian currency (through a system of ‘managed floating’) as a means of pursuing the delicate task of curbing inflation while maintaining the external competitiveness of the Romanian economy. This strategy remained largely unchanged until late 2004, when the central bank announced its intention to limit its interventions in the foreign-exchange markets in line with EU requirements. In the light of the country’s much improved macroeconomic performance, this announcement of the National Bank of Romania’s decision was followed by an 8 per cent appreciation of the leu against a basket composed of 75 per cent euros and 25 per cent US dollars. The National Bank of Romania remained relaxed about this development, arguing that, this time, the appreciation of the national currency was not the product of political short-termism but instead the result of the operation of the free market. The central bank also argued that the value of the leu continued to be compatible with its disinflation objective and contributed to Romania’s real convergence with the EU. This optimism, however, contrasted sharply with the concerns of Romanian exporters, who argued that a strong leu could jeopardize growth and contribute to further deterioration of the trade and the current account deficits. The recent debate over the National Bank of Romania’s exchange-rate policy is another indication of its greater exposure to the judgement of domestic (and international) economic circles, as well as of its delicate role in regulating a highly dynamic and increasingly open economy. The full liberalization of capital markets, scheduled for 2005, will also pose a significant challenge in this respect (European Commission 2004e: 25). By 2005 the Romanian economy was experiencing significant inflows of capital as a result of a much improved FDI record and an increased interest of foreign investors in Romanian assets. However, its ability to absorb these inflows without triggering inflationary pressures or speculative bubbles, similar to those experienced by existing member states in the run up to EU and EMU membership, is far from clear. The National Bank of Romania is, therefore, confronted by a difficult policy puzzle: how to drain an excessive supply of money without damaging Romania’s economic growth and fragile reputation as an attractive place for investment.

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The success with which the National Bank of Romania deploys its monetary and exchange-rate policies, as well as its regulatory role in meeting these challenges, are likely to become a key determinant of the country’s path towards membership of ERM II and eventual entry into the Euro Area. Ultimately, however, the realization of euro entry will depend on the government’s determination to pursue long-delayed structural reforms and stick to a strategy that is conducive to the central bank’s low inflation targets. A consistent strategy for economic reform will also help Romania’s real convergence with the EU and lead to an improvement of living standards for the Romanian population, whose GDP per capita stood at 29.8 per cent of the EU average in 2004 (the lowest in the EU27). The acceleration of economic reform has been at the top of the domestic agenda of Romania’s newly elected prime minister, Popescu-Tariceanu. In a highly symbolic move, the new government—in its first meeting—announced sweeping tax cuts and the introduction of a 16 per cent flat rate income and corporation tax. Supporters of the new government argued that this move would promote entrepreneurship, accelerate growth, and encourage less government spending. For the government’s opponents, the new tax cuts would undermine macroeconomic stability and fuel further inflationary pressures. Either way, the outcome of the new Prime Minister’s gamble will be yet another twist in Romania’s eventful and fitful march towards full integration into the EU structures.

Conclusion Over the past fifteen years the Europeanization of Romania’s economic and monetary policies broadly followed the nature of its transition to a functioning market economy and of its democratic consolidation: delayed, uneven in its pace and its impact across different policy areas, and lacking a firm domestic political drive. These characteristics were shaped by the terrible legacies of the Ceausescu regime, the lack of domestic institutional capacity to manage structural reforms and secure fiscal discipline, and the unwillingness of the post-communist milieu to make credible long-term commitments to stabilize the economy and to deliver structural reforms. As the failures of the FSN’s economic gradualism became apparent, the appetite for change grew stronger, but its success was ultimately compromised by an unsuccessful policy-mix, poor implementation, and political infighting. The process of macroeconomic stabilization did not start until the very end of the 1990s, before gathering pace. In

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comparison, the progress on structural reform has been slower, with privatization in particular confronted by powerful veto points in the wider public sector. Poor governance, judicial inadequacies, and a weak public administration have also undermined the development of clear rules in the private sector and have failed to fully utilize Romania’s potential as a foreign investment destination. Despite these limitations and omissions, the recent acceleration of macroeconomic stabilization and structural economic reforms in Romania is a testament to the domestic transformational effects of EU enlargement. The country’s entry into fast-track accession negotiations with the EU in December 1999 was particularly important. The decision of the Helsinki European Council was perceived by Romanian political elites, especially the Nastase government, as the last chance to catch up with Eastern Europe’s frontrunners. The result was an empowerment of domestic reformers and, not least, the National Bank of Romania. More importantly, the process of negotiating with the European Commission imposed on the Romanian government strong conditionalities and a tight timeframe for the pursuit of domestic reform. While international financial institutions like the IMF have had a significant impact in designing Romania’s strategy for economic recovery, the need for compliance with the Single European Market and the EMU acquis has shaped the overall context of reform. The coincidence of the new Alliance government with difficulties surrounding the accession agreement in 2004–5 added a further catalyst to domestic reforms. However, Romania had much to do before it could contemplate ERM II entry, let alone come to grips with the full implications of the 2014 target date for Euro Area entry.

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Part III Patterns of Sectoral Governance

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12 Financial Market Governance: Evolution and Convergence Piroska Moha´csi Nagy

The transformation of the financial sector in CEE—understood as the eight new EU member states plus Bulgaria, Romania and Croatia—has been one of the fastest and most dramatic in recent economic history. In the matter of a short decade and a half, the sector has transformed from a state-dominated mono-bank system, which performed quasi-fiscal operations on behalf of the government, into a reasonably effective, market-based system with many new competing banks providing increasingly sophisticated financial services (Table 12.1). Financial intermediation, measured as share of domestic credit to GDP, has increased from less than 25 per cent of the CEE’s GDP in 1990 to 54 per cent of GDP in 2004, athough the levels are still much lower than what can be considered their new equilibrium level or what is seen in the Euro Area (117 per cent). Based on a model developed by Cottarelli et al. (2003), the EBRD (2005a) has found that financial intermediation at end 2004 was in most countries well below what one would expect from their level of economic development (with the exception of Croatia). Banking stress and overt banking crises were integral parts of the initial process, which has made the transition economically costly and politically painful. Yet this painful process helped to cleanse the financial system from both inherited and initial transition-related weaknesses. It also crystallized policy options and actions in the direction that was required by the EU accession process. This chapter analyses financial sector development from the vantage viewpoint of the evolution and convergence of financial market governance and the role played by EU accession and EMU in this process. It

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Financial Market Governance Table 12.1. Summary of financial sector transformation in the CEE Region, 1989–2005 1989

2005

State ownership

Privatization is almost complete in most countries Most banks are domestically owned Majority of banks owned by well-established foreign strategic investors; regulations limit ‘pocket’ banks, serving specific industry connected lending or client interest Poor governance structure Improved governance structure with tighter favouring insiders controls on related party transactions and better transparency Financial sector consisting only Non-financial sector is emerging (insurance, of commercial banks mortgage banks, pension funds), but banks are still dominant Lack of medium and long-term lending Maturities extended, albeit still not fully meeting demand for long maturities Little bank finance of enterprise investment Rapidly increasing bank finance of households or of household mortgages and firms Low financial intermediation Rapidly increasing albeit still low level relative to economic development and levels in EU/Euro Area Poor bank asset quality Much improved thanks to balance sheet clean-ups, restructuring, and privatization. Risk management techniques more widely used Banking supervision/regulation Regulatory framework being brought up to does not exists EU standards Pervasive legal uncertainty Significant legal reforms have taken place in conformity to EU standards

explores the twin themes of privatization and foreign ownership and banking sector regulation. Both highlight a CEE ‘exceptionalism’: in the first case the role of ‘political affinity’ through ‘bottom-up’ Europeanization in the wake of bank crisis, in the second an extreme form of ‘topdown’ Europeanization (see Dyson, Chapter 1 above). The chapter also identifies the key remaining governance and institutional-regulatory gaps in CEE financial sectors relative to the EU15, including new sources of systemic risk in banking supervision resulting from global/EU requirements. Financial market governance is defined as the combination of the governance structure of financial institutions—board independence and quality, oversight of related party transactions, disclosure about management remuneration—and the global regulatory framework in which the institutions operate. The chapter focuses on banks because, despite the emergence of non-bank financial institutions—insurance firms, leasing companies, pension funds—banks still dominate the financial sectors in the region, accounting for about 90 per cent of the financial sector assets and 88 per cent of staff at end-2004.

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The Special Attributes of Financial Sector Governance Financial sector governance is a key aspect of economic development. The efficient mobilization of savings and allocation of funds by banks lowers the costs of corporations and increases investment and productivity, ultimately boosting potential growth and employment. This process requires strong and credible bank governance. In contrast, weak bank governance—managers acting in their own interest instead of that of shareholders—leads to inefficient resource allocation, and therefore suboptimal growth and employment. Yet bank governance has two special attributes that weaken traditional governance mechanisms in the sector: first, the governance structure is more opaque than in other industries; and second, government regulation is more widespread (Levine 2003). There is a delicate balance between these two elements: to the extent that bank governance structure can be strengthened through the better ability and incentives of private owners and investors to exert governance over the banks, there may be less need for extensive regulations that, by their nature, produce distortions and lead to suboptimal resource allocation. Regulation can also focus on empowering the private sector, for example, by strengthening investors’ ability to overcome information barriers via more extensive bank disclosure rules and enhancing the legal and bankruptcy procedures to protect investors and to improve monitoring (for details Levine 2003). A higher degree of opaqueness of bank governance structure stems from higher incidence of information asymmetries between the borrower and the bank on loan quality, as well as between bank managers and shareholders on portfolio quality (bad loans can be rolled over, connected lending can be remain hidden, etc.) and on existing bank risk (assets can be quickly restructured, risk mitigation instruments such as derivatives can be very complex, etc.). The ensuing difficulty of obtaining information about bank behaviour and performance weakens traditional governance mechanisms. Moreover, product market competition—an important mechanism to induce efficiency and effective governance—can be weaker in banking where banks form long-term relationships with clients. Hostile takeovers, another mechanism pushing banks to have better governance, are rare because of long regulatory approval processes and/or political concerns. The relatively heavy regulation of the sector is in part the consequence of the banks’ importance in the economy: a disruption in the functioning of the banking system can have serious repercussion for the functioning of

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the whole economy. In other words, the banking sector has strong externalities for the rest of the economy. But the opaqueness of the sector’s governance structure can also be a factor in higher government intervention. At the extreme, it can take the form of direct state ownership of banks. In general, it comes in the form of wide-ranging regulations. Regulations produce distortions; moreover, some of them may directly lessen incentives for better governance. For example, overly generous deposit insurance reduces depositors’ incentive to monitor banks. Moreover, regulators themselves may not always work to maximize social welfare but their own welfare, and they may also act in the interest of banks that they regulate rather than in the interest of the society (regulatory ‘capture’).

Evolution and Convergence of Financial Market Governance during Transition Financial sector transformation in the CEE has been marked by the interplay of these two special aspects of financial market governance: its specific structure and the degree of government regulation in the sector. At the outset of transition—the t 1 moment—there was absolute government intervention: banks were government-owned, performing quasi-fiscal operations, that is, providing capital to enterprises on the basis of government decision rather than market-based profit motivation. They did not act as banks. Market-based regulatory systems simply did not exist. The banks’ governance structure was reduced to being a department of the ministry of finance. The initial position of the banking sectors in transition countries differed, of course, according to the degree of the given country’s pre-transition liberalization effort. Hungary and Poland established in 1987 and 1988, respectively, two-tier banking systems, with a limited number of commercial banks operating on a quasi-commercial basis. Yugoslavia, which, at least formally, had always had a two-tier system even under the socialist regime, started liberalizing its financial sector in the 1980s. But banking sectors elsewhere in the socialist block, from the then Czechoslovakia, Albania, Romania, and Bulgaria to the republics of the Soviet Union, all had state-dominated mono-bank systems. The starting conditions—at the t ¼ 0 moment—were chaotic. Bank governance was astoundingly poor, and there was no government regulation at all. Bokros (2001), in one of the best analyses of the period, vividly describes this environment where state-owned banks coexisted with newly estab-

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lished banks mushrooming in the absence of a regulatory environment. The apparent lack of government regulation—apart from some initial restrictions on deposit taking and foreign-exchange transactions—was both a blessing and a curse. The absence of rules on entry, as well as client range, business line, or pricing helped the growth of a large number of institutions, fuelling competition. At the same time, there were no prudential regulations regarding capital adequacy, liquidity, basic portfolio classification, and provisioning. There were no market-based deposit insurance schemes either: state-owned banks were understood to be covered by state guarantee, but other institutions did not have any financial safety net. In this environment, the banks’ governance structure became a virtual black box: state-owned banks de facto no longer reported to the—itself reforming—ministry of finance or the central bank, and started to act in the interest of their managers and political lobbies. The managers of state banks and the owners of new institutions were not subject to any regulation. In this setting, operations favouring managers, owners, and political lobbies to the disadvantage of depositors and investors—and ultimately the taxpayer—became widespread. The result was substantial related-party lending either in the form of directed credit (in state-owned banks) or connected lending (in private ones). The next stage of banking sector transition—at the t ¼ 1 moment—was therefore an almost inevitable banking crisis and bank restructuring. Bad bank portfolio inherited from the socialist past was a primary reason, with non-performing loans often reaching 30 per cent or more of total bank portfolios. A sharp drop in aggregate demand in the wake of the collapse of old production and market linkages as transition proceeded also gave a large negative shock to the banking sector. Banking supervision was in its infancy and could not cope with challenges that would have been formidable for even seasoned supervisors. But poor bank governance clearly favouring insiders over outsiders also played a significant role in bank failures. As it was often impossible to distinguish old bad bank assets from new bad ones, governments eventually capitulated and provided bailouts to most banks. The bailout and restructuring conditions were overly generous and inadequate in that they often did not require, as precondition for the financial support, a change in management and/or policy. This failure led to a repeat of government bailouts and bank restructuring in several countries; for example, Hungary saw three subsequent major bailout and restructuring waves. The total costs associated with the different rounds of bank restructuring during the 1990s ran high: in Poland—6 per cent of

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GDP, the Czech Republic—18 per cent of GDP, and Hungary—13 per cent of GDP (Szapa´ry 2001). Banking crisis was sometimes accompanied by currency crisis (for example, in the Czech Republic 1995–6, the Baltic countries in the first half of 1990s, Romania several times through the 1990s, and Bulgaria in 1996–7) and/or fiscal profligacy (Hungary 1992–4), further exacerbating the ensuing economic and political costs. Albeit along different time paths, the ultimate policy responses to the crises were similar, containing two main ingredients: first, an acceleration of the privatization process by involving foreign strategic investors; and second, a rapid building up of banking sector supervision and a financial sector safety net in conformity with EU directives, supported by massive Western European technical assistance. Both elements—one at the firm and the other at the national policy level—served the ultimate objective of EU accession. They involved substantial convergence: in the first case, amongst CEE states; in the second, with the EU15.

Privatization with Foreign Participation from the EU: The Role of ‘Political Affinity’ The first element of the policy response to the recurring banking sector crisis was privatization to foreign strategic investors, almost exclusively to foreign banks residing in the EU15 (eventually Euro Area) countries. Allowing the entry of foreign banks served a number of objectives. First, in the absence of significant local purchasing power, it provided much needed revenue to the budget. Second, after a series of bank failures that had blatantly exposed the lack of local skills, transfer of ‘know-how’ from Western banks became a priority. Third, it was hoped that foreign ownership would create conditions for better bank governance, as owners would impose discipline and transparency in bank governance along lines expected of them in their home country. Fourth, speed that came with privatizing to a strategic investor was important, as governments realized that further delays in reforming the financial sector could undermine the whole transition process. Speed was also important with regard to a country’s desire to gain EU accession as rapidly as possible. Fifth, there was a mechanism of ‘political affinity’, as domestic actors exploited the potential of foreign banks taking up participations on the basis that they resided in the EU15, an area to which all countries wanted to link up and eventually join. With parent banks from the EU15—and eventually from the Euro Area—dominating the central European banking sectors, financial sector integration into the EU ‘leapfrogged’ in a major way at the level of the firm.

242

Financial Market Governance

As a result of the privatization process, by 2003 over 70 per cent of banking sector assets in the eight new EU members were foreign owned. Candidate countries—Bulgaria, Romania, and Croatia—boasted similar or higher ratios. Only Slovenia and Latvia had less than 50 per cent of foreign bank ownership. Government was a significant—close to 25 per cent—owner of bank assets only in Poland and Slovenia. Convergence around a high share of foreign ownership was most striking in the cases of the Czech Republic, Estonia, Hungary, Lithuania, and Slovakia. (ECB 2003) (see Table 12.2) The question arises as to why domestic interest groups did not resist such an unlimited opening up of their financial sector to foreigners. After all, foreign ownership of banking sectors in advanced economies is low, and resistance to foreign competition can be sometimes fierce, the most recent example being Italy (where the central bank publicly opposed the takeover of significant domestic banks by foreign banks). At the beginning of transition, domestic interest groups lobbied hard against foreign participation. Moreover, several governments, such as initially the Czech Republic and Slovenia, openly took a stand against selling the financial sector ‘crown jewels’ to foreigners. Indeed, several countries’ privatization programmes were initially not open to foreign participation. Mass privatization schemes in Czechoslovakia and Yugoslavia’s version of privatizing firms to workers by design excluded foreign investors. However, these schemes spectacularly failed to produce a workable and efficient bank governance structure. In the Czech Republic, for example, the two largest ‘mass-privatized’ banks continued to finance many of their traditional and still unreformed clients, many of which they also owned through investment management companies that they had established. The underlying idea behind encouraging equity holdings of banks in their clients’ capital was to imitate the German practice of close relationship between banks and industrial enterprises (‘house’ banks). The Yugoslav way of mass privatization was even more fragile because many banks were owned directly by their clients, who were of dubious creditworthiness. After painful and costly crises, eventually all countries converged around the only viable alternative of opening up their financial sectors to foreigners. It is interesting to compare the foreign takeover of banks in the CEE region with that in New Zealand, one of the very few countries in the developed world where foreign ownership of domestic banks, at over 90 per cent of total bank assets, is comparably high. There are some striking similarities in the circumstances that led to high foreign ownership in the

243

Financial Market Governance Table 12.2. Share of foreign ownership in new EU member states (2003, % of total assets) Foreign banks

Czech Republic Estonia Hungary Lithuania Latvia Poland Slovenia Slovakia Memo items: EU15 Selected emerging markets in Asia*

96.0 97.5 83.3 95.6 46.3 67.8 36.0 96.3 18.3 6.0

Domestic banks Private

Public

3.0 2.5 14.4 4.4 49.5 7.8 40.2 0.0 ... ...

1.0 0.0 2.3 — 4.1 24.4 23.8 3.7 ... ...

Sources: ECB, IMF (2000), EBRD. * Data refers to end-1999 and cover Malaysia, Korea, Thailand

banking sector in these two geographically quite distant areas. As in the CEE region, an overall economic crisis and ensuing major policy reforms necessitated the rapid creation of a sound banking sector in New Zealand. New Zealand had always had a significant presence of foreign—mainly Australian—banks, but until the 1980s the biggest bank, accounting for some 40 per cent of total bank assets, had been locally owned. During the 1980s this bank experienced repeated solvency problems and had to be bailed out and recapitalized twice by the government. After this costly experience, the bank was offered for sale. In the transaction, it was important that, if the buyer was to be a foreigner, it had to be an Australian (and not any other nationality) bank, which was broadly acceptable to the population. This ‘political affinity’ was similar to what the CEE region felt towards the EU. What has been the domestic impact of the large share of foreign ownership in the CEE region? First, has foreign presence helped banking sector development? To answer this question, for the period 1995–2004, this chapter plots data on foreign ownership and the EBRD index of banking sector reform for the eight new EU members, and adds a (red) trend line in Figure 12.1. The relationship between foreign ownership and banking sector reforms is positive (R2 ¼ 0:493; t stat ¼ 34.9), implying a correlation between the two factors. The conclusion is that foreign presence may have helped to implement difficult reform measures, and it may have also made major policy backsliding politically more difficult. The causality may have

244

Financial Market Governance 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0% 1.0

1.5

2.0

2.5

3.0

3.5

4.0

4.5

Figure 12.1. Foreign ownership and EBRD index of banking sector reform (percentage of total assets owned by foreign banks and index value respectively)

worked in the opposite direction as well, in that, following a series of bank failures, any serious reform package may have necessarily contained, almost by default, an open approach to foreign entry. Second, has foreign ownership translated into better bank management and thus better profitability? The answer is yes: transfer of technology and ‘know-how’, particularly in the areas of risk management and operational capacity, are widely considered to have been the main advantages of foreign ownership. Some studies have also found a positive correlation between foreign ownership and profitability of banks (ECB 2005). Third, has it helped bank corporate governance? There is no quantitative evidence, but it is generally believed that the imposition of more developed and usually more transparent governance structures by foreign owners may have helped improve financial corporate governance in general (in terms of board independence, oversight of related-party transactions, management remuneration, and the integrity of the audit process) (see, e.g. Claessen et al. 2001; ECB 2005). The EU15 banks that have penetrated into the CEE market early on have greatly benefited from their increased presence in the new and prospective EU members. In addition to greater income diversification, an increasing share of their consolidated profits derives from new EU member subsidiaries and branches. Some EU15 banks have successfully shifted from low-growth/high competition mature markets to high-growth/medium competition emerging markets in the CEE. This development was notable in Austria, where CEE subsidiaries accounted for 40 per cent of their ten

245

Financial Market Governance 100 80 60 40 20

nk

G

iti

ba

IN C

sb lk Vo

So

an k cG en

B SE

a VB H

es nt

aI nc

U

ni

cr

ed

ed

ba

ito

nk

C KB Sw

R

ai

ffe

is en Er st e

0

Figure 12.2. Share of CEE market in a bank’s total assets (percentage, 2003) (percentage of total assets owned by foreign banks and index value) Sources: Bankscope, EBRD.

parent banks’ operating profits in 2003 (Austrian National Bank 2004). Overall, for a number of large European banks, the CEE market has become an important, if not critical part of their business. As Figure 12.2 indicates, for a few Austrian, Italian, and other banks, the CEE represents a significant share of their business. For Raiffeisen bank, for example, CEE assets represent about 40 per cent of total assets; and some analysts estimate that CEE represents 70 per cent of the bank’s market value (Goldman Sachs 2005). It is estimated that the CEE market in growth value terms, will remain superior to the mature pre-enlargement EU15 market (Goldman Sachs 2005).

Building Up a EU-Compatible Financial Regulatory and Supervisory System: An Extreme Case of ‘Top-Down’ Europeanization The second element of CEE governments’ strategy in dealing with bank failures was to build up rapidly financial regulatory systems and banking supervision. The role of the EU in this process has been direct and very ‘top-down’ because in effect it faced a domestic institutional vacuum. Hence, the conditions for Europeanization were highly favourable (see Dyson, Chapter 1 above). As part of the EU accession process, countries

246

Financial Market Governance

were required to line up their financial regulation, supervision and compliance with the relevant EU directives. According to the ECB (2005), the most important European Banking Directives—concerning bank regulations, insurance, clearing, and payments systems—have been implemented, although some tasks remain in the area of contract enforcement and creditor rights. The mechanism for aligning financial sector regulations in the CEE with those of the EU has also been unique. The process has been has been less of an ‘alignment’ or ‘convergence’ based on domestic adaptation and more of institution-building from scratch, because, as explained earlier, at the start countries had no banking supervision at all. An additional dimension was that this process was a moving target for the CEE countries, as EU regulations are guided by, and derived from, the global Bank for International Settlements/Basle process of banking supervision, itself an evolving enterprise. Global central banker and banking sector supervisory networks have also helped institution building in the CEE. The exclusive ‘club’ of central bankers that regularly meet under the auspices of the Bank of International Settlements has firmly stood behind the central bankers of CEE countries not only in providing ‘know-how’ and technical assistance, but also when these central banks got into serious disagreement with their ministry of finance counterparts. More recently, the European Central Bank has established an even stronger collaboration with new EU member states, as all of them eventually will adopt the euro. ECB advice and technical assistance in the area of monetary and exchange-rate policy, and to some extent banking sector reform, has become the source of perhaps the most important foreign influence in CEE countries as well as providing direct support for national central banks. Beyond informally backing their national counterparts, the ECB has formally supported the National Bank of Hungary in its disagreement with the government on various occasions (see also the chapters on the Czech Republic and Poland). Where central banks are also the agency of banking supervision, this network has supported banking supervisors as well. Banking sector supervisors have also received the—usually less formal but still very important—support of their own network under the Bank of International Settlement umbrella and more recently under the EU’s so-called Lamfalussy process. The Bank of International Settlements’ Committee on Banking Supervision was originally created to serve as a forum of information exchange. However, over the years it has evolved into an industry standard-setting body. The new national supervisory agencies

247

Financial Market Governance

that were created in the CEE immediately became part of the Bank of International Settlements’ processes and regular meetings. At the EU level, national supervisors have also been invited to be part of the work of the so-called Lamfalussy committees—forums that have been set up during the past years to work out the details of rulemaking in the three main areas of financial sector regulation: banking, securities regulation, and insurance. The committees help provide input for Brussels to develop policies as well as approaches to policy implementation, once Brussels has decided on the policy principles. Because the Lamfalussy committees were being established as CEE countries were becoming members of the EU, they have also to some extent served as institutions for facilitating convergence in financial sector regulation. The technical quality of banking supervision built up over time, but the main issue became the independence of the financial regulatory and supervisory agencies. Political interference was strong and dismissals of agency heads not infrequent in the early periods (particularly in the Baltic States and in Hungary, where changes at the helm of the national supervisory agencies had a political overtone). Over time, high foreign bank ownership, EU membership or candidate status, and the support of the global central banking-supervisory network have reduced this problem.

New Sources of Systemic Risk in Banking Supervision Foreign dominance in local financial sectors has, however, raised new issues in the area of banking supervision. Cross-border supervision has become a challenging special issue for CEE host supervisors, when systemically important domestic banks are also supervised, via their parent bank, by the latter’s own (home) supervisors. In this context, information sharing and coordination among home and host supervisors are becoming increasingly important challenges. This aspect gains added significance with the introduction of the Basle II financial sector regulatory framework in the EU at the end of 2006. Under Basel II, the home country regulatory authority formally becomes the ‘lead’ supervisor with responsibilities to oversee the supervision of the consolidated banking group and to lead supervisory coordination with host-country supervisors. This allocation of responsibility has led to concerns by host supervisors, particularly when—as in the CEE region—their banking system is dominated by foreign bank-owned subsidiaries. The concern

248

Financial Market Governance

is that when foreign banks’ subsidiaries are systemically important for the host but not for the home country, the host country may be exposed to systemic risks. Host supervisors will be left with the responsibility for financial sector stability, while most of their instruments will have been handed over to home supervisors. Domestic and EU-wide supervisory interest may openly clash in this new setting. There are three particular areas of concern for CEE host supervisors. First, though host supervisors delegate considerable power and instruments of banking supervision to the home country supervisor, according to their respective national laws they continue to be responsible for financial sector stability in their own country. Host and home supervisors’ mandates and incentives may thus differ. Second, as the ECB (2005) points out, the strong ownership link between the ‘old’ and ‘new’ EU members may give rise to an asymmetric risk transmission mechanism between home and host countries. Crisis in a home country would quickly spill over to the host country via the parent-subsidiary relationship, but the management of a crisis would be eased by the likelihood of a joint and coordinated supervisory response. The reason is that home and host supervisors would have the same strong incentive to act quickly and in a coordinated manner to address the causes of the crisis, as the failure of an important bank in a home country would adversely affect both the home and—through the impact on the subsidiary bank—the host country. In contrast, crisis in a host country would be less likely to be transmitted to the parent bank, when the subsidiary is less important for the parent bank. Therefore, the incentive of the home and the host supervisor may be different: the host may be very concerned about the subsidiary bank’s health, while the home country supervisor may not be (as the impact on the parent bank and thus on the home country would not be significant). Hence, the likelihood of a joint supervisory action would be slimmer. Third, it is unclear what happens in a stress situation in general: if a subsidiary gets into trouble, who is the lender of last resort—who covers the eventual costs: the home or the host country, or perhaps the ECB? Which deposit insurance scheme applies? Who is responsible for winding down an insolvent bank? The problem is that home–host collaboration is not simply about information sharing, it is about burden (cost) sharing (Goodhart 2005). It will not be easy to put in place mutually agreeable crisis management arrangements, involving 25 (and soon 27) countries, which continue to operate under different fiscal and monetary frameworks. EMU membership with one central bank should help. For the foreseeable

249

Financial Market Governance

future, however, this form of systemic risk will remain a problem. While cross-border supervision in the form of information sharing and joint monitoring will gradually improve, prospects for a common crisis management system do not appear good. Such a system would require strong political will and possibly more harmonization of monetary and fiscal regimes. In this area national interest and responsibility in safeguarding financial stability may clash with EU-wide home country oversight in prudential supervision. ELEMENTS OF FINANCIAL SECTOR SAFETY NET There are two additional aspects of financial sector regulation that have been indirectly shaped by EU accession and eventual EMU membership: lender of last resort facility and deposit insurance. These constitute the elements of what is called the financial sector safety net. A lender of last resort facility exists in all new EU members and is provided by the respective national central banks. The extent of this facility may be curtailed under currency board arrangements that exist in some new EU members (Estonia, Lithuania, and de facto Latvia), as well as one prospective EU member (Bulgaria). In theory, currency board arrangements limit money creation to foreign exchange purchases of the central bank. This constraint prevents the central bank from performing lender of last resort functions in case of bank failures, although in the CEE currency boards some relaxation of this tool has been necessary, given that bank restructuring and associated liquidity financing needs have been part of the transition process. In Estonia, a part of foreign reserves has been set aside so that the central bank could exercise its lender of last resort role; Lithuania has also used central bank liquidity to support troubled banks. The lender of last resort facility is still not harmonized and tested within the Euro Area, let alone in the EU where different monetary arrangements exist. The European Commission has started work in this area, not least because of the looming introduction of the Basle II framework with its in-built ‘home–host’ supervisory tension described above. Deposit insurance schemes are in place in all new, as well as prospective EU members (Table 12.3), although there are clear pacesetters and laggards. The first scheme was established in Hungary in 1993 and the last in Slovenia in 2001. Most were put in place in the middle of banking sector crisis or a series of bank failures. The deposit insurance schemes are mandatory and cover both local and foreign currency deposits. The

250

Financial Market Governance Table 12.3. Summary of CEE deposit insurance schemes, end-2004 Deposit insurance exists?

Bank- or government– funded?

Limit amount

Can DI decide to intervene in a bank?

Czech Republic Estonia

Yes (1994)

Banks

n 25,000

No

Yes (1998)

Both

No

Hungary Latvia

Yes (1993) Yes (1996)

Banks Both

Lithuania

Yes (1996)

Both

Poland Slovakia Slovenia

Yes (1995) Yes Yes (2001)

Banks Banks Banks

Equivalent of n 6,391, to increase to n20,000 in 2008 Equivalent of about n25,000 Equivalent of n 8,535, to increase to n18,492 in 2009 Equivalent of n 14,481;to increase to n20,000 in 2008 n 22,500 n 20,000 Equivalent of about n 21,455

Yes Yes No No No Yes

Sources: National governments, IADI, ECB.

level of protection varies, with lower income countries typically having lower levels of protection. Indeed, in this area, the speed of catching up with EU regulations has depended on what level of depositor protection a country could ultimately ‘afford’ to finance. The higher-income CEE countries (Czech Republic, Hungary, Poland, and Slovenia) have already approached or reached minimum levels seen in the EU (n25,000), while the lower-income Baltic countries have lagged behind considerably. Moreover, particularly for the latter low-income group, a high-level EU-compatible protection early on could have led to serious moral hazard concerns, which are usually associated with excessively generous deposit insurance schemes (because depositors do not have strong incentives to scrutinize bank operations if they are generously protected in the case of bank failures). Nevertheless, there is an established schedule for full harmonization of deposit insurance schemes in the coming years in the context of the revision of the EU directive of 1994 on deposit insurance. While moral hazard concerns may remain until real convergence is completed, strong cross-border linkages and integration between CEE and EU15 banks clearly argues for such harmonization. Most schemes are straightforward ‘pay-box’ systems (simply paying when needed), although some have elements of a more sophisticated risk-minimizing scheme, where the deposit insurance agency can take certain preventive action vis-a`-vis a bank if considered necessary (Hungary,

251

Financial Market Governance

and Latvia). Virtually all countries have used deposit insurance to address the consequences of bank failures. The existence of this element of the financial safety net system has played an important role in providing confidence in crisis-ridden, nascent banking sectors, and in providing a safety net to small depositors during bank failures.

How Convergent Is the CEE with the EU15? Assessing the CEE Gap The ‘bottom-up’ mechanism of ‘political affinity’ at the micro/bank level and the ‘top-down’ mechanism of financial regulation alignment with EU regulations considered above, and their synergies, have led to a remarkable convergence in the financial sectors of the CEE region. In this section, a variety of measures are used to assess progress made by individual CEE countries towards achieving EU standards, while identifying remaining gaps.

Financial Sector Development: Hungary, Estonia, and Poland as Pacesetters The EBRD has developed two indices to measure progress towards standards seen in the EU (and in general in advanced economies): one measuring progress in the banking sector (the predominant part of the CEE’s financial sector), and the other progress in developing non-bank institutions (insurance, pension funds, mortgage banks, etc.). An index assesses the extent and quality of the sector’s regulations, associated legal frameworks as well as progress in creating markets. The index rates countries on a scale of 1 (no reform of the state-dominated banking sector or virtually nonexistent non-bank financial sector) to 4þ (approximating advanced economy/EU standards). Since 1997 (when the index was constructed in its present form) the eight new EU members have made more progress in the banking area, with a few countries having broadly achieved EU standards already (Estonia and Hungary). Virtually all other countries have come close to this position, the only slight laggard appearing to be Lithuania. Belated reforms and privatization have slowed the speed of reform in the Czech Republic. The clear pacesetter has been Hungary, which was close to EU standards by 1997. Estonia has caught up after having successfully managed shocks

252

Financial Market Governance 4.5

EU standard

4

2004

3.5

1997

3 2.5 2 1.5 1

nia ve Slo

d

kia va Slo

lan Po

ia hu

an

a Lit

tvi La

ary ng Hu

ia ton

ub ep hR Cz

ec

Es

lic

0.5 0

Figure 12.3. EBRD index of banking sector reform in 1997 and 2004 Source: EBRD 2005.

associated with the Russian crisis in 1998. Reform in the non-bank financial sector has generally lagged behind; the pacesetters have been Hungary and Poland. In the latter case, non-bank financial institutions appear to be slightly closer to EU standards than banks (the opposite is the case everywhere else). Clear laggards include Slovenia and Slovakia (Figs 12.3 and 12.4).

Bank Governance Structure: Out–Performing the EU? Precious little detailed analysis exists on the governance structure of the banks in the region. An exception is an EBRD (2004) survey of forty-four banks in which it had equity stakes at the end of 2003 (ranging from the CEE to South-Eastern Europe and the former Soviet CIS states). The survey drew on bank documents (articles of association, supervisory board rules, management board rules, etc.) as well as interviews with board members. It focused on board structures, independence, and some disclosure rules. The paper identified three types of governance structure: unitary boards (where there is no proper separation between the executive board and the supervisory board, which may hamper independent control of insider interest); two-tier board systems with overlaps (separation between the executive and supervisory board exists, but at least one member of the former can be a member of the latter); and two-tier board systems with no

253

Financial Market Governance 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0

nia ve Slo

d

kia va Slo

lan Po

ia

a

an

tvi La

hu Lit

ary ng Hu

ia ton Es

Cz

ec

hR

ep

ub

lic

EU Standard

Figure 12.4. EBRD index of non-bank financial institutions in 1997 and 2004 Source: EBRD 2005.

overlaps (the supervisory board is independent and rules for nomination and election are clear). The results revealed that in the CEE region (excluding Bulgaria and Romania), all board structures had two-tier fully separated systems. In most cases, the two-tier system, with strict separation between the two boards, is required by law (Croatia, Czech Republic, Estonia, Slovenia, Slovakia, Poland, and Hungary). Unitary boards existed only in less advanced transition economies, mainly in the CIS region but also in Bulgaria. However, the survey also revealed that certain basic rules of the game were not clearly defined in many banks, for example, on who had the right to appoint the deputy chairman of the supervisory board or to call a meeting, and several banks did not have clear procedures to address conflict of interest. Moreover, only in a few banks were the remuneration terms of the chief executive officer known to board members. However, the picture is not necessarily much worse than in the EU. Fitch (2005) considers that the governance structure in mature European markets has clearly evolved from opaque internal bank rules towards self-imposed clearer rules and strengthened supervisory oversight. Nevertheless, it finds that unitary boards are the predominant board structure in the EU. The regulatory focus is therefore on ensuring the inclusion of truly independent board members, for which regulatory requirements often exist. Board member remuneration is not always disclosed (although in most countries it is mandatory for listed banks and recommended for unlisted ones). Family ownership, whose objective is

254

Financial Market Governance

to maximize family wealth and not the welfare of depositors, increases opacity. Reform is clearly driven by the EU institutions in the aftermath of the Parmalat scandal in 2004, but it is slow because of industry resistance. In comparison, it appears that CEE countries have applied a higher quality board model than most EU banks. The question arises as to what may explain this apparent regulatory ‘leap-frogging’ in CEE countries, having jumped from a rudimentary starting position to an advanced level of legislation, skipping intermediate stages. Two factors may have had decisive influence: first, starting from scratch, CEE governments were keen to adopt the ‘best practice’ model of separate supervisory and executive boards, and there were no significant domestic lobbies to mount an opposition. Second, in some of the neighbouring and financially advanced countries, such as Germany or Switzerland, two-tier systems are ‘favoured’ by legislation, reflected in the fact that distinct supervisory and management boards are established in these countries. The ECB has also provided advice on draft legislation favouring ‘best-practice’ models, for example, in the case of Croatia. Naturally, EU-based parent banks have to comply with CEE law requirements for two-tier board systems for their acquired local subsidiary bank, even if their own governance structure is different. However, they typically have introduced clarity to certain governance elements for their subsidiaries along the lines used in their parent structure, for example, on the role and composition of supervisory boards (often mainly staffed by headquarter staff) or disclosure on remuneration.

Bank Portfolio Quality: Slowly Getting Rid of the Past? Another way of assessing the gap relative to the EU is a comparison of the average bank portfolio in a new EU member bank and an average EU15 bank. The difference is significant. Using data from the third quantitative impact study under the Basle II exercise, and taking Hungary as proxy for an average bank in the region, the following points are noteworthy (Table 12.4). First, the share of loans to enterprises is much higher for the corporate sector in Hungary than that in the EU15, reflecting to a large extent the heavy involvement of banks in providing financing to enterprises in the past, but also the relatively slow development of alternative funding for firms (such as corporate bonds). Inter-bank exposure is smaller in the new EU10 members, given the lower level of financial sector sophistication. The higher share of sovereign lending in the EU10 relates to large

255

Financial Market Governance Table 12.4. Portfolio structure of banks in Hungary and the EU15 Portfolio (percentage of total)

Corporate Sovereign Bank Retail SME Securitized assets Trading book Other

Hungary 46.4 18.6 10.4 8.3 14.0 0 2.2 0.1

EU15 17.2 7.0 15.4 24.5 15.1 1.0 14.3 5.5

Sources: EBRD and PricewaterhouseCoopers.

fiscal deficits and associated significant borrowing requirements of the government both in the past and at present. The share of retail loans in the portfolio is low, as this business line is just emerging in this region. Pretransition banks had little retail business, with housing needs managed mainly by the state. However, this asset class has expanded very rapidly in the past years. In contrast, the share of small- and medium-sized enterprises (SMEs) appears to be comparable in the two regions, which augurs well for a clear focus on financing employment-creating small business. Unsurprisingly, there is very little trading book portfolio (financial instruments, like derivatives, held for the purpose of short-term trading) in banks of new EU members, while this represents a significant share of bank portfolio in EU15 banks. Asset quality is considerably weaker in the CEE accession states than in the pre-enlargement EU15, with non-performing loans exceeding 10 per cent on average, in contrast to about 3 per cent in the EU15, albeit bad loans concentrate in a few countries (Figure 12.5). At the same time, loanloss provisioning is smaller in the CEE than in the EU15. Provisioning, measured as a share of non-performing and doubtful loans (i.e. which are either not serviced or are likely not to be serviced in the future) is lower in the new member EU10 than in the EU15 (42 per cent and 65 per cent, respectively), which would indicate that in stress-situations CEE banks would be relatively more exposed. This problem is mitigated by higher capital adequacy in new EU10 banks than in the EU15 (Table 12.5) (average regulatory capital is higher in both regions than the minimum Basle requirement of 8 per cent). Moreover, the new EU10 members’ banks have almost exclusively ‘high-quality’ tier-1

256

Financial Market Governance Non-performing loans (% of total loans), 2003 0.25 0.2 0.15 0.1 EU15 average

0.05

an Sl ov

ak

om

R ep . Sl ov en ia

ia

d la n R

ia

Po

an Li th u

tv ia

ry ga

La

ia un H

to n

R ch C

ze

Es

ep

.

tia ro a C

Bu

lg a

ria

0

Figure 12.5. Non-performing loans in the CEE and the EU15 Source: ECB, Fitch Ratings, IMF.

capital (paid in capital and alike) and a very small share of ‘lower-quality’ tier-2 capital (which can include certain subordinated debt, etc.) (Fig. 12.6).

Banking Sector Profitability and Efficiency: CEE Superiority in Profitability but Inferiority in Efficiency Profitability, measured as return on assets or on equity, is considerably higher in the new EU member states than in the slow-growing mature EU market (Table 12.5). At the same time, productivity and efficiency in the CEE still lags behind that in the EU15, as evidenced by significantly higher cost to income ratios in the new EU members. Improvements in cost efficiency in the future will further widen the profitability gap between the CEE and the EU15 in favour of the former, which will undoubtedly induce further EU15 acquisitions of banks (where still possible).

The Financial Mechanism of Convergence: Rapid Financial Deepening Real convergence that gradually narrows the gap in per capita income between the pre-enlargement EU15 and CEE countries is underway. It is spurred by large differences in capital/labour ratios relative to the preenlargement EU15, expectations of real exchange rate appreciation, in

257

Financial Market Governance 16

Basel minimum

14 12 10 Tier 2

8

Tier 1

6 4 2 0 EU15

EU10

Figure 12.6. Capital adequacy ratios in EU15 and EU10 (%) Source: ECB.

some cases still sizeable nominal interest rate differentials, and the ensuing capital inflows. The main financial channel for this convergence is the ongoing rapid credit growth in the region, which reflects genuine financial deepening (a process by which domestic credit is growing at a higher rate than nominal GDP). Financial deepening is likely to accelerate real sector convergence through financing investment and consumption smoothing. The process of financial deepening has been clearly facilitated by the above-mentioned mechanisms of ‘bottom-up’ use of ‘political affinity’ and of ‘top-down’ globalization and Europeanization of CEE countries. A significant part of the financing of the credit boom that sustains financial deepening comes from bank borrowing abroad, including from their EU-based parents. Borrowing costs have reduced dramatically with EU membership and the expected eventual membership in the Euro Area, Table 12.5. Bank profitability and efficiency, 2003

Return on equity (ROE) Return on assets (ROA) Total income (in percentage of assets) Liquidity (cash and t-bills as percentage of total assets) Cost to income ratio Source: ECB includes Cyprus and Malta.

258

EU10*

EU15

11.6 0.85 4.37

9.9 0.41 2.38

14.9

2.2

64.9

60.4

Financial Market Governance

owing to much improved confidence in overall CEE macroeconomic management and in CEE banks (particularly when foreign-owned), which are monitored and supervised according to EU standards. Political risks and associated risk premiums have much diminished. Eventual Euro Area membership will reduce transaction costs, and markets are already factoring in such expectations. Euro Area membership and even participation in ERMII—the precursor mechanism to Euro Area membership—brings about clear sovereign rating (and subsequently bank rating) benefits that can translate into further lowering of borrowing costs (Fitch Ratings 2003). Lower interest rates in turn help reduce the fiscal deficit (a precondition for EMU membership) and induce higher credit growth and ultimately higher economic growth.

Conclusion Following a series of bank crises and associated high fiscal costs in virtually all CEE countries, the dramatic transformation of their banking sector has been clearly driven by rapid Europeanization. This chapter has analysed two key components of financial sector governance in this process: a ‘bottom-up’ process of Europeanization through political affinity associated with domestic political moves to privatise most banks in the CEE using EU (and mostly Euro Area) financial ownership in the wake of crisis, and an extreme ‘top-down’ Europeanization that has required a rapid alignment of financial sector regulation with EU regulations as part of the accession process. The ensuing improvements in financial market governance, both in terms of the banks’ governance structure and the regulatory framework and financial safety net, have helped create a reasonably efficient banking sector that has been able to increasingly mobilize and allocate funds in the economy. The synergies between the EU bank-owned CEE banking systems, EU-aligned banking supervision and converging financial safety nets, along with EU and eventual EMU membership-related convergence gains, are fuelling rapid credit growth and financial deepening that in turn helps sustain and accelerate convergence to the EU and EMU. The process amounts to a powerful virtuous circle of convergence. Rapid financial sector convergence and integration with the EU and eventually with EMU have involved in some cases ‘leap-frogging’, that is, skipping a stage of development, and thus achieving faster progress; consequent on privatizing to EU-based banks and adopting best practice

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models of bank governance. There have been clear pacesetters: in the banking sector Hungary in central Europe and Estonia in the Baltic. But by 2005, virtually all CEE states have approached EU-standards; the only slight laggard appearing to be Lithuania, although belated reforms and privatization have slowed the Czech Republic’s and Slovakia’s move to EU standards. Pacesetters in the non-banking financial sector (capital markets, insurance, pension funds, etc.) have included Poland and Hungary, but the overall reform gap relative to the EU is still significant in this area. Laggards include Slovenia and Slovakia. Overall, however, there are no major clusters of countries in financial governance: initial reformers have kept up the pace and others are catching up. Virtually EU-bank owned and with regulatory frameworks EU-aligned, the financial sectors in the CEE are broadly ready for EMU adoption. However, there are no formal financial sector convergence conditions for EMU adoption, in stark contrast to other policy areas such as fiscal, monetary, and exchange rate policy. Indeed, the founding fathers of the Maastricht criteria have omitted the importance of financial sector integration in designing preconditions for EMU membership. This is curious for two reasons. First, the theory of optimal-currency areas establishes the importance of product and labour market integration and free mobility of capital and labour (Mundell 1961). Second, it is this area where Europeanization is most advanced among all economic sectors and institutions. Notwithstanding this, EMU admission formally will not depend on financial sector convergence and integration. Yet this sector’s already high convergence will undoubtedly help and support convergence in other areas such as trade and fiscal policy and growth in general, thus indirectly lending strong support to EMU entry.

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13 EMU and Fiscal Policy Vesselin Dimitrov

The impact of EMU on fiscal institutions and fiscal policy can potentially reach further into the core competencies of national governments than the effects of EMU in any other policy area. While in monetary policy EMU involves a much more complete transfer of authority from national governments to supra-national institutions than in fiscal policy, monetary policy—even at the national level—has often been the preserve of a relatively narrow circle of central bank and finance ministry officials. Decisions have been taken on the basis of (or at least have been couched in terms of) an expert, non-political evaluation of the state of the economy. Fiscal policy, by contrast, lies at the heart of national government. It involves not only the key coordinating ministers, such as the finance minister and the prime minister, but also all the line ministries. Furthermore, fiscal policy decisions have always been intensely political, embracing fundamental issues of political competition over taxation and spending. Fiscal policy has also been of central importance in determining a country’s admission to EMU. While there are a number of conditions for membership, most notably the Maastricht convergence criteria on inflation, exchange rates, interest rates, public debt, and fiscal deficit, the requirement that a country should have a general government fiscal deficit at or below 3 per cent of GDP has in practice been the deciding factor. For east central European countries, the fulfilment of the Maastricht deficit criterion can be particularly difficult, given their relatively high levels of public expenditure relative to GDP, most of which consists of statutory welfare spending which is difficult to change and has a tendency towards seemingly unstoppable incremental increases. Accession to the EU brings

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its own considerable expenditure demands, most directly through the co-financing of EU structural fund projects and, perhaps more significantly in the long run, for the development of infrastructure and human capital, which could contribute to a ‘real’ convergence with the pre-2004 member states (see Begg, Chapter 3 above).

Analytical Framework This chapter does not aim to offer a detailed factual account of the interaction between EMU accession and the development of fiscal policy in the east central European countries, since such an account is provided in the country chapters. Its aim—building on previous work by the author (Brusis and Dimitrov 2001; Dimitrov 2005; Dimitrov, Goetz, Wollmann et al. 2006)—is to analyse the domestic and EMU factors that have shaped this interaction. The analytical framework of this chapter is provided by the ‘negotiation of fit’ approach (see Dyson, Chapter 1 above). This approach analyses Europeanization as a ‘two-level’ game, in which national policymakers attempt to influence the fit between the EU level and the domestic level, by trying to shape the fit at both levels. Since east central European policymakers have shown remarkably little capacity for shaping the fit at the EU level—they have, for instance, been notable, until very recently, by their absence from the ongoing discussions on the reform of the SGP—the negotiation of fit has proceeded primarily at the domestic level. In this process, policymakers may try to define the fit between EMU requirements and the national level in a way that enables them to advance their domestic interests. Depending on the policymakers’ interests and preferences, the fit could be defined as involving ‘real’ rather than nominal convergence or, conversely, as a useful external constraint on domestic fiscal irresponsibility or as reinforcing a constraining domestic arrangement already in place, such as a currency board. Another and related aspect of negotiating fit at the domestic level are the strategies that policymakers might choose to use, such as delaying entry in order to gain time for ‘real’ convergence, or, conversely, accelerating entry as a means of imposing or reinforcing a constraint on fiscal policy discretion. In order to analyse the negotiation of fit at the domestic level, we need a systematic framework, which can explain the development of national fiscal institutions and policies. Such an explanatory framework should be able to integrate institutional path dependencies, the role of actors, and

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the depth and significance of the problems with which a country is faced. This chapter follows a historical institutionalist approach, which combines an appreciation of the capacity of institutions to limit actors’ choices and even shape their preferences, with a recognition of the significance of crises, in which actors can establish new institutional structures (Hay and Wincott 1998; Checkel 1999; Featherstone and Kazamias 2001). The approach used in this chapter is an expanded version of the analytical framework developed by Mark Hallerberg in his recent book, Domestic Budgets in a United Europe (2004). He presents a systematic typology of fiscal institutions, develops a theoretical explanation of institutional change, and examines the effect of different types of institutions on policy outcomes. In contrast to the historical–institutionalist approach employed in this chapter, however, Hallerberg’s explanation of institutional change focuses primarily on political actors, giving relatively little attention to the capacity of institutions to shape actors’ preferences, and to the role of crises in providing windows of opportunity for institutional transformation. Hallerberg identifies three main types of fiscal institutions: fiefdom, delegation, and commitment. Fiefdom institutions are highly decentralized, allowing each minister to maximize spending for her or his department without any serious limitations. Delegation involves the empowerment of one minister, who can be assumed to have the general interests of the government at heart, such as the finance minister and the prime minister, vis-a`-vis ministerial colleagues. Commitment involves the negotiation of binding agreements among all the participants in the budgetary process, without lending special authority to any one of them. Hallerberg also identifies a ‘mixed’ type of fiscal institution. His typology of fiscal institutions is limited by his assumption that political actors would in all circumstances wish to control fiscal policy: the types of fiscal institutions that he identifies represent different mechanisms that actors can use to achieve this goal. He does not consider the possibility that political actors may deliberately wish to limit their fiscal policy discretion, or ‘bind their hands’, with a constraint, such as a currency board. At the heart of Hallerberg’s theoretical framework lie three hypotheses on the effect of party systems and the party composition of government on the choice of fiscal institutions. . ‘Uncompetitive party systems are likely to have fiefdom governments.’ . ‘Countries with unstable party systems that generate several different types of government (one-party majority, multiparty coalition, and minority) will have fiefdom governments.’

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. ‘Governments made up of coalitions with few ideological differences are appropriate for delegation, while those with many ideological differences are appropriate for commitment’ (Hallerberg 2004: 38). The main value of these hypotheses lies in the links that they establish between the party composition of government and the choice of fiscal institutions. The links between party systems and the party composition of government, by contrast, are underspecified. In an uncompetitive party system (and by implication, although Hallerberg does not make this explicit, in a government dominated by a hegemonic political party), the absence of effective competition means that there is no reason for the government to fear punishment from the electorate for running high budget deficits. In competitive party systems based on one dominant dimension of party competition and an electoral system close to plurality, we are likely to see the formation of one-party governments or coalitions composed of parties with few ideological differences, forming part of the same electoral bloc. In such governments, ministers can be expected to agree to delegate power to the finance minister and/or the prime minister, in the expectation that they will follow the overall interest of the party or the bloc. In competitive party systems with more than one dimension of party competition and an electoral system with a strong proportional representation element, it is probable that governments would be composed of ministers representing parties with significant ideological differences. In such governments, ministers are not likely to agree to delegation to a finance minister and/or a prime minister, who can be suspected of prioritizing the interests of his or her party. Ministers can, however, agree to the centralization of fiscal institutions through commitment, which would give each party a role in establishing the parameters of fiscal policy. However, Hallerberg underestimates the difficulty of commitment in a situation where parties have different policy preferences, serve different constituencies, and are likely to compete against each other in future elections. Given this underlying conflict, there are party political and electoral incentives for ministers representing one party to maximize spending on their constituencies, even if it means a breach of the coalition fiscal contract. Hallerberg does not provide a satisfactory answer to the question of why parties have an incentive not to breach the coalition contract. The availability of alternative coalition partners, which he identifies as an important factor constraining defection, depends on the existence of non-excludable parties. Hallerberg never defines clearly, however, precisely what characteristics of the party system can make some parties

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non-excludable (Hallerberg 2004: 33–4). In countries with competitive but unstable party systems, the party composition of government can be expected to vary, making it difficult to institute either delegation or commitment, and leading to fiefdom institutions. Hallerberg expects the choice of fiscal institutions to have a significant effect on fiscal policy, in particular, on the level of the general government fiscal deficit (which includes the deficits of both national and sub-national governments). Based on the assumption that budgeting has the characteristics of a ‘common-pool’ problem, centralized fiscal institutions, such as delegation and commitment, can be expected to produce lower deficits than decentralized institutions, such as fiefdom. Hallerberg argues, based on a regression analysis involving the fifteen pre-2004 EU member states for the period 1973–97, that differences in party policy preferences do not have an impact on fiscal performance (Hallerberg 2004: 5–6, 41–2).

Empirical Analysis* This section analyses the factors driving the evolution of fiscal institutions in the countries of east central Europe since the transition to democracy in 1989–90, and examines how these institutions and the resulting policy outcomes have shaped the negotiation of fit between EMU requirements and the domestic level. It is not possible, within the confines of this chapter, to examine all the EU members and candidate members from east central Europe at the necessary level of detail, especially given the need for an analysis of the development of the party system and the party composition of government in each case. The chapter therefore groups countries by the type of fiscal institution (delegation, commitment, fiefdom, and currency board), and for each type of institution, analyses one representative country (with the exception of the Czech Republic, which provides an opportunity to observe both fiefdom and commitment).

Delegation: The Hungarian Case Fiscal system centralization through delegation of authority to the finance minister and/or the prime minister can be observed in a number of east central European countries, most notably Hungary and Poland. Hungary * This section draws partly on Dimitrov (2005). Permission to reprint from PrAcademics Press.

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has perhaps the most extreme form of delegation, in which the prime minister can set expenditure limits for individual ministries at the start of the budgetary process. The country can, therefore, provide a good test case for examining the factors that have led to the development of delegationtype centralization, most notably fiscal crises and the party composition of government, and for analysing the effects of this centralization and the resulting policy outcomes on the negotiation of fit between EMU requirements and the domestic level. The first post-communist Hungarian government, formed after the elections of June 1990 and led by Prime Minister Jozsef Antall, was a coalition of the Hungarian Democratic Forum (MDF), the Christian Democratic People’s Party (KDNP), and the Independent Smallholders’ Party (FKGP). The instability of the Hungarian Democratic Forum, the largest party in the government, ruled out delegation. Commitment institutions could also not be established, given that the parties in the coalition were still at an embryonic stage of their development and lacked clear programmatic identities, which made them unable or unwilling to commit themselves to explicit policy goals. In these circumstances, it is not surprising that there was little change to the decentralized fiscal institutions that were inherited from communism. In the communist system, central coordination had been provided primarily by party institutions operating outside the governmental framework. The government itself had been largely decentralized, with the prime minister and finance minister having few hierarchical powers vis-a`-vis their ministerial colleagues. The decentralized fiscal institutions led to a rising fiscal deficit, peaking at 9.2 per cent of GDP in 1993 (World Bank 2000). The burgeoning fiscal crisis created conditions for a change in institutional structures. The exploitation of this window of opportunity was facilitated by a shift in party composition of government. The 1994 parliamentary elections were won by an alliance of the post-communist Hungarian Socialist Party (MSZP) and the Alliance of Free Democrats (SZDSZ). The two parties formed a stable electoral bloc, which stayed together in the 1998 and 2002 elections. Furthermore, prime minister Gyula Horn was the leader of the MSZP and was able to accept the resignations of his party colleagues with relatively little political damage. This party composition of the government created conditions for a change in the configuration of fiscal institutions in the direction of delegation to a strong finance minister and prime minister. The first step towards tackling the mounting fiscal deficit was the ‘Bokros Package’, named after the then minister of finance, and involved drastic tax increases and expenditure

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cuts. The ‘Package’ was agreed in seclusion by Horn and Bokros, and then imposed by them on their cabinet colleagues, at the expense of the resignation of three ministers (Greskovits 2001). It succeeded in cutting the fiscal deficit to 6.2 per cent of GDP in 1995 and 3.1 per cent in 1996 (World Bank 2000). Bokros was also successful in pushing through a comprehensive reform of fiscal institutions. The Public Finance Act was modified to include all off-budget liabilities in the general budget balance, to introduce a multiyear budget plan, and to create a State Treasury, which made it possible to centralize the financial management of the entire government (Thuma, Polackova, and Ferreira 1998; Brixi, Papp, and Schick 1999; Brusis and Dimitrov 2001). Before the establishment of the State Treasury, budgetary organs had operated their own accounts—approximately 1,200 in total— which allowed them to take on payment obligations that exceeded their revenue estimates. The State Treasury operated a single account for all government payments, which made it possible to control ex ante any such payments against budget estimates (Brixi, Papp, and Schick 1999). The Bokros reforms were driven primarily by domestic factors and were not a case of anticipatory Europeanization, although most of the changes were in line with the European system of economic accounts, ESA95, methodology. The institutional changes undertaken by the Horn government were preserved and taken forward under its successor, the government led by Prime Minister Viktor Orba´n, a coalition of the Alliance of Young Democrats (FIDESZ–MPSZ), the MDF, and the FKGP. Orba´n’s position as party leader of the FIDESZ–MPSZ allowed him to dominate his ministerial colleagues and made possible a substantial delegation of power to the prime minister. In 2000, the prime minister acquired the right to set, on the proposal of the finance minister, the total expenditure limit and to inform each minister of the limit for her or his ministry (Brusis and Dimitrov 2001). This right is exercised through a letter, which is sent by the end of May, and which specifies only the limit for the particular ministry, without indicating the limits for the other ministries. However, the centralization of fiscal institutions did not necessarily lead to lower deficits. Contrary to Hallerberg’s argument (2004) that party policy preferences do not affect fiscal performance, the fact that since 1998, governments in Hungary have been dominated by parties seeking to preserve and extend the welfare state, has had a clear effect on the level of fiscal deficit (see Greskovits chapter). Both the main parties in the Hungarian two-party system, the social-democratic MSZP, and the

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nationalist centre-right FIDESZ–MPSZ, have sought to demonstrate their welfare credentials to the voters. The FIDESZ-MPSZ’s electoral victory in 1998 was based partly on voters’ disillusionment with the welfare policies of the 1994–8 MSZP–SZDSZ government, primarily as a result of the Bokros package. In the 2002 election, the MSZP–SZDSZ alliance regained office on the back of promises to enhance social welfare. The centralization of fiscal institutions has enabled FIDESZ–MPSZ and MSZP prime ministers to ensure that their governments pursue consistently their parties’ policy preferences, which diverged significantly from the ‘sound finance’ paradigm (see Dyson, Chapter 1 above). Not surprisingly, this led to deteriorating deficits, culminating at 9.2 per cent of GDP in 2002 (European Central Bank 2004). In the face of these deficits, the MSZP–SZDSZ government elected in 2002 proved willing to consider some fiscal adjustment, but insisted that, as a precondition, the central bank should relax monetary policy. The major opposition party, FIDESZ–MPSZ, opportunistically attacked both the government’s efforts to force the National Bank of Hungary’s hand, and its attempts to cut welfare expenditure. The government’s falling popularity led to a poor MSZP performance in the June 2004 European Parliament elections and the resignation of Prime Minister Peter Medgyessy. His successor, Ferenc Gyurcsany found himself in a similar trap, corned by the opposition and the National Bank of Hungary. Faced with this situation, all that the MSZP–SZDSZ governments since 2002 could do was to repeatedly postpone the target date for EMU entry, with 2010 as the latest objective. The inability of the MSZP–SZDSZ governments in the early 2000s to deal with the fiscal crisis, in contrast to their predecessors in the mid-1990s, and in spite of the fact that they had at their disposal a centralized institutional framework, indicates that the accumulation of deficit is not sufficient, on its own, to trigger a policy response aiming to restore financial stability. Parties play a critical role in the definition of the problem to be addressed. The fact that since 1998 the two major parties have chosen to compete on defending and extending the welfare state rather than on fiscal rectitude, has meant that the burgeoning deficit has not been perceived as a serious concern. The underlying dynamics of competition between the two major parties on social welfare meant that the negotiation of fit between EMU requirements and the domestic level mainly took the form of the development of a discourse focusing on ‘real’ convergence, that is, on closing the economic and social development gap between Hungary and the pre-2004 EU members, as opposed to achieving a merely ‘nominal’ convergence of

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fiscal policy. FIDESZ–MPSZ, in particular, demonstrated the political potential of a ‘real’ convergence discourse (see Greskovits, Chapter 9 above). The implications of this discourse in terms of strategy for negotiating fit point to a delay in EMU entry until ‘real’ convergence has been achieved. In practice, it means a seemingly endless process of postponing the target entry date.

Fiefdom and Commitment: The Czech Case Most east central European countries have experienced fiefdom fiscal institutions at some point in their post-1989 development. The country that has maintained decentralized institutions for longest—virtually the entire post-communist period—is the Czech Republic. It is also of interest because it made one of the most serious attempts in east central Europe to create ‘commitment’ institutions in 1998–2002. The early years following the transition to democracy in Czechoslovakia were a period of ‘extraordinary politics’, in which the Czech Civic Forum and its Slovak counterpart, Public Against Violence, enjoyed virtually unqualified support thanks to their role in the overthrow of communism. Their unchallenged domination made it possible for the federal finance minister, Vaclav Klaus, a prominent member of the Civic Forum, to push through a radical programme of economic reform, with strict fiscal discipline. These bold policy measures were not, however, accompanied by any significant centralization of fiscal institutions. The weak institutional positions of the prime minister and the finance minister, inherited from communism, were preserved largely unchanged. The gradual disintegration of the Civic Forum served to boost Klaus’s political ascendancy. Its breakdown was not followed by the creation of an unstable party system, composed of a multitude of weak parties, as happened, for instance, in Poland following the dissolution of Solidarity. Instead, Klaus succeeded in replacing the Civic Forum as the dominant party in the Czech Republic with his own party, the liberal centre-right Civic Democratic Party (ODS). The ODS not only won the 1992 parliamentary elections in the Czech Republic but also was largely responsible for the creation of an independent Czech state in 1993. Klaus’s role as the founding father both of the ODS and of the new state made it possible for him to impose a balanced budget, without enhancing significantly either his own or the finance minister Ivan Kocarnik’s institutional powers. The Czech Republic had the unique distinction in east central Europe of being able to maintain a budget surplus for four successive years between 1993

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and 1996 (World Bank 2000). The uncompetitive party system in the Czech Republic led to the preservation of the decentralized fiscal institutions inherited from communism, in line with Hallerberg’s first hypothesis above. However, contrary to Hallerberg’s expectations, the decentralized institutions did not result in fiscal deficits. Klaus’s utilization of his party-political position made it possible for him to ensure that the ODS’s policy preference for a balanced budget was achieved without resort to institutional mechanisms. The decentralized institutions started to exert a negative impact on fiscal policy once Klaus’s political dominance began to decline. As the impact of the transition from communism and the creation of a new state faded, the Czech Republic began to see the development of a competitive party system. The 1996 election seriously weakened the ODS’s position, both in the parliament, where its minority government had to depend on the support of two opposition Social Democrat members of parliament, and within the cabinet, where the ODS held 8 of the 16 seats, in contrast to the 10 of 17 in the previous government. The ODS’s constrained position meant that Klaus could no longer impose his party’s policy preferences on the cabinet. The Finance Minister Kocarnik was forced to resign in June 1997, and Klaus soon followed in November 1997. The parliamentary election of June 1998 brought the ODS’s dominance to an end and created a balance of power between it and the Social Democrats (CSSD). Each of the two parties, with 27.7 and 32.3 per cent of the vote respectively, needed the other’s support to form a government. The fact that the two parties were indispensable to each other created conditions for an experiment with ‘commitment’ institutions. ‘Commitment’ governance took the form not of a grand coalition between the two parties but of an ‘opposition agreement’ by which the ODS agreed to tolerate a CSSD minority government in return for specific policy commitments, including a restriction of the fiscal deficit to CZK 20 billion in 2001. The positive effect of the opposition agreement on fiscal performance was, however, weakened by a severe factional split within the CSSD, between advocates of higher social spending and those supporting fiscal responsibility. The CSSD leader Milos Zeman found himself in the position of a mediator between the two factions. In practice, he was increasingly marginalized by the leftist faction, whose leader Vladimir Sˇpidla eventually replaced him at the helm of the party. The prime minister’s weak position in his own party also meant that he could not force his cabinet colleagues to accept delegation of power to himself or to the finance minister. The ODS proved unable or rather unwilling to enforce the

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opposition agreement, fearful that pushing the CSSD into a corner might precipitate early elections, in which the ODS’s deficit-reduction stance would rebound to its disadvantage. This fear was confirmed when a fiscally expansionary CSSD under Sˇpidla’s leadership won the parliamentary election in 2002. The unenforceability of the fiscal contract and the weakness of the prime minister and the finance minister in the Zeman government were reflected in rising deficits, which reached 5.9 per cent of GDP in 2001 (European Central Bank 2004). The inability of Czech governments in the late 1990s and early 2000s to respond to the problem of rising deficits indicates that crisis conditions are not sufficient, on their own, to trigger institutional change, in the absence of a favourable party political and ministerial configuration. The Czech case demonstrates clearly the difficulty of creating centralized institutions based on a fiscal contract between parties that expect to run against each other in future elections—a problem with which, as noted above, Hallerberg (2004) does not fully come to grips. This difficulty has been replicated to an even greater extent in other east central European countries, and accounts for the relative lack of success of ‘commitment’ institutions in the region. EMU influences have had a rather limited effect on fiscal institutions and policies. Once he became prime minister in 2002, Sˇpidla became increasingly aware of the pressures at the EU level and of the danger that the Czech Republic, which had always regarded itself as a pacesetter in the region, could fall behind its ‘significant others’, that is, competing east central European countries. He attempted to use EMU as a means of creating a discourse focused on fiscal discipline, which would override or at least limit the seemingly endless pursuit of unsustainable expenditure. He was largely unsuccessful in his efforts, partly due to the fact that the decentralized institutional framework made it very difficult for him to constrain the policies pursued by individual ministers. Furthermore, as in Hungary after 1998, the preferences of the majority of CSSD members and of the wider electorate pointed in the direction of the preservation and the enhancement of the welfare state, leaving Sˇpidla isolated within his own party (Mitrofanov 2005). Sˇpidla was thus unable to stem the tide of rising deficits, which reached a high of 12.6 per cent in 2003 (European Central Bank 2004). Ironically enough, the Czech electorate punished Sˇpidla for his ‘sound finance’ rhetoric, with a catastrophic defeat in the European Parliament elections of June 2004. He was replaced as prime minister by Stanislav Gross, who, like his predecessor, attempted to employ EMU as an argument against the opponents of fiscal reform.

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However, Gross’s use of EMU was rendered largely ineffective by the split in his party between the supporters of ‘sound finance’ and defenders of the welfare state (Mitrofanov 2005). In the case of delegation institutions in which the policy preferences of the governing party diverge from the Maastricht deficit criterion, as in Hungary after 1998, policymakers have been able to develop a relatively consistent alternative discourse focusing on ‘real’ convergence. In contrast, in the case of the fiefdom institutions in the Czech Republic, there is likely to be a clash of competing discourses, leaving the government unable to develop a unified discourse.

Currency Board: The Bulgarian Case Currency boards have been present in a number of east central European countries, including Estonia, Lithuania, and Bulgaria, while Latvia has an arrangement that functions in a similar fashion (see Dimitrov, Chapter 7 above, and Feldmann, Chapter 6 above). Currency boards are based on linking the national currency to a foreign currency unit at a fixed exchange rate, and the requirement that the amount of national currency in circulation must not exceed the foreign currency reserve held by the national bank. This arrangement not only deprives governments of control over monetary policy, but also imposes restrictions on their fiscal policy discretion. The surrender of such important powers by governments does not come easily. In each of the countries mentioned above, the introduction of a currency board was the result of a severe crisis situation, such as state (re)creation and/or a financial crisis. Bulgaria represents perhaps the clearest case of an adoption of a currency board as a result of a crisis-driven learning process. In the first five years following the transition to democracy, the Bulgarian party system experienced a high level of instability, resulting in a bewildering array of governments, including three one-party majority governments of the Bulgarian Socialist Party (BSP) (until April 1990, Communist), a oneparty minority government of the anti-communist UDF, two non-political ‘expert’ governments, and one caretaker government. As predicted by Hallerberg’s second hypothesis above, the instability of the party system made it difficult to change the decentralized fiscal institutions inherited from communism, with the inevitable result of rising deficits, reaching a high of 12.1 per cent of GDP in 1993 (World Bank 2000). The BSP re-established its hegemony of the Bulgarian party system with an absolute victory in the November 1994 parliamentary elections. As Hallerberg’s first hypothesis predicts (above), the uncompetitive party

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system meant that the decentralized fiscal institutions remained in place, with the finance minister having little control over the spending demands of his colleagues. By 1996, the government had lost control of the economy, with 311 per cent inflation and a fiscal deficit of 15.4 per cent of GDP (World Bank 2000). This debacle led to a number of institutional changes, the most significant of which was the introduction of a currency board. The board, created at the proposal of the International Monetary Fund, represented the ultimate recognition of the inability of Bulgarian governments to manage monetary policy. It substantially restricted their discretion in fiscal policy by making it impossible to finance the budget deficit by printing money, and by prohibiting the Bulgarian National Bank from lending to the government. Governments could still finance the budget deficit by borrowing on the international financial markets, but Bulgarian cabinets since 1997 have been largely unable or unwilling to resort to that option. The willingness of all the major political parties to commit themselves to the board has meant that the instability of the party system and the changing party composition of government (an effectively one-party UDF government in 1997–2001, followed by a coalition between a newly-formed party, the National Movement for Simeon II, and the Turkish minority party, the Movement for Rights and Freedoms, in 2001–5) has had a very limited impact on fiscal performance. All the budgets since 1997 have been either in surplus or had a deficit far below 3 per cent of GDP. The success of the currency board in controlling fiscal deficit has meant that both technocratic and political actors have viewed EMU accession largely as a reinforcement of an already existing domestic institutional arrangement.

Conclusion This chapter highlights the critical importance of domestic fiscal institutions and policy outcomes in shaping the negotiation of fit between EMU requirements and the domestic level, consistent with the emphasis in Dyson, Chapter 1 above, on core executive configurations. In attempting to analyse the factors influencing the development of national fiscal institutions, the chapter investigated the complex interplay of institutional legacies, actors’ choices, and crises, based on a historical institutionalist approach. Domestic institutional structures have proved to be remarkably resilient. Only a rare combination of a severe crisis, in which the old policy prescriptions demonstrably do not work, with a conducive

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party composition of government along the lines set out by Hallerberg (2004), is likely to lead to a change in fiscal institutions. Unstable party systems, which existed in most east central European countries in the first years following the transition to democracy and led to a succession of different types of government, made it difficult to change the decentralized fiscal systems inherited from communism. Fiscal crises in the mid-1990s, combined with the development of competitive two-party (or two-bloc) systems and the emergence of governments dominated by one party, made it possible in some east central European countries, such as Hungary and Poland, to develop centralized delegation-type institutions. In the Czech Republic, relatively mild fiscal conditions for most of the 1990s led to the preservation of a decentralized system of fiscal institutions. When a fiscal crisis emerged in the late 1990s and early 2000s, the attempt at creating ‘commitment’ institutions was not a success, due largely to an unfavourable party political configuration. Finally, in a cluster of east central European countries including Bulgaria, Estonia, Lithuania, and (in effect) Latvia, the experience of a crisis so severe that it forced political parties to give up a substantial part of their policy discretion, led to the creation of institutions such as a currency board. Domestic fiscal institutions have had important effects on policy outcomes, largely in line with Hallerberg’s predictions (2004), and have been a powerful shaping influence on the negotiation of fit between EMU requirements and the domestic level. More centralized institutional arrangements can deliver low fiscal deficits. In this case, the negotiation of fit would probably take the form of national policymakers presenting EMU as a reinforcement of existing domestic arrangements, and their strategy is likely to be to achieve accession in the shortest possible timeframe. ‘Fiefdom’ institutions, as in the Czech Republic, can result in stubbornly high fiscal deficits and are likely to make the fulfilment of the Maastricht deficit criterion rather problematic and lead to a delay in EMU accession. Perhaps the easiest negotiation of fit can be expected in the case of domestic institutions based on a currency board, which tend to lead to relatively low fiscal deficits, as in Bulgaria, Estonia, Lithuania, and Latvia. In these cases, the negotiation of fit is likely to develop in the direction of policymakers using EMU accession to safeguard and reinforce the existing national institutional arrangements (see Dimitrov, Chapter 7 above, and Feldmann, Chapter 6 above). The analysis in this chapter has also highlighted the impact of party policy preferences on fiscal policy outcomes and on the negotiation of fit,

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an effect which is independent of the influence of fiscal institutions and which has not been studied in sufficient depth by Hallerberg (2004), based on the argument that partisan preferences have no impact on fiscal performance. The analysis in this chapter indicates that differences in party policy preferences, most notably between liberal centre-right parties which seek to compete on the basis of their capacity to deliver fiscal discipline, such as the ODS in the Czech Republic, and Social Democratic parties and nationalist centre-right parties, such as FIDESZ–MPSZ in Hungary, which seek to defend or indeed expand the welfare state, have a considerable effect on the level of deficit. The configuration of fiscal institutions can affect the capacity of the governing parties to achieve their policy preferences, but that applies as much to parties seeking to preserve the welfare state as it does to parties aiming to achieve lower fiscal deficits. If party policy preferences concur with the ‘sound finance’ paradigm, then centralized institutions, such as those based on delegation, can increase the capacity of governments to achieve the Maastricht fiscal deficit criterion, and the negotiation of fit is likely to amount to a reinforcement of domestic institutional arrangements. On the other hand, if the policy objectives of the governing parties diverge significantly from the ‘sound finance’ paradigm, the fiscal policy outcomes and the negotiation of fit are likely to follow a rather different route. Domestic political actors are then likely to tolerate a high level of fiscal deficit, emphasize the importance of ‘real’ as opposed to ‘nominal’ convergence, and advocate, or at least accept, a considerable delay in EMU accession. This pattern of negotiation of fit can be observed clearly in the cases of Hungary and Poland (see Greskovits, Chapter 9 above, and Zubek, Chapter 10 above). While the effects of ‘fiefdom’ institutions on policy outcomes and on the negotiation of fit between the national and the EU level are generally similar to those of centralized institutions in which the governing party is committed to defending the welfare state—in both cases, high fiscal deficits are likely to lead to a postponement of EMU entry, the reasons behind these effects are different. In the case of ‘fiefdom’ institutions, high deficits and postponement of EMU accession are not the result of the emergence of a coherent alternative discourse based on the policy preferences of the governing party, such as one focusing on ‘real’ as opposed to ‘nominal’ convergence, but of the inability of the governing party to develop and follow through any coherent discourse. There can be exceptions, as with the ODS government in the Czech Republic in 1992–6, when Prime Minister Klaus was able to utilize his party-political position to impose the ODS’s policy preference for a balanced budget on the

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cabinet, but even in this case, Klaus’s unwillingness to develop the institutional powers of the prime minister and the finance minister meant that once his political ascendancy came to an end in 1996, the decentralized fiscal institutions made it very difficult for his successors to pursue coherent policies. It is only in the case of countries with currency boards that Hallerberg’s argument (2004) that policy outcomes and the negotiation of fit would be shaped primarily by institutional arrangements and would not be significantly affected by party policy preferences, seems to be valid (although the currency board is one institutional arrangement that Hallerberg [2004] does not consider). Even here, it is not always possible to disentangle the effects of the board from the influence of the policy preferences of the governing parties, as in the cases of Estonia and Latvia, in which centre-right parties have dominated governments for most of the transition period (see Feldmann, Chapter 6 above), and Bulgaria, in which centre-right parties have governed since the adoption of the currency board in 1997 (see Dimitrov, Chapter 7 above). The powerful influence of domestic institutional structures and party policy preferences in the shaping of the negotiation of fit in the area of fiscal policy is unlikely to prove a passing phenomenon. Given the central role of fiscal policy in domestic party and electoral competition, the embeddedness of domestic fiscal institutions, and their resistance to all but the most traumatic crisis-induced change, it is difficult to see how the importance of the game played at the EU level can supersede that of the games played at the domestic level in each of the member states (see also McKay 2002). Even established member states which enjoy unrivalled opportunities to set the terms of the game at the EU level by uploading their national preferences, such as Germany and France, have found it difficult to reconcile the pressures emanating from EMU with the political imperatives at the domestic level. Some east central European countries have been content to be policy-takers, and indeed have been eager to do so, in the hope that by limiting their discretion at the domestic level, through the use of institutional arrangements such as a currency board, their influence at the EU level could be enhanced, by proving themselves model members. The strategy of ‘binding hands’ is only likely to appeal, however, to countries which, due to their small size and/or a legacy of severe policy failures at the domestic level, can expect their economic and political ‘weight’ within EMU to be negligible. For countries whose size and relative policy success at the domestic level can give them more confidence in their capacity to defend their interests at the EU level,

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such as Poland, the Czech Republic, and Hungary, the position of a mere policy-taker cannot be satisfying in the long term. The dilemmas that Poland, the Czech Republic, and Hungary face in reconciling EMU and domestic pressures are similar in essence to those faced by established EMU member states. While these east central European countries have until very recently not shown much success in uploading their preferences to the EU level, and have undertaken their negotiation of fit primarily at the domestic level, with a strategy of postponing EMU accession, this situation is unlikely to be sustainable. At some point the conflict between EMU requirements and domestic political imperatives would have to be faced more directly. How this conflict would be resolved depends mainly on developments at the domestic level, although the evolving nature of EMU may also have an impact. On the domestic level, it is possible that the accumulation of deficits could produce a fiscal crisis. As the example of the transition-era crises demonstrates, such a crisis could result in a dramatic policy change that could contribute to the fulfilment of the Maastricht deficit requirement. For such a change to become sustainable, however, it would probably have to be accompanied by a shift in the basis of domestic party competition, from defending and expanding the welfare state to fiscal probity and, in countries with ‘fiefdom’ institutions, by a reform of the institutional framework to produce a more centralized government. At the EU level, Poland, the Czech Republic, and Hungary may seek to contribute more actively to the debate on the future of EMU. Their willingness and ability to do so would be influenced both by their intensifying elite-level links with the EMU institutions and by the example of ‘significant others’, such as that of the EMU founders, Germany and France, and that of comparable medium-size established member states like Spain and the Netherlands. As demonstrated by the reform of the SGP in March 2005, Poland, the Czech Republic, and Hungary have secured greater domestic discretion in fiscal policy and support for structural reforms to pensions. They have started to develop a capacity to forge coalitions with other member states that share their interests (or, to put it less generously, to ride on the coat-tails of Germany and France). This process is still at an embryonic stage. Given the numerous stresses and strains at the domestic level in the east central European countries, and the evolving nature of EMU, it is difficult to predict the direction of change. It is likely, however, that, in the twolevel game of ‘negotiating fit’, the national level is likely to remain primary in the area of fiscal policy.

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Acknowledgements This chapter is based on a research project on ‘Executive Capacity in PostCommunist Europe’, funded by the Volkswagen Foundation (1999–2001). The project was led by the author, Klaus H. Goetz (both at the London School of Economics and Political Science) and Hellmut Wollmann (Humboldt Universita¨t). Other researchers included Martin Brusis and Radoslaw Zubek. The project was assisted by Tereza Vajdova in the Czech Republic and the Economic Policy Institute in Bulgaria.

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14 EMU and Welfare State Adjustment in Central and Eastern Europe Martin Rhodes and Maarten Keune

This chapter seeks to put in place a comparative basis for understanding the implications of eventual Eurozone membership for CEE welfare states. Based on the present nature of the welfare and public spending ‘problem load’ facing different CEE countries, and what we understand about their respective ‘institutional adjustment capacities’, we assess first the extent to which EMU creates a crisis of public spending and social protection, second the scope for welfare expansion or the necessity of welfare retrenchment and third the extent to which the fiscal constraints created by social spending commitments present political obstacles to EMU convergence. We undertake our analysis in four parts. Part one presents the character and diversity of CEE welfare states and considers the nature of their development trajectories in the post-communist era. That discussion provides the background and context for part two in which we create a social risk index for estimating the relative vulnerabilities of CEE welfare states under EMU to downward pressure on public spending and upward pressure across an array of social risks. This we define as the level of ‘welfare stress’. In part three we link ‘welfare stress’ to institutional capacity for fiscal adjustment and arrive at a final assessment of how CEE welfare states will fare in the Euro Zone. Part four concludes.

1. CEE Welfare States in the Post-Communist Era Before considering their present and future development trajectories, we must first gain an understanding of where the CEE welfare systems have

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come from, why, and in what respects they differ from one another, and how they function. Although there were important national variations under communism, CEE welfare states shared a number of common characteristics. Most welfare state entitlements were regulated centrally, were dependent in one way or another on employment, and were often provided through state enterprises (Kornai 1992; Standing 1999). There were also certain non-employment-related, universal cash benefits, including in some countries child and family benefits, covering the population under working age. In addition, the state subsidized food, housing, and transport, and maintained formally free health and education systems. Welfare arrangements had an equalizing effect, reducing income disparities. In terms of performance, what Kornai (1992) calls ‘premature’ state-socialist welfare provided mainly low quality services, limited choice, and a generally low standard of living. Nevertheless, it did manage to abolish deep poverty and produce high levels of employment and equality. The demise of state socialism in 1989–91 was accompanied by a deep economic crisis in the CEE region. The decline in GDP in Poland and Hungary in 1990–2 was around 17–18 per cent, while elsewhere the collapse was even more precipitous—23 per cent in the Czech Republic and 28–32 per cent in Bulgaria and Romania. In 1990–4, economic growth and wages declined rapidly, while inflation spiralled. There was a substantial transformation of the relationship between social policy and other sources of income. Social payments under communism had functioned as supplements to very low wages. But after communism, wages fell sharply and subsidies for basic consumer goods and services were largely eliminated (Baxandall 2002). The crisis of the early transition years also brought an end to full employment. Employment losses ranged from 10 per cent in the Czech Republic to some 30 per cent in Hungary (Keune 2003). The CEE economies began to grow again from the mid-1990s, and so did real wages, while inflation remained on average below 10 per cent. But Latvia and Lithuania have yet to regain their 1989 GDPs, and only in the Czech Republic and Hungary did real wages surpass their already low 1989 levels by 2003. Employment rates remain low with the exception of the Czech Republic. Despite their defects, CEE welfare states acted as an important buffer in the crisis of the early 1990s. They absorbed the most dramatic social effects of economic crisis and reform, and in particular, the loss of income through unemployment (Fajth 1999; Kova´cs 2002). Early retirement and disability pensions were widely used for redundant workers and unemployment benefit schemes were widely adopted as an immediate response to the crisis

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¨ ller 2002). In addition, all CEE (Nesporova 1999; Fultz and Ruck 2001; Mu countries introduced a minimum wage and income-related social assistance schemes to counter growing poverty. As a result, but in the context of falling national output, social expenditure increased as a percentage of GDP. In the most extreme case, Poland, spending doubled from 17 to 32 per cent between 1989 and 1995 (European Commission 2003a). However, inflation often depleted the real value of wages and benefits, leading to increasing poverty, not only among the old, where it was traditionally concentrated, but also among the young and low wage earners and their families (Nesporova 1999). The number of people on pension-, unemployment- or social assistance benefits increased dramatically, driving up their costs. This was especially true of the larger CEE countries. There, the share of unemployment and pension benefits in GDP increased in the first half of the 1990s from 6.6 to 14.6 per cent in Poland, from 8.3 to 9.1 per cent in the Czech Republic, and from 9.1 to 10.6 per cent in Hungary (Wagener 2002: 161). Because state budgets were suffering from falling tax and social contributions, welfare schemes came under increasing financial strain. As a result, and from the mid-1990s onwards, welfare state reform moved to the top of the political agenda. But reform has proven difficult for two reasons. First, conditions of ‘permanent austerity’ in the CEE countries have created more social needs and demands for welfare. Second, democratization created institutional opportunities for political parties and trade unions to block extensive retrenchment, preventing government elites from cutting taxes and spending at will (Campbell 1996). Two broad types of welfare system emerged from the crisis of the early 1990s and the return to greater stability after 1995 (Table 14.1). Eichengreen (2003) notes that the larger CEE countries have become ‘westernized’ to some degree, with their structured labour markets, regulated product markets, and growing welfare states. Welfare-related transfers have accounted for a large share of the growth in public expenditure. The Czech Republic, Hungary, and Poland also reveal a similar emphasis to their medium-sized west European country counterparts in the weight of social security contributions in revenue. The smaller Baltic countries, on the other hand, have smaller government sectors and place greater emphasis on direct taxes than on social contributions. In that sense, they show similarities to their smaller west European counterparts, suggesting to von Hagen (2004) a similar concern with external competitiveness. Even if spending has converged to some extent since the early 1990s— overall spending has declined somewhat in the larger government countries (the Czech and Slovak Republics and Hungary) and increased in the

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EMU and Welfare State Adjustment Table 14.1. Social expenditure in the new CEE member states and the EU15, 2001 Structure of social expenditure (% of total) Old age Total social and Disability Unemploy- Social expenditure survivor exclusion Housing pensions Sickness Family benefits pension ment (% GDP) EE LV LT SK CZ HU PL SI Average EU15

14.3 14.3 15.2 19.1 19.2 19.8 22.1 25.5 18.7 27.6

42.6 56.4 47.5 38.2 42.5 42.4 55.3 45.5 46.3 46.1

31.0 19.1 30.0 35.0 34.6 27.5 19.2 31.4 28.5 28.0

14.6 10.1 8.3 8.2 8.2 12.9 7.8 8.9 9.9 8.0

7.8 9.6 8.8 8.1 8.5 10.3 13.3 8.7 9.4 8.2

1.3 3.6 1.9 3.6 3.1 3.4 4.3 3.7 3.1 6.3

2.2 0.6 2.3 6.5 2.7 1 0.2 1.8 2.2 1.5

0.6 0.7 1.2 0.4 0.6 2.5 0.0 0.0 0.8 2.1

Source: Eurostat.

very small government countries (Latvia, Estonia, Lithuania) (von Hagen 2004)—the two groups remain quite distinct in terms of welfare state size and their capacities for compensating social risks (Table 14.1). The low spending Baltic countries devote 14–15 per cent of their GDP to social expenditure, while the ‘large’ CEE welfare states break down into ‘moderate’ spenders—the Slovak and Czech Republics and Hungary—at 19–20 per cent of GDP, and the ‘high’ spenders—Slovenia, and Poland (22–26 per cent)—which begin to approach the average of the EU15. As one would expect, levels of spending translate into contrasting welfare outcomes. In Slovenia, Hungary, and Poland, social transfers have maintained or increased their level of effectiveness in poverty reduction during the post-communist period. And although inequality has increased everywhere as the percentage of total net disposable income has moved from the bottom to the top of the income deciles, from 1999 onwards net disposable income increased for the lowest income deciles in Hungary and Poland, revealing a decrease in inequality in those countries (Cerami 2003). By contrast, the Baltic States all exhibit much higher rates of inequality and absolute poverty than their larger CEE neighbours (Paas et al. 2003). But if we turn from the ‘welfare effort’ of social spending as a proportion of GDP to the composition of social spending and its relationship with overall expenditure, the distinction between the smaller and larger CEE welfare states begins to break down. In terms of composition, average CEE spending on pensions (old age, survivors, and disability) is at the same level as the average for the EU15, with high peaks in the ‘pensioner’s welfare states’ of

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Latvia and Poland. The health spending average is also similar (but with significant lows in Poland and Latvia, reflecting the pensions priorities of those two countries). The average for family benefits spending is higher than the EU15 average (with still higher peaks for Estonia and Hungary), but noticeably much lower for unemployment benefits and housing. The key contrast here is the gap between spending on pensions and unemployment in both the smaller and larger CEE welfare states. The example of Hungary reveals a more general trend in the larger CEE countries. Regardless of quite extensive reforms over the last decade (including a stronger relation of pensions to employment histories, an increasing pension age and the introduction of voluntary schemes), pensions spending has been relatively stable while other benefits (e.g. unemployment benefits, family support, and sick pay) have lost pace. As Lelkes (2000) explains, much of this decline was due to a lack of appropriate indexation for these benefits in the high inflation environment (20–30 per cent per annum) of the mid–1990s. But pensions spending stayed relatively high, due to certain indexation guarantees and the political costs of alienating this large and expanding group: the number of pensioners grew in line with the widespread use of early retirement and disability pension schemes, from19 to 30 per cent of the population in 1989–95. According to Eurostat data, the weight of invalidity pensions in total social expenditure in 2001–2 ranged from 7.9 per cent in Estonia to 10.3 per cent in Hungary and 13.6 per cent in Poland. The contrast with spending on unemployment is clear. In the mid1990s, only Poland and Hungary devoted a significant portion of their spending to the labour market. This was related to some extent to unemployment rates which were relatively low in the Czech Republic and the Baltic countries, but high in Hungary, Poland, and Slovakia. But by 2001, that link had been lost. By then, unemployment was high—between 9 and 20 per cent in the Baltic countries, Poland, and Slovakia, and between 5 and 7.5 per cent in Slovenia, Hungary, and the Czech Republic. But expenditure on labour market policies was below one per cent of GDP in all of them, compared to an average of 1.93 per cent in the EU15 though rising to 1.3 per cent in Slovenia by 2001. Expenditure had declined rapidly—by more than half—in Poland and Hungary, even though in Poland unemployment had significantly increased. In the Baltic States, both passive and active labour market spending were extremely low given their high rates of unemployment after the mid-to-late 1990s, providing very low levels of unemployment benefit coverage. In Latvia and Lithuania, the long-term unemployed are likely be left entirely without income ¨ rgo ¨ tter, and Raju 2003). support (Paas et al. 2003: 56 ff.; Vodipec, Wo

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EMU and Welfare State Adjustment

These developments reveal an interesting ‘pathology’ in the larger postcommunist welfare states in particular and provide our first link with the issue of CEE welfare state compatibility with EMU membership. As Boeri (1997) notes, except for the Czech Republic (whose relatively low unemployment is due in part to design: unemployment benefits were tightened when unemployment was still below 5 per cent, and cuts in benefits levels and duration were accompanied by large-scale active labour market programmes), reforms in unemployment benefits did not increase flows from unemployment into employment in these countries. Instead, especially in Poland, the Czech Republic, and Hungary, there was a greater recourse to disability pensions and early retirement schemes. This policy choice set in train a dynamic with deleterious consequences for public finances. The consequent shrinkage of employment led in turn to a decline in the tax base, making higher taxes necessary to maintain the financial viability of the welfare system (Appel 2003; Feldmann 2004; Lenain and Rawdanowicz 2004). What Boeri (2003) calls the ‘Visegrad model’ of welfare thus combines low employment participation with a high social security burden on formal employment, creating a vicious circle in which a small tax base requires higher statutory social security contributions to fund social expenditure. In the process, the size of the tax wedge (taxes on labour) has risen to 40–45 per cent of labour costs, sustaining high levels of unemployment and inducing an increasing number of employers to evade their tax and social security obligations. Hence, the large size of informal sectors in Poland, Hungary, and the Slovak Republic and the link between low rates of employment, high rates of unemployment, and large public sector deficits.

2. CEE Welfare State Vulnerability under EMU But how specifically does this CEE welfare state ‘pathology’ relate to eventual EMU membership? We can begin to answer this question by setting out some basic insights from the experience of welfare state adjustment to EMU in Western Europe. Social expenditure in west European countries did not necessarily decrease during the EMU convergence decade of the 1990s (Rhodes 2002). The political and/or distributive difficulties of welfare retrenchment meant that governments sought to ring-fence social expenditure from budgetary cuts—even in those countries furthest away from conformity with the debt and deficit convergence criteria.

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EMU and Welfare State Adjustment

In some cases they increased welfare spending as a quid pro quo for sacrifices elsewhere (e.g. wage moderation and tax increases). But even if there was no direct correspondence between EMU convergence and welfare state retrenchment, EMU was certainly used as an occasion and excuse for tackling some long-standing social policy problems, especially in pensions. The 1990s was therefore a period of intense reform and institutional innovation in those countries (e.g. Greece, Italy, Belgium, and Spain) which were ill-equipped for EMU entry, due to problems in the labour market (inflation control) and public finances (deficits and debts above the Maastricht norms). This combined ‘problem load’ triggered some interesting institutional responses. These sometimes involved emergency or ‘headline’ social pacts between employers, trade unions, and governments in countries where the problem load was high, and the political capacities for dealing with it weak (Hancke´ and Rhodes 2005). The basic intuition to be derived from EMU convergence in Western Europe is that ‘problem loads’ and ‘institutional capacities’ may be important for understanding adjustment to a new monetary and fiscal policy regime elsewhere. And yet there are some critical differences between the situation in Europe in the 1990s and the CEE countries in the 2000s (Hemerijck, Keune, and Rhodes 2006). First, most of the CEE countries have already implemented important reforms in their welfare systems, especially in pensions, under the aegis and influence of international organizations (the World Bank, the EU). Second, although many of the CEE countries are still not yet in conformity with the Maastricht norms, the problem loads facing them, either in the labour market or public spending, are not, on the face of it, nearly as grave as those that originally confronted (and in some cases still confront) a number of first-wave Euro Zone members. Third, the role of the social partners is quite different in the CEE systems: with the exception of the Czech Republic and Slovenia, they have not been essential partners in reform (Lado and Vaughan-Whitehead 2003; Avdagic 2005). Thus, if the problem load is less acute, so too is the need to undertake EMU adjustment via macro-concertation—in fact, the opportunity for the state to use such concertation is largely foreclosed. Nevertheless, this does not mean that everything will be smooth and easy in welfare adjustment to EMU in the CEE countries. Four key points should be considered concerning the link between deficits, debts, and inflation—the critical variables in the EMU-convergence equation. First as discussed above, the employment rate and its link with welfare sustainability are very important. The employment rate is very low in

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Poland but also (though less dramatically) in Hungary and Slovakia. Thus, these countries face the double constraint of low contributions and revenues and high social expenditures. Second, there is a link between public sector wages, deficits, and inflation. Deficits in Hungary and the Czech Republic, for example, have grown in part because public-sector wage hikes have been used to defuse political tensions and reduce public-private sector wage differentials. As we argue below, they have also fuelled inflation. Reversing them is constrained by the impact of social discontent on the electoral fortunes of the major political parties. Third, there is also a link between deficits and inflation rates deriving from the nature of CEE debt markets. Large fiscal deficits originally emerged in the CEE countries from a collapse in the tax base that was unmatched by spending cuts. In the absence of developed markets for debt in most CEE countries, fiscal deficits have subsequently made a direct input into monetary growth and the inflation rate (Budina and van Wijnbergen 1997). Finally, the old-age dependency ratio is increasing rapidly, especially in the Czech Republic, Hungary, and Poland, and under EMU this may force a reduction in social benefits other than pensions. The CEE unemployed have a high risk of poverty relative to the EU average. But correcting this problem is constrained by already high deficits and existing spending commitments (Klugman, Micklewright, and Redmond 2001). These are general issues, the dynamics of which will vary by country. In order to gain a more systematic understanding of the challenges facing the new member states in the welfare domain in the run-up to Euro Zone membership, we must first distinguish between different problem loads. The CEE countries differ enormously from one another in this respect. Some face budgetary, inflationary, and pension problems while others do not. They also differ considerably in terms of adjustment capacity. We begin with inflation and capacity for wage coordination, an issue that received a great deal of attention among the EU15 in the 1990s. We argue that the standard analysis regarding wage coordination and incomes policies in Western Europe is much less applicable to the CEE countries. Building a new institutional capacity for removing wage inflation from the labour market is much less important there than it was for some of the original Euro Zone members. We then proceed to examine the capacity of these countries to reconcile EMU membership with what we call ‘welfare stress’. We estimate levels of ‘welfare stress’ first by developing an index of social risk across four indicators—long-term unemployment, unemployment, the old age dependency ratio, and poverty after social transfers. We

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then relate our aggregate measure of social risk with levels of public sector debt, in order to compare each country’s welfare ‘problem load’ with their budgetary capacities under EMU convergence.

Labour Markets: Inflation and Wage Coordination In Figure 14.1, we plot the difference between real wage and productivity growth in the CEE countries during the period 1997–2003 against an index of wage coordination developed by Jelle Visser (European Commission 2004f: 44–6) based on levels and consistency of bipartite bargaining and pattern setting. We use the difference between real wage and productivity growth since this measure provides the best indication of the extent to which wage moderation has occurred. If real wage growth lags behind productivity growth, wage moderation is taking place; if wages outperform productivity, the reverse is true. The results show that Slovakia is the only country in which serious wage moderation took place in the 1997– 2003 period, while the contrary is true above all for Hungary. The results also reveal that overall there is no strong relationship in the CEE countries between wage coordination and wage moderation. Thus, the country with the highest coordination score, Slovenia, and the lowest score, Lithuania, perform the same in terms of wage moderation. Slovakia and Hungary, with very similar coordination scores, represent the two extremes on the wage-productivity index. This suggests that coordination between employers and unions has been of little importance in most cases, and that other factors—the political orientations of governments and the type of executive—may be much more significant. The results also demonstrate how cautious one must be in drawing conclusions about the recent labour market histories of the CEE countries biased by Western European experience. Two points illustrate why this should be the case. First, it is important to note that because the institutional links between national and enterprise levels in the industrial relations systems of most CEE countries are poorly developed, trade unions and employers’ organisations have little possibility to enforce wage commitments made at the national level among their members. The exceptions are Slovenia (which is an outlier in terms of its degree of wage coordination and wage bargaining coverage—see Figure 14.1) and to some extent Slovakia. Both have relatively strong trade unions, with membership density rates of between 35 and 40 per cent. Apart from those two countries, rates of union membership are low (25 per cent in the Czech Republic and 15 per cent in

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Coordination of wage bargaining index

EMU and Welfare State Adjustment 0.7 SI

0.6 0.5 0.4 SK

0.3 0.2

HU

LV

PL EE

CZ

LT

0.1 0 −4.0

−3.0

−2.0

−1.0

0.0

1.0

2.0

3.0

4.0

Average real wage growth minus average productivity growth 1997-2003

Figure 14.1. Wage coordination and wage moderation 1997–2003 Source: OECD, Eurostat and European Commission (2004f ).

Lithuania, Estonia and Poland in 2002), as are levels of bargaining coverage, ranging from 40 per cent for Poland to 10 per cent for Lithuania, and this clearly limits the scope of wage coordination (European Commission 2004f: 19). Employers are still attempting to establish organisational structures with uneven results and low affiliation rates. Where collective agreements are made—especially sectoral agreements—the content is poor, and circumvention, disregard or open breaches are frequent (Lado and Vaughan-Whitehead 2003). This may change. For example, in Hungary there are important attempts underway to foster an improvement in sectoral wage bargaining. Nevertheless, and interestingly enough, trade unions have often largely internalized the conviction that they should not cause inflation through high wage demands, and industrial conflicts are rare (Ost 2005). This suggests that in the CEE countries, low levels of wage coordination are compensated for by organizational fragmentation and/or well-embedded norms of wage moderation that in Western Europe (e.g. in Italy and Spain) required significant institutional innovations to achieve in the run-up to EMU (Molina 2004; Hancke´ and Rhodes 2005). Second, if in most CEE countries trade unions and employers’ organizations have not played an especially significant role in wage setting, the importance of wage centralization and coordination indicators and argu-

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EMU and Welfare State Adjustment

ments is diminished, and our attention is directed elsewhere. Wage developments in these countries have been strongly influenced by the state, through often substantial increases in public sector and minimum wages (e.g. in Hungary and the Czech Republic in 2000–3). These wage hikes have been less a response to trade union pressure than the result of political deals. Such policies, compounded by private sector imitation of public sector wage deals, have provided an added impetus to wage-push inflation (Feldmann 2004). Earlier in the 1990s, the state also played the central role in regulating inflation, through central wage regulation or wage freezes in the public sector (Matthes and Thode 2001). Given the poorly developed institutional basis for employer–union wage coordination in most of the CEE countries, this instrument of regulation is likely to play an important role in securing EMU inflation convergence in the future.

Public Spending and ‘Welfare Stress’ Investigating the relationship between EMU adjustment in the CEE countries and welfare states requires some methodological innovation. As discussed above, it is not obvious that EMU will have a direct impact on welfare systems. Moreover, the exogenous shock of joining EMU is nothing compared to the shock created by the shift from the command economy to capitalism in the early 1990s. In order to estimate the degree of likely policy turbulence associated with EMU convergence and eventual membership in the CEE countries, we begin by developing an index of social risk which we subsequently plot against levels of public debt. The aim is to demonstrate the relative difficulties that these countries may face in simultaneously adjusting to the Maastricht criteria while also dealing with social problems across four key risks—non-employment, long-term unemployment, the old-age dependency ratio, and poverty after social transfers. We use the non-employment rate because this better reflects the reality of the social situation and levels of employment-related risk than the unemployment rate. There is a similar problem in measuring old-age dependency. Old-age dependency ratios alone do not correctly reflect the attendant risks: growth rates differ a great deal across the CEE countries, and the real issue at hand is not present but future risks. A more accurate picture is provided by combining present and projected old-age dependency ratios. We therefore take the present ratio for 2003 and the

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EMU and Welfare State Adjustment Table 14.2. Old-age dependency ratio, 2003–20* Czech republic Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia

25.6 25.0 25.6 24.8 23.3 21.7 19.7 25.4

Sources: Eurostat, UN.

Table 14.3. Purchasing power standard (PPS) income levels in the CEE countries, 2003 GDP per capita, PPS, EU25 ¼ 100

LV PL LT EE SK HU CZ SI

2003 41 46 46 49 52 61 69 77

Sources: Eurostat.

projected one for 2020, and use the average of the two to calculate the absolute value of the risk indicator (Table 14.2). There is also a problem in comparing standard post-transfer poverty rates. The ‘at-risk-of-poverty’ rate is a national relative poverty rate which is not well suited for international comparison, especially when comparing countries with quite different levels of income. Hence, we also include an indicator reflecting Purchasing Power Standard (PPS) income levels (Table 14.3). Based on the above, we set out the social risk indicators for the CEE countries in Table 14.4. In turn, we normalize these indicators (the GDP per capita variable is inverted) and give them equal weights to create our index of social risk (Table 14.5). The resulting plot for the risk-debt relationship—which we refer to as ‘welfare stress’—is illustrated in Figure 14.2.

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EMU and Welfare State Adjustment Table 14.4. Social risk indicators: absolute values Non-employment Old-age Poverty after GDP per rate 2003 dependency ratio transfers capita in PPS, EU25 ¼ 100 Czech Republic Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia

35.3 37.1 43 38.2 38.9 48.8 42.3 37.4

25.6 25 25.6 24.8 23.3 21.7 19.7 25.4

8 18 10 16 17 17 21 10

69 49 61 41 46 46 52 77

Source: Eurostat and own calculations.

Table 14.5. Social risk indicators: normalized (0–1) values (max ¼ 1)

Czech Republic Estonia Hungary Latvia Lithuania Poland Slovakia Slovenia

Non-employment rate 2003

Old-age dependency ratio

Poverty after transfers

GDP/ Capita PPS

Social risk index

0.723 0.760 0.881 0.783 0.797 1.000 0.867 0.766

0.962 0.940 0.962 0.932 0.876 0.816 0.741 0.955

0.381 0.857 0.476 0.762 0.810 0.810 1.000 0.476

0.443 0.729 0.557 0.843 0.771 0.771 0.686 0.329

0.157 0.205 0.180 0.208 0.203 0.212 0.206 0.158

Source: Own calculations.

From Figure 14.2, we identify four groups of countries with different relationships between public expenditure pressures under EMU and social risk (Cyprus is something of an outlier with low risks and high debt).

Group 1: Hungary—Medium Risks and High Debt Hungary has a high debt, high deficits, and an intermediate level of social spending. But it also has a relatively low position on the social risk index. This would suggest that while EMU will be constraining in relation to the rest of the group, Hungary is less likely to be faced with unpopular social policy choices and trade offs than, say, Poland and Slovakia.

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EMU and Welfare State Adjustment 80

Public debt

70 60

HU

50 CZ SI

30

LT

20

LV

10 0 0.130

PL

SK

40

EE 0.150

0.170

0.190

0.210

0.230

Social risk index

Figure 14.2. ‘Welfare Stress’: social risk and public debt in the new member states

Group 2: Poland and Slovakia—High Risks and Medium—High Debt For this group, EMU public expenditure constraints pose a more significant problem, demanding retrenchment and cuts which may well prevent a straightforward social expenditure response to relatively high levels of welfare stress. Social conditions in these countries are likely to remain poor, while gaining popular support for welfare reforms is likely to prove extremely difficult.

Group 3: The Czech Republic and Slovenia—Low Risks and Medium—High Debt This group differs somewhat internally, with the Czech Republic suffering from a low-to-moderate debt, high deficits but a low level of social expenditure and a low level of social risk. It also has the best employment record amongst the CEE countries. Slovenia (the first CEE state to enter the Euro Area as of 1 January 2007) is in an even better condition, with a low deficit and debt, high employment, and low welfare stress, alongside a relatively high level of social spending—making it the best performer of the wider CEE group.

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Group 4: The Baltics: Lithuania, Latvia, and Estonia—High Risks and Low Debt This group of countries enjoys high levels of employment, low deficits, and debts but high levels of social risk, alongside low levels of social spending. Even within EMU, these countries (with their largely residual welfare states) could, should they wish to do so, embark on a path of welfare catch up in line with the EU15. In terms of our trade off between the capacity for maintaining or improving protection against multiple social risks (‘welfare stress’), Slovenia and the Czech Republic are in the best position, while Poland and Slovakia are worst off, followed by Hungary. But this is a snapshot picture. It does not allow for the dynamics of past and present fiscal developments, which may substantially affect our assessment above, nor does it allow for public deficit and debt projections for these countries. Nor, further, does it take fully into account the political and institutional capacities for adjustment. It is to those issues that we now turn.

3. Social Policy and Fiscal Adjustment Dynamics under EMU Convergence Extending the Model We begin to tackle the issue of social policy spending dynamics by examining the recent past of the relationship between social transfers and overall expenditure growth. Table 14.6 reveals a rapid increase in the share of social transfers in public spending between 1995 and 2000 in the Czech and Slovak Republics. Their share of social security contributions in public revenue has also markedly increased. Those growth rates suggest potential problems of social policy sustainability compared with other CEE countries. While Slovenia managed to keep its share of social transfers low, Hungary, Estonia, and Latvia have managed to let transfers grow at a slower pace than general public spending (von Hagen 2004). Both Slovenia and Hungary have also managed to reduce their shares of social contributions in revenue. Poland’s rate of growth in social transfers has remained relatively stable (at one of the highest levels among the EU

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EMU and Welfare State Adjustment Table 14.6. Social security contributions and social transfers

Share of social security contributions 1995 2000 Share of social transfers 1995 2000

CZ

HU

PL

EE

LT

LV

SK

SL

36.3 38.4

32.7 27.9

27.5 34.5

28.9 24.8

31.8 27.0

21.7 26.1

25.8 28.0

37.8 31.7

41.3 52.7

55.8 49.1

55.9 57.3

58.6 54.0

57.1 52.9

56.8 59.8

34.4 50.4

41.6 40.2

Note: As a percentage of total current revenues and total spending, respectively. Source: von Hagen (2004).

countries) but the weight in revenue of social contributions has significantly increased. How does this alter our assessment? Remember that in the analysis in section two above, we concluded that Slovenia and the Czech Republic were in the best positions in terms of ‘welfare stress’ under EMU convergence, while Poland and Slovakia were worst off, followed by Hungary. Slovenia remains in its leading pole position, and Slovakia remains at the tail end of the league. Poland remains in the group of countries most likely to face important social welfare dilemmas and trade offs. The major change concerns the Czech Republic which has been revealed to be much more vulnerable in terms of rising shares of social transfers in spending as well as the country with the highest share of social contributions in revenue. This may have an impact on its otherwise good employment record, though it is worth noting that Czech unemployment and especially long-term unemployment rates already increased significantly in the latter half of the 1990s and that the high employment rate concealed a degree of hidden employment in firms hoarding surplus labour (Gitter and Scheuer 1998; Nesporova 2002). Studies of future spending liabilities also suggest that the Czech Republic should be relegated from its pole position alongside Slovenia. Orba´n and Szapa´ry (2004) observe that future pension payments obligations and health care outlays for the elderly, based on projected dependency ratios, look especially bad by 2050 for the Czech Republic, followed by Hungary and Poland. Buiter and Grafe (2004: 84 ff.) forecast an expansion of the Czech Republic’s deficit by up to 6.8 per cent of GDP before 2050 due to pension liabilities if no reforms are made to the present system, while that

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of Poland (one of the worst case countries in our ‘welfare stress’ assessment) is forecast to contract by 1.8 per cent of GDP. But any complete forecast of ‘welfare stress’ under EMU convergence and membership must also take inflation, primary deficits, and growth into account, for these factors will determine the public spending trajectory of the coming years. Hughes Hallett and Lewis (2004) provide us with just such a forecast of overall public spending expansion. According to their analysis, with the exception of Estonia, most accession countries are running an underlying policy of debt expansion. But including inflation, interest, and growth rate effects, the Czech Republic, Poland, and Slovakia face the most serious deterioration in their debt positions. After accession to the Euro, the authors calculate that given their higher current primary deficits than in the other CEE countries, Hungary, Latvia, and Slovakia will need to shed some two per cent of GDP from their current deficits, Poland 3.5 per cent and the Czech Republic 5.5 per cent to ensure debt stability. Under a fast growth scenario, the Czech Republic and Hungary are forecast to exceed the 60 per cent threshold within ten years, due in the former to large primary deficits and in the latter to a much closer to 60 per cent starting point. Slovenia, Latvia, and Slovakia will see only slow increases in their debt ratios while Estonia, Lithuania, and Poland are forecast to face no problems at all. In the slow growth scenario, Hungary, and the Czech Republic violate earlier, and Slovakia also faces violation by 2009. Poland experiences a slowly rising debt but still falls short of 60 per cent. Slightly different projections from the European Commission (2003b) and von Hagen (2004) show that given its current fiscal position, Hungary is most vulnerable to breaching the 60 per cent limit in the short-term, while all other countries are currently well inside this parameter (see Table 14.7). In this forecast, the Czech Republic is the only other country close to exceeding the 60 per cent threshold in 2015 with its current EMU preaccession programme, though current fiscal stances put Hungary and the Slovak Republic in breach by 2015, and a combination of low growth and high real interest rates will create considerable challenges for the Czech Republic, Hungary, and Latvia. The common denominator forecast from the above is that Hungary, the Czech Republic, and Slovakia are the countries most likely to breach the 60 per cent limit in the short term. This produces a slightly different grouping of ‘welfare stress’ from that elaborated above. Slovakia emerges as the country that combines high social risks and a high degree of budget vulnerability, followed by Hungary with medium social risks and high budget vulnerability. The Czech Republic has relatively low current social

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risks but a much higher level of budget vulnerability than in our original assessment. All three countries are likely to face complicated choices and difficult distributive politics during EMU convergence (and eventual membership) as current spending levels come under pressure, and as rising national income generates greater demands for social policy spending. All three exceeded the 3 per cent deficit reference value in 2004 and also consistently exceeded that level over 1999–2003 (Table 14.7). Poland remains a high risk country (especially given its very high unemployment rate of around 18 per cent in 2005, just above Slovakia’s 17 per cent), but perhaps with greater scope for balancing its spending priorities in the medium term. While the Baltic States preserve their high risk-low debt position, according to our own assessment of ‘welfare stress’ above, only Estonia and Slovenia appear to have scope for fiscal expansions while also maintaining their current debt burdens (European Commission 2003b; von Hagen 2004).

Politics and Institutions The discussion to this point has been rather rarefied. Our intention was to set out systematically what we have referred to as ‘welfare stress’ in the CEE countries—the likelihood, that is, that these countries will face difficult pressures in accommodating their social systems (in terms of current commitments and potential needs) with Euro Zone membership. We have not included an account of the political and institutional characteristics of these countries, an appreciation of which is obviously important for making a link between their levels of ‘welfare stress’, the political saliency of social policy issues, and their institutional capacities for adjustment. A full analysis of that link is beyond the scope of this chapter. But before concluding, it is worth considering some of the political and institutional constraints on budgetary discipline in those countries most vulnerable to fiscal and welfare stress—the Czech and Slovak Republics, Hungary, and Poland. Political scientists have sought a connection between the structure of political systems and fiscal policymaking. Brusis and Dimitrov (2001) argue that budget deficits of less than 3 per cent for most years in the late 1990s in Poland and Hungary could be attributed to a strengthening of the institutional positions of the prime minister and financial ministers in those countries. This compared with the Czech Republic where decentralized budgetary institutions led to a deteriorating fiscal performance. But deficit developments since 1999 (see Table 14.7) reveal poor fiscal

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EMU and Welfare State Adjustment Table 14.7. Fiscal imbalances in the new CEE member states Fiscal deficit average 1999–2003 Poland Hungary Slovak Republic Latvia Lithuania Estonia Slovenia Czech Republic

3,0 5,7 6,9 2,8 2,7 0,3 2,4 6,8

Fiscal deficit 2004 6,0 4,9 4,1 2,2 2,8 0,7 1,7 5,9

Debt 2003 45,4 59,1 42,6 14,4 21,6 5,3 29,5 37,8

Source: Eurostat.

discipline especially in Hungary, but also in Poland and the Slovak and Czech Republics. Other analyses by economists (Eichengreen 2003; Gleich 2003; Afonso, Nickel and Rother 2005) have shown that while the small countries (Estonia, Latvia, and Slovenia) have more efficient budgetary institutions, Hungary, and Poland in fact have two of the worst (also Eichengreen 2003). Yla¨outinen (2004) argues that although still developing, most CEE fiscal systems are of the ‘commitment’ rather than ‘delegation’ type, securing commitment, that is, via a set of binding limits or targets on budget aggregates at the beginning of the budgetary process, rather than through the ‘delegation’ of significant fiscal powers to a ‘fiscal entrepreneur’. Because they are based on political commitments, the resulting fiscal targets are ‘weak’ and serve as non-binding or indicative benchmarks only. Yla¨outinen also points out that the majority of countries do not discuss deviations between the objectives laid out in the multi-annual plans and actual outcomes, thus weakening the credibility of multi-annual targets or guidelines. Nor do they have clear provisions in place on what should be done in times of economic under- or over-performance. This reinforces von Hagen’s conclusion (2004) that, except for the Baltic States and Slovenia, there is a need for more effective fiscal management to control annual deficits. This is especially so given that the Czech and Slovak Republics, Hungary and Poland have engaged in fiscal consolidations via revenue expansion. The success of such strategies may be limited in the CEE countries by weak revenue-collecting administrations. Broader comparative research has also shown that such strategies are typically of a lower medium-term quality than expenditure-based strategies (von Hagen 2004). In any case, all four governments are heavily constrained in the extent to which they can close the fiscal gap through taxation. Tax burdens at around

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40 per cent are rather high given the low per capita incomes found in these countries. They have also seen a general trend in these countries towards fiscal decentralization, which will constrain future reforms given the difficulties of reducing fiscal deficits in fiscally decentralized environments. Higher taxes in the future should probably come from higher property and corporate taxes, for while labour is over-taxed, capital is typically undertaxed (Appel 2003; Bernardi, Chandler, and Gandullia 2005). But spending cuts are also constrained by the electoral cycle: there have been major elections in all four countries in 2005–6. As Eichengreen (2003) has noted, when poor fiscal institutions clash with electoral pressures (the electoral budget cycle), then fiscal goals will be readily sacrificed. Coricelli (2005: 9) argues that this will be truer for the larger CEE countries than their smaller counterparts, for ‘in small and more homogeneous countries there is less scope for using the budgetary process to buy consensus for election and re-election’. A large-country example is provided by Hungary where fiscal policy is closely tied to the electoral cycle, and social policy is frequently used to bolster political support. Fugaru (2004) recounts that in 2000 the government decided on a 100 per cent increase in the minimum wage, which triggered a desire to correct new relativities in wages, especially in the public sector. In the following pre-election year, the government raised public-sector wages in response, promised substantial capital funds to local government, and also raised social security benefits. The 2002 elections were won by the opposition socialists who kept their promise to raise public-sector wages by 50 per cent—leading to a 23 per cent increase in the government wage bill. The political difficulties in bringing down deficits are delaying all of the large CEE countries’ prospective EMU entry dates. In July 2004, the Council, following recommendations from the Commission, invoked the provisions of the Stability and Growth Pact (SGP) and directed Hungary, Poland, and the Czech and Slovak Republics to bring their budget deficits down to less than 3 per cent of GDP in 2005–8. Differences with the European Commission have recently triggered clashes with Hungary over its expanding budget deficit (suggesting that its projected 2010 entry date will be delayed). Poland is apparently still on track for EMU entry in 2009, but has only avoided an excessive deficit procedure by recent changes to the SGP: in line with the new rules, in 2005–10, only part rather than all of the money transferred to open-end pension funds will add to the Polish budget deficit. As for the Czech Republic, the 3 per cent reference value is thought to be achievable with a debt-GDP ratio broadly constant at around 37–38 per cent. But the problems of

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longer-term sustainability noted above have led the European Commission to recommend pension and health care reforms which will not be easy to achieve. Slovakia updated its convergence programme for 2005–8 in December 2005, with the aim of correcting its excessive deficit by 2007, mainly through expenditure restraint, again implying a problematic engagement with welfare recalibration and retrenchment (Je˛drzejowicz 2003; Deutsche Bank 2004; von Hagen 2004; Alfonso, Nickel, and Rother 2005; Coricelli 2005).

4. Conclusion In the analysis above we have laid out the first systematic assessment of CEE welfare state vulnerabilities in the EMU convergence process. In conclusion we wish to make three major points. First, despite some growing similarities between the larger CEE welfare states and their counterparts among the EU15, it is important not to observe the process of welfare state adjustment to EMU in the central and eastern part of the continent through a western lens. In reducing inflation rates to a level compatible with EU membership, incomes policies and institutional innovations in industrial relations are likely to be much less important, and direct state intervention much more important than in Western Europe. The ‘problem load’ facing the CEE countries is also, at least on the surface, less of a burden than was the case for the Western laggards in the run up to EMU in the 1990s. Nevertheless, second, as we have also demonstrated through our estimation of levels of ‘welfare stress’, certain of the larger CEE countries—especially the Czech and Slovak Republics, Hungary and Poland— face some very difficult choices in the near future in reconciling public expenditure and revenue trends with fiscal sustainability under the Maastricht criteria. In all four countries, those choices will relate to the weight of transfers in social spending and the ways in which they are allocated and funded. They will not only have to ensure that social spending and financing choices are compatible with fiscal constraints, but that a rebalancing occurs between the risks identified as priorities in the 1990s (when pensions of various kinds were used to cushion the transition process) and those that have become more pressing in recent years. The latter include the risks of falling into poverty for the most vulnerable groups, and the social stress generated in the labour market, where spending priorities—on both active and passive policies—have been low. More generally, for the

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EMU and Welfare State Adjustment

time being, there is a clear and growing incompatibility between the political pressures underpinning fiscal policy choices in the larger CEE economies and the tight constraints bearing on prospective membership of the Euro Zone club. Our third concluding point concerns the electoral cycle and fiscal policy in the CEE countries. As in Western Europe, the rules of the SGP have been challenged, and their appropriateness for the emerging markets of Central and Eastern Europe in particular questioned. Many economists agree that the inflation criteria are too rigid for economies that are growing faster than the older EU member states. Regarding the deficit criteria, and in line with the analyses of Buti and Van den Noord (2003) and Coricelli (2005) we would also note that if the electoral budget cycle is still alive and well and has not been curbed by EMU’s fiscal policy rules among the existing Euro Zone members, then the chances for conflict between unpopular choices, electoral pressures and budgetary policy in those countries awaiting membership may be even greater. This suggests that something will have to give. Greater monetary and fiscal policy stability under EMU could well deliver better budgetary policy and an improved allocation and funding of public expenditure on social policies once the CEE countries are in. But there is also a good chance that the electoral budget cycle in those CEE countries suffering from the highest levels of ‘welfare stress’ will continue to delay their membership of EMU—unless, of course, the rules of the club are changed.

300

15 Domestic Transformation, Strategic Options and ‘Soft’ Power in Euro Area Accession Kenneth Dyson

Europeanization as a Process of Defining and Negotiating fit This volume has presented EMU accession as a process of defining and negotiating fit across the EU and the domestic levels. This perspective on Europeanization has a number of advantages: it highlights the closely intertwined cognitive and strategic dimensions of EMU accession as domestic elites seek to navigate by reference to the European ‘map’ of EMU; it recognizes that EMU accession connects elite actors across two levels; it looks beyond the boundaries of institutional explanation to examine indirect Europeanization effects through contagion processes in markets and policies; it ties together structural characteristics with attention to the dynamics of EMU accession; it breaks free from the simplifying dichotomy of ‘top-down’ and ‘bottom-up’ accounts of Europeanization; it avoids the simplifying sets of expectations in the literature on ‘Europeanization East’, in which one account emphasises ‘external incentives’ (Schimmelfenning and Sedelmeier 2005) and another domestic factors (Goetz 2005); it provides a better means of addressing the central question of domestic room for manoeuvre; and it comes to grips with the key strategic options that are available to domestic policymakers and the question of why some options are preferred over others—using EMU to import and provide an external discipline, using EMU to reinforce a pre-existing domestic discipline, and using political time management to accelerate or delay entry and thereby seek to control the scope and pace of domestic transformation. Not least,

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as this chapter suggests, the ‘negotiating fit’ framework offers a more flexible way of identifying ‘clusters’ of member states that cut across conventional distinctions between east central Europe, Mediterranean, and ‘core’ EU states. Fit has to be at the centre of EMU accession for the simple reason that formal conditionality requirements have to be met for Euro Area entry and for the deeper reason of informal conditionality. Conditionality is a powerful mechanism of Europeanization because the rewards of membership offer external incentives for domestic transformation and because of the asymmetry of power in accession (Schimmelfennig and Sedelmeier 2005, 2006). The combination of prolonged timescale, mounting constraints with each phase up to entry, and immediate, direct and macro-level effects on domestic core executives through national central bank independence make it an extreme case of Europeanization. EMU accession involves powerful systemic pressures from misfit between EMU requirements and domestic institutional and policy arrangements. For this reason, a ‘bottomup’ approach that seeks to ‘de-centre’ fit in Europeanization studies seems misconceived as a means of understanding the domestic effects of EMU accession. Fit is pre-defined (though, as Dyson, Chapter 1 above, shows, there is some room for constructing it). It frames how EMU accession is negotiated across the EU and domestic levels. However, for two reasons, fit remains embedded in a process of negotiation. First, actors are able to exploit ambiguities and inconsistencies surrounding EMU accession (spelt out by Dyson’s in Chapter 1). Second, fit is not experienced in the same way by different accession states. These differences relate in part to contrasts in economic size, structure, and external dependence and vulnerability (cf. the Baltic States and Poland) and in part to variations in post-communist legacies and in processes of transition (cf. Hungary and Romania in market liberalization). These differences shape domestic policy preferences and institutional arrangements, notably for fiscal policy (see country chapters). These policy preferences and institutional arrangements, in turn, mediate how domestic policymakers negotiate EMU accession. They help to explain the particular choice of strategic options and why some states are ‘pacesetters’ (like the Baltic States), some ‘laggards’ (like Romania), and some shift roles in different directions (like Bulgaria and Hungary). EMU accession highlights the primacy of the domestic level in the negotiation of fit. However, as Dyson stresses in Chapter 1, the terms of negotiation—how fit is defined—are set by structural conditions, in particular an asymmetry of power expressed in formal and informal

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conditionality and the weak economic and financial weight of these states within the EU, and a temporal sequencing of tightening constraints on domestic economic policy, especially with ERM II entry. New EU accession states have a weak ‘uploading’ capacity at the level of EMU institutions. Their ability to redefine fit to accommodate their specific policy preferences, notably in reconciling meeting the Maastricht convergence criteria with ‘catching–up’, is tightly circumscribed by the overriding requirement to demonstrate their credibility at the EU level when they are not gatekeepers. The individual incentive to establish EU-level credibility on Euro Area entry with the EMU gatekeepers trumps any collective incentive to change the terms of entry. Hence there was no substantial effort to coordinate positions on the reform of the Stability and Growth Pact (SGP) in 2004–5. ‘Pacesetting’ does not translate into increased ‘uploading’ capacity. The interesting question is whether the strategic option of delay offers a prospect for enhanced ‘uploading’ capacity over the longer term through accelerated ‘catch-up’. In this case, delay would increase potential negotiating power over fit in the longer term.

Room for Manoeuvre in EMU Accession: Persuasive Domestic Narratives and Strategic Options The room for manoeuvre of accession states over Euro Area entry varies between defining fit and negotiating fit. Defining fit is tightly circumscribed and reflects the saliency that EU institutions attach to the sound money and finance paradigm. In consequence, it poses a challenge to domestic political and technical elites— how to construct a persuasive narrative for domestic audiences, a legitimating discourse that resonates not just across different elites but also with electorates (Schmidt 2002)? The domestic scope to construct narratives about EMU accession shapes the choice amongst the three strategic options—providing an external discipline, reinforcing a domestic discipline, and deferring entry. From the perspectives of existing studies of Europeanization and of EMU, the interesting conclusion is that ‘importing and providing an external discipline’ has proved less attractive than the other two options. The finding is interesting because research, especially on the Mediterranean ‘world’, notably Greece and Italy, has stressed the strategic use of EMU as external discipline (Dyson and Featherstone 1996; Featherstone and Kazamias 2001; Dyson 2002). This conclusion may prove provisional, reflecting an initial reluctance to follow the enormous

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domestic stresses and strains of both transition and EU accession with the prospect of negative effects (e.g. on welfare policies and catch up in living standards) from tightening constraints associated with Euro Area entry. It is, nevertheless, interesting and potentially significant. Rapid real convergence of living standards consequent on deferred entry and/or the domestic establishment of an effective stability culture would reduce the domestic costs of opting for a strategy of external discipline. In short, an imported, external discipline may prove a residual rather than first-choice domestic strategy. Domestic political elites have hesitated to embrace a strategy of importing and providing an external discipline through early ERM II entry because of the risk that it could provoke a powerful narrative of EMU as a ‘harsh master’, threatening welfare-state provision and living standards, especially of those groups already disadvantaged by transition. They calculate—especially in the Czech Republic and Poland—that there is a significant potential for Euro-scepticism to take root and spread from the Left and Right of the political spectrum into the centre (Taggart and Szczcerbiak 2001; Kopecky and Mudde 2002). Britain’s brief and painful experience with ERM membership in 1990–2 provides a relevant model. Hence, EMU accession has to be framed in a discourse that highlights its role as a ‘good servant’ of domestic economic and political interests and preferences. A ‘good servant’ discourse is more compatible with strategies of using EMU accession to reinforce a pre-existing domestic discipline—as in the three Baltic States and Bulgaria—or of delaying Euro Area entry—as in the Czech Republic, Hungary, Poland, and Romania—till the domestic conditions are in place for credibly fulfilling the Maastricht convergence criteria in a sustainable manner. The preference for the strategic option of using EMU accession to reinforce (as opposed to provide) domestic discipline suggests that the prime catalyst for domestic economic policy transformation is not Europeanization but a pre-existing domestic crisis of transition and subsequent radical changes, whether with international (typically IMF) pressure and support (as in Bulgaria) or in the face of international scepticism (as in Estonia). EMU accession was a way for domestic technical elites to firmly anchor a valued domestic framework for economic policy. The strategic option of delay is similarly readily linked to a ‘good servant’ narrative. Delay offers a means of accommodating the narrative of ‘sound’ money and finance with narratives that privilege ‘real’ convergence in living standards and infrastructure and the preservation and enhancement of welfare states. In short, competing and potentially

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conflicting domestic narratives can co-exist behind this strategy, as for instance, in the Czech Republic. Moreover, the strategic option of delay has a potential to transform the long-term negotiating power of accession states over Euro Area entry. A rapid ‘real’ convergence, allied to a continuing superior performance to the Euro Area average in economic growth and job creation, reduces the asymmetry of power in negotiating fit. At the same time, a focus on the connections between narratives in defining fit and choice of strategic option can obscure more complex and elusive—though nevertheless important—questions about elite interests and motives in selecting strategies and using narratives. In instances where EMU accession is used by domestic technical elites to reinforce their position, the EU faces the risk of becoming captive to popular resentment at low levels of welfare provision (see Feldmann, Chapter 6 above, on the Baltic States). An elite-based ‘pacesetter’ role in EMU accession can transform into a populist domestic critique of EMU as ‘harsh master’: in effect, a displacement of blame from the domestic to the EU level. Similarly, a ‘laggard’ role can serve to disguise the motives of political elites. The notion of delay as a means of accommodating competing narratives may hide a long-term process that is equivalent to an ‘opt-out’. Because of superior economic performance, EU states with ‘opt-outs’, or which— like Sweden—behave in this way, could prove rival role models for states seeking rapid ‘catch-up’. As this chapter argues, strategic choice about EMU entry is bound up with the question of where ‘soft’ power—the power to support persuasive narratives of success—is perceived to lie.

EMU as ‘Poor’ Master or ‘Bad’ Servant? Core Europe, Declining ‘Soft’ Power, and Changing Incentives Strategic choices about EMU accession were closely tied to changing images of the Euro Area. The EU accession negotiations of 1997–2003 were framed by a widely held belief amongst east European negotiators and economic policy reformers that the Euro Area represented ‘core’ Europe, a powerful inner elite of EU states. The powerful incentive for joining this elite as soon as possible—for acting as pacesetter—was to ensure that, even after EU entry, they could escape from relegation to the historic periphery and become part of Europe’s core. Early entry offered to these historically marginalized and small states increased geo-strategic security, the economic potential of a huge and rich market, and enhanced capacity for projecting political profile. In addition, accession states could leap frog

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over some important older EU member states that might remain outside the Euro Area. Euro Area membership could be the ‘good servant’ of an historic escape from isolation and ‘second-class’ status. Though these incentives did not disappear, even before EU accession— and even more so by 2005—they became hedged with new uncertainties. The policy behaviour of its most significant members lent the Euro Area an image problem. Its magnetic attraction as core Europe was diminishing. Accelerating globalization, US economic performance in productivity, growth, and job creation, and new competition from east and south Asia highlighted an economic performance problem. The Euro Area lagged in growth and employment and accumulated fiscal deficit and debt problems. This problem was intensified by competition from the low-cost, high-skill east European economies in the framework of membership of the single European market. Investment shifted eastwards, with consequent stresses and strains in the labour markets and welfare states of the Euro Area (Sinn 2002). Divergences of competitiveness within the Euro Area raised additional serious policy problems. The traditional ‘soft’ power of the Euro Area was eroding. The most striking symptoms of this changing condition were: . The persisting economic stagnation in the Euro Area since 2000, especially of its leading economies France, Germany and Italy . The failure of the Lisbon agenda to close the gap with the United States on growth, productivity, and job creation indicators, and thereby to create the most advanced, knowledge-based economy in the world . The trials, tribulations, and atmosphere of crisis around the SGP and its acrimonious reform in 2005 . Consequent inability to match monetary union with economic union . Worries about persisting divergences in growth and inflation within the Euro Area and about the deteriorating competitiveness of some Euro Area economies, like Italy . Increasing contest between French and German political leaders and the EU institutions, notably over the directive on freedom of service provision . The highly symbolic popular rejection of the European Constitutional Treaty in referenda in two founder members of the EU and the Euro Area, France and the Netherlands . The bitter and prolonged EU budget wrangles about how to finance EU enlargement, raising questions about the willingness of core European states to show similar solidarity with new members as with previous enlargements.

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The crisis in European political unification and in economic union, as exemplified in the Lisbon process and in the SGP, meant that the Euro Area had lost its promise of becoming a community of solidarity, with EMU embedded in supportive structure of political union. Its problems of credibility were deepened by evidence that public opinion in leading Euro Area member states was less than supportive for the kinds of domestic economic policy transformation that were required by EU enlargement and the wider processes of Europeanization and globalization. Especially in the larger Euro Area states, EMU accession did not appear to act as a powerful incentive for domestic structural reforms (Duval and Elmeskov 2005). By 2005 the EU was confronted by a series of crises: an institutional crisis of legitimacy over the Constitutional Treaty, centred on France and the Netherlands and with potential for contagion; a leadership crisis as the traditionally privileged Franco-German relationship seemed to have changed its role from motor of, to brake on, European integration; a crisis of the EU and especially the Euro Area political economy, centred on an ideological conflict about the liberal market versus the social solidarity models; and, not least, a crisis of EU enlargement as the limits of political toleration in core Europe for this process were demonstrated. The centre of attention shifted from the prospective problem of domestic ‘reform fatigue’ in accession states to actual domestic ‘reform blockage’ in Euro Area member states. The central question was not simply whether new accession states could comply with EMU conditionality but whether existing Euro Area member states could live with the disciplines of EMU and the competition from accession states. Defining and negotiating fit with EMU was becoming increasingly a problem within the Euro Area. Enlarging the Euro Area was caught up in this multi-headed crisis in a way that exacerbated problems of defining and negotiating fit in accession. On the one hand, domestic public opinion and influential political elite opinion in core EU states exhibited increasing anxiety about, and fear of, EU enlargement in general. By extension, the context of negotiating fit for euro entry by the new accession states was more difficult. EMU enlargement threatened to sharpen problems of competitiveness and divergence within the Euro Area economy. From the perspective of Euro Area member states fit was more likely to be defined in a highly restrictive way, and negotiating fit made more problematic. This wider political development in public and elite opinion within core Europe combined with greater internal problems of growth, employment, and divergence within the Euro Area to indicate a more limited absorption capacity for Euro Area enlargement.

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On the other hand, for many in the political and technical elites of the new accession states, fit with the Euro Area could seem a less inviting prospect when what was being defined as fit was associated with failure rather than success. The overall effect is added incentive to pursue the strategic option of delay in order to maximize room for manoeuvre in economic policy, especially to retain sufficient macroeconomic flexibility to ensure rapid catch up in living standards. This option is consistent with a pragmatic ‘wait-and-see’ attitude to the Euro Area’s crisis. What comes to matter in this context is contagion from the policy behaviour of Euro Area institutional actors and member states and from the market effects of this behaviour. The Euro Area faces the prospect that domestic narratives in accession states may come to see it as a ‘poor’ master or a ‘bad’ servant.

Euro Area Accession and the Europeanization of East Central Europe This book is concerned with two interrelated questions: what domestic effects is the protracted process of EMU accession having on east central Europe; and, more tentatively, what kind of Europe is emerging from this interaction? Though answers are necessarily provisional and incomplete, and limited mostly to the pre-EU accession phase of 1996–2003, they offer insights into important patterns of continuity and change in Europe. Chapter 1 stresses EMU as an extreme case of accession Europeanization and the embeddedness of domestic transformation in an asymmetry of power. This asymmetry derives from the low material weight of individual east central European states in population, GDP, and financial assets, their smallness in the economic sense of high dependence on trade and inability to influence international prices, the absence of effective sub-regional coordination to press their interests in EMU, the formal—and especially the informal—conditionality attached to EMU accession, and the impact of an extended ‘gate-keeping’ mechanism that extends from EU, through ERM II, to Euro Area accession. The protracted process of phased EMU accession offers exceptional opportunities for EU influence on domestic transformation in east central Europe. It also provides an external incentive for anticipatory Europeanization through structural reforms (Agh 2003). This incentive is at its greatest in pre-ERM II accession because of the tight constraints that it imposes post-entry. Anticipatory Europeanization is sustained by the incentive to keep ERM II membership as short as

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possible through having put in place the conditions for sustainable nominal convergence prior to ERM II entry. At the same time Chapter 1 argues that the adaptive behaviour of east central European political elites conceals their strategic interest in exploiting the room for manoeuvre that they possess within the tightening constraints of EMU accession. This room for manoeuvre is defined by the uncertainties that are attached to EMU conditionality. Technical elites within the ESCB, the Economic and Financial Committee, Eurostat, and east central European central banks have an interest in reducing this uncertainty by restrictive definitions of conditionality, for instance, about exchange-rate policy or statistical case law relating to the surveillance of budgetary data (Savage 2005). By a firm binding of their own hands, they seek to empower themselves and shape the scope, timing, and pace of domestic transformation. Nevertheless, uncertainties remain, most notably about timetables for ERM II and Euro Area entry, and political elites in east central Europe have domestic party and electoral incentives to use them. Uncertainty has grown above all in fiscal policy, where political elites within the Euro Area have sought to loosen constraints. East central European political elites can use this loosening to legitimate an increased room for manoeuvre in seeking euro entry. Moreover, they have to balance the incentives from the trade-creation effects of Euro Area accession with cautionary evidence that the Euro Area has been associated with low growth, even stagnation, in the economies of its leading members. EMU accession is also a process of exposure to, and learning about, the ‘hidden’ side of conditionality (cf. Jacoby 2002). Scandals about the credibility of budgetary data, associated with Greece’s attempts at compliance with the fiscal criteria, and also with Italy, raise questions about whether incentives to comply with EU fiscal surveillance evoke ‘rogue’ behaviour. Because this behaviour puts the credibility of the whole process at risk, it is likely to lead to a tightening EU case law to harmonize national accounts. However, it also offers a lesson in what can be achieved by concealment and cheating. The ECB (2004: 6) is placing greater stress on statistical standards in assessing convergence and in particular on the independence, integrity, and accountability of national statistical institutes. Asymmetry of power, protracted ‘gate-keeping’ and anticipatory and adaptive Europeanization in EMU accession also disguise a potential for EU policy shaping by east central European states. This policy shaping has the potential to create major problems of policy misfit between traditional core European states and the EU. This potential seems less clear-cut in

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EMU because the formal acquis is established. In other policy areas where accession is complete, and east central European vital interests engaged, these states have displayed a new activism: for instance, in pushing the agenda of spreading freedom and democracy in external relations and playing a strong role in Croatia and the Ukraine; over the proposed directive on freedom of services; and over flat tax systems based on a single rate for personal income, value-added and corporate taxes. However, single European market issues like service provision and tax harmonization versus competition have an important ‘backdoor’ impact through their effects on the economic union pillar of EMU. Flat tax systems in Estonia (1994) and later Slovakia and Romania (2005) and Poland (planned for 2008) combine with low wages to make these east central European states highly attractive locations for inward investment. The effect is increased pressures for tax reforms in the traditional core states of the Euro Area. Asymmetry of power expresses itself differently: most sharply in institutional arrangements for monetary policy and, with ERM II entry, in exchange-rate policy; less acutely in structural policies to improve competitiveness (where the problems of fit are if anything greater for the traditional Euro Area states); and ambiguously in fiscal policy (where key member states in the Euro Area have sought more flexibility over rules, but statistical case law has tightened). Despite their relative material size, trade dependency, protracted EMU accession, and the constraints of informal conditionality, east central European states possess the potential to play a pivotal role in unleashing domestic transformation in older member states. Chapter 1 argues that the main mechanism through which this change takes place is contagion through markets and policy behaviour.

Transformation of Domestic Policies, Politics, and Polities EMU accession in east central Europe confirms the main findings of Europeanization research in the traditional EU member states: effects are more pronounced in domestic policies than in politics or polities (Dyson and Goetz 2003). These differential effects are repeated within domestic policies, where they are greater in monetary than in fiscal policies, and greater in these two areas than in structural policies. This variation reflects the degree of specificity in EU policy frameworks (Grabbe 2001, 2002, 2003). It also differs over time, for instance, in exchange-rate policy, which becomes more specific and constraining with ERM II accession. In turn, a

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tightening exchange-rate constraint acts as an added discipline on domestic fiscal policy. The extent to which domestic policy transformation represents Europeanization reflects, first, the complex relationship between EMU conditionality and domestic macroeconomic policy capacity. Macroeconomic policy capacity has two components: intellectual understanding of formal and especially informal conditionality, and institutional leadership. Europeanization depends, in the first instance, on a well-developed domestic intellectual capacity to comprehend and act on EMU conditionality and gain the confidence of EMU ‘gate-keepers’. For this reason domestic technical elites in the Czech Republic, Hungary, and Poland made faster progress in Europeanizing economic policies than their equivalents in Bulgaria and Romania. Their technical and political elites had a stronger grasp of how market economies functioned and of how to gain the confidence of markets and EU policymakers. This component of domestic macroeconomic capacity was more likely to be developed to the extent that during the communist era technical elites had been exposed to international markets. It was also strengthened where states could import technical expertise from a Diaspora, as for instance in the Baltic States and Poland. Institutional leadership, especially in fiscal consolidation, is variable in east central Europe. It depends on whether core executives are centralized or decentralized, the degree of administrative professionalism, and whether party political competition focuses on defending and extending the welfare state (Agh 2001; Dimitrov, Goetz and Wollmann 2006; Goetz 2001; Van Stolk 2005). Europeanization tends to be confined to islands of technical excellence within the executive: to central banks and to parts of finance ministries. Otherwise, earlier patterns of administrative organization and behaviour tended to persist (cf. Page 2003). For this reason domestic policy transformation consequent on EMU conditionality remains sporadic and limited rather than comprehensive and systematic. The nature of EMU conditionality has enabled greater domestic institutional leadership in monetary than in fiscal policies. In fiscal policy domestic institutional arrangements have varied and carry the imprint of transition experience rather than Europeanization (see Dimitrov, Chapter 13 above). Second, the extent to which domestic policy transformation represents Europeanization reflects the incidence, scale, and in particular timing of economic crisis in transition. Not all accession states experienced major crisis. Slovenia, for instance, was able to pursue a more cautious long-term

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approach to EMU accession in which anticipatory Europeanization figured strongly, for instance the modelling of central bank independence on the Bundesbank. More typically, states experienced crises that provided opportunities for domestic actors to pursue institutional reforms. This type of crisis was important in highlighting the problems of weak domestic macroeconomic policy capacity and in providing incentives for institutional innovation to strengthen leadership and ensure appropriate technical expertise. Examples include the currency boards in Estonia and in Bulgaria, and the centralization of executive power in fiscal policy in Hungary. In these cases crisis preceded EU accession negotiations and led to innovations that only very imperfectly, if at all, anticipated eventual EMU. They were designed domestically to build credibility from a very low level and to compensate for lack of domestic macroeconomic capacity. Transition crisis delivered domestic institutions that were better able to provide economic policy leadership. In these ways early crises of transition, outside the timeframe of EU accession negotiations, had a cathartic effect in preparing the ground for, and facilitating, a later process of defining and negotiating fit with EMU. The Czech crisis of 1997, and to a lesser extent the Hungarian crisis of 2003, were more firmly anchored within EU accession, raised issues about EMU compliance, and were a source of policy learning that had important implications for euro entry strategies. Czech policymakers drew the conclusion that the Maastricht condition of two years in ERM II was less relevant in a monetary policy world in which belief in pegged exchange rates had given way to floating or to currency boards (The Banker 2004). Even Hungary’s relatively moderate currency crisis of 2003, on the eve of EU entry, was important in shifting domestic elite attitudes towards a more cautious approach to ERM II entry. Currency volatility and crisis in a context of freedom of capital movement and large swings in foreign direct investment risk highlighting a fundamental misfit between compliance with ERM II conditionality and domestic policies. Especially where, as in the Czech Republic, Euro-scepticism is widespread, the outcome is likely to be a shift of blame to the EU, as in Britain after the ERM crisis of 1992. In this case domestic inertia and resistance are more likely to predominate over accommodation in the Europeanization process (cf. Radaelli 2003). Euro entry strategies would then lose practical relevance to domestic economic policymaking. Though the effects of EMU accession on domestic polities are less apparent, they repeat this pattern of differentiation. The main effect on domestic institutional configurations is observable in shoring up national

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central bank independence. As the chapters on Hungary and Poland show, political attacks on this independence prove impotent once EU accession negotiations begin. In contrast, the domestic institutional frameworks for fiscal policy prove much more resilient. This resilience reflects the degree to which domestic fiscal policy is embedded in core executive institutions whose character predates EU accession. These fiscal institutions vary between centralized (Hungary) and decentralized (Czech Republic) in ways that either facilitate or impede EMU compliance by their effects on domestic political leadership. However, political leadership can be exercised to serve the defence and strengthening of the welfare state (as in Hungary and Poland) as opposed to fiscal discipline. Collective interest in the credibility of EU fiscal surveillance is important in providing support for developing the independence and capacity of national statistical services to ensure the reliability of budgetary data on deficits and debt. Eurostat rulings have to be integrated into domestic accounting rules (Savage 2005). EMU accession may accordingly serve to shore up the independence of national statistical offices and to evolve a European statistical community as a transnational epistemic community akin to central bankers (cf. Haas 1992). The difficulty of using EU policy as external empowerment for domestic political leadership is even more apparent in structural policy reforms, where the EU lacks clear policy templates to ‘download’. Here, however, anticipatory and indirect Europeanization has affected the nature, scale, timing, and tempo of reform. The key incentive for structural reforms comes from the incentive to establish a strong competitive position within the single European market in order to attract foreign direct investment. Unlike in EMU accession for existing Euro Area states, welfare-state reforms anticipated rather than followed entry. Domestic incentives also play a role. Because of weak employer and trade-union organizations, there is little need to prioritize wage coordination and negotiate domestic social pacts, in contrast to EMU accession for existing Euro Area states. The effects of EMU accession on domestic party and electoral politics were limited to the extent that the critical choices about ERM II entry and Euro Area entry were deferred. The choices about EMU-related EU accession were of limited political salience, though national central bank independence produced domestic debate about whether the preferences of governing parties were being subverted by central bank governors who had formerly been prominent politicians in opposition parties (see chapters on Hungary and Poland). These choices were eased by being nested

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within the much bigger political saliency of the EU accession process as a whole (Avery 2004). The political saliency and potential effects of EMU accession were likely to increase with ERM II accession and Euro Area accession. For this reason, in the Czech Republic, for instance, governing parties were inclined to defer these decisions till a high level of domestic credibility had been accumulated and the consistency of nominal convergence conditionality with real convergence been clearly demonstrated. Domestic electoral incentives and party competition induced political elites to attend to issues of economic growth and employment before nominal EMU conditionality requirements. To this extent Europeanization effects were blunted. The effects of EMU on domestic political elites were broad and shallow in contrast to the narrower and deeper effects on key technical elites. Technical elites in domestic central banks, finance ministries, and statistical services attended to their reputations within the transnational policy communities of which they were members. In the case of finance ministry officials this professional loyalty to the ‘sound money and finance’ paradigm was hedged by loyalty to domestic political leadership. Hence, central bankers and statistical services found themselves potentially isolated and exposed on EMU accession. Domestic political elites depended for their survival and career advancement, first and foremost, on intra-party and electoral support. Fiscal consolidation, exchange rates, privatization, pension reforms, and other labour-market and welfare-state reforms were viewed through this lens. Hence, EMU accession was bound up in strategic party political and electoral calculations and manoeuvrings. Political incentive structures introduced a domestic conditionality into EMU accession. Domestic transformation of policies, polities, and politics was far from being a process of painting EMU requirements onto a blank canvas. In the case of first-wave accession states, substantial experience of transition and pre-accession negotiation crises had bequeathed a legacy of executive institutional structures and macroeconomic policy capacity for engaging in a process of defining and negotiating EMU accession. The result was a constrained but nevertheless real room for manoeuvre in macroeconomic policy. This institutional and intellectual legacy bore isolated imprints of anticipatory Europeanization. However, it was also strongly rooted in the dissemination of global norms through the IMF and the World Bank in the transition process (norms that in any case were anchored in EMU) and, above all, in domestic political developments.

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Mechanisms of Europeanization This book has shown that the effects of EMU accession on domestic transformation take different forms across policy space and over time (see Chapter 1) and hence are variable. Fit is central to understanding how Europeanization works because of the formal conditionality attached to EMU (especially in monetary policy), the informal background conditionality of the ‘sound money and finance’ paradigm and of currency area theory, and the privileged role of EU institutions as the ‘gate-keepers’ to different stages of EMU accession. ‘Bottom-up’ approaches to Europeanization risk failure to grasp this structural context in which domestic transformation is embedded. However, this book argues that fit is best understood not as a ‘top-down’ process, triggered by challenge to domestic policies, politics and polities from an EU ‘given’. Europeanization through EMU accession is a dynamic process of defining and negotiating fit across various actors and levels in a context of conditionality (formal and informal), uncertainties, contagion, and domestic politics. Europeanization literature foregrounds the domestic level in the study of European integration because of its focus on the effects of European integration. Especially in the hands of comparativists, it has a bias towards a ‘bottom-up’ approach that identifies in the strategic use of the EU as a source of external empowerment the central mechanism of Europeanization. However, by its nature Europeanization is embedded in processes that transcend the domestic. Crucially, formal EMU conditionality relating to EU, ERM II, and Euro Area accession gains its coherence, persuasiveness, and cutting edge from an economic policy paradigm and theories on which it rests that are transnational. Above all, EMU accession is a protracted process of staged ‘gate-keeping’, which privileges the ESCB, the European Commission, Eurostat, and the Euro Group in defining what represents fit. They have sought to orchestrate a tight and firm interpretation of fit. Thus, compliance with the Maastricht convergence criterion on inflation will mean the Treaty provision that makes the three best performers in the EU the benchmark and not the Euro Area average. The European Commission has stressed that compliance with the exchangerate criterion means a period in the narrow 2.25 per cent band of fluctuation within ERM II. ‘Gate-keeping’ gives weight to Commission, Eurostat, and ESCB technical advice and guidance, for instance, about how much progress in nominal convergence before seeking to negotiate ERM II entry and about how to calculate domestic deficits and debt. More importantly,

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it implies strict compliance with EMU institutional templates. This compliance is clearest and most specific in monetary policy. Despite this constraining framework, the mechanisms of Europeanisation are far from being simply top-down. The acquis is associated with numerous sources of uncertainty, especially about the timetable for entry; Europeanization expresses itself in indirect effects mediated by markets and the policy behaviour of others; and domestic political frameworks condition adaptation to EMU accession. No single EU actor—the ECB, the European Commission, Euro Group or ECOFIN—is in complete control of the process of defining conditionality. Member states bring their own beliefs and interests to this process and contribute a measure of uncertainty. Though the Maastricht convergence criteria remain the Treaty basis for Euro Area entry, leading member states drove the process of reform of the SGP, legitimating the notion of greater flexibility in fiscal policy and weakening the surveillance role of the Commission. To the extent that the reformed Pact focuses more on debt than deficits and gives greater flexibility to states with lower debts and high growth potential, accession states are bigger gainers than leading Euro Area members like France, Germany, and Italy. The status of member states with a derogation in EMU is not accompanied by either a firm timetable for Euro Area entry or a requirement to negotiate euro entry strategies. The effects of EMU on existing Euro Area states was accentuated by the final Treaty deadline of 1 January 1999 that served to spur domestic reforms. No equivalent time discipline exists for the new accession states. They can, moreover, benchmark their behaviour on Sweden as model rather than on Greece; and Greece raises questions about the use and abuse of budgetary data. In short, euro entry strategies are a matter of individual responsibility. Individual accession state governments have enormous discretion to vary the timetable to suit domestic party political and electoral interests and even to explore the ‘hidden’ side of conditionality by engaging in ‘rogue’ behaviour (cf. Jacoby 2002). Another source of uncertainty is the proper sequencing and prioritization of domestic transformation. This uncertainty is reduced to some extent by the different requirements associated with EU, ERM II, and Euro Area accession. However, attempts by EU actors to be more detailed and specific have not eliminated uncertainty about the relative importance that is attached to real and nominal convergence. The relationship between fiscal policy and economic growth in ‘catch-up’ economies remains contested, especially when fiscal policy must support big infrastructural improvements and EU structural fund spending. Compliance

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with Maastricht nominal convergence criteria may seem less urgent than investing in capacity building in the economy, for instance, communications, transport, education, and environment. Effective capacity building can be seen as another and higher priority form of Europeanization around the effective exploitation of structural funds. Europeanization escapes the bounds of domestic politics in another sense. East central European states are caught up in mechanisms of contagion that reflect market behaviour in the euro time-zone (of which they are part) and the policy behaviour of each other and of Euro Area members and institutions. These dynamic processes cut across boundaries and highlight how domestic transformation is linked to indirect Europeanization, especially the single European market and the use of the euro in financial markets and trade. This mechanism of Europeanization is captured neither by ‘top-down’ nor by ‘bottom-up’ accounts. It is, however, central to how fit is defined and negotiated in EMU accession.

Patterns of Convergence The question of whether, and in what ways, EMU accession—and subsequent Europeanization—is associated with a tendency of east European states to converge does not lend itself to easy answers. The difficulties include: . The point of reference. Are they becoming more alike each other or more alike existing Euro Area members? Are they replicating the experience of current members? . What is being measured. Institutional, monetary, fiscal or real convergence? . How convergence is measured. For instance, what is the base year for comparison? . How different aspects are weighed, not just against each other but also internally. For instance, whether in measuring real convergence the emphasis is on differentials in GDP growth, GDP per capita, trade and financial integration, or infrastructural modernization? Is more weight attached to deficits or debt in measuring fiscal convergence? . The dynamics of convergence. Is it a one-way street? Varying these dimensions can produce different answers. In consequence, there are contrasting pictures of convergence (cf. European Commission Progress Reports since 1998 and its Convergence Report

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2003; EBRD Transition Reports; IMF Transition: Experience and Policy Issues 2000; the Deka Converging Europe Indicator (DCEI) Scoring Model for measuring convergence; also Piazolo 2002). The European Commission Progress Reports and Convergence Report took the Maastricht convergence criteria as the point of reference and focused on nominal convergence (monetary and fiscal), with some attention to institutional convergence. By November 2001 the Commission was stressing the ‘considerable progress’ by all ten states. In contrast, the EBRD Transition Reports prioritised institutional convergence, especially of financial and legal systems, and led to a broadly optimistic portrait of post-transition economies converging with global and EU norms. The DCEI Scoring Model offers the most comprehensive measure and also seeks to categorize accession states according to convergence. It weighs all four components of convergence: institutional, fiscal, monetary, and real. Holtemoeller (2004) focuses on monetary convergence and offers a different categorization of convergence. The DCEI 2003 report identified a top-class of east central European states, scoring over 75 per cent for convergence, and including the Czech Republic (78 and consistently the best performer since 1992), Estonia, Hungary, and Slovenia. Slovenia was top scorer on real convergence, the Czech Republic on monetary convergence, while Hungary did better on institutional and fiscal convergence, and Estonia scored highly on monetary and fiscal convergence. Poland and Slovakia had particular problems in real convergence, leading to respective scores of 72 per cent and 67 per cent, with Lithuania the worst scorer amongst the ten. Overall, Bulgaria and Romania registered substantial progress on convergence: up respectively from 21 per cent in 1995 to 56 per cent and from 27 per cent to 40 per cent. Hence, broad patterns of convergence were discernible but hid a great deal of complexity. The consensus is that, since the mid-1990s, there has been a clear overall real convergence or ‘catch-up’ process with respect to GDP growth and trade integration with the EU. They have had higher average growth than their Euro Area counterparts (Sueppel 2003). The EU share of their exports was over 60 per cent for Hungary (72.9), Poland (68.3), Slovenia (65.5), the Czech Republic (64.2), and Romania (64.5), and below 50 cent only for Bulgaria (49.7) and Lithuania (38). Trade integration is important for cyclical convergence and avoidance of asymmetric shocks (its importance is stressed by the theory of optimum currency areas). However, despite real convergence through trade integration, business cycles in the accession states have on average been less synchronized with the Euro Area than the existing member states outside the euro (Britain, Denmark, and Sweden). This lack of synchronization is most striking in

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the cases of the Czech Republic, Slovakia, and the Baltic States and suggests a continuing risk of sizeable idiosyncratic shocks (Sueppel 2003). At the same time two qualifications are in order. First, there were significant differences in synchrony amongst east central European states. Hungary, Poland, and Slovenia showed a much closer alignment with the Euro Area. Second, overall, it was unclear that these states were any less synchronized than the existing Euro Area ‘peripherals’, Greece, Ireland, and Portugal (Sueppel 2003). On this measure, though they may remain peripheral and problematic, they do not differ from some states already in the Euro Area. Real convergence in GDP growth and in GDP per capita is more mixed and relatively modest. The effects of stabilization crises, as in Bulgaria and Czechoslovakia after 1995, show that real convergence is not a one-way street; it can be disrupted. In 2001 GDP per capita (measured in purchasing power terms) reached some 45 per cent of the EU average for the ten accession states, compared to around 41 per cent in 1995. Between 1993 and 2002 the ten new accession states enjoyed average annual growth rates of real GDP of 4.5 per cent (approximately 2.5 per cent more than the EU average over this period) (Sueppel 2003). However, even if this difference in GDP growth rates could be sustained, it would take some twentyeight years to halve the gap with the former EU15. Problems of real convergence are highlighted by the composition of GDP and employment (and what it reveals about economic structure and productivity) and by GDP per capita. The economic structures of accession states tend to be weighted disproportionately heavily to agriculture (notably in Bulgaria and Romania but also in Lithuania and Poland) and to industry (especially in Romania, the Czech Republic, and Poland). The stark nature of the ‘catch-up’ problems are revealed by figures of GDP per capita as a percentage of the EU average, even calculated at purchasing power rather than market exchange rates. Slovenia with 68 per cent comes top, reaching the same level as Greece, and the Czech Republic achieves 60 per cent. The rest fall below 50 per cent: Hungary 49, Poland 39, Estonia 36, Romania 27, and Bulgaria 23. Faced with these greatly increased economic differences within the enlarged EU, the EU has—primarily for reasons of political self-interest— opted to avoid the very costly option of extending existing transfer systems to these new members in favour of a policy—especially in agriculture—of promoting structural reforms. The result is sharp domestic criticism of the inequities in the treatment of former EU member states and new members in official EU transfer payments. Thus Poland—the biggest (with a population of 38 million) and also one of the poorest

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new members (with an annual per capita GDP of some 9,000 euros)—will receive in 2006 only 10 per cent of the net transfer payments received by Spain in 2001 (which has a slightly bigger population of about 40 million and an annual per capita GDP of 19,000 euros). At the same time, doubts remain about whether these new member states possess either the institutional capacity, especially at regional and local levels, or the fiscal capacity, because of requirements of budget consolidation, to develop and co-finance projects with EU structural fund aid. Real convergence is a long-term process. Because of equity issues, it will be highly politicized in EU budget negotiations. It will also take a differentiated spatial form, with some parts of east central Europe catching up much faster than other parts. There will, in short, be different regional clusters of real convergence that may not be well captured in national figures. Hence, real convergence is likely to be linked to growing internal economic and political tensions. Nominal convergence manifests an instability and uncertainty that was not apparent in Greece two years before entry (though the appropriateness of Greece as a benchmark is cast in doubt by budgetary data scandals). Moreover, both fiscal and monetary indicators suggest that divergence can occur. Measuring monetary convergence by interest rate spreads, risk premiums, and exchange-rate stability provides a picture of how financial market participants assess convergence by accession states. These measures make it possible to identify three groups: a top converging group of Estonia and Lithuania, which show stable relationships between domestic interest rate, Euro interest rate, and exchange rate; a middle group of the Czech Republic, Latvia, and Slovakia that are moving to monetary convergence; and a bottom group of Hungary, Poland, and Slovenia, along with Bulgaria and Romania, which show high and more volatile interest rate spreads and a low level of monetary convergence (Holtemoeller 2004). Hungary, and to a lesser extent, the Czech Republic, exemplify how accession states can exhibit monetary divergence. The ECB Convergence Report (2004) confirmed a broad picture of more successful nominal convergence by smaller states. In effect, Estonia, Latvia, Lithuania, and Slovenia formed a first division on the basis that they were already meeting a substantial number of the Maastricht criteria or close to doing so. Overall, the nominal convergence experience of the accession states illustrates a complex and differentiated process in which their relative positions can alter over time as well as across space. Four patterns can be identified. First, as the experience of existing Euro Area members shows,

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pressures for nominal convergence are at their strongest in ERM II accession and on the cusp of Euro Area accession. After final accession both inflation and fiscal convergence gave way to divergence. This suggests that formal conditionality is an important variable but alters over time. ERM II is likely to be the key catalyst. However, Bulgarian experience with a currency board suggests that a tough external discipline does not in itself deliver monetary convergence. The second pattern—which explains the Bulgarian case—is domestic politics. Domestic political developments can drive nominal convergence in different directions, as the Czech Republic and Hungary showed. Third, small states with high trade integration with the EU are more likely to make speedy progress with monetary and fiscal convergence. This pattern is also discernible amongst existing Euro Area members: Austria, Finland, and the Netherlands have continued to deliver higher nominal convergence than larger members. Even then, as Portugal shows, domestic politics remains a critical variable. The final pattern comes from different pressures for institutional convergence in fiscal and in monetary policy. The strongest pressures are in monetary policy, where the EU requirement of central bank independence produces institutional convergence and, by firmly anchoring a specific policy preference for price stability, constrains the scope for domestic politics. However, weaker pressures in fiscal policy are associated with contrasting experiences of institutional convergence in domestic fiscal policy. Hungary and Poland have shifted towards core-Europe-style ‘delegation’; the Czech Republic has experienced ‘commitment’ (1998–2002); the Czech Republic and Romania have exhibited fiscal ‘fiefdom’; while the three Baltic States and Bulgaria have operated currency boards. There is no EU institutional template for fiscal policy around which to converge. Moreover, there is a distinction—in contrast to monetary policy—between convergence in executive arrangements and fiscal outcomes. Centralized executive arrangements in fiscal policy enable the effective delivery of either fiscal discipline or expansion of the welfare state. In short, outcomes depend on how governing parties use centralized executive arrangements, in other words on their preferences.

The Erosion of ‘Exceptionalism’? There has been a strong tendency in the literature on comparative Europeanization to treat east central European states as exceptional and distinct in sharing certain governance and institutional characteristics. They

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appear to represent a particular ‘world’ of Europeanization, different from the Mediterranean and the Nordic worlds, as well as from the North-West world of ‘core’ Europe represented by the original six founder members (Dyson and Goetz 2003). This distinctiveness derives from the role of preaccession programmes and instruments in the accession process as levers for change, the asymmetry of power in accession negotiations, their late accession, their ongoing status outside the Euro Area, their legacies as post-communist societies, their recent and painful experience of transition from more or less planned socialist economies to market economies, and the scale of their problems of ‘catch-up’ with living standards in the EU. It is claimed that this exceptionalism expresses itself in institutional weakness and malleability of their core executives. The one world of Europeanization with which east central Europe might be said to have some shared characteristics is the Mediterranean. They seem to have in common periphery status, late accession, smaller, and weaker economies, asymmetry of power, executive fragmentation, and conflicts between modernizers and traditionalists (Featherstone and Kazamias 2001; Van Stolk 2005). In consequence, both worlds share a lack of capacity to ‘upload’ domestic policy preferences to the EU level. The EU provides them with external incentives to economic, political, and administrative modernization and to democratic consolidation. It also offers an arena for accelerated policy learning from the core. In consequence, they are more likely to be policy ‘takers’ rather than ‘givers’ in European integration and to be selective in the policies on which they focus, giving a high priority to subsidies, tax competition, and producer-friendly policies (Zimmer, Schneider, and Dobbins 2005). Seen from a policy content angle, the Mediterranean and east central European worlds seem difficult to differentiate from each other; the latter strengthens the former (Zimmer, Schneider, and Dobbnis 2005: 418). Euro Area accession represents a critical test for the view of east central Europe as a distinct, exceptional world of Europeanization. For the above reasons, including their post-communist trajectory, there are good grounds for continuing to see east central Europe as different. In practice, however, EU enlargement and EMU are undermining the cohesion of once distinct worlds, not least the North-West ‘core’ itself, and producing crosscutting patterns. The assumption was that the core Euro Area states would display relatively peaceful patterns of co-existence and co-evolution with Euro Area institutions and policies. Other Euro Area member states would either converge towards this relationship of accommodation or experience sharp and enduring conflict over the domestic implications

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of membership. In practice, the Euro Area developed in a more complex, ambiguous way that blurred the boundaries between these worlds. On the one hand, the Euro Area represents ‘core’ Europe: Franco-German leadership gave birth to it, while Germany defined its key policy templates and hence the conditions of fit (Dyson and Featherstone 1999). On GDP and trade indicators Germany continues to represent the economic core of Europe (Gros and Steinherr 2004). The Mediterranean and a part of the Nordic worlds joined, though more as attached periphery. In essence, the Euro Area represents a final bastion—a ‘hardening’—of ‘core’ Europe in an enlarging Europe. Otherwise, EU enlargement is leading to a ‘shrinking core (Dyson and Goetz 2003). The Euro Area remains the final institutional venue through which traditional ‘core’ Europe can continue to anchor its values in domestic policies. The ECB acts as institutional guarantor. Notably, reform of voting rights in its governing council to accommodate an enlarged Euro Area was based on a principle (GDP size and financial assets) that gave extra weight to the central bank presidents of the core members. Also, external incentives to comply with the SGP gave to prime ministers and finance ministers, especially of Mediterranean Euro Area member-state governments, opportunities to shift domestic fiscal arrangements away from executive fragmentation and fiscal ‘fiefdom’ to ‘commitment’ or ‘delegation’. On the other hand, the Euro Area has metamorphosed into a symbol of the declining ‘soft’ power and potential implosion of traditional core Europe. This symbolism takes two forms. First, the attached Mediterranean world—where EMU was supposed to serve as external discipline— has only to a limited extent absorbed the values of the stability culture and of how to pursue competitiveness without the instrument of devaluation. Greece, Italy, and Portugal remain central problems of economic divergence within the Euro Area and testify to the relative weakness of external discipline within EMU. Second, leading states in core North-West Europe experienced increasing problems of tension and conflict with Euro Area policies. As implementation of the SGP showed, these problems could internally divide the traditional core: notably the Netherlands (for strict application) from France and Germany (for flexible application). Germany in particular had fewer gains from EMU than other members (who benefited from lower real interest rates) and underwent a protracted and painful process of competitive disinflation to restore lost competitiveness (Dyson and Padgett 2006). In short, leading parts of the North-West core and the Mediterranean periphery of the Euro Area began to share some characteristics in the ways that they related to the Euro Area. Boundaries

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between the North-West and Mediterranean worlds of Europeanization continued to be recognizable but were becoming fuzzy, while these worlds were also internally less cohesive—even within a policy sector that represents core Europe better than any other and can claim to be an ‘extreme’ case of Europeanization. This book suggests that the process of enlarging the Euro Area is eroding the coherence, distinctiveness, and exceptionalism of east central Europe. Its states are differentiating into different clusters, according to institutional and governance characteristics and to their roles as pacesetters or laggards in euro entry. They differ in central institutional traits and characteristics of governance in ways that have major implications for their individual roles within, and relationships to, the EU and the Euro Area. They can be seen as involved in the same dynamic interaction between the structural requirements of the Euro Area, contagion processes, and domestic politics as members of the original core and of the Mediterranean world. This interaction has in particular empowered national central banks and their policy preferences in similar ways. Most crucially, east central European states do not possess the weak and malleable domestic core executives, either in monetary or in fiscal policies, that some analysts have ascribed to them. These executive structures are resilient and mediate the process of EMU accession. They also differ in significant ways. Hungary, for instance, has a more centralized core executive in fiscal policy; the Czech Republic’s is more fragmented. Currency boards have locked others into a tough framework of external discipline. On this institutional variable some east central European states—the pacesetters with currency boards, and Hungary and Poland—can claim to be part of clusters with some traditional core EU members; others are closer to the Mediterranean world. Hence, in terms of core executive structures, there does not appear to be a single east central European world of EMU accession. This picture is reinforced if one looks more widely at characteristics of governance. European Bank for Reconstruction and Development (EBRD) (1999) rankings of quality of governance cover macroeconomic governance (most central to this book) but also include microeconomic governance (like taxes and regulation), physical infrastructure, and law and order. The quality of macroeconomic governance index highlights Estonia, Hungary, Lithuania, Slovakia, and Slovenia; on the overall governance index Estonia, Hungary, and Slovenia form a top category. Bulgaria and especially Romania appear as laggards (though Bulgaria scores better on macroeconomic governance). However, this index has two limitations: it does not

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allow a comparison with the old EU15 or the Euro Area; and it is based on performance as perceived by market participants. Gros and Steinherr (2004: 139–40) have produced a quality of governance index based on World Bank figures that permits more useful comparisons. On the indicator of political stability, again Hungary and Slovenia lead, followed by the Czech Republic. On government effectiveness, Poland, Hungary, and the Czech Republic excel. These best performers in east central Europe outscored the lowest performers in the EU15. On political stability they exceeded the EU15 average, though were much further away from the EU average in government effectiveness than from the east central European average. This pattern of differentiation is reinforced in Gros and Steinherr’s ‘gravity’ index (2004: 330–37). This index measures core-periphery ranking by trade potential on the basis of casting a wide net to include geographic proximity, size of markets, trade arrangements, and cultural affinities. It identifies the Czech Republic and Slovenia as not far behind Spain and Ireland (two Euro Area members), followed by Slovakia and Hungary (which are ahead of Greece and Portugal), with Bulgaria and Romania trailing. East European countries benefit to the extent that they are close to the core around Germany. Though this index goes well beyond institutional and governance characteristics, it shows that east central European states are very differently positioned in relation to political economy notions of core Europe. Advocates of accelerated Euro Area entry in east central Europe saw in EMU accession a mechanism for speeding up the end of their exceptionalism. It represented not just the final confirmation that transition was over but also the final end of the accession period. As the previous section stressed, the question was—with what, in institutional terms, was east central Europe converging? In monetary policy its states had converged rapidly with core European standards: just as Mediterranean central banks had converged on these standards, so had those of east central Europe. In fiscal policy evidence suggested more complex and differentiated patterns of core executive convergence: in Hungary and to some extent Poland with core Europe; in the Czech Republic and Romania, where fiscal fiefdom and executive fragmentation were characteristic, with the Mediterranean world of Europeanization. Hungary and Poland had converged more on core European arrangements of ‘delegation’. Though delegation worked with difficulties, with policies aimed at defending the welfare state, this feature did not distinguish them from some core Europe members, let alone make them exceptional. There was, in other words, shape to

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processes of convergence, but they were complex and differentiated and blurred the boundaries of different worlds of Europeanization. Taking into account the currency board arrangements in the three Baltic States and Bulgaria, it cannot be claimed that fiscal fiefdom and executive fragmentation is a shared characteristic of east central Europe that differentiates it from core Europe or that it shares with the Mediterranean world. The differentiation into ‘pacesetters’ and ‘laggards’ in Euro Area entry suggests that internally the east central European world is losing its coherence. Some states are likely to remain exceptional, especially if their distance from core Europe translates into weaker trade effects on domestic development. Exceptionalism is likely to be ended first in states where these trade effects are strong and dynamic, where the domestic experience of transition has thrown up credible stability cultures, and where EMU accession strategy is about locking in these pre-existing cultures. The ‘pacesetters’—all countries with currency boards—are, strikingly, not replicating the Mediterranean world, in which EMU accession strategy has been about importing an external discipline (though with far from convincing results in economic convergence). Their strategy is to anchor what has already been domestically created. In contrast, policymakers in those east central European states whose transition experience has not delivered a resilient domestic stability culture have shown an initial preference for a strategy of delay. They too have been wary of attempting to import stability through external discipline. This choice can be seen as confirming the continuing distinctiveness of an east central European world of Europeanization in EMU accession, albeit diminished in size, from the Mediterranean world. The distinctiveness derives from the scale and centrality of the ‘catch-up’ problem in relation to Euro Area accession; consequent difficulties of reconciling nominal and real economic convergence and of complying with inflation and fiscal deficit criteria; problems of reconciling different domestic economic interests; fragile governments whose parties face incentives to compete on the basis of defending and extending welfare states; and electorates that are susceptible to Euro-populism or Euro-scepticism. In this context governments lack the confidence to make credible long-term commitments by pegging their currencies to the euro and have greater incentives to opt for a strategy of delay on EMU. The challenge of EMU accession faces them with three strategic options: ‘Mediterraneanizing’ their strategies by importing discipline (where they show reluctance); affirming an east central European exceptionalism by continuing to delay; or emulating the

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pacesetting states of east central Europe by putting in place a secure framework of domestic discipline and then locking it in by euro entry. The structure of domestic incentives suggests that strategies two and three will prevail.

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Index

agglomeration effects 23 agriculture, and employment in 83 Amsterdam Treaty (1997) 115 Antall, Jozsef 266 Argentina 60 Asian financial crisis (1997) 60 Austria 13, 23 Balassa–Samuelson effect 68, 69, 73, 81, 88, 104–6 and Czech Republic policy 175 Balcerowicz, Leszek 72, 173, 199, 200 Baltic States: and banking and financial sector 242 and central bank independence 133, 136–7 and convergence 296 and currency reform 133–4 support for 135–6 and Economic and Monetary Union: elite support for 140 locking-in of domestic policies 140–3 maintaining support for 142–3 possible disillusionment with 143–4 suitability for membership 127–8, 140 and economic and political transition 228 economic reform 131–2 flat-rate tax policy 131 integration into EU 129–30

and fiscal policy 135, 136–7 and Maastricht convergence criteria 137–41 as pacesetters 11, 36, 127 and party system volatility 143 and stability culture 128, 133, 135–6 and top-down Europeanization 140 and weak Euro-scepticism 130–1 and welfare state: demands for spending 140 post-communist era 309, 310 social risk/welfare stress 320 Bank of International Settlements 247, 248 banking system, and east central Europe 86–7 and bank governance 239 government regulation 239–40 opaqueness of structure 239 and banking sector supervision 242 Bank of International Settlements 248 cross-border supervision 248–9 European Central Bank 248 independence of 248 institution building 247 Lamfalussy process 248 role of European Union 246–7 role of global networks 247–8 and convergence of: bank governance structure 253–5

353

Index banking system (cont.) bank portfolio quality 255–7 EBRD index of 252–3 profitability/efficiency 257 rapid financial deepening 257–9 and crisis and restructuring 241–2 and financial sector safety net: deposit insurance schemes 251 lender of last resort 249–50 and pre-transition conditions 240–1 and privatization with foreign participation 242–6 acceptance of 243–5 advantages for European banks 245–6 impact on banking reform 245 impact on corporate governance 245 impact on profitability 245 objectives of 242 ‘political affinity’ 242 and transformation of 237–8, 259–60 see also central banks Barroso, Jose Manuel 110 Basescu, Traian 226 Bauc, Jaroslaw 204, 205 Belka, Marek 203, 205, 206, 207, 211 ‘binding hands’: and ‘bottom-up’ Europeanization 147 and Bulgaria 145, 153–4, 158–9 and euro entry policy 20–1 and euro entry strategies 38–9 and inflation 146 and negotiating fit 146–8 and political actors 146 as response to crisis 146 and technocratic decisionmakers 146 and ‘top-down’ Europeanization 147 ´ kos 188 Bod, Pe´ter A Bokros, Lajos 180, 266–7

354

Bosnia-Herzegovina 159 Brazil 60 Bretton Woods system 52, 53, 58 Broad Economic Policy Guidelines (BEPG) 29, 96, 109 and economic governance 114 and reform of 115 Bulgaria 8, 13, 14 and adoption of global norms 64–5 and banking and financial sector 242 bank governance structure 254 privatization 243 and ‘binding hands’ approach 145 adoption of currency board 153–4 costs of 158–9 success of 158 and Bulgarian National Bank 153, 154–5, 156, 158 and convergence 296, 298 and core-periphery ranking 303 and democratic transition 150 and development of fiscal institutions 149, 157–9 compatibility with EMU requirements 154 currency board (19972005) 153–7, 158 decentralized institutions (1989-97) 150–3 and economic crisis 152, 157 and economic growth 61 and economic reform 150–1, 156–7 and euro entry strategy 154–5 and exchange-rate policy 54, 62, 63 currency board 153–7, 272–3 and fiscal deficits 150, 151, 152, 154, 156, 159 and governance quality 302 and inflation 62, 152 and interest rates 152 and international financial markets 155–6 and International Monetary Fund 25

Index and Maastricht convergence criteria 148, 160 and monetary policy 156 and political party system 150, 151–2, 157–8 limits on party competition 159 and Pre-Accession Economic Programme 157 and stability culture 157 and transition to market economy 24–5 and welfare system 157 Bulgarian National Bank 153, 154–5, 273 Bundesbank 52, 53–4, 86 bureaucratic politics, and euro entry strategies 39 business cycles 296–7 Buzek, Jerzy 200 capacity building, and real convergence 4 capital flows: and east central European countries 83 and timing of Euro Area membership 68 Cardiff process 110, 115 Ceausescu, Nicolae 217 central banks: and Baltic States 133, 136–7 and ‘binding hands’ approach 21, 146 and Bulgaria 153, 154–5, 156, 158 and Bundesbank 52, 53–4, 86 and competition with governing parties 39–40 and conditionality requirements 11 and Czech Republic 160, 164, 169–71 Euro-Area Accession Strategy 160, 169, 174

and formal conditionality 14–15 and Hungary 178, 181–2, 184 controversy over independence of 186–90, 193, 196 speculative attacks 190–2 and ideas about euro entry 33 and independence of 15, 26, 302 criticism of extent of 18 and inflation targeting 53–4 and institutional weakness 24 as lender of last resort 249–50 and Maastricht convergence criteria 93 and Poland 197 challenged on monetary convergence 202–3 independence of 201 monetary convergence 199–202 and privileging of 19 and Romania 215 capacity of 263 challenges facing 286 exchange-rate policy 229–31 government interference with 221 independence of 227 inflation 227 policy objectives 229 stability of 227 and transnational policy networks 19 see also European Central Bank China, and liberalization 48 cohesion funds 97 Cologne process 110, 115 commitment institutions 263, 326 and Czech Republic 269, 270–1 Committee of Monetary, Financial and Balance of Payments Statistics (CMFB) 15 competitiveness, and east central European countries 84–6 competitiveness policy, and EMU conditionality 29

355

Index conditionality, and EMU 3 and competitiveness policy 29 and convergence criteria 65 and diverse approaches to euro entry 32 and domestic contexts 11 and domestic transformation 9, 14, 21–5 executive institutional structures 23–4 transition to market economies 22–3, 24–5 and equality of treatment 31 and euro entry 2 and Europeanization 262 and exchange-rate policy 27–8 and fiscal policy 28–9 and formal 14–19 forms of 14–15 hard mechanisms 16, 18–19 limited nature of 13 soft mechanisms 15, 17–18 and gate-keeping mechanisms 31 and informal 19–21, 213 constraints of 14 optimal currency area 20 ‘sound money and finance’ 10, 13, 20–1, 31–2 variability in domestic effects 19 and macroeconomic policy 29 and monetary policy 26–7 and state discretion 11 and uncertainty 10, 11–12, 25 and variation across policy space 25–6 and variation over time 30 see also Maastricht convergence criteria consumer debt 84 contagion processes 3, 91 and Baltic States 142 and domestic transformation 301

356

and east central European governments 34 and Economic and Monetary Union 32–5 and euro entry 2 and impact of derogations/optouts 34 and indirect effects of European integration 12 and mediators of 32–3 and policy behaviour of Euro Area states 33–4 and processes of 10–11 and role of central banks/finance ministries 33 and Single Market programme 16, 32 convergence: and annual convergence programmes 28 and Baltic States 297 and banking and financial sector: bank governance structure 253–5 bank portfolio quality 255–7 EBRD index of 252–3 profitability/efficiency 257 rapid financial deepening 258–9 and Bulgaria 272, 280, 298 and capacity building 4 and compliance/capacity tensions 12 and Czech Republic 296, 297, 298 and domestic politics 315 and east central European countries 56–8, 74–6 and eastern Europe ‘catch-up’ 18, 316–17, 318 and Estonia 293, 295 and European Central Bank 15, 26, 87, 271 and European Commission 296 and fiscal policy 300 and Hungary 296, 297, 298

Index and institutional 5 and Latvia 293, 295 and monetary policy 273 and nominal 4, 308–9 and patterns of 317–21 and Poland 199–203, 296, 297, 298 and real 5, 72, 318–326 and Romania 317, 318 and Slovakia 317, 318, 319 and Slovenia 317, 318, 319 and Stage 2 adjustment 79–81 and structural reform 18, 100 and structure of economic activity 84 and timing of euro entry 71–2 and transfer payments 297–8 see also Maastricht convergence criteria Copenhagen economic criteria 15, 30, 64 core executives: and euro entry strategies 38–9 and impact of EMU 9 and misfit in EMU accession 22 core-periphery rankings 325 corner regimes, and exchange-rate policy 60 corporate debt 84 credibility: and ‘binding hands’ approach 146 and macroeconomic policy 50, 52 and ‘rogue’ behaviour 309 Croatia, and banking and financial sector: bank governance structure 254 privatization 243 currency boards 60 and Bulgaria 153–7, 272–3 limitation of party competition 159 and constraint on lender of last resort 249 and Estonia 132

and Lithuania 134 and party policy preferences 276 and Romania, rejection by 229–30 current account balances, and east central European countries 98–9 Cyprus 8, 13, 14 and excessive deficits 97 and exchange-rate policy 95 as pacesetter 69 Czech National Bank 160, 164, 169–71 and Euro-Area Accession Strategy 172–3, 174 Czech Republic: and adoption of global norms 64 and banking and financial sector 242, 260 bank governance structure 254 convergence of 253 privatization 243 and budgetary crises 56 and convergence 296, 297, 298 and core-periphery ranking 303 and Czech National Bank 160, 164, 169–71 Euro-Area Accession Strategy 172–3, 174 and deficits 162–3, 325 excessive 97, 175–6 reduction of 174 and Economic and Monetary Union accession 63, 161, 177 Czech National Bank 169–71 domestic controversy over 164–5 economic challenges of 161–3 negotiating fit 162 weak reform capacity 165–8 and economic growth 176 and euro entry 88, 89, 99 and Euro-Area Accession Strategy 160, 169, 177 formulation of 171–5 implementation of 175–6

357

Index Czech Republic: (cont.) and Euro-scepticism 164–5, 167–8 and exchange-rate policy 54, 62, 95, 162 EMU effects 175 Maastricht convergence criteria 160 volatility of rate 163 and fiscal policy 161–2 constraints on 324–5 EMU effects 175–6 evolution of fiscal institutions 269–72, 275–6 fiscal reform 173–4 impact of political conditions 323, 325 slow-down of reform 176 and foreign direct investment 161 and governance quality 303 and inflation 62, 175 and labour market 314, 315 as laggard 69, 71, 160 and Maastricht convergence criteria 161 exchange-rate 163 and monetary policy 162 EMU effects 175 and political constraints on reform 165–8 and Pre-Accession Economic Programme 172 and referendum on EU membership 173–4 and structural reform 176 and trade 102 integration with EU 100 and weak economic alignment with Euro Area 162, 163 and welfare spending 143 and welfare state: debt positions 295 post-communist era 279, 282, 302, 322

358

social risk/welfare stress 292, 293, 295 social transfers 294 Czechoslovakia: and banking and financial sector privatization 242 and exchange-rate policy 54 and market liberalization 49 see also Czech Republic debt crises 56 deficits: and Bulgaria 150, 151, 152, 154, 156, 159 and Czech Republic 97, 162–3, 173, 175–6, 325 and east central European countries 75–6, 80, 87 and European Commission 175–6 and European Council 97–8 and Excessive Deficit Procedure 66 and Hungary 80, 97, 325 and Maastricht convergence criteria 56–8, 74–79, 79–80, 148–9 and Poland 97, 325 and Romania 219–20, 222, 224 and Slovakia 97, 325 and sustainability of public debt 56 and Visegrad countries 62 see also fiscal policy Dekabank DCEI indicator 85, 318 delegation institutions 272 and Hungary 265–9 Demja´n, Sa´ndor 191 Denmark 13 and opt-out 34, 92, 96 deposit insurance schemes 251 domestic opportunity structure literature 9 domestic politics, and influence of: and Bulgaria 222, 240, 242, 325–6 and convergence 299

Index and Czech Republic 165–9 and euro entry strategies 11 bureaucratic politics 39 core executive structures 38–9 party and electoral competition 37–8 public opinion 38 structures of economic interest 36–7 and evolution of fiscal policy/ institutions 265 Bulgaria 272–3 Czech Republic 269–72 Hungary 265–9 party policy preferences 274–5 and fiscal policy 276–7, 325–6 and Hungary 183–5, 192–3, 194–5 and Poland 215, 219, 241–2, 243 and Romania 218–19, 220, 225 executive reform 224 domestic transformation: and contagion processes 301 and east central European countries: conditionality requirements 21–5 domestic policy 301–3 domestic politics 315 domestic polities 312–13 EU gate-keeping mechanisms 31 euro entry 9, 14 executive institutional structures 23–4 market liberalization 23, 48–50 Pre-Accession Economic Programme 17–18 sequencing of reforms 31–2 transition to market economies 22–3, 24–5 and older member states 310 Duval, Romain 101 East Asia, and liberalization 48 east central European countries:

and adoption of global norms 64–5 and banking and financial sector 86–7 and capital flows 83 and competitiveness 84–6 and contagion processes 10–11 and core-periphery rankings 325 and Economic and Monetary Union: domestic contexts 11 domestic impact 3, 9–10 good servant narrative of 41–3 harsh master narrative of 40–1 and economic growth 61 and erosion of exceptionalism 321–27 and EU policy-shaping 309–10 and Euro Area membership 86–7 advantages of early entry 66–7, 72, 77 challenges in obtaining 98–100 costs and benefits of 100–7 economic aspects of 74–9 issues arising over 87 likely effects of 73–4 reasons for delay 67–9, 73, 77 risks of early entry 77–8 Stage 2 adjustment 79–81 Stage 3 adjustment 82–7 timing of 87–9, 92 and euro as parallel currency 35 and euro entry strategies 88–9 bureaucratic politics 39 context of 34–5 core executive structures 38–9 domestic contest over 33 factors affecting 33–5 party and electoral competition 37–8 public opinion 38 structures of economic interest 36–7 unofficial ‘euroization’ 35 vulnerability of 35

359

Index East Asia, and liberalization (cont.) and euro-centred financial markets 4, 34–5 and European Union, fast-track accession 222 and Europeanization 301–3 and exchange-rate policy 60 exchange-rate pegging 54 timing of Euro Area membership 67–8 and fiscal policy 56, 64 Maastricht convergence criteria 56–8 and foreign direct investment 8, 49, 61 and free-trade agreements 48–9 and governance quality 302–3 and inflation 62, 81 and institutional convergence 5 and integration into world economy 60–1 and interest rates 76 and legal obligation to join single currency 92 and limited economic weight of 14 and Maastricht convergence criteria 56–8, 74–6, 117–18 exchange-rate policy 59–60 inflation 93–4 interest rates 94 performance against 95, 98–9 public debt 97–8 and market liberalization 22–3, 24–5, 48–50, 61–2 impact of monetary integration 101–2 and membership of EMU 65–6 and patterns of convergence 317–321 and policy choices 4 and position on entry to European Union 62–4 and productivity 239

360

and public debt 65, 81, 98 and real convergence 71 and stability culture 62 advantages of Euro Area 66–7 and structure of economic activity 83–4 and trade 102 and transition to market economies 22–3 as ‘world’ of Europeanization 1–2 see also domestic transformation; entries for individual countries Economic and Financial Committee (ECOFIN) 15, 19 and convergence programmes 28 and economic governance 115 and excessive deficits 97 and exchange-rate policy 27–8 Economic and Monetary Union (EMU): and accession Europeanization 2, 8, 143, 308–10 defining and negotiating fit 9–13 institutional convergence 5 market-led processes 4 phases of 30 power asymmetries 13 and contagion processes 32–5 and convergence criteria 65 and domestic narratives of 40 good servant narrative 41–3 good servant narrative of 304 harsh master narrative 40–1 harsh master narrative of 40–1 strategic options 303–5 and domestic transformation 2, 9–10 domestic policy 301–3 domestic politics 315 domestic polities 312–13 and east central European countries 63–4 and eastern enlargement of EU 1 and evolution of fiscal institutions: Bulgaria 272–3

Index Czech Republic 269–72, 275–6 Hungary 265–9 party systems 274 resilience of domestic structures 273–4 as extreme Europeanization 2, 8–9 and fiscal policy: domestic political considerations 276–7 impact on 265 negotiating fit 262, 277 and global norms 4, 14 and impact of domestic variables 213–14 and impact on actors 3 and impact on east central European states 3 and impact over time 3–4 and importance of domestic leadership 212–14 role of external incentives 213 and indirect effects of 23 and justification for 7 and legal obligation to join single currency 92 and negotiating fit 86, 91, 306–8 economic aspects of 74–9 Stage 2 adjustment 79–81 Stage 3 adjustment 82–7 and origins of 8 and phases of 30 and protracted nature of 9 and room for manoeuvre of accession states 3, 3–5, 30, 31 and Single Market programme 16 and structural reform 42–3, 164 and use of language in describing 72 see also conditionality, and EMU; convergence; Euro Area; euro entry; Maastricht convergence criteria economic governance, and European Union 5

and commitment-implementation gap 120 and credibility gap 119 and current institutional framework 115–16 and dependence on Euro Area success 123 and dilemma faced by 129 and eastern enlargement 13, 28 and emergence of new global norms 47, 91 adoption by east central European countries 40–1 exchange-rate policy 58–60 fiscal policy 55–6 market liberalization 48–50 monetary policy 52–4 stability culture 50–8 and European Constitutional Treaty 90–92 and impact of new members 112 and implementation problems 115, 118 and institutionalist approach to 112 and integration of east central European countries 60–1 and methodological difficulties in assessing 112–13 and past experience 113 and policy coordination 109–10, 115–16, 123–4 involvement of domestic actors 119 and scenarios of development: as learning process with open outcome 121–3 maintenance of status quo 116–17 worsening of coordination 117–20 and scepticism over coordination 111–12

361

Index economic governance, (cont.) and towards optimal economic governance 123–4 economic growth: and Czech Republic 176 and east central European countries 61 and Euro Area 90 and Romania 254 Economic Policy Committee 114, 115 Economic Policy Dialogue 17 Eesti Pank 133 electoral competition, and euro entry strategies 37–8 Elmeskov, Jørgen 101 Employment Committee 114, 115 Estonia: and adoption of global norms 64 and banking and financial sector 36 bank governance structure 253–55 convergence of 257–9 lender of last resort 249–50 privatization 243 and competitiveness 86 and convergence 296, 299 and Economic and Monetary Union 63 suitability for membership 127–8, 140 and economic reform 132 and euro entry strategy 139 and exchange-rate policy 58, 59, 60, 103, 163 currency reform 133, 135 and fiscal policy 153, 198 and flat-rate taxation policy 23 and governance quality 321 and labour market 314 and Maastricht convergence criteria 138 and misfit in EMU accession 22 as pacesetter 66, 69, 127 and stability culture 128, 133, 135–6

362

and weak Euro-scepticism 130–1 and welfare state: debt positions 296 post-communist era 279–284 social risk/welfare stress 295 social transfers 294 Euro Area 3 and adapting to 8 and challenges in joining 98–100 and contagion processes 33 and costs and benefits of membership 73–4, 91, 100–7 and creation of 8 and economic governance 5 eastern enlargement 13 and economic growth 75 and enlargement of 90, 91 and gate-keeping mechanisms 16 and image of: as core Europe 8, 301, 305–308 credibility problems 285 economic performance 305 erosion of ‘soft’ power 305–8, 323 multiple EU crises 307 and legal obligation to join 92 and market liberalization 23 and Mediterranean members 12 and monetary policy 26 and policy behaviour of member states 33–4 and structural reform 100–2, 103 exchange-rate policy 103 fiscal policy 103, 106 monetary policy 103–4 trade creation 106–7 and trade growth 67 see also euro entry euro entry: and defining fit 2, 5, 9–13 as dynamic process 9–13 and diverse approaches to 32 and domestic contexts 11 bureaucratic politics 39

Index core executive structures 38–9 party and electoral competition 37–8 public opinion 38 structures of economic interest 36–7 and domestic transformation 9, 14 and domestic transmission of ideas about 33 and equality of treatment 31 and implications for convergence 71 and laggards 5 and negotiating fit 2, 5, 9–13 as dynamic process 2 and pace-setters 5 and power asymmetries 10, 91 and protracted nature of 9 and strategies for 88–9 changing image of Euro Area 308–10 context of 34–5 deferring entry 303–4 domestic contest over 33 domestic narratives of EMU 40–3 factors affecting 33–5 manipulation of timetable for 11 providing external discipline 301–2 reinforcing domestic discipline 303 room for manoeuvre 303–5, 308, 309 unofficial ‘euroization’ 35 vulnerability of 35 and timing of 66, 71–2, 87–9, 92 advantages of early entry 66–7, 72, 77 economic aspects of 74–9 indefinite postponement 71 issues arising over 87 reasons for delay 67–9, 73, 77 risks of early entry 77–8 Stage 2 adjustment 79–81

Stage 3 adjustment 82–7 Euro Group of finance ministers 5, 124, 198 Europe Agreements 60, 64 and east central European countries 49 European Bank for Reconstruction and Development (EBRD) 49, 61 and Baltic States 128–32 and financial sector in east central Europe 261 bank governance structure 253–5 convergence of 252–3 and governance rankings 324–5 and Transition Reports 318 European Central Bank: and banking sector supervision 242 on convergence 95 and Convergence Reports 15, 26, 318 and corner regime analysis 60 and diverse approaches to euro entry 32 and exchange-rate policy 27–8 and gate-keeping 31 and modeled on Bundesbank 53 and National Bank of Hungary 187 and national central bank independence 15 criticism of extent of 18, 26 and Poland 205–6, 240, 252–53 and power asymmetries 10 and price stability 27 and sequencing of domestic reforms 31–2 and ‘sound money and finance’ 10 European Commission: and Convergence Report 318 and diverse approaches to euro entry 32 and economic governance 115 and excessive deficit procedure, Czech Republic 175–6 and exchange-rate stability 95

363

Index European Commission: (cont.) and gate-keeping 31 and Poland 205–6, 240, 252–3, 265–6 and power asymmetries 10 and Progress Reports 317 and Regular Reports on accession states 15, 16, 18 Romania 226–7 and Romania 216, 221 and sequencing of domestic reforms 31–2 European Community, Treaty on the, and economic governance 109–10 European Constitutional Treaty 8 and economic governance 108–10 and French/Dutch rejection of 8, 34, 90, 306 and ratification process 33–4 European Convention 119 European Council, and excessive deficits 97–8 European Court of Justice 228 and economic governance 115–16 and Stability and Growth Pact 116 European Economic Area 48 European Employment Strategy 109 and economic governance 115–16 European Free Trade Association (EFTA) 48 European Investment Bank, and east central European countries 49 European Monetary System 59, 92 European Parliament, and economic governance 115–16 European System of Central Banks (ESCB) 8 and national central bank independence 14 European System of Economic Accounts (ESA95) 17, 18 European Union: and crises in 274

364

and eastern enlargement: challenges posed by 7–8 Economic and Monetary Union 1 European ‘re-unification’ 7 fast-track accession 222 impact of numbers 13 limited economic impact 14 transformational effects of 233 waves of 8 and gate-keeping mechanisms 15, 16, 31, 223, 226, 308 and global norms 64–5 and market liberalization 48, 64 and policy coordination 109–10 and stability culture 64 see also economic governance, and European Union Europeanization: and accession Europeanization 2, 8, 198, 308–9 defining and negotiating fit 9–13 institutional convergence 5 market-led processes 4 phases of 30 power asymmetries 13 and conditionality 302 and diversity of impact 217 and domestic transformation: domestic policy 301–2 domestic politics 315 domestic polities 312 and erosion of exceptionalism 321–27 and fit 4 and growth in study of 1 and mechanisms of 315–17 and multi-level context of 2 and negotiating fit 268–9, 277, 301–2, 303 and top- and bottom-down approaches 146–7, 301–2 and ‘worlds’ of 1–2, 322

Index Euro-scepticism 38 and Baltic States 130–1 and Czech Republic 165–6, 167–8 and Hungary 178–9, 184 Eurostat 15, 28, 31 exceptionalism, and erosion of 321–27 Excessive Deficit Procedure (EDP) 66 Exchange Rate Mechanism (ERM) 8, 59–60 and ‘binding hands’ 21 Exchange Rate Mechanism (ERMII) 2, 11, 95 as ‘boot camp or purgatory’ 78 and domestic monetary policy 26 and east central European countries 63–4 and fears of speculative attacks 163, 164 and gate-keeping mechanisms 16 and Maastricht convergence criteria 65, 71 and premature entry 80 as testing phase 27–8 and timing of entry into 66 exchange-rate policy: and Bulgaria 54, 62, 63 currency board 153–7, 272–3 and competitiveness 84–5 and ‘corner regimes’ 60 and currency area theory 20 and currency reform, Baltic States 132–4, 136 and Czech Republic 54, 62, 95, 162 EMU effects 175 Maastricht convergence criteria 160 volatility of rate 163 and east central European countries 62, 80 exchange-rate pegging 54 timing of Euro Area membership 67–8

and EMU conditionality 27–8 and Estonia 54, 62, 73, 95, 105 currency reform 133, 135 and global norms 58–60, 66 and Hungary 53, 62, 95, 178 Bokros package 180 Hungarian model 180–3 speculative attacks 190–2 and inflation targeting 54 and Latvia 54, 62, 95 currency reform 133–4, 135 and Lithuania 54, 62, 73, 95, 105 currency reform 134 and Maastricht convergence criteria 76, 79–80 and monetary integration 103, 105 and monetary policy 54, 60 and Poland 54, 62, 95 and Romania 62 failures of 220 influence of domestic politics 195 managed floating 231 opposition to currency board 230–1 strong leu policy 230, 231 and Slovakia 61, 62, 95 and Slovenia 54, 62, 95 and Stage 2 adjustment 79–81 and timing of Euro Area membership 67–8 and types of regimes 59 and Visegrad countries 80 see also currency boards external incentives literature 9 extreme Europeanization, and Economic and Monetary Union 2, 8–9 fiefdom institutions 263 and Czech Republic 269–70, 271–2 and fiscal policy 275–6 finance ministers, Euro Group of, see Euro Group of finance ministers

365

Index finance ministries: and ideas about euro entry 33 and institutional weakness 24 financial sector, and east central Europe 86–7 crisis and restructuring 241–2 financial sector governance 239 definition of 268 government regulation 240–41 opaqueness of structure 239 pre-transition conditions 240–1 see also banking system, and east central Europe Finland 13, 23 fiscal policy: and analytical framework for 262–5 commitment institutions 266 delegation institutions 272 fiefdom institutions 263 historical institutional approach 263 impact of party systems 149 and Baltic States 135, 137–8 and ‘binding hands’ 38–9 Bulgaria 145 and convergence 299 and Czech Republic 161–2 constraints on 310 EMU effects 175–6 evolution of fiscal institutions 265–73 fiscal reform 173–4 impact of political conditions 203–5 slow-down of reform 176 and east central European countries 64–5 and economic adjustment 20 and Economic and Monetary Union: accession 148 conditionality 28–9 impact of 261–2

366

negotiating fit 262, 277 and Estonia 135, 136 and evolution of policy/institutions: Bulgaria 272–3 Czech Republic 269–72, 275–6 fiefdom institutions 275–6 Hungary 265–9 party policy preferences 274–5 party systems 274 resilience of domestic structures 273–4 and Hungary: Bokros package 180, 266–7 boosting domestic economy 182 constraints on 310 evolution of delegation institutions 272 impact of political conditions 203–5 and Latvia 135, 136 and Lithuania 135, 136–7 and Maastricht convergence criteria 117–18, 79–80 and monetary integration 103, 104 and national government 261, 265 and new global norms 60–4 and Poland 197 commitment to restrictive 202 constraints on 324–5 EU constraints on 210 failure of fiscal stabilization 205–7 fast-track EMU entry strategy 183 Hausner’s stabilization plan 211 impact of economic conditions 203–4 impact of political conditions 203 Kolodko’s stabilization package 208 tax increases 205 and political structures 323–5 and political/electoral constraints 276–7, 325–6

Index and Slovakia: constraints on 324–5 impact of political conditions 325 and stability culture 50, 52 see also deficits fit, defining and negotiating 5, 9–13, 91 and ‘binding hands’ 146–7 as dynamic process 13 and Economic and Monetary Union 82, 91, 306 economic aspects of 74 fiscal policy 262, 274 Stage 2 adjustment 79–81 Stage 3 adjustment 82, 89 and euro entry 2, 5, 9–13 and Europeanization 4, 9–13, 146–7, 262, 267, 301 and misfits 22, 185 and power asymmetries 218 flat-rate tax policy 208, 209 and Baltic States 131 and Romania 231 foreign direct investment: and Czech Republic 161 and east central European countries 49, 61 and eastern Europe 8 and Poland 68 and Romania 220 France: and fiscal indiscipline 221 and rejection of European Constitutional Treaty 8, 34, 90 and Stability and Growth Pact 20, 96 Fraser Institute 85–6 free-trade agreements, and integration of east central European countries 48–9 gate-keeping, and European Union 197 and euro entry velocity 31

and formal conditionality 16 and Romania 221, 222, 225 General Agreement on Tariffs and Trade (GAT T) 49 Germany: and fiscal indiscipline 58 and monetary policy 52–4 and Stability and Growth Pact 12, 20 Gerschenkron, Alexander 195 governance, and quality of 324 Greece 8, 12, 13 and dubious fiscal statistics 31, 294 and economic divergence 323 and Euro Area membership 34 Gronicki, Miroslaw 212 Gross, Stanislav 176, 271 Gyurcsa´ny, Ferenc 193, 268 Hallerberg, Mark 149, 263–5, 267, 270, 272, 274 Hansson, Ardo 131 Hausner, Jerzy 209–12 Havel, Va´clav 170, 171 Helsinki European Council 223, 233 Heritage Foundation 86 Horn, Gyula 180, 188, 266 Hungary: and adoption of global norms 64 and banking and financial sector 240, 242, 260 bank governance structure 253 bank portfolio quality 255 convergence of 240 privatization 243 and budgetary crises 56 and conflicting economic/political interests 182–3 and convergence 294, 295, 296 and core-periphery ranking 325 and Economic and Monetary Union accession 63 explanation of failure of 179 favourable conditions for 178–9

367

Index Hungary: (contd.) and economic development 179, 193, 195 transnational restructuring 116 and economic reform: Bokros package 180–1, 266, 268 calls for retrenchment 191 calls for social pact 191–2 Hungarian model 181–2 policy drift and volatility 185 and education sector 191 and euro entry strategy 37 central bank independence 186–89 conflicting interests 182 impact of Europeanization on 218 institutional problems 196 lack of political consensus 178 political conflict over 183–5, 192–3, 194–5 postponement of entry 192, 195 rival advocacy coalitions 185–6 structural problems 204 and Euro-populism 179, 184, 193 and Euro-scepticism 178, 194 and exchange-rate policy 58, 60, 103, 177 Bokros package 180 Hungarian model 181–2 speculative attacks 190–1 and fiscal policy: Bokros package 180, 266, 268 boosting domestic economy 182 constraints on 303 evolution of delegation institutions 272 impact of political conditions 176, 177 and governance quality 302, 303 and inflation 180–1 and labour market 314 as laggard 11, 69, 178

368

and Maastricht convergence criteria, failure to meet 178 and misfit in EMU accession 22 and National Bank of Hungary 160, 185 controversy over independence of 186–90, 193, 196 speculative attacks 190–1 and political party system 183–4, 194, 266–9 and public debt 81, 98, 292 and social solidarity 37 and trade 102 and transition to market economy 25 and wage levels 23 and welfare state: debt positions 295 post-communist era 279 social risk/welfare stress 318–19, 321, 322 social transfers 294 Iliescu, Ion 218, 222 Index of Economic Freedom 86 inequality 282 inflation: and Balassa–Samuelson effect 106 and ‘binding hands’ approach 146 and Bretton Woods system 52 and Bundesbank 52, 53–4 and Czech Republic 177 and east central European countries 62, 81 and European Central Bank 27 and Hungary 180–1 and inflation targeting 53–4 and Maastricht convergence criteria 74, 75, 79 and Poland 62, 199, 202 and Romania 62, 216, 227, 228

Index and ‘sound money and finance’ 20 and Stage 2 adjustment 79 and wage coordination 313 interest rates: and currency area theory 20 and east central European countries 76 and inflation targeting 54 and Maastricht convergence criteria 74, 75, 79 and Poland 199, 201 Intergovernmental Conference, and economic governance 119–20 International Monetary Fund (IMF): and Baltic States 128 and Bulgaria 25, 153, 273 and Czech Republic 172 and east central European countries 48 and euro adoption 87 and Romania 223, 232 Ireland 13 Isarescu, Mugur 217, 220, 223, 225, 26, 228 Italy 12 and competitiveness 84, 86 and criticism of fiscal statistics 31 and economic divergence 323 and Stability and Growth Pact 20 Ja´rai, Zsigmond 173, 181, 189 Kallas, Siim 136 Klaus, Vaclav 49, 269 Kocarnik, Ivan 269, 270 Kolodko, Grzegorz 203, 207–9 Korea, and liberalization 48 Kosovo 222 Kova´cs, La´szlo´ 193 Kwasniewski, Aleksander 203, 206 labour markets: and economic adjustment 20, 90

and inflation and wage coordination 313 see also wage levels Lamfalussy process 247 La´szlo´, Csaba 187, 190 Latvia: and banking and financial sector privatization 243 and convergence 299 and Economic and Monetary Union 67 suitability for membership 127–8, 140 and economic reform 132 and euro entry strategy 139 and exchange-rate policy 58, 60, 103 currency reform 133–4, 135 and fiscal policy 135, 136 and inflation 62 and Maastricht convergence criteria 138 as pacesetter 69, 127 and stability culture 128, 135–6 and weak Euro-scepticism 130 and welfare state: debt positions 295 post-communist era 279 social risk/welfare stress 320 social transfers 294 Latvijas Banka 133 liberalization: and Baltic States 131–2 and Bulgaria 222, 240 and east central European countries 309, 310, 322 and European Union 48 and importance of 91 see also structural reform Lietuvos Bankas 137 Lisbon process 29, 307 Lithuania: and banking and financial sector 36 convergence of 240

369

Index Lithuania: (contd.) lender of last resort 250 privatization 243 and convergence 237, 240 and Economic and Monetary Union 91 suitability for membership 120 and economic reform 132 and euro entry strategy 139 and exchange-rate policy 58, 60, 103 currency reform 134 and fiscal policy 135, 136–7 and governance quality 324, 325 and labour market 314 and Maastricht convergence criteria 138 as pacesetter 127, 137 and stability culture 128, 135–6 and weak Euro-scepticism 130 and welfare state: debt positions 295 post-communist era 279 social risk/welfare stress 295 Luxembourg Council (1998) 61 Luxembourg process 29 Maastricht convergence criteria 4, 56, 74, 79 and Baltic States 137–40 and Bulgaria 154, 158 and central banks 99 and Czech Republic 161, 163 and east central European countries 149, 150 performance against 95, 98–9 and Estonia 138 and exchange-rate policy 58, 59, 60 and fiscal policy 56–8, 99, 148–9, 261 and Hungary, failure to meet 178 and inflation 65, 93–4 and interest rates 65, 94 and Latvia 138

370

and Poland 198, 208 and public debt 56, 98, 148 and Stage 2 adjustment 79–81 and weakening of 119 see also convergence Maastricht Treaty 8, 92 and ‘sound money and finance’ 20 macroeconomic policy: and ‘binding hands’ 20 and development of European framework 95–6 and EMU conditionality 13, 21–22, 26 and Exchange Rate Mechanism 124 and policy capacity 311 and stability culture 47, 50–2 fiscal rules 55 monetary rules 52 and Stage 3 adjustment 82 Malta 8, 13, 14 and cohesion funds 97 and excessive deficits 97 and exchange-rate policy 103 as pacesetter 69 market behavior, and contagion processes 12 market reform, see liberalization; structural reform Medgyessy, Pe´ter 184, 186, 190, 192, 193, 268 Mediterranean, as ‘world’ of Europeanization 300 Mexico, and liberalization 48 Miller, Leszek 200, 202, 205, 206, 207, 209, 211 monetary policy: and Bretton Woods system 52 and Bulgaria 156 and Bundesbank 53–4 and convergence 299 and Czech Republic 162, 175 and EMU accession 148

Index and EMU conditionality 24–5 and Exchange Rate Mechanism 21 and exchange-rate policy 58, 60 and Germany 58 and inflation targeting 53–4 and monetary integration 103–4 and Poland 197, 199–203 and Romania 216 and stability culture 52 and Stage 2 adjustment 79 Nastase, Adrian 217, 221, 223, 224, 225 National Bank of Hungary 178, 181 and controversy over independence of 186 and euro entry strategy 185 and speculative attacks 190–1 National Bank of Poland: and challenged on monetary convergence 202 and independence of 206 and monetary convergence 199–202 and pro-EMU policy 197 National Bank of Romania 215 and capacity of 177 and challenges facing 286 and exchange-rate policy 229, 231 and government interference with 221 and independence of 227 and inflation 229 and policy objectives 229 and stability of 229 Netherlands, and rejection of European Constitutional Treaty 8, 34, 90 New Zealand, and banking and financial sector 243, 247 Nice, Treaty of 65 non-governmental actors, and economic governance 120 Noyer, Christian 28

open method of coordination (OMC) 110 optimal currency area: and informal conditionality 20 and Stage 3 adjustment 82 and suitability for monetary union 76 Orba´n, Viktor 181, 189, 267 Organization for Economic Cooperation and Development (OECD) 101 and Czech Republic 172 and east central European countries 149 Papademos, Lucas 32, 101 Parragh, Ferenc 191 Poland: and adoption of global norms 64 and banking and financial sector 36 bank governance structure 253 convergence of 240 privatization 243 and cohesion funds 97 and competitiveness 86 and convergence 294, 295, 296 and criticism of Pre-Accession Economic Programme 15 and Economic and Monetary Union 60 as Europeanization 198 failure of Kolodko’s fast-track strategy 208–9 impact of domestic variables 213 importance of domestic leadership 212–13 postponement of entry 192 role of external incentives 213 unbalanced convergence 197–8 and economic growth 75 and euro entry 41, 42, 43 and excessive deficits 97 and exchange-rate policy 58, 59, 60

371

Index Poland: (contd.) and fiscal policy 197 commitment to restrictive 202 constraints on 303 EU constraints on 210 failure of fiscal stabilization 205–7 fast-track EMU entry strategy 183 Hausner’s stabilization plan 210–12 impact of economic conditions 203–4 impact of political conditions 161, 175, 176, 177, 203 Kolodko’s stabilization package 208 tax increases 205 and foreign direct investment 68 and governance quality 303 and inflation 62, 199, 202 and interest rates 199, 202 and labour market 314 as laggard 69 and Maastricht convergence criteria 160, 185 and market liberalization 48 and monetary policy 197 challenge to monetary convergence 199, 200 monetary convergence 199–202 and National Bank of Poland: challenged on monetary convergence 202–3 independence of 206 monetary convergence 199–202 pro-EMU policy 213 and Pre-Accession Economic Programme 205 and public finances 204 budgetary crises 56, 204–6 constitutional constraints 210 public debt 292 and social solidarity 37

372

and structural reform 200, 207, 210 and trade 102 and transfer payments 319–20 and transition to market economy 25 and welfare state: debt positions 295 post-communist era 279 social risk/welfare stress 319, 321 social transfers 294 political parties: and competition with central banks 39–40 and euro entry strategies 35, 36 see also domestic politics, and influence of Popescu-Tariceanu, Calin 226, 232 Portugal 12, 13 and economic divergence 323 poverty 299 power asymmetries 10 and accession Europeanization 13, 308 and expressions of 288 and negotiating fit 91, 301–02 Pre-Accession Economic Programme (PEP) 15 and Bulgaria 157 and Czech Republic 172 and objective of 17 and Poland 205 Pre-Accession Fiscal Surveillance Procedure (PFSP) 15, 117 and domestic transformation 17–18 and elements of 17 price stability, and central bank independence 26–7 see also inflation primary economic activity 83 privatization 48 and banking and financial sector 242–6 and Bulgaria 156

Index and east central European countries 61 and Romania 220, 224 productivity: and Balassa–Samuelson effect 104–6 and east central European countries 85 public finances: and accounting standards 17 and conditionality requirements 16 and east central European countries 75–6, 80–1, 87 and fiscal policy 55–8 and Maastricht convergence criteria 56–8, 74, 75, 138, 148 and Pre-Accession Fiscal Surveillance Procedure 15 and sustainability of public debt 56 see also deficits; fiscal policy public investment: and east central European countries 80 and Euro Area membership 71 public opinion, and euro entry strategies 37 Repsˇe, Einars 138 Reserve Bank of New Zealand 53 Romania 8, 13, 14 and adoption of global norms 64 and banking and financial sector 242 bank governance structure 253 privatization 243 and capital inflows 230 and capture of state economic policy 37 and communist-era economic strategy 217–18 and convergence 296, 299 and core-periphery ranking 325 and domestic politics: economic reform 219–20, 224 executive reform 224

resilience to change 220–1 and domestic weakness 215 and Economic and Monetary Union: central bank capacity 226–7 central bank independence 227 target date for membership 226 and economic growth 75, 226 and economic reform 22, 24–5, 232–33 economic gradualism 219–20 failure of radical programme 219 flat-rate tax policy 231 government subsidies 224 inadequate basis for 241 under Nastase 216, 223 need for consistency 231 privatization 220, 221 and EU accession 216 conditionalities of 216 Europeanizing effects 218 EU’s gate-keeping strategy 222 failure to adapt to 220–1 fast-track accession 223 galvanizing effects of 224–5 negotiations over 222–3 transformational effects of 233 and European Commission’s Opinion on 221 and exchange-rate policy 60 failures of 232 influence of domestic politics 195 managed floating 231 opposition to currency board 229–30 strong leu policy 228–9 and foreign direct investment 312 and governance quality 302 and inflation 62, 220, 224, 27 as laggard 215 and misfit in EMU accession 22 and monetary policy, failures of 213 and National Bank of Romania 215 capacity of 177

373

Index Romania (contd.) challenges facing 230–1 exchange-rate policy 229, 231 government interference with 221 independence of 227 inflation 227 policy objectives 229 stability of 229 and political economy of 179 and post-communist political development 215 and public finances: fiscal deficits 220 quasi-fiscal deficits 220 Rome, Treaty of 7, 48 Russia, and Baltic States 129–30 Simeon Saxe-Coburg-Gotha 154 Single Market programme 4 and contagion processes 16, 32 and Economic and Monetary Union 16 and market liberalization 48 Slovakia: and banking and financial sector 260 bank governance structure 253 convergence of 268 privatization 243 and competitiveness 86 and convergence 294, 295, 296 and core-periphery ranking 325 and euro entry 79, 92, 127 and excessive deficits 97 and exchange-rate policy 58, 59, 60 and fiscal policy: constraints on 396, 303 impact of political conditions 325 and flat-rate taxation policy 23 and governance quality 302 and inflation 62 and labour market 314 as laggard 69

374

and public debt 292 and welfare state: debt positions 295 post-communist era 279 social risk/welfare stress 319, 321, 322 social transfers 204 Slovenia: and adoption of global norms 64 and banking and financial sector 260 bank governance structure 253 convergence of 240 privatization 243 and convergence 94, 95, 96 and core-periphery ranking 325 and Economic and Monetary Union 91 and economic convergence 36 and economic growth 61 and exchange-rate policy 59, 60, 103 and governance quality 321, 324 and inflation 105 and labour market 314 as pacesetter 69 and welfare state: debt positions 295 post-communist era 279, 309 social risk/welfare stress 319, 321 social transfers 294 Sobotka, Bohuslav 172, 173 social risk, and welfare states 316–20 social solidarity, and defence of 37 Sofianski, Stefan 153 sound money and finance, and informal conditionality 10, 13, 20–1, 31–2 South-East Asia, and liberalization 48 Spain 13 Sˇpidla, Vladimir 160, 270 Stability and Growth Pact (SGP) 96, 303 and annual convergence programmes 28

Index and cohesion funds 97 and conditionality requirements 25, 26 and controversy over 186 and economic governance 115 and lack of enforcement 97 and problems of compliance with 12, 118 and reform of 20, 28–9, 39, 58, 115, 294 stability culture 50–2, 59 and Baltic States 128 Estonia 133 and Bulgaria 157 and east central European countries 62 and European Union 108 and fiscal policy 55–8 and membership of Euro Area 66–7 and monetary policy 52–4 state identity, and Euro Area membership 8 statistics, and national statistical offices 31 structural reform: and Baltic States 131–2 and Bulgaria 150–1, 156–7 and Czech Republic 176 and eastern Europe ‘catch-up’ 18 and importance of 108 and monetary integration 100–2, 103 exchange-rate policy 103 fiscal policy 103, 106 monetary policy 103–4 and Poland 200, 208, 210 and reform blockage 32 and reform fatigue 31 and Romania 22, 24–5, 218–20, 221, 224 and sequencing of domestic reforms 31

and trade creation 106–7 and trade-off over time 103 see also liberalization ¨ rgy 187, 188 Sura´nyi, Gyo Sweden 13 and derogation from Euro Area membership 34, 87 Swiss Institute for Management Development 85 Sze´les, Ga´bor 186, 187 Taiwan, and liberalization 48 Tosˇovsky, Josef 166, 169 trade: and east central European countries 101–2 and Euro Area, growth within 67, 83, 106–7 transfer payments 319, 320 transnational policy networks: and ideas about euro entry 33 and informal conditionality 19 Tu`ma, Zdene˘k 171 uncertainty: and compliance/capacity tensions 12 and conditionality requirements 10, 11–12, 25 and domestic transformation 301–02 and EMU accession 277 unemployment: and east central European countries 98–9 and welfare state spending 306, 311 United Kingdom 53 and opt-out 34, 96 and privatization 48 Vasile, Rudu 225 ¨ nther 223 Verheugen, Gu Videnov, Zhan 151

375

Index Viksnins, George 131 Visegrad countries 49, 61 and exchange-rate policy 60 and fiscal deficits 78 see also Czech Republic; Hungary; Poland; Slovakia wage levels: and Balassa–Samuelson effect 104–6 and economic adjustment 20 and Hungary 180–1 and inflation and wage coordination 315 see also labour markets Washington Consensus 48 welfare states, central and east European countries 325 fiscal policy: impact of political conditions 325–6 impact of political structures 323–5 post-communist era 279 buffer functions in 307–8 economic crises 307 increase in benefit recipients 308 pensions spending 283 reform difficulties 308 spending levels 296 taxation implications of 311 unemployment spending 310–11 welfare outcomes 282

376

social policy spending dynamics under EMU 320–3 debt positions 295 social transfers/expenditure growth 293–4 under state socialism 307 vulnerability under EMU 284 dependency ratio 294 employment rate 294, 296 inflation 315 inflation and wage coordination 313 problem loads 285, 286 public sector wages 298 public spending and ‘welfare stress’ 293, 295 role of social partners 285 Western European experience 311–12 ‘welfare stress’ 295–6, 299–300 Werner, Riecke 187 World Bank 25 and Czech Republic 172 and east central European countries 48, 49 and Romania 224 World Economic Forum 85 World Trade Organization 49, 61 Yugoslavia, and privatization 243 Zeman, Milosˇ 167, 270