European Journal of POLITICAL
European Journal of Political Economy ECONOMY Vol. 13 (1997) 247-259 ELSEVIER
Convergence of the EU Member States towards the EMU requirements, 1986 to 1993
Peter Guldager Department of Economics, The Aarhus School of Business, Fuglesangs Allg 4, 8210 Aarhus V,
Accepted 1 August 1996
This paper analyzes the five convergence criteria of the Maastricht Treaty by means of factor analysis. The results show that the criteria may be summarized by two independent factors, inflation and public debt performance, with inflation figuring more prominently. The factor scores suggest that between 1986 and 1990 France, Ireland, Spain, Portugal and the United Kingdom progressed substantially towards convergence. Some backsliding, however, occurred between the years 1991 and 1993. The performance of Greece deterio- rated, while that of the other EU Member States remained largely stationary. To meet the EMU requirements by 1999, economic convergence would have to take place at an accelerated pace in Stage II of the EMU.
JEL classification: F02; F15; F33
Keywords: European economic and monetary union; Maastricht criteria; Convergence; Factor analysis; Inflation and public debt performance
The Treaty on European Union as agreed at Maastricht stipulates that the Economic and Monetary Union (EMU) is to be achieved in three stages, i The
Stage I of the Economic and Monetary Union commenced on July 1, 1990 and Stage II on January 1, 1994.
0176-2680/97/$17.00 Copyright 1997 Elsevier Science B.V. All rights reserved. PII S0176-2680(96)00038-9
248 P. Guldager / European Journal of Political Economy 13 (1997) 247-259
final stage (III) will be initiated on January 1, 1999. The authors of the Treaty originally envisaged the possibility of an EMU taking place before 1999. If, by the end of 1996, a majority of EU Member States were to have fulfilled the five criteria of economic convergence set forth in the Treaty, an earlier date could have been set. This option was abandoned by the European Council in Madrid in December 1995. A decision of the Council in early 1998 will determine the Member States qualifying for participation in the EMU. The abandonment of the early option indicates that convergence of national economic policies among a majority of the Member States was not taking place at a sufficient pace to establish the EMU before January 1, 1999.
The European Commission has initiated a number of detailed country studies to assess the convergence of fiscal policies towards the EMU of all Members except Luxembourg, which had already met the criteria by the end of 1993. Based upon these studies, De Haan et al. (1994), after assessing in detail the margins for consolidating the budgets of the 11 Member States, found scope for consolidation both on the expenditure and the revenue side, but generally that more scope existed for cutting expenditure. The need for consolidation was deemed most urgent in Greece, Belgium and Italy. 2
My intention here is to analyze economic convergence among the EU Member States by specifying a simplifying aggregative framework to assess the pace of progress towards the EMU. This framework is based upon all the requirements of the Union Treaty for membership in the EMU and is established by factor analysis. A factor analysis such as I undertake here is a useful procedure in the context of EMU evaluation. The main features of the five convergence criteria can be summarized into a few common factors which offer insight into the basic common dimensions that the criteria are measuring. Understanding is thereby enhanced of the basic impediments to Member States' meeting the criteria. The assessment, which covers the period 1986 to 1993, also determines the extent to which the necessary degree of convergence envisaged in the Union Treaty for Stage I of the EMU took place.
The paper is organized as follows: In Section 2 the five criteria of economic convergence set forth in the Maastricht Treaty are briefly discussed. The method of factor analysis is reviewed in Section 3. In Section 4 a factor analysis is performed to establish the independence of and the correlation among the criteria, and the factors which the criteria are measuring in common are identified. In Section 5, I calculate the factor scores for the EU Member States which form the basis for assessment of convergence towards the EMU requirements. Section 6 presents concluding comments.
2 For further elaboration of the conflict between the public finance requirements and the stabilization function of fiscal policy, see Jensen and Jensen (1995).
P. Guldager / European Journal of Political Economy 13 (1997) 247-259 249
2. The convergence criteria of the Treaty on European Union
The Union Treaty stipulates that a Member State aspiring to membership in the EMU must satisfy the following conditions: 3
Condition 1. Consumer price inflation over the previous year must not exceed by more than 1.5 percentage points that of, at most, the three best performing Member States in terms of price stability (article 109j with protocol).
This formulation leaves some room for interpretation. It is, however, the received opinion that an average of the inflation rates in the three best performing Member States will be used as the threshold value unless one country exhibits an extreme value (e.g. negative inflation). In that case it could be disregarded. 4 One would expect that convergence in inflation to a common rate would be a major requirement for sustaining a monetary union, although theoretically this common rate need not be low or even stable.
Condition 2. Long-term government bond yields, observed over a period of one year, must not exceed by more than 2 percentage points that of, at most, bond yields in the three countries with the best inflation performance (article 109j with protocol).
Again, the opinion is that the threshold value will be an average of the bond yields in the three best performing Member States. Theoretically, one would expect Members of a monetary union with low rates of inflation to have low bond yields if real interest rates are assumed to equalize throughout the union (the Fisher effect). 5
Condition 3. The currency should have remained within the normal exchange rate band of the ERM for at least 2 years, without devaluing against the currency of any other Member State (article 109j with protocol).
On August 2, 1993 the normal fluctuation band of the ERM was temporarily suspended by the decision to introduce the wider 15 percent band. 6 This suspension followed the removal of capital controls mandated by the Single European Act which, as Eichengreen (1993) points out, undermined the viability of the ERM and brought the Community to a choice between greater exchange rate flexibility and monetary unification.
3 An extensive discussion of criteria can be found in Gros and Thygesen (1992). 4 This notion has recently been confirmed by the Danish Ministry of Economic Affairs. 5 For elaboration, see Fisher (1896). 6 The Netherlands and Germany, however, continue bilaterally to use the normal band.
250 P. Guldager / European Journal of Political Economy 13 (1997) 247-259
Condition 4. The ratio of the planned or actual government deficit to GDP should not exceed 3 percent, unless the ratio has declined substantially and continuously, or is only temporarily above 3 percent (article 104c with protocol).
Condition 5. The ratio of government debt to GDP should not exceed 60 percent unless the ratio is sufficiently diminishing and approaching the 60 percent limit at a satisfactory pace (article 104c with protocol).
The qualifications to the two principles of fiscal discipline allow Members with excessive deficit-GDP and/or debt-GDP ratios some latitude and make a liberal interpretation of both fiscal criteria possible. This suggests that the convergence process towards the EMU is more than simply fulfilling a list of ironclad criteria.
3. Factoring the Maastricht criteria
Economic theory postulates relationships among the five Maastricht criteria. Govemment budget deficits and public debt are related, and nominal bond yields and the stability of the intra-ERM exchange rates are affected by changes in nominal inflation rates (the Fisher effect and Cassel's purchasing power parity theory). 7 In some cases, inflation may also relieve pressure arising from budget deficits, and some EU governments could be tempted to reduce the pressure of high public debt by inflation taxation. 8
Common elements thus influence the five convergence criteria. Factor analysis can identify these common elements. Factor analysis is a statistical method that attempts to explain correlations among a set of variables in terms of a small number of such common factors. The common factors cannot be observed directly, as the variables are subject not only to the factors themselves but also to random disturbances. If common factors of the five Maastricht criteria can be established, the convergence process towards the EMU can be assessed in a more aggregative framework than each of the five criteria individually.
The factor model can be written in the form
x (p X l) is a random vector of the variables representing the Maastricht criteria. 9 e (p X l) is a vector of random errors with zero mean and covariance matrix qr which is assumed to be diagonal. A (p x k) is a matrix of constants (factor loadings) and f (k X l) is a vector of common factors. It is assumed that all the
7 For elaboration, see Cassel (1918). 8 See Keynes (1923) on the theoretical possibilities. 9 The definition of the variables is that used by Amundsen and Guldager (1993).
P. Guldager / European Journal of Political Economy 13 (1997) 247-259 251
factors are uncorrelated with one another and standardized to have variance 1 and 10 zero means.
As formula (1) implies, the covariance matrix (~) of x, can be expressed in terms of A and qs as
= AA' + ~. (2)
The estimation of the parameters of the factor model below is based upon principal components. The Maximum Likelihood Method is not feasible as the data cannot be assumed to be normally distributed with one of the variables expressed as a dummy. As the variables are not measured in the same units, the correlation matrix (R) rather than the covariance matrix (S) is used.
To interpret the factor loadings, the factors are rotated using the varimax method of orthogonal rotation. This method makes the interpretation of the factor loadings the most straightforward, as the axes are provided with a few large loadings and as many near-zero loadings as possible. This is accomplished by iterative maximization of a quadratic function of the factor loadings. Following Kaiser's rule of thumb, only factors with eigenvalues above unity are included in the analysis. ~1 This rule excludes those factors where the eigenvalues are less than the average, i.e. less than one when the correlation matrix has been used.
4. Identification of the factors
Table 1 presents the results of the factor analysis of the five Maastricht Treaty criteria performed for each year between 1986 and 1993. All the eigenvalues are displayed together with the varimax-rotated matrices of factor-loadings. 12 The figures show that the first and the second factor together account for 85 and 83 percent of the total variation in 1986 and 1993 respectively, whereas the three remaining factors may be discarded, in accord with Kaiser's rule of thumb. 13 Consequently only two factors are needed to explain the data adequately. It appears that the two factors generally increase in importance until 1991, and account for 91 percent of the total variation in that year. Beyond 1991, the fit of the model becomes less precise. The communalities also vary on a year-to-year basis reaching a peak for all variables in 1991 except for bond yields, for which communality peaks in 1989. 14 Turning to the factor loadings themselves, some
10 See Harman (1976) for details of the factor model. tl For elaboration, see Kaiser (1960). 12 Note that the eigenvalue of the second factor is below one for 1993. 13 The variation explained is calculated as the sum of the eigenvalues retained by the model divided
by the total number of factors, e.g. (3.29 + 0.88)/5 = 0.83 for 1993. 14 The communality of a variable is the sum of its squared factor loadings, e.g. the communality of
the inflation variable for 1993 is (0.952 +0.092) = 0.91.
252 P. Guldager/ European Journal of Political Economy 13 (1997) 247-259
Table 1 Eigenvalues and principal factor solution for factor loadings, Varimax rotation, 1986-93
1986 1987 1988 1989 1990 1991 1992 1993
Eigenvalues A1 2.91 2.83 3.05 3.18 3.34 3.42 3.30 3.29 A2 1.32 1.43 1.41 1.34 1.20 1.15 1.14 0.88 A3 0.48 0.50 0.30 0.26 0.30 0.32 0.35 0.55 A4 0.24 0.21 0.20 0.19 0.12 0.09 0.17 0.23 A5 0.05 0.04 0.04 0.03 0.04 0.02 0.03 0.04
Inflation fl 0.94 0.93 0.96 0.96 0.93 0.96 0.95 0.95 f2 0.08 0.08 0.07 0.09 0.14 0.11 0.10 0.09
Bond yields fl 0.90 0.95 0.95 0.96 0.95 0.92 0.91 0.90 f2 0.09 0.09 0.17 0.18 0.22 0.24 0.29 0.27
Exchange rate stability fl 0.82 0.79 0.89 0.90 0.90 0.89 0.88 0.75 f2 0.16 0.14 0.01 0.00 0.00 0.01 0.03 0.14
Government deficit fl 0.49 0.41 0.50 0.55 0.64 0.70 0.63 0.72 f2 0.81 0.86 0.80 0.76 0.72 0.67 0.69 0.56
Government debt fl -0.06 -0.08 -0.13 -0.10 -0.01 0.02 0.01 0.13 f2 0.96 0.96 0.96 0.96 0.98 0.99 0.98 0.97
caution should be applied in comparing the loadings, as the matrices employed in the rotation are not identical. However, the weighting between the first factor and the dummy representing exchange rate stability is substantially lower in 1993 than in the previous years. This means that the dummy is explained less well by the first factor in 1993. The loadings for government budget deficit also appear to vary over time. In 1991 and 1993 the first factor is most important in explaining the variation in government budget deficit, whereas up to 1990 it is the second factor which is consistently the most important.
A pattern is clear from the rotated loadings. The criteria of inflation rates, bond yields and exchange rate stability are heavily loaded on the first factor, the criterion of government debt is heavily loaded on the second, while the criterion of government deficit is loaded on both. 15 Thus, the five criteria may be reduced to
15 The loading of the budget deficit on factor 1 may be partly explained by seigniorage. As Gros and Vandille (1995) point out, revenue from seigniorage is lowered by disinflation. It may also be explained by the positive relationship between budget deficits and nominal interest rates found by Knot and De Haan (1995).
P. Guldager / European Journal of Political Economy 13 (1997) 247-259 253
Factor I ( f l) and Inflation 4
I -1-2 -1
Factor 2 (f2) and Debt
Fig. 1. EU Member States performance, 199...