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

Enlarging the Euro Area

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Enlarging the Euro Area

External Empowerment andDomestic Transformation inEast Central Europe

Edited byKenneth Dyson

1

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Acknowledgements

This study follows on from four previous books on Economic and Monet-

ary Union (EMU) in Europe. The first two dealt with EMU as European

integration. Elusive Union (1994) examined the deeper historical and struc-

tural 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’ Europeaniza-

tion works by asking what euro entry means for, and tells us about, the

direction, content, and processes of transformation in east central Euro-

pean 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.

v

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 whoweremy 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, European-

ization 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

Acknowledgements

vi

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 inter-

ested should contact the editor.

Kenneth DysonCardiff University, [email protected]

Acknowledgements

vii

Contents

List of Figures x

List of Tables xiNotes on Contributors xiii

Introduction 1

Kenneth Dyson

1. Euro Entry as Defining and Negotiating Fit:

Conditionality, Contagion, and Domestic Politics 7

Kenneth Dyson

Part I. European and Global Contexts 45

2. EMU and the New Member States: Strategic

Choices in the Context of Global Norms 47

Jim Rollo

3. Real Convergence and EMU Enlargement:

The Time Dimension of Fit With the Euro Area 71

Iain Begg

4. Economic Adjustment and the Euro in New Member States:

The Structural Dimension of Fit 90

Erik Jones

5. Optimal Economic Governance in an Enlarged

European Union: Scenarios and Options 108

Ingo Linsenmann and Wolfgang Wessels

Part II. Domestic Political and Policy Contexts 125

6. The Baltic States: Pacesetting on EMU

Accession and the Consolidation of Domestic Stability Culture 127

Magnus Feldmann

viii

7. From Laggard to Pacesetter: Bulgaria’s Road to EMU 145

Vesselin Dimitrov

8. From Pacesetter to Laggard: The Political Economy

of Negotiating Fit in the Czech Republic 160

Frank Bonker

9. The First Shall Be the Last? Hungary’s Road to EMU 178

Bela Greskovits

10. Poland: Unbalanced Domestic Leadership in

Negotiating Fit 197

Radoslaw Zubek

11. Persistent Laggard: Romania as Eastern Europe’s Sisyphus 215

Dimitris Papadimitriou

Part III. Patterns of Sectoral Governance 235

12. Financial Market Governance: Evolution

and Convergence 237

Piroska Mohacsi Nagy

13. EMU and Fiscal Policy 261

Vesselin Dimitrov

14. EMU and Welfare State Adjustment in Central

and Eastern Europe 279

Martin Rhodes and Maarten Keune

15. Domestic Transformation, Strategic Options

and ‘Soft’ Power in Euro Area Accession 301

Kenneth Dyson

References 328

Index 353

ix

Contents

List of Figures

3.1. The euro membership ‘J’-curve 74

5.1. The Institutional Setting of European Economic and

Employment Policy 114

8.1. Support for EMU accession 168

12.1. Foreign ownership and EBRD index of banking sector reform 245

12.2. Share of CEE market in a bank’s total assets 246

12.3. EBRD index of banking sector reform in 1997 and 2004 253

12.4. EBRD index of non-bank financial institutions in 1997 and 2004 254

12.5. Non-performing loans in the CEE and the EU15 257

12.6. Capital adequacy ratios in EU15 and EU10 (%) 258

14.1. Wage coordination and wage moderation 1997–2003 288

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

member states 292

x

List of Tables

2.1. Membership of IBRD, IMF, WTO, and OECD 50

2.2. Private sector share of GDP in % 50

2.3. General government expenditure (% of GDP) 51

2.4. Foreign direct investment, net inflows (% of GDP) 51

2.5. GDP (constant 1995 US$) 1990 ¼ 100 52

2.6. Inflation, consumer prices (annual %) 55

2.7. General government balance (% of GDP) 57

2.8. General government debt (% of GDP) 57

2.9. Monetary and exchange rate strategies in accession countries 63

3.1. The Maastricht fiscal criteria: recent values and prospects 75

3.2. Various indicators of competitiveness 85

4.1. Nominal convergence indicators 96

4.2. Fiscal convergence indicators, growth potential, and

the need for structural reform 99

4.3. Size, openness, and trade with Europe 102

6.1. Annual inflation rates in Baltic states, in %, measured by CPI 134

6.2. General government budget balance in Baltic States, in % of GDP 135

6.3. Estonia: prime ministers, finance ministers, and

central bank governors 137

6.4. Latvia: prime ministers, finance ministers, and


6.5. Lithuania: prime ministers, finance ministers, and


7.1. Bulgarian governments, prime ministers, finance ministers

and governors of the Bulgarian National Bank (1990–2005) 151

8.1. Czech general government balances, 2000–6 (ESA 95 definitions) 162

8.2. Czech prime ministers, finance ministers, central bank

governors and party composition of cabinets 166

xi

8.3. Euro-scepticism in EU-accession states 168

9.1. Transnationalization of selected ex-socialist economies 183

9.2. Hungarian prime ministers, ministers of finance

and central bank presidents (1990–2005) 189

10.1. Poland: fiscal and monetary convergence with

the Maastricht criteria 1997–2004 198

10.2. Polish prime ministers, finance ministers, central bank

governors, and party composition of cabinets 201

11.1. Prime ministers, finance ministers, government coalitions,

and central bank governors in Romania, 1989–2004 217

12.1. Summary of financial sector transformation in the

CEE Region, 1989–2005 238

12.2. Share of foreign ownership in new EU member

states (2003, % of total assets) 244

12.3. Summary of CEE deposit insurance schemes, end-2004 251

12.4. Portfolio structure of banks in Hungary and the EU15 256

12.5. Bank profitability and efficiency, 2003 258

14.1. Social expenditure in the new CEE member states and the EU15, 2001 282

14.2. Old-age dependency ratio, 2003–20 290

14.3. Purchasing power standard (PPS) income levels in the

CEE countries, 2003 290

14.4. Social risk indicators: absolute values 291

14.5. Social risk indicators: normalized (0–1) values (max ¼ 1) 291

14.6. Social security contributions and social transfers 294

14.7. Fiscal imbalances in the new CEE member states 297

List of Tables

xii

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, Prin-

cipia 2002); (edited) Urban Competitiveness (Policy Press 2002); (edited)

Europe Government and Money: Running EMU, the Challenges of Policy Co-

ordination (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.

Frank Bonker is assistant professor in the Department of Economics at

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

Press 1998); (co-edited with Eckehard F. Rosenbaum and Hans-Jurgen

Wagener) Privatization, Corporate Governance and the Emergence of Markets

(Macmillan 2000); (co-edited with Klaus Muller and Andreas Pickel) Post-

communist Transformation and the Social Sciences: Cross-Disciplinary Ap-

proaches (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 trans-

formation 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 Europeaniza-

tion. He recently led, with Klaus H. Goetz and Hellmut Wollmann, a

xiii

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 Gov-

ernment at Harvard University, where he is also affiliated with the Weath-

erhead Center for International Affairs and theMinda de Gunzburg Center

for European Studies. His articles have appeared or are forthcoming in

Comparative Political Studies, The World Economy, Government and Oppos-

ition, Demokratizatsiya and in various edited volumes. His main research

interests are comparative and international political economy, post-social-

ist transition and European politics.

Bela 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 Ameri-

can 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 Post-

Socialist Development’ in Ronald Dworkin et al. (eds.) From Liberal Values


xiv

to Democratic Transition (Central European University Press 2003), ‘The

Path-Dependence of Transitology’ in Frank Bonker, Klaus Mueller, and

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 Janos Kornai, Stephan Haggard, and Robert

Kaufman (eds.), Reforming the State: Fiscal and Welfare Reforms in Post-

Socialist 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 Gov-

ernance’, located at the Robert Schuman Centre for Advanced Studies,

European University Institute, Florence.

PiroskaMohacsi 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 Melt-

down of the Russian State (Edgar Elgar 2000). She is a member of the

editorial board of the journal Finance and Development, Washington, DC.


xv

Dimitris Papadimitriou is lecturer in European Politics in Government,

International Politics and Philosophy (GIPP) at the University ofManches-

ter, 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 European-

ization 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, Sep-

tember 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

wasDirectorof theESRCresearchprogramme ‘OneEuropeor 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.

WolfgangWessels is holder of the JeanMonnetChair of Political Science at

theUniversity ofCologne,Germany, and isVisitingProfessor at theCollege

of Europe, Bruges andNatolin. Furthermore, he ismember of the executive

board at the Institut fur Europaische Politik (IEP, Berlin), and Chairman of

the Trans European Political Studies Association (TEPSA, Brussels). Most

recent publications include: ‘Theoretischer Pluralismus und Integrations-

dynamik: Herausforderungen fur den acquis academique’, in H.-J. Bieling


xvi

and M. Lerch (eds.), Theorien europaischer 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 andDefence Policy’, in J.Weiler andC. 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

Europaischen Verfassung: Hohere Dynamik—neue Koalitionen?’, Integra-

tion, 3, 2004, pp. 161–75; ‘Theoretical Perspectives. CFSP beyond the Supra-

national 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 Europaische Parlament nach Amsterdam und Nizza:

Akteur, Arena und Alibi (Baden-Baden 2003).

Radoslaw Zubek is research fellow at the University of Potsdam in Ger-

many. He holds a Ph.D. from the London School of Economics and Polit-

ical Science.


xvii


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: Eco-

nomic and Monetary Union (EMU) and eastern enlargement of the Euro-

pean 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

1

Europe? Are at least some states converging with traditionalmember 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 ‘acces-

sion’ 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 trans-

formation 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 ‘condition-

ality’ 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 in-

tensifies 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 condition-

ality (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 con-

text 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 acces-

sion 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 mar-

kets 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 stra-

tegic options.

Introduction

2

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 dynam-

ics 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 domes-

tic 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 follow-

ing questions:

. WhataretheeffectsofEMUonthepolicies,politics,andpublic 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 act-

ors? 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 institu-

tions 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

Introduction

3

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-commun-

ist’ 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 diver-

gence 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 European-

ization. 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’ Europeaniza-

tion 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 distinct-

ive dynamics within east central Europe.

Rollooffersaninternationalpoliticaleconomyperspective thatstresses the

embedding of EMU policy requirements in global norms. To the extent that

EMUanchorsthesenorms,it isdifficulttodisentangleits independenteffects,

other than in focusing and speedingupdomestic transformation. The Single

MarketprogrammeandEMUhave themselves beenpacesetters in the spread

of global norms. Accession states are caught up in this dynamic.

Introduction

4

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 import-

ance 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 dependsmore on internal reforms

within the existing Euro Area than on domestic adjustment.

Linsenmann and Wessels (Chapter 5) highlight the problems of design-

ing optimal economic governance in an enlarging EU and different scen-

arios 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

EuroArea; and thecontinuingproblemsof compliance evenamongst existing

Euro Area member states and their implications for Euro Area enlargement.

The early chapters offer an essentially ‘top-down’, ‘outside-in’ perspec-

tive 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. Com-

parative 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’

Introduction

5

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.

Introduction

6

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 legitim-

ated as historic. EMU is justified as making European integration irrevers-

ible 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 ser-

ious 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

7

more profound. Eastern enlargement extended the single European mar-

ket 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 enlarge-

ment 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 Mechan-

ism (ERM) of 1979. The discipline of the ERM served as a training ground

for EMU entry, and member states displayed some evidence of anticipa-

tory Europeanization (Dyson 1994, 2000). However, EMU as a process of

‘accession’ Europeanization for the EUmember 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 nego-

tiations 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 embry-

onic ‘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

Euro Entry as Defining and Negotiating Fit

8

make themcloser to oldermember states). Third, EMU is an extreme case of

Europeanizationbecause entry remains aprotracted andunfinishedproject

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

mechanismsof formal and informal conditionality and throughan intensi-

ficationof institutional ties in preparing for euro entry. The combinationof

extendedaccession in timewith increasing constraintsmakes 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 implica-

tions for domestic adaptation not just within different policy sectors but

also in macro-institutional arrangements, especially within core execu-

tives. 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 sim-

plifying and constraining expectations from two contending literatures:

the external incentives literature that stresses the efficacy of EU condi-

tionality 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


9

structures, which result in divergent as well as convergent outcomes. In

addition, domestic effects are conditioned by the varying margins of un-

certainty 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 tech-

nical 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 sim-

ply, 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 ques-

tions 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 EUmember states’, policy choices and their effects.

This sensitivity takes the form of fear: of being left behind as a laggard,


10

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 inter-

est, 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 time-

tables to defer reforms, while oppositions are tempted to engage in euro-

populism. 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 domes-

tic 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, some-

times weak, and occasionally non-existent. There is an obligation to pre-

pare 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 discre-

tion over the sequence of policy reforms. In major areas, like exchange-

rate 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 inter-

pretation 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


11

‘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 prob-

lems of compliancewith the Stability andGrowth 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 con-

vergence criteria and the SGP, and capacity to promote and deliver stronger

economic and social cohesionwithin the EU through ‘real’ convergence in

GDP per capita, wages, and social benefits. Though the European Commis-

sion 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 whichmodel

from the previous 1995 EU enlargement to follow: Austria and Finland,

which rapidly joined the Euro Area in 1999, or Swedenwhich—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 orGreece; laggards could look to Sweden.

These paradoxes and uncertainties offer space in which east central Euro-

pean 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, cross-

national 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 con-

strained 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. Conta-

gion 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.


12

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 condi-

tionality (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 con-

strained 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 envir-

onment, agriculture, and free movement of goods, the number of domes-

tic 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 hadweight. Previous EU enlarge-

ments involved three (Britain,Denmark, and Ireland) in1973, 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

addedtenstates (eight ineastcentralEurope,andCyprusandMalta)andthe

second in 2007–8 promised another two (Bulgaria andRomania). Thenum-

bers problem forces attention to the composition of, and voting rights in,

the structures of European economic governance like the ECB governing

council and theEconomic andFinancialCommittee.However, numbersdo

not translate intomatching power over EMU accession.


13

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 popu-

lation), 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 cooper-

ation as a means of projecting their interests more strongly in EMU acces-

sion. 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, infor-

mal 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 con-

ditionality is embedded in pre-existing global and domestic processes of

transition. It forms an element in a more complex constraining frame-

work. 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 mechan-

isms. 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.


14

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 Pro-

cedure (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 ofMonetary, Financial, and

Balance of Payment Statistics (CMFB), which develops statistical policies

to inform the preparation of national accounts and support the exces-

sive 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 fi-

nally 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 pre-

vailed 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.


15

However, the Commission’s reports were ‘harder’ when they monitored

progress in transposing the EMU acquis into national laws. The key elements

ofhardconditionality in theEMUacquiswerederivedfromTreatyprovisions:

. 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 discip-

line)—Article 102 and Regulation 3604/93.

. The independence of the national central bank (functional, institu-

tional, financial, and personal).

In these areas the Commission conducted a critical monitoring of com-

pliance 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 increas-

ingly constraining effects were felt. Though their effects could be apparent

in ‘anticipatory’ Europeanization, such effects were domestically origin-

ated and voluntary. The EMU negotiating chapter was not in itself com-

plex, 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 pres-

sure 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 mar-

ket 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.


16

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 andbenchmarking andmonitor-

ing 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, report-

ing 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 particu-

lar, they were to be prepared on amulti-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 frame-

work. They focused on strengthening analytical and institutional cap-

acity in fiscal policy and identifying appropriate structural reforms and

their budgetary effects. The PEPs were targeted on promoting real con-

vergence rather than on the Maastricht convergence criteria. They were

seen as forerunners and training mechanisms for the convergence pro-

grammes 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 finan-

cial stability in the accession states.

The PFSP process was a device throughwhich 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 exchange-

rate flexibility was lost.


17

. Acceleration of structural reforms in order to speed real convergence

and improve economic flexibility to cope with shocks.

PEPswereexpected to set clearpriorities forpublic 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’ pro-

cess 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 euromembership. 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 acces-

sion 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 pro-

gress 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 condi-

tionality 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 andwith 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


18

to comply with the fiscal rules. These programmes were subjected to

Commissionmonitoring, 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 man-

oeuvre to new accession states with low debt and high growth potential. In

addition, the attitudes andbehaviour of existingmember 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 net-

works. 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 fin-

ance 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 indus-

try ministries, where attitudes are more conservative and inward-looking

and Europeanization effects shallower. Hence, informal conditionality is

variable in its domestic effects.


19

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 adjust-

ment—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. Fis-

cal 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 fundamen-

talists 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 infla-

tion; the second that inflation is a phenomenon of expectations so that

effective anti-inflation policies depend on building credibility. They con-

verge around the policy prescription that ‘binding hands’ inmonetary and

fiscal policies is essential for sustainable growth and employment. ‘Bind-

ing hands’ delivers credibility and reduces the costs of disinflation by


20

ensuring thatmacroeconomic policies are insulated from the electoral and

party incentives of politicians to create inflation.

States can ‘bind hands’ and gain credibility by twomechanisms: import-

ing discipline by fixing policy to a strong external anchor (classically, tying

the domestic currency to a ‘hard’ currency, for instance, through mem-

bership of the Exchange Rate Mechanism (ERM)); and the domestic cre-

ation of discipline by giving independence to the national central bank,

which has the single objective of price stability. Euro entry strategy com-

bines 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, instru-

ment, and institutional independence of the ECB, and the ‘hard’ coordin-

ation of the SGP. EMU accession involves a commitment by east central

European states to this policy paradigm of ‘enabling constraint’. Propon-

ents 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 acces-

sion are challenging for the east central European states. They represent

systematic pressures and incentives for domestic transformation. How-

ever, 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 macro-

institutional 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 execu-

tive 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’


21

(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 dif-

ferent 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 formanoeuvre 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 com-

petitive market economies before EMU accession Europeanization begins

to impinge (Mattli and Plumper 2004). Some had started in more favour-

able 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 Recon-

struction 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 polit-

ical shadows over EMUaccession. Therewas still amarked post-communist

legacy of a higher share of employment in industry and a higher energy


22

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 mar-

ket, 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 fundamen-

tal challenges to many east European states from the direct effects of EMU

compared with the potentially even more fundamental challenges to at

least some existingmembers from EMU’s and the single Europeanmarket’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 fi-

nance 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


23

particular possessed significant institutional capacity to the extent that

they had formal competences and resources, notably of economic, finan-

cial, 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 minis-

try 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 coordin-

ating 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 require-

ments 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 prior-

ity to defence or even extension of the welfare state (as in Hungary

where, despite a centralized institutional framework, the FIDESZ gov-

ernment (1998–2002) and the Socialist government (2002–) proved

disinclined to pursue fiscal prudence).

Consequent domestic difficulties of sustaining fiscal consolidation com-

plicated 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 condi-

tionality.

In Bulgaria and Romania initial conditions were poorer, they had opted

for a ‘laggard’ role in transition, and consequently transition was less com-

plete. Here too EMU conditionality faced constraints. The lack of an

early shock therapy—on Estonian and Polish lines—through radical market


24

liberalization andprivatization 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 condi-

tionality, especially in retaining state subsidies that made for fiscal compli-

cations. Bulgaria differed from Romania in undergoing a traumatic

economic and political crisis in 1997. The result was a delayed shock

therapy: the InternationalMonetary Fund (IMF) imposed tough condition-

ality requirements for its financial assistance. These IMF requirementswere

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 theWorldBank reframed their ownconceptof conditionality. Fromthe

late1990s they shifted their policyparadigmfroma ‘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


25

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 require-

ments 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 accept-

ance 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, nevermind 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


26

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-acces-

sion 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 con-

fined 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 negoti-

ated a central rate for ERM IImembership 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


27

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), vice-

president of the ECB, argued that some accession states would need the

flexibility of longer in ERM II (on themodel 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 amutually

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 bemeasured 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 acces-

sion (see the earlier discussion of the PFSP) after which the excessive deficit

procedure is governed by the SGP and EU statistical case law. East Euro-

pean 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 sanc-

tioned 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 andGermany.

Despite German leadership in designing the Pact, these two core Euro Area

members evaded the excessive deficit procedure in November 2003, pre-

cipitating 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


28

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 finan-

cial contributions to ‘achieving European policy goals, notably the unifi-

cation 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 punish-

ing 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 frameworkmeans 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

COMPETITIVENESS POLICIES

Conditionality is much less specific and detailed inmacroeconomic policy

coordination and structural reforms to boost competitiveness. Mechan-

isms of ‘soft’ coordination prevail: policy ‘guidelines’, peer review, bench-

marking on the basis of best performance, and policy learning. The Broad

Economic Policy Guidelines (BEPG) tighten the obligation to treat eco-

nomic 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


29

reforms accession state governments retain considerable room for man-

oeuvre. 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 com-

plying with an acquis (Agh 2003). The EU was part of a wider inter-

national 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 mar-

ket 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 sustain-

ability of nominal convergence, especially in relation to fiscal policy. In

this period of at least two years the constraints are tightest.


30

The Role of EU Actors in Shaping EMU Templates and Entry Velocity

The gate-keepingmechanism 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’ conditional-

ity 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 con-

strain 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 condition-

ality, 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 back-

ground 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 govern-

ments as part of the SGP framework mean that governance of the Euro-

pean 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

amore 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 pre-

condition for reconciling nominal and real convergence and for abandon-

ing the exchange rate as a policy instrument. However, this logic becomes

more difficult to apply when existing Euro Area members like France,

Germany, and Italydisplay a greater reluctance thanaccession states tounder-

take the structural reformsnecessary for their owncompetitiveness 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


31

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 EuropeanCommission 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 conditionsmean ‘ . . . 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 condition-

ality 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 condi-

tioned by contagion processes and domestic political structures and

dynamics.

Contagion: Indirect Europeanization

The room formanoeuvre 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 Euro-

peanization is mediated by the market effects of EMU and the single

European market programme on firms, and by the policy behaviour of


32

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 mech-

anisms of contagion are the knowledge, status, and power of a very small

number of pivotal domestic actors in transmitting certain ideas into eco-

nomic 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 influ-

enced 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 coun-

terbalanced by interests in the domestic economic structure, and by tech-

nical 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 oppor-

tunities 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 ambigu-

ous signals. More serious was the process of ratification of the European


33

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 sub-

verting 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 illus-

trates 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 mem-

bers, 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 gov-

ernments—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 pro-

cess 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 struc-

tures, the number of private agents with cash deposits in euros, the rela-

tively 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


34

importance of Euro Area banks in the ownership and modernization of

their banking sectors and financial intermediation. The result is poten-

tially 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 pace-

setter 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 super-

vision 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 reac-

tions. 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.


35

Domestic Consensus Building

Negotiating fit in EMU accession is a dynamic process of reconciling

formal and informal conditionality requirements and contagion in mar-

kets and in policy behaviour with domestic political problems of consen-

sus 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 oncemonetary policy autonomy is lost and fiscal policy autonomy

constrained. Slovenia, for instance, is more convergent in economic struc-

ture 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 dom-

estically 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 pol-

icy. 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 con-

flicts in euro entry strategy, while opposition parties have an incentive to

exploit them. The concluding chapter focuses on the different strategic


36

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 gov-

erning 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 demo-

cratic 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


37

instance, pensions. Procrastination on the euromay reflect Euro-populism,

as opposed to Euro-scepticism.

Nevertheless, fears of potential Euro-scepticism provide another incen-

tive 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 Euro-

scepticism. 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 inter-

est 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 nega-

tive 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 polit-

ics also play a prominent role in shaping how fit is negotiated. Executive

structures in east central Europe display a variety of patterns, from cen-

tralized—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

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 credibil-

ity 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 nego-

tiate 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 elect-

oral 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 minis-

tries use EMU to empower themselves in domestic bureaucratic politics.

ESA95 is a tool for consolidating public finances. Finance ministries are

ambivalent about it. Theywelcome ESA95 as a tool for their own control of

line ministries and independent agencies; they also fear that it may con-

strain 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

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 require-

ments (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 asHarsh 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 commu-

nicate them in ameaningful 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 priori-

tize 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

in ERM II—a precondition of EMU entry—means a sharply reduced con-

trol 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 require-

ments in precise terms, and inviting the market to judge states in these

terms, EMU is potentially a harsher (and more visible) master than glob-

alization. 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 internation-

ally oriented firms EMU enables the achievement of sustainable conver-

gence, 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 instrumenta-

lized 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 ColdWar.

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

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’ nar-

rative 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 em-

phasizes 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 techno-

cratic 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 sustain-

able 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 tech-

nocratic 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 gov-

ernor). 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

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 pro-

found debate.’

The ‘good servant’ narrative of EMU cannot, however, disguise an

underlying asymmetry of power and an edifice of ‘informal’ conditional-

ity that overshadows Euro Area entry. There is domestic room for man-

oeuvre 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.


43


Part I

European and Global Contexts


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 eco-

nomic governance paradigm. The shift in paradigm was towards rules-

bound, 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 cen-

tral 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—liberalizingmarkets, 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.

47

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 inte-

gration 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. Twomarkers of this global move to a liberal approach to economic

policy governance was the push byMexico and by Korea to join theOECD,

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 mem-

bers of the EU or contemplating membership. Austria and the Scandi-

navian 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 dem-

ocracies 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 intoWestern systems of trade and payments quickly

48

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 prefer-

ential 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 transi-

tion, underlined the perceived role of FDI both in transition and in the

global governance model. The EBRD was specifically tasked to help estab-

lish new enterprises, privatization, and to leverage private-sector invest-

ments, 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 analyt-

ically perceptive critiques of state intervention in resource allocation—the

‘soft budget constraint’ (Kornai 1986) meaning that there was no incen-

tive 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

rowing back in Poland on tariff reductions, but generally successive gov-

ernments 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 tomacroeconomic 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-

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

date of membership

Country IBRD IMF WTO OECD

Bulgaria Sep 25, 1990 Sep 25, 1990 Dec 1, 1996Czech Republic Jan 1, 1993 Jan 1, 1993 Jan 1, 1995 Dec 21 1995Estonia Jun 23, 1992 May 26, 1992 Nov 13, 1999Hungary Jul 7, 1982 May 6, 1982 Jan 1, 1995 May 7, 1996Latvia Aug 11, 1992 May 19, 1992 Feb 10, 1999Lithuania Jul 6, 1992 April 29, 1992 May 31, 2001Poland Jan 10, 1946 June 12, 1986 July 1, 1995 Sept 22 1996Romania Dec 15, 1972 Dec 15, 1972 Jan 1, 1995Slovak Republic Jan 1, 1993 Jan 1, 1993 Jan 1, 1995 Dec 14 2000Slovenia Feb 25, 1993 Dec 14, 1992 July 30, 1995

Table 2.2. Private sector share of GDP in %

Private sector share of GDP in %

Year BulgariaCzechRepublic Estonia Hungary Latvia Lithuania Poland Romania

SlovakRepublic Slovenia

1991 20 15 10 30 10 10 40 25 15 151995 50 70 65 60 55 65 60 45 60 501996 55 75 70 70 60 70 60 55 70 551997 60 75 70 75 60 70 65 60 75 601998 65 75 70 80 65 70 65 60 75 601999 70 80 75 80 65 70 65 60 75 602000 70 80 75 80 65 70 70 60 80 652001 70 80 75 80 65 70 75 65 80 652002 75 80 80 80 70 75 75 65 80 652003 75 80 80 80 70 75 75 65 80 652004 75 80 80 80 70 75 75 70 80 652005 75 80 80 80 70 75 75 70 80 65

Source: EBRD (2005a).


50

economic theory and, in part, by empirical research. New classical macro-

economics, especially in its rational expectations form, reinforced the view

thatneithermonetarypolicynorpermanentdeficit financingof thebudget

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-termpublic debt accumulation. The injection

Table 2.3. General government expenditure (% of GDP)



1992 45 50 na 60 na na 50 42 58 431993 48 41 38 60 na 35 50 34 79 441994 46 44 39 60 37 37 51 33 58 441995 41 40 39 53 37 35 50 35 54 411996 42 40 38 49 36 33 50 34 61 401997 33 39 35 50 37 33 49 34 65 411998 37 38 38 50 40 35 47 35 61 421999 40 43 40 50 41 37 47 35 57 422000 40 42 36 47 37 33 44 35 63 482001 39 45 35 48 35 37 44 33 44 482002 37 47 35 52 36 31 44 32 43 482003 38 53 35 50 35 31 45 31 39 482004 37 44 37 50 36 33 43 31 39 482005 38 43 40 51 38 31 43 31 37 47


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



1989 .. .. .. 1 .. .. .. 0 .. ..1990 .. .. .. 1 .. .. 0 0 .. ..1991 1 .. .. 4 .. .. 0 0 .. ..1992 0 .. 2 4 1 0 1 0 .. 11993 0 2 4 6 1 0 2 0 2 11994 1 2 6 3 5 0 2 1 2 11995 1 5 5 11 4 1 3 1 1 11996 1 2 3 5 7 2 3 1 2 11997 5 2 6 5 9 4 3 3 1 21998 4 6 11 4 6 8 4 5 3 11999 6 11 6 4 5 5 5 3 2 12000 8 10 8 4 6 3 6 3 10 12001 6 10 10 5 2 4 3 3 8 32002 4 13 4 1 5 5 2 3 17 82003 7 3 10 3 3 1 2 3 2 1

Source: World Bank (2005).


51

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 mar-

kets, investors, businesses, consumers, andwage earners would adjust their

behaviour to compensate if they found policy incredible. These theoretic-

ally based predictions had backing from studies that suggested that infla-

tion 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 infla-

tion andmore 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

Table 2.5. GDP (constant 1995 US$) 1990¼100


SlovakRepublic Slovenia*

1992 85 88 73 85 58 74 95 79 80 ..1993 84 88 67 85 50 62 99 81 77 1001994 85 90 65 87 50 56 104 84 81 1051995 88 95 68 89 50 58 111 90 86 1091996 79 99 71 90 51 61 118 93 91 1131997 75 99 78 94 56 65 126 88 96 1191998 78 98 81 99 58 70 132 83 100 1231999 80 98 81 103 60 68 138 82 101 1292000 84 101 87 108 64 71 143 83 103 1352001 87 104 92 112 69 76 145 87 107 1392002 92 106 98 116 73 81 147 91 112 1432003 96 109 105 120 78 89 153 96 117 1472004 102 114 113 125 85 96 161 104 123 1532005 107 121 124 130 94 103 166 108 131 159

Source: World Bank (2004) and own calculations.

Notes: Slovenia* 1993 ¼ 100.


52

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 BrettonWoods 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 institu-

tional mapping of the Bundesbank except, arguably, that it is even more

independent. ECB independence is guaranteed by treaty, whereas Bundes-

bank 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 mon-

etary governance. At the end of the 1980s, an alternative model of infla-

tion 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 account-

able 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.


53

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 low-

inflation 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 emergingmarket economiesmore 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 policymodel takes such forms as a variant on fixed but adjustable

exchange rates through toharder 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 intro-

duced 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 intro-

duced a currency board in 1998 in response to a severe economic crisis,

while others persevered with adjustable pegs on wider or narrower mar-

gins (Latvia and Slovenia). However, the Czechs, Hungarians, Poles, and

Slovaks moved towards floating as they confronted competiveness prob-

lems on fixed rates and as inflation fell (Table 2.6) and as their domestic

monetary policy becamemore credible (Poland and the Czech Republic in

particular).


54

Fiscal Rules

Prior to the Keynesian revolution, the normwas 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 intensificationof thewelfare state increased the effect of the stabilizers,

but the impact on the tax burden became increasingly heavy with an

increasing share of public spending inGDP. 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 incum-

bents (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

Table 2.6. Inflation, consumer prices (annual %)



1989 6 .. .. 17 .. .. 245 .. .. ..1990 24 .. .. 29 .. .. 555 .. .. ..1991 338 .. .. 34 .. .. 77 231 .. ..1992 91 .. .. 23 243 .. 45 211 .. ..1993 73 .. 90 22 109 410 37 255 .. 331994 96 10 48 19 36 72 33 137 13 211995 62 9 29 28 25 40 28 32 10 131996 122 9 23 24 18 25 20 39 6 101997 1058 9 11 18 8 9 15 155 6 81998 19 11 8 14 5 5 12 59 7 81999 3 2 3 10 2 1 7 46 11 62000 10 4 4 10 3 1 10 46 12 92001 7 5 6 9 2 1 6 34 7 82002 6 2 4 5 2 0 2 23 3 72003 2 0 1 5 3 �1 1 15 9 62004 6 3 3 7 6 1 3 12 7 42005 5 2 4 4 6 3 2 9 3 2



55

steep discount, pushing up real interest rates and reducing maturity dates

sometimes steeply. In developing countries dependency on foreign sav-

ings 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, inboththeOECDcountriesandmiddle-incomedevelopingcountries

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 fore-

casting errors on future growth rates and real interest rates. Fiscal pro-

grammes were increasingly judged on a case-by-case basis by international

institutions and themarkets. 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 themedium 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, therewas 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 intro-

duced. Thecollapseof enterprises and the rise of theblack economyrestricted

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 slowermotion 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


56

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). TheMaastricht 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 assump-

tions in the late 1980s about trend growth and real interest rates, deficits

below3percentofGDPwereconsistentwithadebt toGDPratio thatdidnot

Table 2.7. General government balance (% of GDP)



1991 �5 �2 na �3 na na �2 na �na 31992 �3 �3 na �6 na na �5 �5 �12 01993 �11 3 na �6 na �5 �3 0 �6 11994 �6 �1 1 �8 �4 �5 �3 �2 �1 01995 �6 �1 �1 �7 �4 �4 �3 �3 0 01996 �10 �2 �2 �5 �2 �4 �3 �4 �1 01997 0 �2 2 �7 1 �1 �4 �5 �5 �21998 2 �4 0 �8 �1 �3 �4 �4 �5 �21999 0 �4 �4 �6 �5 �6 �3 �2 �7 �22000 0 �4 �1 �3 �3 �3 �2 �4 �12 �32001 1 �6 0 �3 �2 �2 �4 �3 �6 �32002 0 �7 2 �8 �2 �1 �3 �2 �8 �32003 1 �12 3 �6 �1 �1 �5 �2 �4 �32004 1 �3 2 �5 �1 �1 �4 �1 �3 �22005 2 �3 2 �6 �1 �2 �3 �1 �3 �2

Source: EBRD (2005a).2005 Estimates

Table 2.8. General government debt (% of GDP)

Country 1995 1999 2000 2001 2002 2003 2004 2005

Bulgaria 115 99 89 70 56 48 41 32Czech Republic 15 15 17 19 18 22 24 26Estonia 9 8 6 6 6 6 5 5Hungary 86 61 58 52 55 57 57 58Latvia 16 13 13 15 14 15 15 11Lithuania 23 24 23 22 21 20 19Poland 50 40 37 37 40 44 42 43Romania 21 24 23 23 23 21 19 19Slovak Republic 23 47 50 49 43 44 44 35Slovenia 18 25 27 28 30 29 30 29

Source: EBRD (2005a).2005 Estimates.


57

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—tomeet. 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 emergingmarkets experiencing rapid catch-upgrowth.

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 diffi-

cult global norm with which to comply. The starting conditions were

extremely difficult, as noted above, and the prevalence of the black econ-

omy and non-payment of taxes by the state-owned enterprises made

sustaining revenue and social policies and transfers difficult without run-

ning 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 Commu-

nity and to allow integrated policies to work. Hence, they opted for the


58

(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 theUSA and the rest of theworld 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 inter-

vention 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, nor-

mally 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 macroeco-

nomic 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 ERMmoredifficult, if not impossible. This view is basedon the so-called

inconsistent quartet (see ECB 2003: 53 for a summary), which states that


59

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 cur-

rency 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 contro-

versial. 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 ofAccession 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-


60

ment of monetary policy institutions, fiscal policy rules, and changes in

exchange-rate regimes. In effect, Europeanization and globalization pro-

cesses were simultaneous.

In any case, the prospect of EU entry did not really become firmuntil 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 join-

ing the world economy. They all joined the Bretton Woods institutions

and theWTO. Four of them aremembers of OECD, exposing them to peer-

group 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 foundingmembers 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 econ-

omies. 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 pre-

transition levels by 2002, and in Polandunemployment remains very high.

This outcome reflects interestingly on the debate over fast or slow adjust-

ment 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


61

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 adjustmentmight be the bestway

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 hyper-

inflation 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 anchoredmarket 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

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 time-

table, and, while Hungary and the Czech Republic speak of 2008–09,

there are no timetables for membership of ERMII. The adjustment that is

necessary tomeet thefiscal criteria in the timescales set looks challenging in

all of the Visegrad 4.

Table 2.9. Monetary and exchange rate strategies in accession countries

ExchangeRate Regime Currency Features

Currency Board

Bulgaria Currency board to the euro Lev Introduced in 1997Estonia Currency board

to the euro & memberof ERM II with 0%margins since 2004

Kroon Introduced in 1992

Lithuania Currency board tothe euro and memberof ERM II with 0%margins since 2004

Litas Introduced in 1994;repegged from the US dollarto the euro in February 2002

Conventional Fixed Peg

Latvia Peg to the Euro(earlier pegged toSDR) and memberof ERM II with 1% margin

Lats Exchange Rate Band �1%

Slovenia Member of ERM II Tolar Monetary targeting; theeuro is used as referencecurrency

Unilateral Shadowingof ERM II

Hungary Peg to the euro,with �15% fluctuationbands

Forint Exchange rate regimecombined with inflationtargeting 2.5%–4.5%by end-2005

Managed Float

Romania Managed float Leu Currency basket (US dollar,euro) is used informallyas reference

Slovakia Managed float Koruna

Independent/ Free Float

Czech Republic Free Float Koruna Inflation targeting: 2%–4%by end-2005

Poland Free Float Zloty Inflation targeting:2.5% � 1%

Source: ECB Bulletin July 2002 and national central banks.


63

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 illus-

trates, EMU accession andmembership 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 pur-

sued 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 criteriamade it clear

that the central Europeans had to be functioning market economies and


64

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, member-

ship 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, accord-

ing 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


65

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 non-

traded 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 re-

main outside EMU without coming under pressure to join, even when

there would be no problem in meeting the fiscal and monetary conver-

gence 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 Areamembers 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 man-

datory 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 irrevoc-

able 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


66

for both domestic and foreign investors, with a consequent increase in the

trend rate of growth. Recent, if contested, research (Rose 2004) also sug-

gests trade gains of 40–90 per cent frommembership 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 imme-

diate 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 member-

ship 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, domes-

tic 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 newmembers’

position as emerging market economies in a process of rapid catch-up

growth. In these circumstances the benefits of rapid increases in product-

ivity 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 appreci-

ates, driving down prices and raising real wages across both traded and

non-traded sectors. If, however, the exchange rate is fixed, increased prod-

uctivity will be captured by higher wages in the traded sector, and hence


67

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 (inflationmust 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 pres-

sure 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 member-

ship 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 foreign-

exchange 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 mem-

bership, 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 ram-

ifications for governments in the new member states.


68

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-orientatedmacroeconomic policy frame-

work with low inflation and prudent fiscal policy.

Estonia, Lithuania, and Slovenia joined ERMII in June 2004 and Latvia

(along with Cyprus andMalta) in April 2005, signalling their intentions to

adopt the euro early. Poland, Hungary, the Czech Republic, and Slovakia

all seem to bewaiting. This pattern of pacesetters and laggardsmay suggest

that the smaller countries among the newmembers aremore 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 ofmembership is essentially in the hands of

each national government, with entry into ERMII as the likely key deci-

sion. The benefits of early membership are very significant, especially for

any country with a history of economic instability. Lower long-term inter-

est 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


69

markets would ease any adjustment problems in the real economy, but

managing capital and budgetary inflows could still put significant pres-

sures 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 credibil-

ity 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.


70

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. For-

mally, 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 dic-

tate otherwise, and it is already evident that there are conflicting perspec-

tives 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 con-

vergence. 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 cur-

rency area criteria by the intrusion of the element of timing. Managing the

71

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 macroeco-

nomic 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 independentmonetary 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 tomean 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 integra-

tion 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.

Real Convergence and EMU Enlargement

72

However, EMU imposes constraints on macroeconomic policy and can

restrict flexibility by eliminating the exchange rate as a potential instru-

ment 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 re-

balancing 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 inde-

pendence 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 coun-

tries, together with Latvia, are now widely expected to join Slovenia as the

next of the newmembers 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 trajec-

tory for the economy in the absence of full adoption of the euro. The

introduction of the change to it initially causes a worsening of perform-

ance, but then induces a superior performance. The crucial issues, espe-

cially 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


73

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 candi-

dates 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 theMaastricht

convergence criteria. Among the existing twelve Euro Area members,

attaining this ambition was a struggle formany, but easy for others, reflect-

ing the underlying performances of their economies, their recent eco-

nomic 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

Nationalcurrency

GAINS

PerformanceFully in EMU

A B C

LOSSES

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


74

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 tomeet the criteria

is less daunting for many than it was for several existing members of the

Table 3.1. The Maastricht fiscal criteria: recent values and prospects

Fiscalindicator

Trendfrom 2000–03

Ratio in2004 %of GDP

Forecasts fornext years

Outlook forEMU accession

CzechRepublic

DeficitDebt

High and worseningLow but growing

�2.630.5

Excessive deficitStable Comfortable

Estonia Deficit In surplus þ1.6 Staying in surplusVery favourable

Debt Negligible 4.8 Lower still

Latvia Deficit Low and stable �0.2 Slight worseningFavourable

Debt Low and stable 11.9 Stable

Lithuania Deficit Low and stable �0.5 Steady ComfortableDebt Low and stable 18.7 Stable Favourable

Hungary Deficit Persistently high �6.1 Remaining‘excessive’

Needs to fall

Debt Approaching60% limit

58.4 Stabilizing Too closeto limit

Poland Deficit Creeping over 4% �2.5 Slightincrease

Under control

Debt Rising beyond 40% 43.6 Slight increase Acceptable now

Slovenia Deficit Shrinking �1.8 SteadyComfortable

Debt Stable 29.1 Stable

Slovakia DeficitDebt

FallingFalling

�2.934.5

ImprovingSteady

Reasonablycomfortable

Cyprus Deficit Increasing �2.4 Improving FavourableDebt High and growing 70.3 Coming down

a littleOver limit

Malta Deficit High, rising �3.3 Steady In rangeDebt Going over 70% 74.7 Stays high Uncomfortably

high

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.


75

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. TheMaastricht convergence thresh-

old 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 can-

didate 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.


76

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 (impli-

citly, 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 out-

look for real convergence. Exchange-rate flexibility probably makes it

easier to manage short-term adjustment, but without the anchor of exter-

nal obligations imposed by EMU, governments may fail to take the neces-

sary 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 prac-

tice, 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 main-

tained, 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


77

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 stand-

ards 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 pre-

cluded 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 infrastruc-

ture 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 conse-

quently 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 cap-

ture 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 Areamembers.


78

Since the estimation period does not include the consolidation of transi-

tion and the relatively better recent performance of the east central Euro-

pean 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 collec-

tion 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 clear-

cut, 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


79

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 newmembers (Cyprus,

Latvia, and Malta) waited until May 2005. In theory, because of the two-

yearmembership criterion, thismeans 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 stabil-

ity) 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 newmembers), 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 ex-

change-rate target and a price-stability targetwill be problematicwith 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 newmembers. 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.


80

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 newmember 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 Areamembers 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.


81

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 prob-

lems 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 endo-

genously achieved, rather than being a pre-condition for successful par-

ticipation in a monetary union (Frankel and Rose 1997; De Grauwe and

Mongelli 2005).

Three overlapping, but distinct dimensions of negotiating fit and domes-

tic 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 macroeco-

nomic 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 distribu-

tive 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 transform-

ations that they have already undergone during transition have resulted

in relatively freer labour markets than in many current Euro Area

members.

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


82

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, under-

anticipated 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 econ-

omies thanmost EU15member 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 macroeco-

nomic 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 agricul-

ture, 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 com-

pared with 20.8 per cent in the Euro Area. However, the Irish manufactur-

ing share is marginally higher than the Czech one, andGermany, 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 Struc-

tural Funds may have played a part. Most of the new members have a


83

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 activ-

ity where the newmembers 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 rela-

tively 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 currentmembers 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 dis-

tinctive 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 corpor-

ate sector will increase. Zdenek Tuma, 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 envir-

onments’ (Tuma 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 influ-

ence the trajectory of the economy in the short- to medium-run. In prac-

tice, 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 newmembers, ‘getting the parity right will be

another key part of the strategy’, as Schadler et al. (2005: 9) note.


84

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 competi-

tiveness of the different economies have been compiled and are summar-

ized 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

GlobalcompetitivenessReport 2003–04

World com-petitivenessyearbook 2004

EFW Index2004

Index ofEconomicFreedom2004

DEKADCEI Index7/2004

DEKAStandort-Indikator8/2004

GCI BCI

Cyprus — — — 7 2 — —Czech Republic 6 4 4 4 5 3 5Estonia 2 1 1 1 1 1 4Hungary 4 5 3 2 8 6 6Latvia 5 2 — 3 4 8 3Lithuania 7 6 — 6 3 6 2Malta 1 7 — 5 7 — —Poland 9 9 6 9 10 4 7Slovakia 8 8 2 8 6 4 1Slovenia 3 3 5 10 9 2 8

Source: Lalinsky (2005).


85

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 competitive-

ness index, for example, could look anomalous. Nevertheless, they pro-

vide 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 theCzech Republic, are economically less developed than the

Euro Area by an order ofmagnitude. This is especially true of their financial

sectors; as Issing (2005: 193) notes, coinciding with a lower level of eco-

nomic 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 conse-

quently 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 com-

pared 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


86

hitting the home countries of these foreign banks that cause them to rein-

in lending to a greater degree than if they were responding only to host

country conditions. Non-performing loans, at a markedly higher propor-

tion 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


87

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 bemuch 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 un-

employment. 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 rela-

tively rapid Euro Area accession raises other problems for the new mem-

bers 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 integra-

tion with potentially long-lasting repercussions, a point made by Balcer-

owicz 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 Maas-

tricht 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


88

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 long-

term 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.


89

4

Economic Adjustment and the Euro in

New Member States: The Structural

Dimension of Fit

Erik Jones

Thenegative referenda outcomes on the EuropeanConstitutional Treaty in

France and theNetherlands inMay–June 2005 encouraged awave of specu-

lation about the future viability of the euro and the progress of EU enlarge-

ment. 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 macroeco-

nomic conditions in order? Should the new member states that joined on

1May 2004—Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithu-

ania,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. Mean-

while, 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 policymak-

ing. This combination of challenges is daunting. Nevertheless, political

leaders across Central and Eastern Europe have pledged their intention to

90

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 eco-

nomic 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 newmember

states from joining the single currency outweigh the costs. By implication,

the rest of the Euro Area should encourage the newmember 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 compla-

cency. 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.

Economic Adjustment and the Euro in New Member States

91

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 depend-

ence for the willingness of politicians across the EU to encourage an

expansion of the single currency (and to engage in a process of support-

ive 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 newmember 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 existingmember states during theMaastricht 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 refer-

endum. 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’smonetary 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 influ-

ence and its limits arise from the criteria for membership. The new mem-

ber 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:


92

. ‘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 bymore than 1½percentage points that of, atmost,

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 perform-

ing 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 refer-

ence 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 word-

ing have changed: first, because of the creation of the euro; and, second,

because of the increasingly elaborate framework for macroeconomic pol-

icy 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


93

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 calcu-

lations, then the average of averages rises to slightly above 1.5 per cent per

annum. Finally, understanding of the implications of inflation conver-

gence 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 par-

ticipation 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 persist-

ence 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 perform-

ance 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


94

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 fluctu-

ationmargins 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, theCommission indicated that itwould apply

the same standards to any enlargement of the Euro Area (European Com-

mission 2000: 66–8). The 15 per cent number continues to define ‘normal

fluctuationmargins’ in thenewERMII, but variationsofmore than2.25per

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 vari-

ation 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. Mean-

while, 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 coord-

ination andmarket-structural reform played a much greater role. Here it is

useful to point out that the prohibition against excessive deficits appears


95

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 par-

ticipate 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 run-

ning 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 medium-

term 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

Table 4.1. Nominal convergence indicators

Country(2004) Inflation

InterestRates

ExchangeRates*

ExchangeRate regime

Date JoinedERM II

Cyprus 1.9 5.8 0.7 ERMII 2 May 2005Czech Republic 2.5 4.8 2.3 FloatEstonia 2.9 4.4 0.0 ERMII 28 June 2004Hungary 6.6 8.2 2.4 Managed

FloatLatvia 6.0 4.9 1.7 ERMII 2 May 2005Lithuania 1.1 4.5 0.0 ERMII 28 June 2004Malta 2.7 4.7 0.6 ERMII 2 May 2005Poland 3.5 6.9 5.0 FloatSlovakia 7.1 5.0 1.2 Euro-pegSlovenia 3.6 4.7 0.4 ERMII 28 June 2004Euro Area 2.1 4.1

Note: The indicator for exchange rate volatility is the standard deviation of daily euro exchange rates against anindex 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 takenfrom the AMECO database published by the European Commission. Exchange rate data is calculated using dailyexchange rate data downloaded from the on-line statistics of the Dutch National Bank.


96

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, includ-

ing 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 re-

spect 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 fromallparties, ECOFIN(2004: 8) adoptedadifferentiatedapproach.

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 singledout forhaving 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


97

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 nega-

tive growth rate or from the accumulated loss of output during a pro-

tracted 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 contribu-

tions’ to the EU or to European objectives. Finally, the European Council

established differentmedium-term budgetary objectives formember states

that have low public debts and high growth potential, and member states

that have high public debts and low growth potential. Low-debt, high-

growth countries can aim to run a modest deficit (1 per cent of GDP) over

themedium 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 margin-

ally greater leeway in assessments that an existing deficit is temporary and

exceptional. These are not major concessions, but they constitute an im-

provement over the previous interpretation of the fiscal criteria. Table 4.2

summarizes the performance of the newmember states in 2004. The same

table also includes data for labourmarket participation,GDPper 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 mar-

ket-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


98

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 par-

ticipation in the euro are structurally determined.

Even a cursory read through the literature made available by the central

banks of the newmember 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 condi-

tions 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

Table 4.2. Fiscal convergence indicators, growth potential, and the need for structuralreform

Country(2004) Deficit Debts

Real GDPgrowth

GDP peremployee

Adjustedwage share

Participa-tion rate

Unem-ploymentrate

Currentaccountbalance

Cyprus 4.2 72 3.7 37.4 53 67 5.0 �5.7Czech Republic 3.0 39 4.0 17.7 53 67 8.3 �5.2Estonia 1.8 5 6.0 14.8 50 65 9.2 �12.9Hungary 4.5 59 3.9 20.6 53 56 5.9 �9.0Latvia 0.8 14 8.2 11.0 47 64 9.8 �12.4Lithuania 2.5 20 6.5 12.5 49 62 10.8 �8.3Malta 5.2 74 1.4 29.1 51 55 7.3 �10.1Poland 4.8 48 5.2 14.3 54 51 18.8 �1.3Slovakia 3.3 45 5.4 16.1 44 57 18.0 �3.4Slovenia 1.9 29 4.5 29.0 44 64 6.0 �0.9Euro Area 2.7 71 2.0 56.0 63 65 8.8 0.6

Note: Deficit and debt data are percent GDP; real growth is annual percentage change; GDP per employee is in eurothousands; 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.


99

ERM II membership in order to support the process of nominal conver-

gence (National Bank of Slovakia 2004).

Despite the influence of structural differences, there is a clear and con-

sistent prioritization of interests; market-structural reform is at the top and

joining the single currency is further down. This prioritization is consist-

ent with what Dyson describes as the ascendant Europeanmacroeconomic

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 monet-

ary integration is that market-structural reform is vital to the success of the

single currency. Efficient local market structures facilitate the implemen-

tation 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 con-

flict (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 integra-

tion, European integration, and globalization more generally.

The consistent prioritization of market-structural reform manifests dif-

ferently 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 EMUmembership 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


100

speech made by ECB Vice President Lucas Papademos and on a paper

presented by two economists from the Organization for Economic Co-

operation 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 flexibil-

ity 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


101

neighbours, all of the newmember 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 integra-

tion 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 re-

sult 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 shareof GDP*

EU (15) shareof total trade**

Country(2004)

Population(thousands)

GDP(* bln) Exports Imports Exports Imports

Cyprus 741 12.4 46 51 49 42Czech Republic 10,218 86.3 71 72 69 61Estonia 1,349 8.8 81 88 57 54Hungary 10,110 80.3 65 69 75 56Latvia 2,315 11.1 43 59 60 53Lithuania 3,440 17.9 53 59 48 43Malta 400 4.3 76 84 39 56Poland 38,361 195.2 39 41 69 62Slovakia 5,368 33.1 77 79 61 50Slovenia 1,996 25.9 60 61 59 68

Note: All trade shares are in percentages. Exports and imports as a share of GDP are for goods and services. GDPshares 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 EUtrade shares, which are taken from the Direction of Trade Statistics annual yearbook of the IMF.


102

The claim that participation in the Euro Area slows market structural

reform in the larger member states starts with the assumption thatmarket-

structural 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 coun-

tries 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 corre-

sponding 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

commonmonetary 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 infla-

tion 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


103

currency than they can once having made a credible commitment to join

the Euro Area. Thus, while it is technically true that the newmember 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 market-

structural 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 with-

out 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 struc-

tural 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 prod-

uctivity differential emerges between manufacturing and services, enab-


104

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 manu-

facturing 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 with-

out 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 strength-

ening 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 donemore 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 fol-

lows the implementation of market-structural reforms with a considerable


105

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 attribu-

tion. 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 plaus-

ible 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 incen-

tive 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 some-

where 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


106

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 newmember 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 market-

structural 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 domes-

tic 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 newmember 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 market-

structural 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 andGermany 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.


107

5

Optimal Economic Governance in an

Enlarged European Union: Scenarios and

Options

Ingo Linsenmann and Wolfgang Wessels

A Weak Acquis and Problematic Compliance: The LegalProvisions

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, demon-

strates 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

108

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 employ-

ment policies of themember 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 coordin-

ation 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 respect-

ive procedures of Articles 99 and 128 TEC might eventually lead to a loss

of reputation for member-state governments that are ‘named, blamed

Optimal Economic Governance in an Enlarged European Union

109

and shamed’ by their peer group and, potentially, in the mind of the

broader public. Several other instruments complement these two treaty-

based 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 ‘trad-

itional’ 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, Bahr, and Falkner 2004; NEW-

GOV 2005; Wallace 2005).

The amount and variety of these mechanisms already indicate a lack of

functional coherence. At the same time in European economic govern-

ance the EU faces a major dilemma. On the one hand, EU actors andmany

member states acknowledge that the Union ‘has to deliver’. The 2005 half-

time 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 exclu-

sion (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).


110

Enlargement: The Search for an Optimal Area ofEconomic 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 fragmen-

ted 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 newmembers 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 surveil-

lance procedure of ‘soft’ and eventually ‘hard’ coordination have (the

normative question) and what impact can we expect (the positive ques-

tion)? 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 dis-

played a greater convergence of key economic variables and of their wel-

fare systems at the time of theMaastricht negotiations for EMU than is the

situation today with most of the ten new member states. Economic gov-

ernance at the European level should alleviate this heterogeneity in the

long run. Even more, most of the newmember 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


111

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, competi-

tion 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 appropri-

ate 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 newmembers

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 regu-

larly 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 proced-

ures 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


112

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 experi-

enced 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 extrapo-

late 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 openmethods 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 deter-

mine 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 polit-

ical 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.


113

EClevel

Nationallevel

Europeanparliament

Employment and socialpolicy council

Economic andsocial committee

Commiteeof the regions

Employmentcommittee

Europeancommission

Europeancouncil

Economic and employment policy

Heads of government

National parliaments

Ministries for employment/social affairs Economic and finance ministries

Natioanl centralbanks

ECOFIN

Euro-group

Economic andfinancial committee

Europeancentral bank

Media

Economic policycommittee

Socialpartners

Macro-econdialogue

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

Scenarios of Development

Current Institutional Framework of European Economic Governance

The institutional architecture signals a complex multi-level and multi-

actor 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 Com-

mittee (Article 130) (Jacobsson and Vifell 2006b). In addition, the Eco-

nomic 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 introduc-

tion of several new procedures (e.g., the ‘Cardiff process’ on structural

reform, the macro-economic dialogue named ‘Cologne process’, the ‘Lis-

bon Strategy’ with its ‘new’ instrument of the ‘OMC’, subsequently appli-

ed 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 proced-

ures 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 Euro-

pean 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 coord-

ination of policies, the less they can rely on ‘shared commitments’ and


115

‘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 elec-

tions, 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 imple-

mentation and commitment to commonly agreed guidelines. The trend

towards softer coordination (cf. Meyer, Linsenmann, andWessels 2006) in

terms of constraints on member states can also be identified in the deci-

sion of the member states in early 2005, in agreement with the European

Commission, to soften the sanctions and reform the surveillance mech-

anism 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 (Euro-

pean Council 2005b: intent 10 and annex 2). These measures demon-

strated the willingness of member-state governments to reconsider and

perhaps advance European level coordination. However, they do not over-

come 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.


116

Scenario I: Keeping the Status Quo—‘Soft’ Coordination as AmbiguousGovernance 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 ac-

cession negotiations, which included not only guidelines but also a ‘com-

mand and control’ type of interaction with the European level, they have

nodifficulties in following the administrative demandsof the coordination

procedures, for example, submitting national plans for the implementa-

tion of guidelines, or other reports required by the provisions. In addition,

the new member states have taken part in open method of coordination-

type bilateral cooperation activities with the European Commission in

employment policy since 1999, and later on in inclusion policy and pen-

sions (de la Rosa 2005), as well as in the Pre-Accession Fiscal Surveillance

Procedure (PFSP), which included the drafting of Pre-Accession (Conver-

gence) 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 employ-

ment policies, as well as those along the lines of the open method of

coordination, this scenario concludes that the ‘top-down’ approach to co-

ordination has had and continues to have limited impact on the policies of

themember 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, bothnewandoldmember stateswill continue todeliberate on

the European level without expecting that anymember statewill unequivo-

cally pursue this Europeanagenda for economic reform.Moreover, given the

rather common-sense guidelines both for economic and employment pol-

icy, they can be applied to all 25member 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


117

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 leni-

ency was applied to Greece when it joined the Euro Area two years later.1

‘Pre-ins’ will be encouraged to join the EuroArea in order todemonstrate 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 newmember 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, espe-

cially in domestic economic and social conditions, we can assume that

the range of interests will also be broader. From the perspective of domes-

tic 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 Coun-

cil the conditions for majority voting have been reduced, and with it the

probability of getting to a constructive majority (Baldwin and Widgren

2004). Moreover, the present members of the Euro Area do not have a

qualified majority in the Council. Both sets of factors (increase in hetero-

geneity and changes in the Commission and Council) point to a scenario

in which member-states can be expected to make less use of the oppor-

tunity 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 infavour of Greece’s entry into the Euro Area was based on grossly falsified information providedby the Greek government and, in fact, demonstrated a clear failure of multilateral surveillance(cf. European Commission 2005c: 32).


118

This assessment is reinforced by the past and present records of Euro-

pean economic governance. Given that the ‘top-down’ strategy of the EU

guidelines has had a very limited impact on domestic actors so far (Gove-

cor 2004; Meyer and Umbach 2006), the less experienced administrations

of the newmembers’ countries will be even less able (and perhaps willing)

to take the Brussels guidelines seriously (Lippert and Umbach 2005). The

‘misfit’ (for the term, Borzel and Risse 2004; Falkner et al. 2004) between

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 tenden-

cies 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 mem-

bers with relatively strong economies have shown a poor record in com-

pliance (four out of six foundingmembers, 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 sub-

stantial fine according to the Excessive Deficit Procedure.

In this scenario, the path has been set towards a permissive (non–stabil-

ity) 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

criteriamight be welcomed by newmember states which, in pursuing high

growth and real convergence, aim for higher public expenditures, for

example on infrastructure or research and development (European Cen-

tral 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 Commis-

sion 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 institu-

tional hierarchy or some kind of hegemonic power, coordination activities


119

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, newmembers can be seen as imitat-

ing 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 thenew interpretations of the SGP as concludedby the

European Council (cf. European Council 2005a: annex 2) do not work either.

If, after a trial-and-error period, performance remainsweak, the EUwill 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-i-

nertia’ trap: themore 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 newmember 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 demon-

strated 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 pol-

itical 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


120

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 newmember 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 newmember 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’ coor-

dination 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 undertakenwith 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 periodwill improve the oppor-

tunity 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


121

circles in the institutional governance network would prepare and intro-

duce 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 allmembers of the EU. Arguing in a peer groupwill 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 amore extensive use of

the EU budget. With this growing convergence of viewpoints, a new con-

sensus 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 coordin-

ation 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 com-

mittees and, at a later stage, in the Council (for the terms, Risse 2000).

In this scenario, the acceptance of newmembers 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


122

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 Governancein 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 govern-

ance or government (gouvernement economique) 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 command-

and-control type, a fiscal agency or Stability Council on the supra-national

lines of the EuropeanCentral Bank, ormore room for fiscal transferswithin 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 Con-

stitutional Treaty has not formulated major changes in this direction, and

thedebate on thefinancial 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 governancewill continue tobe pursuedby

coordination. Since the ‘soft’ character of policy coordinationwill remain, it

will be more important to secure a better vertical integration of economic

policymaking at thenational level. Asprevious studieshave shown (Govecor

2004;Linsenmann,Meyer, andWessels2006), Europeanpolicycoordination

may have contributed to the strengthening of administrative linkages

between departments and agencies involved in socio-economic policymak-

ing on the national level. However, it has left out the key political actors

involvedindomesticpolicymaking.Thus, ifEuropeaneconomicgovernance

should have a greater impact on the actual decision-making and subsequent


123

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 Com-

munity 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 mech-

anisms 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 emer-

ging as the main deliberation body for finance ministers and the discus-

sions 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 scen-

arios 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 ‘commit-

ment–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 accommo-

date 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.


124

Part II

Domestic Political and Policy Contexts


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 member-

ship 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 fron-

trunner 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 macroeco-

nomic 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

127

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 con-

sensus 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 macro-

economic 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 domes-

tic 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 independ-

ence, which Estonia, Latvia, and Lithuania had lost during the Second

World War as a result of the Molotov–Ribbentrop Pact and foreign occu-

pations, 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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The Baltic States: Pacesetting on EMU Accession

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 organizationsmarks 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 co-

incided with deep economic crisis, shortages, hyperinflation and the col-

lapse 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 rela-

tionship 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, unlikemost 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 impli-

cations 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, policy-

making was focused more sharply on EU accession (Mikkel and Kasekamp

2002: 12). Since there were Russian troops in the three Baltic States—in

129


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 DemocraticWorkers’ 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 negoti-

ations. When in government, however, these parties have supported EU

integration and been instrumental in advancing it (though some disagree-

130


ments remained in the Centre Party). In Lithuania, themost 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 Euro-

scepticism (Paas et al. 2003: 97).

The Baltic States stand out not only because of their exposed geopolit-

ical situation but also because of the rapid and radical market-oriented

reforms that they pursued, even compared to most central and east Euro-

pean 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 market-

liberal 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 reces-

sion 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 suc-

cessful 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).

Theradicalismofmarket-orientedreforminEstonia,LatviaandLithuania

constitutes a ‘Baltic puzzle’ (Feldmann 2001). The roots of these except-

ional policy choices can be found in the depth of the initial crisis, geopolit-

ics, weak interest groups, and the institutional vacuum at the outset of

transition. Under these circumstances radical market reform was seen as

themost viable policy strategy. An important role was played by emigres as

policy advisers, likeArdoHansson inEstonia andGeorgeViksnins inLatvia.

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.).

131


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 Lithu-

ania 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 inter-

est 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 predomin-

ant 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 cur-

rencies, 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 andLithuania even chose currencyboards.

This choice resulted in part from their small size and resulting trade

dependence. More importantly, it was a means of establishing credibility

132


for their new currencies in the absence of an inherited domestic central

banking capacity and very limitedmonetary policy expertise.

Estonia was the first mover in rapidly establishing a national currency,

the kroon, in June 1992. Initially this initiative was against the recom-

mendations 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 arrange-

ment 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, inMarch 1993, but the

currency reform was implementedmore gradually. A transitional currency

(the Latvian rouble) was introduced in May 1992 and was not fully with-

drawn 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 inde-

pendent and ensured that money in circulation was fully backed by for-

eign 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

Repse enabled it to resist government demands to use seignorage to

finance budget deficits, especially in periods of cabinet instability (Lainela

133


and Sutela 1994). InMay 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 (liter-

ally 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 1¼ 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 con-

tinued 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.

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

1996 1997 1998 1999 2000 2001 2002 2003

Estonia 23.1 11.2 8.2 3.3 4.0 5.8 3.6 1.3Latvia 17.6 8.4 4.7 2.4 2.7 2.6 1.9 2.9Lithuania 24.6 8.9 5.1 0.8 1.0 1.3 0.3 �1.2

Source: ECB (2004).

134


In all three states this monetary policy regime has been complemented

by prudent fiscal policy. Since 1997 they havemet theMaastricht 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 attrib-

uted to the dire initial conditions of the three states. Weak, even non-

existent 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

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

1996 1997 1998 1999 2000 2001 2002 2003

Estonia �1.7 1.7 �0.3 �3.7 �0.6 0.3 1.4 3.1Latvia �0.5 1.5 �0.6 �4.9 �2.8 �2.1 �2.7 �1.5Lithuania �3.6 �1.2 �3.0 �5.6 �2.5 �2.0 �1.5 �1.9

Source: ECB (2004).

135


(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 forhardpeggedexchange

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 Agricul-

tureMinistry). Similar proposalsweremadeby representatives of Saimnieks

in Latvia in 1995 (Nissinen 1999: 185). In Lithuania the proposal to aban-

don the currencyboard in1999was reversed in the aftermathof theRussian

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 ad-

verse 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 author-

ities 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;

Aima 1998). The independence of the central banks has been a relatively

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 Repse in Latvia) subse-

quently 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

136


independence, there has been some debate about the degree of real inde-

pendence of the central bank, Lietuvos Bankas, from political influence in

the early years of transition (Aima 1998). External influence, initially from

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. European-

ization 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 negoti-

ations 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

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

Primeministers

Termin office

Ministersof finance

Termin office

Central Bankgovernors Term in office

EdgarSavisaar

Jan. 1990–Jan. 1992

Rein Miller May 1990–Jan. 1992

Rein Otsason Jan. 1990–Sept. 1991

Tiit Vahi Jan. 1992–Oct. 1992

Madis Uurike Jan. 1992–Jan. 1994

Siim Kallas Sept. 1991–Apr. 1995

Mart Laar Oct. 1992–Nov. 1994

Heiki Kranich Jan. 1994–June 1994

Vahur Kraft Apr. 1995–

AndresTarand

Nov. 1994–Apr. 1995

Andres Lipstok June 1994–Apr. 1995

Tiit Vahi Apr. 1995–Nov. 1995

Mart Opmann Apr. 1995–Mar. 1999

Tiit Vahi Nov. 1995–Mar. 1997

Siim Kallas Mar. 1999–Jan. 2002

MartSiimann

Mar. 1997–Mar. 1999

Harri Ounapuu Jan. 2002–Apr. 2003

Mart Laar Mar. 1999–Jan. 2002

Tonis Palts Apr. 2003–Oct. 2003

Siim Kallas Jan. 2002–Apr. 2003

Taavi Veskimagi Oct. 2003–Apr. 2005

Juhan Parts Apr. 2003–Apr. 2005

Aivar Soerd Apr. 2005–

Andrus Ansip Apr. 2005–

137


Maastricht convergence criteria is used as the baseline. Estonia and Lithu-

ania 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.

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

Primeministers

Termin office

Ministersof finance

Termin office

Central bankgovernors Term in office

Ivars Godmanis May 1990–Aug. 1993

Elmars Silins May 1990–March 1993

Einars Repse Sept. 1991–Dec. 2001

Valdis Birkavs Aug.1993–Sept. 1994

Uldis Osis Mar.1993–Sept. 1994

Ilmars Rimsevics Dec. 2001–

Maris Gailis Sept. 1994–Dec. 1995

Andris Piebalgs Sept. 1994–May 1995

Andris Skele Dec. 1995–Feb. 1997

Indra Samite May 1995–Dec. 1995

Andris Skele Feb. 1997–Aug. 1997

Aivars Kreituss Dec. 1995–Feb. 1996

Guntars Krasts Aug. 1997–Nov. 1998

Andris Skele Feb. 1996–Jan. 1997

Vilis Kristopans Nov. 1998–July 1999

Vasilijs Melniks Jan. 1997–Jan. 1997

Andris Skele July 1999–May 2000

Andris Skele Jan. 1997–Feb. 1997

Andris Berzins May 2000–Nov. 2002

Roberts Zile Feb. 1997–Nov. 1998

Einars Repse Nov. 2002–Mar. 2004

Ivars Godmanis Nov. 1998–July 1999

Indulis Emsis Mar. 2004–Dec. 2004

Edmunds Krastins July 1999–May 2000

Aigars Kalvitis Dec. 2004– Gundars Berzins May 2000–July 2002

Valdis Dombrovskis July 2002–Sept. 2004

Oskars Spurdzins Sept. 2004–

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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

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

Prime ministers Term in officeMinisters offinance Term in office

Central BankGovernors Term in office

KazimieraPrunskiene

Mar. 1990–Jan. 1991

RomualdasSikorskis

Mar. 1990–Jan. 1991

BroniusPovilaitis

Mar. 1990–July 1990

AlbertasSimenas

Jan. 1991–Jan. 1991

ElvyraKuneviciene

Jan. 1991–July 1992

ViliusBaldisis

July 1990–Mar. 1993

GediminasVagnorius

Jan. 1991–July 1992

AudriusMisevicius

July 1992–Nov. 1992

RomualdasVisokavicius

Mar. 1993–Oct. 1993

AleksandrasAbisala

July 1992–Nov. 1992

EduardasVilkelis

Dec. 1992–Feb. 1995

JouzasSinkevicius(acting)

Oct. 1993–Nov. 1993

BronislovasLubys

Dec. 1992–Mar. 1993

ReinoldijusSarkinas

Feb. 1995–Feb. 1996

KazysRatkevicius

Nov. 1993–Jan. 1996

AdolfasSlezevicius

Mar. 1993–Feb. 1996

AlgimantasKrizinauskas

Feb. 1996–Nov. 1996

Jonas Niaura(acting)

Jan. 1996–Feb. 1996

LaurynasStankevicius

Feb. 1996–Nov. 1996

RolandasMatiliauskas

Dec. 1996–Feb. 1997

ReinoldiusSarkinas

Feb. 1996–

GediminasVagnorius

Dec. 1996–May 1999

AlgirdasSemeta

Feb. 1997–May 1999

RolandasPaksas

June 1999–Oct. 1999

JonasLionginas

June 1999–Oct. 1999

AndriusKubilius

Nov. 1999–Nov. 2000

VytautasDudenas

Nov. 1999–Nov. 2000

RolandasPaksas

Oct. 2000–June 2001

JonasLionginas

Oct. 2000–June 2001

AlgirdasBrazauskas

July 2001–Dec. 2004

DaliaGrybauskaite

July 2001–May 2004

AlgirdasBrazauskas

Dec. 2004– AlgirdasButkevicius

May 2004–April 2005

ZigmantasBalcytis

May 2005–

139


on fiscal discipline represents continuity and a lock-in of the macroeco-

nomic 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, ‘top-

down’ 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 strength-

ening 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-heart-

edly 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 sta-

bility 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 transi-

tion, including pensioners, have had reservations about the stability cul-

ture 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

140


high growth and bring down unemployment from relatively high levels

(European Central Bank 2004).

Conclusion: Locking-In Domestic Policies through EMUAccession

EMU accession has been associated with low to moderate rather than

significant misfits between Baltic State and the acquis. Hence the ‘top-

down’ Europeanization effects on policy adjustments have been relatively

small, and they are pacesetters in EMU accession. The informal condition-

ality 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 do-

mestic 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 consoli-

dation 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

141


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 Esto-

nian 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 outperform-

ing 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 espe-

cially 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 adop-

tion 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 uncon-

tested among elites at the level of discourse, EMU accession will necessar-

ily follow easily. Can the domestic stability cultures of the Baltic States be

sustained both before and after Euro Area entry? One of the main ration-

ales for radical market-based reform, European integration and the stabil-

ity 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

142


the referenda on EU accession (Raik 2004). During the EU accession pro-

cess 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’ European-

ization, 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 eco-

nomic adjustment and recession. EMU could become a convenient scape-

goat for people who perceive themselves as faring less well. Heightened

controversy would be particularly likely if economic performance deteri-

orates. 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 crack-

down 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 Euro-

populist 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 pre-

existing parties, and major policy shifts have been avoided. Future eco-

nomic performance and the potential for mobilization of economic losers

143


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.

144


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 vari-

ant, domestic actors, both political and technocratic, use European inte-

gration 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; Feather-

stone and Kazamias 2001; Radaelli 2002). However, the Bulgarian case is

distinguished by the consistency and effectiveness of the framework en-

forcing ‘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 European-

ization 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 thecreationof ‘non-majoritarian’ institutions (ThatcherandStoneSweet

145

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 ‘cred-

ibility’ approach to inflation, which views expectations as a key variable

in shaping inflation. By limiting their own policy discretion, decision-

makers can gain credibility in fighting inflation by reducing public

expectations (Dyson 1994). While both political and technocratic deci-

sion-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 under-

take 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 political-

business 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 destabiliz-

ing 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 backward-

ness 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

146

From Laggard to Pacesetter

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 Euro-

pean 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 perspec-

tive 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 pre-

ferred outcomes at the national level. In contrast, however, to the assump-

tion 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 Euro-

peanization 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 influ-

ence 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

147


large member states which have played a pivotal role in setting the stand-

ards for the entire Union. This rationale also applies, in a more complex

way, in a case in which the reduction of policymakers’ discretion is under-

taken 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 con-

trast, 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 tax-

ation and spending, which lie at the heart of political competition in

modern democracies and provide vital legitimating mechanisms for pol-

itical parties representing the often-conflicting interests of different con-

stituencies. 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 domes-

tic 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

148


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 inves-

tigate 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 prefer-

ences 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 actor-

centred 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 insti-

tutions 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 require-

ments and the domestic level. The analysis focuses on factors such as

institutional continuities, fiscal crises, the development of the party sys-

tem, 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 larg-

est 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 prefer-

ences of the Turkish minority party, the Movement for Rights and Free-

doms (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, whichmanaged 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 al-

together. While, following Zhivkov’s removal, the finance ministry was

re-established, the position of the financeminister 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 financeministry 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 public-

sector organizations. The savings involved were quite substantial. The

removal of subsidies to the industrial sector alone led to a cut of over 35

150


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

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

Govern-ment term

Party compositionof government

Prime minister(term the same asthe government)

Finance minister(term the same asthe government)

Governor ofBulgarianNational Bank

8.2.1990–22.9.1990

BulgarianCommunist(since April 1990Socialist) Party

Andrei Lukanov Belcho Belchev Ivan Dragnevski,20.12.1989–9.1.1991

22.9.1990–19.12.1990

Bulgarian SocialistParty

Andrei Lukanov Belcho Belchev Ibid.

20.12.1990–7.11.1991

Non-party govern-ment

Dimitur Popov Ivan Kostov Ibid. Todor Vulchev,9.1.1991–24.1.1996

8.11.1991–29.12.1992

Union of DemocraticForces

Philip Dimitrov Ivan Kostov Ibid.

30.12.1992–17.10.1994

Non-party govern-ment (nominallyunder the auspicesof Movement forRights and Freedoms)

Liuben Berov StoyanAlexandrov

Ibid.

17.10.1994–25.1.1995

Caretakergovernment

Reneta Indzhova Hristina Vucheva Ibid.

25.1.1995–11.2.1997

Bulgarian SocialistParty and allies

Zhan Videnov Dimitar Kostov Ibid. LiubomirFilipov, 24.1.1996–11.6.1997

12.2.1997–20.5.1997

Caretakergovernment

Stefan Sofianski Svetoslav Gavriiski Ibid.

21.5.1997–24.7.2001

Union ofDemocraticForces and allies

Ivan Kostov Muravei Radev Ibid. SvetoslavGavriiski,11.6.1997–9.10. 2003

24.7.2001–17.8.2005

National Movementfor Simeon II andMovement for Rightsand Freedoms

Simeon Saxe-Coburg-Gotha

Milen Velchev Ibid. Ivan Iskrov,9.10.2003–

151


reasserting its dominant position was facilitated by the seemingly irrevers-

ible implosion of the UDF. The UDF had reacted to the fall of its govern-

ment 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 economywent 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 in-

crease 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 twomonths 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 gov-

ernment 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 financeministry 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 themwith 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 isolatingmonetary 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 becamemore 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-Coburg-

Gotha, 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 govern-

ments’ own policy preferences. The policy outcomes were, however, un-

ambiguous: 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—itwas established in response toadomestic crisis andat a

time when not only the prospect of Euro Areamembership, 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 theboard inconstrainingfiscaldeficitmeans that it canenableBulgaria 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

requirementsmeans that thenegotiation of fit can take the formof preserv-

ing the already existing constraining domestic arrangement. Bulgarian do-

mestic 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 cur-

rency 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

154


soonafter EUaccession is a feasibleoption (see Feldmannchapter). TheBNB

expects full Euro Area membership for Bulgaria in 2009 or 2010. Senior

central bank andfinanceministry officials have also been farmore effective

than their counterparts in other institutions in playing a ‘two-level’ game,

not only at the domestic, but also at the EU level. Theyhave 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 spend-

ingministries, in particular, those concernedwith socialwelfare, 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 restric-

tions imposed by the currency board, no government has seriously consid-

ered 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

underBSP stewardship that the1996–7hyperinflationoccurred,means that

the party has had tomake 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 cata-

strophic 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 dispro-

portionate impact on the country’s ability to attract finance. While Bul-

garian 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

155


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 indi-

viduals around Simeon rather than a normal political party, the raison

d’etre of the government has been defined primarily in terms of techno-

cratic efficiency, along the lines of the ‘sound money and finance’ para-

digm. The government’s priorities have been clearly demonstrated by the

emphasis on debt reduction, rather than on increasing welfare expend-

iture. 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 forth-

coming 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 coun-

try’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 institu-

tional arrangements. A potential problem for Bulgaria could arise due to

the fact that, under the currency board, the BNB is deprived ofmany 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 secur-

ity 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

156


still receive state aid, but according to the Pre-Accession Economic Pro-

grammes (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 Com-

mission 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 inter-

ests, 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, la-

bour market rigidities, and the efficiency and quality of the education

system (European Commission 2004). In the longer term, the accumulat-

ing problems in the welfare system, partly due to high levels of social

deprivation and partly to ineffective government policies, may put pres-

sure 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. Em-

ployers’ 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 requi-

rements and the domestic level is shaped to a large extent by the evolution

of domestic institutions. The analysis of the factors shaping the develop-

ment 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

157


Hallerberg’s expectations (2004), of the evolving domestic party system

and the changing party composition of national government. The in-

stability 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 ambi-

tions 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 institu-

tional framework that produced fiscal policy outcomes compatible with

the Maastricht deficit criterion. Consequently, the negotiation of fit be-

tween 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 cur-

rency board. They have proved much more successful than their rivals in

the spendingministries 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

158


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 im-

portant 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 differ-

ence’. Given the limiting effect of the currency board on party competi-

tion, 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, Lithu-

ania, 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 Post-

Communist Europe’, funded by the Volkswagen Foundation (1999–2001).

Theprojectwas ledbytheauthor,KlausH.Goetz (bothat theLondonSchool

of Economics and Political Science) and Hellmut Wollmann (Humboldt

Universitat). Other researchers included Martin Brusis and Radoslaw

Zubek.Theprojectwasassistedby theEconomicPolicy Institute inBulgaria.

159


8

From Pacesetter to Laggard: The

Political Economy of Negotiating

Fit in the Czech Republic

Frank Bonker

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 ‘soundmoney and finance’ in the region. Vaclav Klaus, the self-

confident 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 newmember 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 Spidla 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 ap-

proach 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 ‘EMUiza-

tion’ 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.

160

The first section of this chapter outlines the economic and political

context of EMU accession in the Czech Republic by sketching the chal-

lenges associated with Euro Area entry, the positions of the main domestic

actors on EMU accession, and the reform capacity of the post-1998 gov-

ernments. The second section reconstructs how these economic and pol-

itical 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 Re-

public has been characterized by a combination of strong reform chal-

lenges 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, theCzech 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 criter-

ion has required a substantial fiscal adjustment with the associated

From Pacesetter to Laggard

161

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

favourable fiscal record (Bonker 2006). Ever since the late 1990s, how-

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 restruc-

turing 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 eco-

nomic recovery (Bezdek 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 2003 2004 2005 2006

Czech Republic �4.0 �5.6 �6.7 �11.7 �3.0 �4.5 �4.0Estonia �0.3 0.2 1.8 3.1 1.8 0.9 0.5Hungary na �4.4 �9.3 �6.2 �4.5 �3.9 �4.1Latvia �2.7 �1.6 �3.0 �1.5 �0.8 �1.6 �1.5Lithuania �2.6 �2.1 �1.6 �1.9 �2.5 �2.4 �1.9Poland �2.9 �2.9 �3.9 �4.5 �4.8 �4.4 �3.8Slovak Republic �12.3 �6.0 �5.7 �3.7 �3.3 �3.8 �4.0Slovenia na na �1.9 �2.0 �1.9 �2.2 �2.1

* Figures for 2005 and 2006 are Spring 2005 forecasts.

Source: European Commission, Public Finances in EMU, various issues.


162

run-up to EMU accession will not result in as strong a reduction of interest

payments as in Hungary and Poland (Orban and Szapary 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 Inter-

national Monetary Fund (IMF) and the World Bank in the 1990s (Bezdek

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 success-

ful two-year participation in ERM II. This requirement is highly contro-

versial 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 destabil-

izing 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 frommid-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 (Komarek 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 correl-

ation 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.


163

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 theMaastricht 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 argu-

ments. 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 ‘catch-

up’ 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 safe-

guarding 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 Vaclav Klaus, the long-serving chairman of the centre-right


164

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 opti-

mumcurrency areas, and thus comewith 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 harmon-

ization 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, theweak economic performance of the EuroAreahas strengthened

the third camp. Moreover, in February 2005 Vaclav Klaus used his presiden-

tial powers regarding the central bank to make two well-known opponents

of euro entry members of the board of the Czech National Bank.

The threepositions onEMUandEMUaccessioncanbe found inothernew

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 enthu-

siasm 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. InMay 1997, speculative attacks forced

the authorities to give up the exchange-rate peg that had been introduced

at the outset of transition (Begg1998;Horvath1999). Similar only to theUK,

thepainful experience of being ejected out of a soft-peg systemhas 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 macroeco-

nomic tightening on economic growth. Finally, the third camp could not

exist without Vaclav 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

and Ucen 2003; Hanley 2004a).

Weak Reform Capacity

Negotiating fit in EMU accession has been further complicated by domes-

tic political-institutional constraints. While the Czech Republic had a


165

strong government during the first half of the 1990s, the post-1998 gov-

ernments have demonstrated a limited reform capacity (Williams 2003;

Bonker 2006, Chapter 6). This weak reform capacity applies both to the

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 partycomposition of cabinets

ParliamentsParties ingovernment Prime Minister Finance Minister

Central BankGovernor**

January 1993–June 1996*

ODS, KDS,KDU–CSL,ODA

Vaclav Klaus(ODS)

Ivan Kocarnik Josef Tosovsky

January 1993–November 1997

July 1996–June 1998

ODS, KDU–CSL, ODA

Vaclav Klaus(ODS)

Ivan Kocarnik

July 1996–May1997

July 1996–November 1997

Ivan Pilip

June 1997–November 1997

Josef Tosovskycaretakergovernment

Ivan PilipDecember1997–July 1998

December 1997–July 1998

July 1998–June 2002

CSSD (minoritygovernment)

Milos Zeman(CSSD)

Ivo Svoboda Josef Tosovsky

July 1998–July 1999

July 1998–November 2000

Pavel MertlıkJuly 1999–April 2001

Zdenek Tuma

Jirı Rusnok November2000-present

April 2001–June 2002July 2002–present

CSSD,KDU–CSL,US-DEU

VladimırSpidla (CSSD)

Bohuslav Sobotka

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

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


166

The Social Democratic CSSD, which has dominated both post-1998

governments, has suffered from strong internal rifts and weak party dis-

cipline. 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 Milos Zeman led a minority government. Although an

agreement with the centre-Right ODS, the so-called ‘Opposition Agree-

ment’, 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 KDU-

CSL 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

Minister’s office (Goetz andWollmann 2001: 869–71; Muller-Rommel and

Mansfeldova 2001). The Finance Minister has suffered from the institu-

tional 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 Milos 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 initi-

ation and consolidation of unpopular reforms.

Finally, the Czech Republic has been characterized by a high level of EU-

scepticism on the mass and the elite levels (Kopecky and Ucen 2003;

Taggart and Szczerbiak 2004; Beichelt 2004). As evidenced by Eurobarom-

eter 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

newmember 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 centre-

right ODS—have catered for EU-sceptic voters. For this reason, the parties


167

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 Euro-

sceptic electorate.

Table 8.3. Euro-scepticism in EU-accession states (percentages)

Country 2001* 2002* 2003* ‘No’ in referendum

Bulgaria 2 5 3Czech Republic 9 14 15 22.17Estonia 14 16 16 33.00Hungary 7 5 10 16.16Latvia 17 21 16 32.33Lithuania 11 12 9 8.85Poland 11 11 11 22.39Romania 2 2 2Slovakia 5 5 8 6.20Slovenia 11 14 8 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 personallyknow more in favour or against the idea of introducing the

euro in (YOUR COUNTRY)?

57%

55%

45%

40%

38%

38%

38%

34%

33%

31%

41%

22%

22%

38%

48%

36%

41%

40%

45%

46%

44%

21%

22%

17%

12%

26%

21%

21%

22%

21%

25%

39% 20%

0% 20% 40% 60% 80% 100%

NMS

SI

HU

SK

CZ

CY

EE

LT

PL

MT

LV

In favour Against [DK/NA]

Figure 8.1. Support for EMU accession

Source: European Commission and EOS Gallup Europe 2004: 11.


168

Czech Economic Policy and Euro Entry

How have these conditions shaped the Czech approach to, and the do-

mestic effects of, EMU accession? The formulation of a ‘Euro-Area Acces-

sion 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;

Dedek 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. ‘EMUiza-

tion’ took different forms which ranged from the implementation of the

EMU chapter of the acquis, through the gradual integration of the pro-

spective new member states into formal and informal EU-level policy-

coordination, 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 cen-

tral banks by shielding them against political pressure (cf. the chapters on

Hungary and Poland). The Czech case is broadly in line with these obser-

vations (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 begin-

ning 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

Tosovsky for pursuing too tight a monetary policy. Whereas Klaus and the


169

ODS blamed the central bank for having caused the 1997 currency crisis,

which put an end to their rule, Zeman andmany CSSD politicians believed

that the Czech National Bank had delayed the post-1997 economic recov-

ery 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 mon-

etary 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 Vaclav

Havel and the central bank. These attempts were in part driven by the

strong dissatisfaction with the CzechNational Bank. Theywere also part of

a broader power struggle between the two big parties and President Vaclav

Havel, who had strongly criticized the cooperation between the ODS and

the CSSD from the beginning and had been at odds with Vaclav Klaus

since the early 1990s. A major element of the ‘Opposition Agreement’

between the ODS and the CSSD was the commitment to curtail the con-

stitutional 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 require-

ment entered the domestic agenda in early 2000, the ODS seized the

opportunity and used the legislative process for bringing in its own pro-

posals. The ODS aimed at limiting central bank independence by obliging

the Czech National Bank to set its inflation target and the exchange-rate

regime inagreementwith thegovernment andby subjecting its operational

budget to parliamentary approval. It also sought to alter the appointment

process by obliging the President to appoint boardmembers 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 oppos-

ition, and a number of individual CSSD and ODS members of parliament.

These actors tried to capitalize on the concerns of the European Commis-

sion, 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


170

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 rejec-

tion by the second chamber.

The conflicts between the ODS and the CSSD, on the one hand, and the

CzechNational Bank andPresidentHavel, on the other, further heightened

when Havel appointed a new central bank governor in November 2000.

The resignation of governor Tosovsky, 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 Tuma the new governor. While

the ODS and the CSSD did not question the chosen candidate, they criti-

cized 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 Tuma.

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’ European-

ization. Signals and interventions by the EU could not prevent the parlia-

mentary 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


171

investors, most notably investment funds and banks, and by other inter-

national 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 (seeDyson, Chapter 1 above).

However, before the 2002 parliamentary elections the Czech govern-

ment 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 acces-

sion. 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 com-

mitment to fiscal reform, a condition sine qua non for any credible strat-

egy 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 them-

selves 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 strat-

egy became a major political issue. The eventual presentation of a strategy

tookmore 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 thenewPrimeMinisterVladimır

Spidla 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


172

bringing in the Czech National Bank, with its insistence on fiscal

reform, Spidla 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 bankwas 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 Tuma, a former academic, had a much

weaker political background than Leszek Balcerowicz in Poland and Zsig-

mond Jarai 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 Spidla 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 public-

sector 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 one-

vote majority.

A second obstacle to the passage of fiscal reform was the referendum on

EUmembership 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


173

referendum signalled a much higher support for the EU than expected

(Hanley 2004b). By reducing the need to please voters, and by strengthen-

ing the authority of Prime Minister Spidla within the CSSD, the referen-

dum 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 adjust-

ment 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


174

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. Fur-

thermore, 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 illus-

trate 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


175

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 agree-

ment 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 gov-

ernment 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 elec-

tions 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 re-

duced the government’s capacity to act. Following the bad showing of

the CSSD in the elections to the European Parliament, Prime Minister

Spidla 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 un-

favourable political conditions, the government slowed down fiscal re-

form. Despite the acceleration of economic growth, it confined itself to

minor changes in the fiscal targets. Reacting to the initiation of the exces-

sive 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 rela-

tively 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

debates on labour-market reform (Schuttpelz 2004).


176

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 mar-

ket 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. More-

over, political conditions in all three countries have been rather unfavour-

able to the launching of fiscal reform, the key precondition for a speeding

up of EMU accession. However, political conditions have been unfavour-

able 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 scep-

ticism on both themass and the elite levels. In contrast, the main problem

in Hungary has been the strong political polarization between the two

main political camps.


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9

The First Shall Be the Last? Hungary’s

Road to EMU

Bela 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 conver-

gence criteria for euro entry? Analysts point either to the government’s

unwillingness or incapacity to tighten fiscal policy or to the lack of coord-

inated 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-social-

ism, contentious trade-union movements, and Euro-sceptic populist par-

ties for missed opportunities of early EMU membership (EIROnline 2004).

None of these actors seems to be prominent in Hungary. The high level

ofWestern integration of the Hungarian economy undercuts the influence

of traditional protectionist lobbies. Trade unions rarely engage in confron-

tation. All major Hungarian political parties consider euro entry as a

national priority. Open Euro-scepticism is virtually absent, except in

178

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 polit-

ical system failed to generate support for a rapid entry?

The chapter argues that this fiasco stems from the contradictory prefer-

ences 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 rhet-

oric, 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 pol-

icymaking 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 dee-

per problem at work in Hungary’s euro entry strategy: namely the com-

patibility 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 theHungarian 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.

179

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

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 Socialist-

Liberal 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 govern-

ment launched a stabilization programme named after its architect, Min-

ister 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 aban-

doned 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 trans-

national corporations and domestic businesses. Attracted by low labour

costs and generous subsidies, transnational corporations relocated labour-

intensive production to Hungary, while many domestic firms became

their subcontractors.

This boom lasted only as long as three conditions were met: a prosper-

ous world economy, a depreciating forint, and low wages. Usually Hun-

garian 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-

180


ation. Nominal wage increases were relatively easily achieved, but real

wage growth was slow (Hethy 2000: 19). Thus, in the export sector, busi-

ness 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 think-

ing, 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 Orban’s claim in 2001 that his ‘Hungarian model’ was superior to

the Left alternative, even in social welfare. What was the Hungarian

model? In Orban’s interpretation it combined growing output and

employment with improving macroeconomic fundamentals, despite

unfavourable external conditions. More specifically, Orban 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-in-

tensive 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 Orban government raised min-

imumwages 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 Orban

appointed his minister of finance, Zsigmond Jarai, as president of the

National Bank of Hungary. Jarai 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

181


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 Orban government

no longer considered that the labour-intensive export economy was the

main engine of growth. Instead, it boosted domestic output and consump-

tion by fiscal measures. Large-scale development programmes for trans-

port infrastructure, tourism facilities, and public construction were

launched. Additional growth stimuli came from generously subsidized

loans for residential construction and renovation for middle and upper-

middle class home builders and from the ‘Szechenyi plan’, which com-

bined 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 busi-

nesses, and other producers of ‘non-tradeables’. Similarly, the petrol mon-

opoly MOL, the property developer TRIGRANIT, the telecommunications

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 evi-

dence 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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in lowwages 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, Euro-

peanization 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 atmos-

phere 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 Parlia-

ment 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.

Table 9.1. Transnationalization of selected ex-socialist economies

Cumulative FDI-inflowsper capita (1989–99,USD)

Outward FDI flows(1997–9, mn USD)

Selected labour intensivegoods’ share in totalexports (1997–9, per cent)

CzechRepublic

1447 301 17.8

Estonia 1115 217 27.6Hungary 1764 1096 39.3Poland 518 326 26.1Slovak

Republic391 259 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 (SITC75,76,77), furniture, garment, and footwear products (SITC 82, 84, 85).

183


http://intracen.org/tradestat/sitc3-3d

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 (MIEP)

taught them that Euro-sceptic nationalism was a non-starter. Given the

sentiments of centre-Right and centre-Left voters alike, opposition rhet-

oric had to be pro-European in order to be attractive. Second, the popu-

larity of the MSZP’s new prime minister Peter 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 Med-

gyessy’s programme of ‘transformation with welfare’ but vehemently op-

posed 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 simul-

taneously demonstrate the administration’s incompetence in ‘European-

izing’ 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 gov-

ernment made fiscal adjustment conditional on relaxed monetary pol-

icies. 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.

Jarai made the relaxation of monetary policy conditional on convincing

results in fiscal tightening. Otherwise, the central bank’s disinflation tar-

get would be threatened. For political reasons of domestic electoral and

party competition, the opposition was eager to see the Medgyessy govern-

ment trapped between unpopular fiscal adjustment and a failure to com-

ply with the macroeconomic convergence criteria, allowing them to

184


simultaneously attack it for lack of sensitivity to social welfare consider-

ations 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 Maas-

tricht 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 elect-

oral and party interest in urging early entry, and the government in delay-

ing entry, to the Euro Area. Given a combination of conflicting economic

and social interests with polarized political interests and strategies, by 2002

the stagewas set for protracted trenchwarfare between twomajor 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 polit-

ics 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

185


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, Jarai raised the interest rate right after the election. The new gov-

ernment 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 behaviourmight

be explained by their relative independence from domestic policy con-

texts 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 con-

cern for them. They competed less on the basis of price than of quality,

product differentiation, and consumer services. Second, as major import-

ers 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 Gabor Szeles, VIDEO-

TON’s owner, and the president of the National Alliance of Employers and

Industrialists (MGYOSZ), the top association of exporting and import-

competing domestic businesses. In his view, Jarai’s policy undermined

the competitiveness of exporters and favoured nobody but speculators.

Szeles demanded a tripartite negotiation of government, the National

Bank of Hungary, and MGYOSZ to determine a more appropriate ex-

change rate (NOL 2002: June 7).

While the government refused to mention any concrete entry date in its

medium-term strategy paper, Jarai continued making policy with the year

2006 in mind. In July 2002 he warned about the inflationary conse-

quences 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

186


norms in differentially empowering Hungarian policymakers is revealed

by the way in which Jarai 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

Laszlo, theminister of finance, predicted that the budget deficit would not

exceed 4.5 per cent in 2003, and asked the National Bank of Hungary to

lower the interest rate. FormerNational Bank of Hungary president Gyorgy

Suranyi argued that there was no need to rush to euro entry. He believed

that it would be amistake to hurriedly dress theHungarian economy in the

straitjacket of the Stability andGrowth 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). Jarai 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

thatwasunprecedented inthehistoryof theHungariantransitionMGYOSZ

and four other business associations signed a petition demanding Jarai’s

resignation, a 5–10 per cent depreciation, and a representation for actors of

the ‘real economy’ in thecentral bank’smonetary council. Szeles claimed to

represent the viewofmany entrepreneurswhenhe asserted that the central

bank’s policy was harming output, profits, and employment without suc-

cessfully taming inflation. Two ministers publicly shared these concerns.

However, two major associations, including the National Federation of

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EntrepreneursandEmployers (VOSZ),didnottakepart intheprotestaction.

Similarly, the president of the State Supervisory Board of Financial Organ-

izations (PSZAF), appointed under the Orban administration, criticized

MGYOSZ for undermining the independence of theNational Bank of Hun-

gary. The FIDESZ–MPSZ parliamentary party leader also defended Jarai on

thegroundsthatastrongforintandearlyeuroentrywere inthe interestofall

Hungarians, whereas incoherent government policy damaged the econ-

omy. The conflict peaked at a debate before the Parliament’s economic

committee, which was richer in political blame-shifting than in profes-

sional arguments. Szeles criticized Jarai for appointing his own intimates

to themonetary policy council. Jarai stressed the inflationary impact of an

‘outrageous’ budgetdeficit.He rejected theaccusation that thehigh interest

rate facilitated speculative ‘hot-money’ inflows and explained Hungary’s

increasing attraction for short-term investors solely motivated by the pro-

spect of EUmembership (NOL 5, 6, 7, 10, 13 December, 2002). In the early

years of transition such grave discontent would have most likely ended

Jarai’s career as president of the National Bank of Hungary. However, in

2002, the policy deadlock could not be resolved by Jarai’s resignation or

removal, despite continuing political allegations of his abuse of institu-

tional independence for partisan decisions.

Earlier Hungarian prime ministers dismissed central bankers or readily

accepted their ‘voluntary’ resignation if they appeared not loyal or co-

operative enough. Indeed, appointments of new National Bank presidents

and efforts to strengthen central bank independence occurred in a reveal-

ing 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-

placement of president Gyorgy Suranyi by Peter Akos Bod of MDF in 1991

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 Suranyi, whose authority was not

questioned as long as the Horn government was in power. Although

Suranyi served his term, by its end, he was vehemently attacked byOrban’s

minister of finance, Jarai. While Suranyi 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 Jarai.

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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 justministers of finance

but even primeministers. ‘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 influen-

tial 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

Jarai 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 Term in office

National Bankof Hungarypresident Term in office

Jozsef Antall May 1990–Nov. 1993

Ferenc Rabar May 1990–Dec. 1990

Gyorgy Suranyi May 1990–Dec. 1991

Peter Boross Dec. 1993–June 1994

Mihaly Kupa Jan. 1991–jan. 1993

Peter Akos Bod Jan. 1992–Dec. 1994

Gyula Horn July 1994–June 1998

Ivan Szabo Feb. 1993–June 1994

Gyorgy Suranyi Jan. 1995–Dec. 2000

Viktor Orban July 1998–May 2002

Laszlo Bekesi July 1994–Feb. 1995

Zsigmond Jarai Jan. 2001–

PeterMedgyessy

June 2002–Aug. 2004

Lajos Bokros March 1995–Feb. 1996

FerencGyurcsany

Sept. 2004– Peter Medgyessy March 1996–June 1998

Zsigmond Jarai July 1998–Dec. 2000

Mihaly Varga Jan. 2001–May 2002

Csaba Laszlo June 2002–Feb. 2004

Tibor Draskovics March 2004–April 2005

Janos Veres May 2005–Months inoffice (average)

30 18 45

Sources:Magyarorszag Politikai Evkonyve (Yearbook of Hungarian Politics) Budapest: Demokracia Kutatasok MagyarKozpontja Alapitvany. Various volumes.Heti Vilaggazdasag April 23, 2005: 8.

189


while the prime minister retained a right of veto (Gyenis 2004; Varhegyi

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. Jarai resisted

any significant lowering of the interest rate until it was too late. Govern-

ment technocrats, and even independent experts and some monetary

council members, criticized his intransigence as unnecessary and harmful.

However, speculators interpreted Jarai’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 interven-

tion 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. Accord-

ing to the amended National Bank of Hungary Act of July 2002, Jarai 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; Varhegyi 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, do-

mestic 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 Laszlo,

referring to a consensus between the government and the monetary coun-

cil, 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 inministry budgets

across the board, stricter eligibility criteria for housing loan subsidies, and

wage policy constraints in the public sector. Thesemeasures weremeant to

achieve improvements both in export competitiveness and in the budget-

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ary position against the background of deteriorating economic perform-

ance. 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 Sandor Demjan, 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 Demjan

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) Dem-

jan’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

revealedmuch less sensitivity for social welfare issues than the left-leaning

rhetoric of FIDESZ–MPSZ.

Parallel to the above suggestions some scholars and policymakers iden-

tified a European template of negotiated industrial relations (‘new corpor-

atism’) 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 char-

acterized this solution as preferable to its alternative: ‘if financial market

actors consider the Hungarian economy too risky. . . they will refrain from

investment. Disinvestmentmight provoke sharp depreciation, accelerated

191


inflation, and erode previously achieved real wage gains’ (Bruszt, Oblath

and Toth 2003).

An Old Government Toppled by New Problems, and a New GovernmentStruggling 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 Orban’s policy-

makers, 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 wel-

fare and public services and increasing revenues from taxes and privatiza-

tion—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’ solu-

tion 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 per-

formance and an adverse change in the political climate, and consistent

with its original aversion to a fast-track strategy, the Medgyessy govern-

ment 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 Laszlo Kovacs andMedgyessy had

to resign.

In Autumn 2004, Ferenc Gyurcsany, 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 experi-

enced adversaries. On EMU-related issues Gyurcsany 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 Hun-

garian politics than the conflict provoked by the new amendment of the

central bank law. The verbal duel that took place between Orban and

Gyurcsany in late 2004 reflects both the lack of any significant advance

towards reconciliation since 2002 and the increasing costs of the deadlock.

Orban’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 Gyurcsany: ‘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 eco-

nomic development impossible’ (Csabai 2004: 6). Predictably, while

Gyurcsany gave weight to his concerns by a joint public declaration signed

with MGYOSZ, Orban sided with Jarai’s concerns that the intervention

violated the National Bank of Hungary’s independence and undermined

the stability of the forint. Jarai 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

193


independent experts warned that a drop in the interest rate and specula-

tive 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 Hungar-

ian 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 inten-

sified 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. How-

ever, 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

withinadiscursivespacedefinedandtightlycompressedbyEuropeanization.

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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 mon-

etary 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 ex-

change-rate policies have beenmore strongly affected by a divisive process

of ‘bottom-up’ Europeanization, in which domestic actors instrumenta-

lized a variety of Europeanmodels, 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 transnational-

ized 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, Hun-

gary 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 devel-

opment?

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 distribu-

tional struggles and stronger resistance to certain policies than in some

other East European countries. In this sense, Hungary shares older mem-

bers’ apparent problems with the EMU straitjacket.

Second, because of Hungary’s early start and rapid advance on a labour-

intensivemanufacturing export path, a relatively powerful transnationally

195


integrated andpolitically 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 labour-

intensive 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 corpor-

ations of east European origin. The question of whether to keep these firms

at home or encourage their eastward expansion became central for devel-

opment 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 signifi-

cant 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 mem-

bership 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 uncoordin-

ated, 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 macroeco-

nomic conditions, policy legacies and party political considerations. The

stability of the Polish central bank’s policy choice was reinforced by acces-

sion conditionality and by a domestic elite consensus. In fiscal policy, by

contrast, Polish financeministers largely failed tomatch 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 eco-

nomicsministry within the core executive, and limited external empower-

ment from the European Union. This constellation of monetary and fiscal

1 The author would like to thank Frank Bonker, Kenneth Dyson, Vesselin Dimitrov, BelaGreskovits, Klaus Goetz, Jim Rollo, and other participants of the British Academyworkshop on‘Enlarging the Euro-zone: the Euro and the Transformation of East Central Europe’ for theiruseful comments and suggestions on an earlier version of this chapter. The author also thanksBartlomiej Osieka for research assistance.

197

leadership resulted in an unbalanced pattern of domestic convergence

with EMU. Although, in late 2004, Poland did not meet any of the nom-

inal criteria for EMU membership, it clearly missed the monetary criteria

by a narrow margin, while divergence in fiscal policy was more pro-

nounced (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 observa-

tions about themodalities 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 adapta-

tion to EMU. Significantly, it identifies accession conditionalities as a

major resource empowering domestic leaders (see Dyson 2002; Feather-

stone 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 illustra-

tion 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.

Table 10.1. Poland: fiscal and monetary convergence with the Maastricht criteria1997–2004

1997 1998 1999 2000 2001 2002 2003 2004

Government deficit �4.0 �2.1 �1.4 �0.7 �3.8 �3.6 �3.9 �5.6Public debt 44.0 39.1 40.3 36.8 36.7 41.1 45.4 47.2Long-term interest rate n/a n/a 9.53 11.79 10.68 7.32 5.78 6.9Inflation (HICP) 15.0 11.8 7.2 10.1 5.3 1.9 0.7 2.5

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

198

Unbalanced Domestic Leadership in Negotiating Fit

http://europa.eu.int/comm/eurostat

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 stra-

tegic preference for using external discipline to secure domestic macro-

economic stability (Dyson, Chapter 15; Lutkowski 2004; Orlowski 2004).

Using direct inflation targeting, the bankmanaged to lower inflation from

15 per cent in 1997 to an all-time lowof 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

levelnot exceeding3–5per cent ayear’ (RPP1998: 4).As Polandapproached

EUaccession, EMUmoved to the topof 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

afteraccession, that is, in2007(RPP2003).Themonetarypolicystrategywas

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 macroeco-

nomic risks to which Poland’s floating exchange rate regime was exposed

199


(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 advo-

cated 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 minim-

ize 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 induc-

ing 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 ap-

pointment, Balcerowicz had been leader of the economically liberal Free-

domUnion (UW) andfinanceminister in theAWS-UWgovernment, 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-in-

clined, 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 Demo-

cratic, LabourUnion, 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 mem-

bership 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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haste (Slojewska 2002b). The lack of external empowerment was, however,

compensated by the bank’s domestic autonomy, which allowed it to pur-

sue its preferred policy. The central bank had had its independence en-

sured 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 con-

stitutional 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 independ-

ence after appointment. The deep institutionalization of the National

Bank of Poland’s and its monetary policy council’s independence re-

inforced the bank’s bargaining position vis-a-vis the government and

allowed it to maintain a policy aimed at rapid disinflation.

Thebank’s choiceofmonetarypolicywas further reinforcedby economic

conditions.Significantly,akeyrationalebehindthe1999decisiontoadopta

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 inflowsof foreigncapital (cf.Belka2001;Rostowski2003).By tightening

Table 10.2. Polish prime ministers, finance ministers, central bankgovernors, and party composition of cabinets

Prime ministers Finance ministers Parties NBP governors

Jerzy Buzek(1997–2000)

Leszek Balcerowicz AWS, UW Hanna Gronkiewicz–Waltz (1992–2000)

Jerzy Buzek(2000–1)

Jaroslaw Bauc(2000–1)

AWS

Leszek Miller(2001–3)

Marek Belka(2001–2)

SLD, UP, PSL Leszek Balcerowicz(2000—present)

Grzegorz Kolodko(2002–3)

Leszek Miller(2003–4)

Grzegorz Kolodko(2003)

SLD, UP

Andrzej Raczko(2003–4)

Marek Belka(2004–2005)

Miroslaw Gronicki(2004–5)

SLD, UP

Source: Own compilation.

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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 slowdownwas influencedby the experienceof 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 (Slo-

jewska2002d). Thus,when responding todeclining inflation in2000–1, the

council preferred to err on the side of caution. It waited until February 2001

tocarryout thefirst reduction in interest rates and,eventhen, loweredthem

ina seriesof small steps rather thansweepingcuts. This strategycontributed

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 andweak recovery (Belka

2001; Orlowski 2004). The government called on the council to substan-

tially 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, theMiller cabinet made a written commitment to pursue a restrict-

ive fiscal policy in 2002–6 (see below). When, unimpressed by these prom-

ises, 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 chan-

ging 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 un-

employment and rapid disinflation, the bank is obliged to support the

government’s policy by reducing interest rates (Sejm RP 2002).

However, theMiller government did not succeed in inducing the central

bank tochange itsmonetarypolicyas theproposedchangeswere rejected in

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mid–2002. A key factor that reinforced the status quowas the Polish consti-

tution. 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 themonetary 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 sal-

vaged by a strategic domestic coalition of high-level technocrats and polit-

ical 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 rela-

tively 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 fi-

nances. 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, sched-

uled 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 amere 15 per cent of the vote. Hence, the AWS party wished to

avoid a painful fiscal rationalization, fearing a further decline in its elect-

oral fortunes. The prospect of fiscal stabilization was further undermined

by the disintegration of the AWS party in late 2000. Its demise was accel-

erated 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 intra-

party 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 (Rzeczpos-

polita 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 educa-

tion, 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 Janu-

ary 2002, went as far as to lay down definite amounts of aggregate expend-

iture 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 acces-

sion, 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 spendingcuts andenter intoafiscal contract.Agovernmentofficial

said: ‘nobody was more grateful to Bauc for revealing the true scale of the

fiscal imbalances thanMiller and Belka, who used this to justify the painful

decisions that had to be made at the start of the term’ (interview January

205


2005, Warsaw). Besides using the budgetary crisis, Belka was able to justify

his proposals by arguing that some evidence of fiscal tightening was neces-

sary if the government wanted the central bank’s monetary policy council

to effect deeper and quicker reductions in interest rates. The financeminis-

ter’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 primeminister 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 ra-

tionalize spending. During the adoption of the guidelines for the 2003

budget, however, finance minister Belka lost his bid for further rational-

ization of public spending. The informal cabinet meeting in early July

2002 demonstrated that line ministers were unwilling to reassign expend-

itures within their budget heads to find resources for new policy projects.

The cabinet adopted budget guidelines that provided for a total expend-

iture 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 div-

ision 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 cab-

inet, 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 contest-

ing 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 sup-

ported 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 labour-

market 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 un-

employment (Raciborski 2002; Olczyk 2002a). Meanwhile, electoral con-

siderations became a top priority for the SLD due to the approaching local

government elections scheduled for September. A poor electoral perform-

ance would havemeant 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 conver-

gence, 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 associ-

ated with the era of high growth in the mid-1990s and his appointment

helped to boost political confidence. But, although the new finance min-

ister 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 in-

crease 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. Kolodkomanaged to persuadeMiller that

early EMU membership would be politically beneficial because it would

solve the problem of restrictivemonetary policymaintained 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-termmonetary policy strat-

egy, 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 pack-

age 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 col-

lapsed when, in May 2003, the primeminister 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, whichmade 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 rapidmembership in EMU. Both these institutionswere concerned

208


that, once EMU members, Polish decision-makers would not show suffi-

cient 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, financeminister 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. BetweenMarch and April 2003, he emerged as a competi-

tive 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 endorse-

ment from trade unions and the business community. The finance minis-

ter’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,

209


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) maymake it difficult to implement structural adaptations in

the Polish economy that are more important for delivering lasting eco-

nomic 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’ (Les-

niak 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 Euro-

pean Commission warned that, once Poland joined the EU inMay 2004, it

would be required to present a credible plan for achieving fiscal conver-

gence: 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 govern-

ment to prepare a balanced budget (Rzeczpospolita 2003).

Responding to these external and domestic opportunity structures, eco-

nomics and labour minister Hausner prepared a public finance stabiliza-

tion 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

210


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 imple-

mentation, 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 inMarch 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 sched-

uled for June 2004. The SLD began to suspect that, in the face of plummet-

ing 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 under-

mined party discipline within parliament and forced the formally minor-

ity 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 irregu-

larities 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 tomake 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 struc-

tures 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 inwhich funded pension schemes were classified in

the budget. In late 2004, finance minister Miroslaw Gronicki made delib-

erate 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

primeminister 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 pol-

icies 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

212


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 mon-

etary 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 Haus-

ner 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 entrepre-

neurship. 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 inde-

pendence 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 justi-

fication 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 coali-

tion government greatly facilitated the commitment to a fiscal contract in

2001, whereas the weak and disintegrating AWS and later SLD-UP govern-

ments proved unable to provide political leadership in fiscal policy. Polit-

ical party competition also extended to the Polish central bank, whose

governor had been closely identified with the opposition parties and was

213


often accused of imposing deliberate constraints on the work of the gov-

erning 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 excel-

lence in a sea of low institutional capacity to deliver on the formal and

informal conditionality attached to euro entry. Of all the ten East Euro-

pean candidates, Romania’s domestic context offered arguably the poorest

‘goodness of fit’ (Borzel 1999) with the letter and the spirit of the EMU

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 pol-

icies 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.

215

Romania’s laggard role was summed up when it was the last of the

initial ten Central and Eastern European applicants1 to conclude accession

negotiationswith the EuropeanCommission on 9December 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 asNovember 2003, the EuropeanCommission

(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 imple-

mentation of eleven additional measures in these fields, envisaging a one-

year 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 strin-

gent. 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 polit-

ical stability and amuch 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 join-

ing the Euro Area by 2014 (Table 11.1).

1 Bulgaria, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Poland, Romania, Slo-vakia, and Slovenia.

216

Romania as Eastern Europe’s Sisyphus

Table 11.1. Primeministers, finance ministers, government coalitions, and central bankgovernors in Romania, 1989–2004

Prime minister Finance minister Supported byCentral BankGovernor

26.12.89–20.6.90 Petre Roman (FSN) Victor Stanculescu(military)

FSN

Teodor Stolojan(non-affialted)

20.6.90–26.9.91 Petre Roman (FSN) Teodor Stolojan(non-affiiated)

FSN Mugur Isarescu1

Eugen Dijmarescu(FSN)

1.10. 91–4.11.92 Teodor Stolojan(non-affiliated)

Gheorghe IonDanielescu (PNL)

FSN/FDSN þPNL þ MER þPDAR

Mugur Isarescu

4.11.92–6.3.94 Nicolae Vacaroiu(non-affiliated)

Florin Georgescu(non-affiliated)

FDSN/PDSR Mugur Isarescu

6.3.94–3.9.96 Nicolae Vacaroiu(non affiliated;PDSR)


PDSR þ PUNR2 Mugur Isarescu

3.9.96–12.12.96 Nicolae Vacaroiu(PDSR)


PDSR Mugur Isarescu

12.12.96–30.3.98 Victor Ciorbea(PNTCD)

Mircea Ciumara(PNTCD)

CDR (PNTCD,PNL, PAR) þPD3 þ UDMR

Mugur Isarescu

Daniel Daianu(non-affiliated)

2.4.98–14.12.99 Radu Vasile (PNTCD) Traian DecebalRemes (PNL)

CDR (PNTCD,PNL, PAR4) þPD þ PSDR þUDMR

Mugur Isarescu

22.12.99–28.12.00

Mugur Isarescu(non affiliated)

Traian DecebalRemes (PNL)

CDR (PNTCD,PNL) þ PD þPSDR5 þ UDMR

Mugur Isarescu

28.12.00–21.12.04

Adrian Nastase(PDSR/PSD)

Mihai NicolaeTanasescu(PDSR/PSD)

PDSR/PSD Mugur Isarescu

29.12.04 - present Calin Popescu-Tariceanu (PNL)

Ionut Popescu(PNL)

DA (PNL, PD)þ UDMR þ PUR

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 MovementPAR: Alternative Party of RomaniaPD: Democratic PartyPDAR: Agrarian Democratic Party of RomaniaPDSR: Party of Social Democracy in Romania (PSD > 16 Jun 2001)PSD: Social Democratic PartyPNL: National Liberal PartyPNTCD: National Peasant Party Christian DemocraticPUNR: Party of Romanian National UnityPUR: Humanist Party of RomaniaUDMR: Hungarian Democratic Federation of RomaniaSource: Author’s own calculations.

217


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 Euro-

peanization literature has been that the non-negotiable content of the EU

acquis, coupled with the strong conditionalities and the huge power asym-

metries associated with the enlargement process, produce strong adapta-

tional 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 vari-

ous 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 dem-

ocracies. 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 eco-

nomic andmonetary 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: DomesticBlockage and Elusive Europeanization

The violent overthrow and subsequent execution of Romania’s commun-

ist 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 ex-

treme 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

218


reservesexceeded1.7billionUSdollars (Daianu1997:97). In theprocess the

Romanian people suffered unimaginable hardship. The draconian restric-

tions on imports resulted inmajor shortages of basic goods, and household

energy consumptionwas severely rationed (Ronnas 1991). By theendof the

decade the economic implosion caused by the debt-repayment programme

reducedGDPpercapitabyalmostone-third,makingRomanians the second

poorestnation inEasternEurope (aheadofAlbania),withayearly incomeof

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 Czechoslo-

vakia 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 out-

look of the FSN was blurred, reflecting the diverse origins of its supporters

and the conflicting personal ambitions of its leadingmembers. Overall the

party engaged in a heavily patriotic and populist rhetoric, constantly

emphasizing the virtues of national unity and social cohesion. This rhet-

oric 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 andmonetary 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’, encapsu-

lated 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

219


Democratic Party—PDSR) with a powerful network of electoral support

and a rich source of political financing. The heavy shadow of an increas-

ingly 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 Roma-

nia’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 prom-

ises, 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 coali-

tion withered away and was followed by a quick succession of govern-

ments 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 twomajor recessions

during 1991–3 and 1997–8. In the intervening periods export-led eco-

nomic 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

averagingwell over4percentofGDP. Fiscal imbalanceswere further exacer-

batedby the existenceof substantial quasi-fiscal deficits thatwere fuelledby

bad debts between state-owned enterprises and tax arrears, as well as gov-

ernment subsidies on fuel for both industrial and domestic consumption.

220


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 mis-

management 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 confi-

dence in the Romanian currency remained low, and the country experi-

enced 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 eco-

nomic transition during the 1990s highlights a weak adaptive and antici-

patory Europeanization of economic and monetary policies compared to

other east European states. For many central European and Baltic appli-

cants 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 Ro-

mania this domestic context was shaped by the catastrophic legacies of the

Ceausescu era, powerful veto players in the state-owned sectors, the ab-

sence of a post-communist elite knowledgeable about market economies,

221


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 constella-

tion that failed to respond adequately to the adaptational pressures asso-

ciated with EU and with EMU accession.

In July 1997, the Commission’s Opinion on the Romanian EU member-

ship application listed the shortcomings of its transition process in painful

detail. Romania had failed to meet the Copenhagen criterion on a func-

tioning 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 inMarch 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 appli-

cants in their ascent of the EU ladder of contractual relations with post-

communist 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 eco-

nomic strategy structured around a strong commitment to complete EU

accession negotiations by the end of 2004.

Post-Helsinki Romania: External Empowerment andUnlikely 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

222


supported the NATO-led operations against Serbia. The new European

Commissioner for Enlargement, Gunter Verheugen, argued for an end to

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 pro-

posals 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 eco-

nomic 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 tradition-

alists 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 unexpectedwindow 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 con-

tinued, Romania risked real and imminent international isolation. Against

this background, theNastase government’s target for completing accession

negotiationsbytheendof2004introducedarenewedsenseofurgencyanda

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) helpedRomania’sweakpublic

223


administrationtoidentifyspecificreformagendas foreachpolicyareaunder

discussion.TheCommission’sclosescrutinyover thedesignandimplemen-

tation 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 im-

provement 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) policymak-

ing. 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 cab-

inet fully and to coordinate its work effectively. Unlike most of his prede-

cessors, Nastase was able to address this problem with some success,

mainly through the strengthening of the General Secretariat of the gov-

ernment 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 Roma-

nia’s macroeconomic indicators was remarkable (European Commission

2004e: 22). Annual GDP growth averaged over 5 per cent, driven predom-

inantly 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 vulner-

abilities 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.

224


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 en-

terpriseswereprivatizedby theendof2003 (WorldBank2004b: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, par-

ticularly, 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 for-

eign investors in 2003–4. In the energy sector the government proceeded

with the breaking up of the electricity (CONEL) and gas (ROMGAS) mon-

opolies, 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 privatiza-

tion of some of Romania’s loss-making industrial mammoths partially

eased the pressure for direct government subsidies. However, the govern-

ment’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 invest-

ment 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 failuresduring the1990s.Within thecontextofRomania’s turbulent

democratic consolidation the distinction between pro-European modern-

izers and unreconstructed communist sympathisers had become increas-

ingly blurred and highly interchangeable. The prospect of claiming the

prized conclusion of EU accessionnegotiations during their tenure in office

galvanized theSocialDemocrats to support a reformagenda that ranagainst

the ideological grainofmanyof their leadingmembers.Had theprospect of

EU membership not been so credible and tied to a timetable, it is highly

225


unlikely that the impetus for reformwouldhave able to overcomepowerful

domestic veto points. In short, EUgate-keeping strategywas a crucial factor

in shaping the domestic discourse of reform and in altering domestic op-

portunity 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 eco-

nomic 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 andFuture 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 mem-

bership of EMU. First and foremost, the EMU acquis for EU entry required

226


legal compliance with ECB and European Commission opinions on cen-

tral bank independence. In June 2004, the Nastase government intro-

duced 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 cen-

tral bank’s new role was viewed with suspicion by many traditionalists

within the PSD who, during the course of the 1990s, had grown accus-

tomed 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 Na-

tional 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

227


institutions best equipped to perform its tasks, with regard both to the

quantity and qualification of staff’ (European Commission 1999).

TheNational Bankof Romania’s domestic strengthwas also reinforcedby

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

Thismade himby far the longest-serving public official in Romania, andhe

wasby2005 the third longest-servingcentral banker in theworld. Theother

eightmembers of theNational BankofRomania’s Board alsohadapowerful

claim to independence, having been appointed (like Isarescu) for a renew-

able five-year term through consensual procedures involving both cham-

bers 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 to-

wards 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 ‘lend-

ing 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 Gov-

ernor ‘ . . . 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 politiciza-

tion and unpredictability that has dogged Romania’s economic policy-

making 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 hisrole as president of the National Bank of Romania.

228


introduced a sharper focus of its policy objectives, with price stability now

recognized as the bank’s ‘primary’ responsibility (Article 2). This redefin-

ition 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 re-

sponsibility in this respect. Yet its new priorities carry with them signifi-

cant 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 repu-

tation and accountability to the Romanian public. Above all, however, its

biggest test will be its ability to exercise its responsibilities with the sig-

nificant 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 (particu-

larly 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 govern-

ment. 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 govern-

ment 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

229


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 mul-

tiple 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 inte-

gral part of the effort to curb inflation, the pressure to sustain an over-

valued 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 sur-

vive, 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 mar-

kets took a turn for the worse in 1998, the leu came under strong pressure,

leaving the National Bank of Romania struggling to contain its depreci-

ation 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 onwhether 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 incen-

tive 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 ofmonetary policy as ameans 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

230


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

bankingmelt down, similar to the one experienced by Bulgaria in themid-

1990s, 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 competi-

tiveness of the Romanian economy. This strategy remained largely un-

changed 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 macroeco-

nomic performance, this announcement of the National Bank of Roma-

nia’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 freemarket. 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 bub-

bles, 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 eco-

nomic growth and fragile reputation as an attractive place for investment.

231


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—an-

nounced 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 domes-

tic 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 be-

came apparent, the appetite for change grew stronger, but its success was

ultimately compromised by an unsuccessful policy-mix, poor implemen-

tation, and political infighting. The process of macroeconomic stabiliza-

tion did not start until the very end of the 1990s, before gathering pace. In

232


comparison, the progress on structural reform has been slower, with pri-

vatization 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 Ro-

mania is a testament to the domestic transformational effects of EU en-

largement. 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 domes-

tic reformers and, not least, the National Bank of Romania. More import-

antly, the process of negotiating with the European Commission imposed

on the Romanian government strong conditionalities and a tight time-

frame for the pursuit of domestic reform. While international financial

institutions like the IMF have had a significant impact in designing Roma-

nia’s strategy for economic recovery, the need for compliance with the

Single European Market and the EMU acquis has shaped the overall con-

text of reform. The coincidence of the new Alliance government with

difficulties surrounding the accession agreement in 2004–5 added a fur-

ther 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.


233


Part III

Patterns of Sectoral Governance


12

Financial Market Governance: Evolution

and Convergence

Piroska Mohacsi 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 increas-

ingly sophisticated financial services (Table 12.1). Financial intermedi-

ation, 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 pol-

icy 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 govern-

ance and the role played by EU accession and EMU in this process. It

237

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’ Europeaniza-

tion in the wake of bank crisis, in the second an extreme form of ‘top-

down’ 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 require-

ments. 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 manage-

ment 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.

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

1989 2005

State ownership Privatization is almost complete inmost countries

Most banks are domestically owned‘pocket’ banks, serving specific industryor client interest

Majority of banks owned by well-establishedforeign strategic investors; regulations limitconnected lending

Poor governance structurefavouring insiders

Improved governance structure with tightercontrols on related party transactions andbetter transparency

Financial sector consisting onlyof commercial banks

Non-financial sector is emerging (insurance,mortgage banks, pension funds), but banksare still dominant

Lack of medium and long-term lending Maturities extended, albeit still not fullymeeting demand for long maturities

Little bank finance of enterprise investmentor of household mortgages

Rapidly increasing bank finance of householdsand firms

Low financial intermediation Rapidly increasing albeit still low level relative toeconomic development and levels in EU/Euro Area

Poor bank asset quality Much improved thanks to balance sheet clean-ups,restructuring, and privatization. Risk managementtechniques more widely used

Banking supervision/regulationdoes not exists

Regulatory framework being brought up toEU standards

Pervasive legal uncertainty Significant legal reforms have taken place inconformity to EU standards

Financial Market Governance

238

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 productiv-

ity, 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 sub-

optimal 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 alloca-

tion. 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 monitor-

ing (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 share-

holders 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 informa-

tion about bank behaviour and performance weakens traditional govern-

ance 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


239

the whole economy. In other words, the banking sector has strong exter-

nalities for the rest of the economy. But the opaqueness of the sector’s

governance structure can also be a factor in higher government interven-

tion. 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. Regu-

lations 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, regu-

lators 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 Governanceduring Transition

Financial sector transformation in the CEE has been marked by the inter-

play of these two special aspects of financial market governance: its spe-

cific structure and the degree of government regulation in the sector. At

the outset of transition—the t�1moment—there was absolute government

intervention: banks were government-owned, performing quasi-fiscal

operations, that is, providing capital to enterprises on the basis of govern-

ment 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 dif-

fered, of course, according to the degree of the given country’s pre-transi-

tion 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 gov-

ernancewas astoundinglypoor, and therewasnogovernment regulation at

all. Bokros (2001), in oneof thebest analyses of the period, vividly describes

this environment where state-owned banks coexisted with newly estab-


240

lishedbanksmushrooming in theabsenceofa regulatoryenvironment.The

apparent lack of government regulation—apart from some initial restric-

tions 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, orpricinghelped thegrowthof a largenumberof institutions,

fuelling competition. At the same time, there were no prudential regula-

tions regarding capital adequacy, liquidity, basic portfolio classification,

and provisioning. There were no market-based deposit insurance schemes

either: state-ownedbankswereunderstoodtobecoveredbystateguarantee,

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 regula-

tion. In this setting, operations favouring managers, owners, and political

lobbies to the disadvantage of depositors and investors—and ultimately

the taxpayer—becamewidespread. 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 formid-

able 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


241

GDP, the Czech Republic—18 per cent of GDP, and Hungary—13 per cent

of GDP (Szapary 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’

Thefirst elementof thepolicy response to the recurringbanking sectorcrisis

wasprivatizationtoforeignstrategic investors, almostexclusively 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 purchasingpower, it providedmuchneeded revenue to the

budget. Second, after a series of bank failures that hadblatantly 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 condi-

tions 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 in-

vestorwas important, asgovernments realized that furtherdelays in reform-

ing 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

upparticipationsonthebasis that theyresided intheEU15,anarea towhich

all countrieswanted to linkup andeventually join.Withparent banks from

the EU15—and eventually from the Euro Area—dominating the central

European banking sectors, financial sector integration into the EU ‘leap-

frogged’ in amajor way at the level of the firm.


242

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 Yugosla-

via’s version of privatizing firms to workers by design excluded foreign

investors. However, these schemes spectacularly failed to produce a work-

able 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 credit-

worthiness. After painful and costly crises, eventually all countries con-

verged 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

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 im-

portant 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 own-

ership 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 EUmembers, 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 presencemay have

helped to implement difficult reformmeasures, and it may have alsomade

major policy backsliding politically more difficult. The causality may have

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

Foreign banks Domestic banksPrivate Public

Czech Republic 96.0 3.0 1.0Estonia 97.5 2.5 0.0Hungary 83.3 14.4 2.3Lithuania 95.6 4.4 —Latvia 46.3 49.5 4.1Poland 67.8 7.8 24.4Slovenia 36.0 40.2 23.8Slovakia 96.3 0.0 3.7Memo items: . . . . . .EU15 18.3 . . . . . .Selected emergingmarkets in Asia*

6.0

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


244

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 quantita-

tive 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 gen-

eral (in terms of board independence, oversight of related-party transac-

tions, 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 CEEmarket 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 subsi-

diaries 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

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

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 (per-

centage of total assets owned by foreign banks and index value respectively)


245

parent banks’ operating profits in 2003 (Austrian National Bank 2004).

Overall, for a number of large European banks, the CEEmarket 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 signifi-

cant 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 SupervisorySystem: 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

0

20

40

60

80

100Raif

feise

nErs

te

KBCSwed

bank

Unicre

dito

ncaI

ntes

aHVB

SEBVolk

sban

kSoc

Gen ING

Citiban

k

Figure 12.2. Share of CEE market in a bank’s total assets (percentage, 2003) (per-

centage of total assets owned by foreign banks and index value)

Sources: Bankscope, EBRD.


246

were required to line up their financial regulation, supervision and com-

pliance with the relevant EU directives. According to the ECB (2005), the

most important European Banking Directives—concerning bank regula-

tions, insurance, clearing, and payments systems—have been implemen-

ted, although some tasks remain in the area of contract enforcement and

creditor rights.

Themechanism 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 Inter-

national Settlements/Basle process of banking supervision, itself an evolv-

ing 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 Inter-

national 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, theEuropeanCentralBankhasestablishedanevenstronger

collaborationwithnewEUmemberstates,asallof themeventuallywilladopt

the euro. ECB advice and technical assistance in the area of monetary and

exchange-rate policy, and to someextentbanking sector reform,has become

the source of perhaps themost important foreign influence inCEE countries

as well as providing direct support for national central banks. Beyond infor-

mally 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).

Wherecentral banksarealso theagencyofbanking supervision, thisnetwork

has supported banking supervisors aswell.

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’ Com-

mittee 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

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 con-

vergence 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 sys-

temically important domestic banks are also supervised, via their parent

bank, by the latter’s own (home) supervisors. In this context, informa-

tion 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 regula-

tory 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 super-

visors. 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

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 instru-

ments of banking supervision to the home country supervisor, according

to their respective national laws they continue to be responsible for finan-

cial 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 manage-

ment arrangements, involving 25 (and soon 27) countries, which con-

tinue to operate under different fiscal and monetary frameworks. EMU

membership with one central bank should help. For the foreseeable


249

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 man-

agement 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 ten-

sion 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 lag-

gards. 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

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 estab-

lished 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,

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

Depositinsuranceexists?

Bank- orgovernment–funded?

Limitamount

Can DI decideto intervenein a bank?

CzechRepublic

Yes (1994) Banks n 25,000 No

Estonia Yes (1998) Both Equivalent of n 6,391,to increase to n20,000in 2008

No

Hungary Yes (1993) Banks Equivalent of about n25,000 YesLatvia Yes (1996) Both Equivalent of n 8,535,

to increase to n18,492 in 2009Yes

Lithuania Yes (1996) Both Equivalent of n 14,481;toincrease to n20,000 in 2008

No

Poland Yes (1995) Banks n 22,500 NoSlovakia Yes Banks n 20,000 NoSlovenia Yes (2001) Banks Equivalent of about n 21,455 Yes

Sources: National governments, IADI, ECB.


251

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? Assessingthe 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 remark-

able 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 remain-

ing gaps.

Financial Sector Development: Hungary, Estonia, and Poland asPacesetters

The EBRD has developed two indices to measure progress towards stand-

ards seen in the EU (and in general in advanced economies): one measur-

ing progress in the banking sector (the predominant part of the CEE’s

financial sector), and the other progress in developing non-bank institu-

tions (insurance, pension funds, mortgage banks, etc.). An index assesses

the extent and quality of the sector’s regulations, associated legal frame-

works 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 EUmembers havemademore 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

associated with the Russian crisis in 1998. Reform in the non-bank finan-

cial 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 every-

where 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

00.5

1

1.5

2

2.5

3

3.5

4

4.5C

zech

Rep

ublic

Esto

nia

Hun

gary

Latv

iaLi

thua

nia

Pola

nd

Slov

akia

Slov

enia

EU standard

19972004

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

Source: EBRD 2005.


253

overlaps (the supervisory board is independent and rules for nomina-

tion 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 separ-

ation 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 remu-

neration 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. Never-

theless, 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 require-

ments 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

00.5

11.5

22.5

33.5

44.5

Cze

ch R

epub

lic

Esto

nia

Hun

gary

Latv

iaLi

thua

nia

Pola

nd

Slov

akia

Slov

enia

EU Standard

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

Source: EBRD 2005.


254

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 execu-

tive 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 require-

ments for two-tier board systems for their acquired local subsidiary bank,

even if their own governance structure is different. However, they typic-

ally 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 (oftenmainly 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 cor-

porate 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 sophistica-

tion. The higher share of sovereign lending in the EU10 relates to large


255

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. Pre-

transition 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 enter-

prises (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 instru-

ments, 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, loan-

loss 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 ismitigated by higher capital adequacy in new EU10 banks

than in the EU15 (Table 12.5) (average regulatory capital is higher in both

regions than theminimumBasle requirement of 8 per cent). Moreover, the

new EU10 members’ banks have almost exclusively ‘high-quality’ tier-1

Table 12.4. Portfolio structure of banks in Hungary and theEU15

Portfolio(percentage of total)

Hungary EU15Corporate 46.4 17.2Sovereign 18.6 7.0Bank 10.4 15.4Retail 8.3 24.5SME 14.0 15.1Securitized assets 0 1.0Trading book 2.2 14.3Other 0.1 5.5

Sources: EBRD and PricewaterhouseCoopers.


256

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 Profitabilitybut 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 FinancialDeepening

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 pre-

enlargement EU15, expectations of real exchange rate appreciation, in

0

0.05

0.1

0.15

0.2

0.25

Bulgar

ia

Croat

ia

Czech

Rep

.

Estonia

Hunga

ryLa

tvia

Lithu

ania

Poland

Roman

ia

Slovak

Rep

.

Sloven

ia

EU15

Non-performing loans (% of total loans), 2003

average

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

Source: ECB, Fitch Ratings, IMF.


257

some cases still sizeable nominal interest rate differentials, and the ensu-

ing capital inflows. The main financial channel for this convergence is the

ongoing rapid credit growth in the region, which reflects genuine finan-

cial 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 finan-

cial 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,

0

2

4

6

8

10

12

14

16

EU15 EU10

Tier 2

Tier 1

Basel minimum

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

Source: ECB.

Table 12.5. Bank profitability and efficiency, 2003

EU10* EU15

Return on equity (ROE) 11.6 9.9Return on assets (ROA) 0.85 0.41Total income (in percentageof assets)

4.37 2.38

Liquidity 14.9 2.2(cash and t-bills as percentageof total assets)Cost to income ratio 64.9 60.4

Source: ECB includes Cyprus and Malta.


258

owing tomuch improved confidence in overall CEEmacroeconomicman-

agement 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 factor-

ing 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 associ-

ated 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 rea-

sonably efficient banking sector that has been able to increasingly mobil-

ize 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 mem-

bership-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


259

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 mar-

kets, 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 inte-

gration 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 European-

ization is most advanced among all economic sectors and institutions.

Notwithstanding this, EMU admission formally will not depend on finan-

cial 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.


260

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 inmonetary policy EMU

involves a much more complete transfer of authority from national gov-

ernments 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 econ-

omy. 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. Further-

more, fiscal policy decisions have always been intensely political, embra-

cing 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 infla-

tion, exchange rates, interest rates, public debt, and fiscal deficit, the

requirement that a country should have a general government fiscal def-

icit 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 def-

icit 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

261

its own considerable expenditure demands, most directly through the

co-financing of EU structural fund projects and, perhaps more signifi-

cantly 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 inter-

action 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 policy-

makers 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 domes-

tic interests. Depending on the policymakers’ interests and preferences,

the fit could be defined as involving ‘real’ rather than nominal conver-

gence 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


262

the depth and significance of the problems with which a country is faced.

This chapter follows a historical institutionalist approach, which com-

bines 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).

Theapproachused in this chapter is anexpandedversionof theanalytical

framework developed by Mark Hallerberg in his recent book, Domestic

Budgets in a United Europe (2004). He presents a systematic typology of fiscal

institutions,developsa theoreticalexplanationof institutionalchange,and

examines the effect of different types of institutions onpolicy outcomes. In

contrast to the historical–institutionalist approach employed in this chap-

ter, however, Hallerberg’s explanation of institutional change focuses pri-

marily onpolitical actors, giving relatively little attention to the capacity of

institutionstoshapeactors’preferences,andtotheroleofcrises inproviding

windows of opportunity for institutional transformation.

Hallerberg identifies three main types of fiscal institutions: fiefdom,

delegation, and commitment. Fiefdom institutions are highly decen-

tralized, allowing each minister to maximize spending for her or his

department without any serious limitations. Delegation involves the em-

powerment of one minister, who can be assumed to have the general

interests of the government at heart, such as the finance minister and

the primeminister, 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.’


263

. ‘Governmentsmade up of coalitions with few ideological differences are

appropriate for delegation, while those with many ideological differ-

ences 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(andby implication, althoughHallerberg does notmake 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 expect-

ation that they will follow the overall interest of the party or the bloc. In

competitive party systems with more than one dimension of party com-

petition and an electoral systemwith a strong proportional representation

element, it is probable that governments would be composed of ministers

representing parties with significant ideological differences. In such gov-

ernments, 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 iden-

tifies as an important factor constraining defection, depends on the exist-

ence of non-excludable parties. Hallerberg never defines clearly, however,

precisely what characteristics of the party system can make some parties


264

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 com-

mitment, 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 character-

istics 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, fief-

dom, 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 PrAcademicsPress.


265

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 delegation-

type 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 require-

ments and the domestic level.

The first post-communist Hungarian government, formed after the elec-

tions 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, whichmade 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 gov-

ernmental framework. The government itself had been largely decentral-

ized, with the primeminister and financeminister having few hierarchical

powers vis-a-vis their ministerial colleagues. The decentralized fiscal insti-

tutions 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 institu-

tional structures. The exploitation of this window of opportunity was

facilitated by a shift in party composition of government. The 1994 par-

liamentary 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 resig-

nations 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 primeminister. 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


266

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 resig-

nation 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 multi-

year 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 Orban, a coalition of the Alliance of Young Demo-

crats (FIDESZ–MPSZ), the MDF, and the FKGP. Orban’s position as party

leader of the FIDESZ–MPSZ allowed him to dominate his ministerial col-

leagues 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, andwhich 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


267

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 1994–8MSZP–SZDSZ government, primarily as a result of the Bokros

package. In the 2002 election, theMSZP–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 en-

sure that their governments pursue consistently their parties’ policy pref-

erences, 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 govern-

ment’s falling popularity led to a poorMSZP performance in the June 2004

European Parliament elections and the resignation of PrimeMinister 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 theMSZP–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 finan-

cial 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 per-

ceived as a serious concern.

The underlying dynamics of competition between the twomajor parties

on social welfare meant that the negotiation of fit between EMU require-

ments and the domestic level mainly took the form of the development of

a discourse focusing on ‘real’ convergence, that is, on closing the eco-

nomic and social development gap between Hungary and the pre-2004 EU

members, as opposed to achieving a merely ‘nominal’ convergence of


268

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 negoti-

ating 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 discip-

line. 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 breakdownwas not followed by the creation of an

unstable party system, composed of a multitude of weak parties, as hap-

pened, 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 parlia-

mentary 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


269

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 com-

petitive 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 con-

strained 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 Demo-

crats (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 partieswere indispensable to each other created conditions for

an experiment with ‘commitment’ institutions. ‘Commitment’ govern-

ance 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 leaderMilos 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 Spidla eventu-

ally 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


270

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 confirmedwhen a fiscally

expansionary CSSD under Spidla’s leadership won the parliamentary elec-

tion 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, Haller-

berg (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, Spidla 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 Spidla isolated within

his own party (Mitrofanov 2005). Spidla 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

Spidla 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.


271

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 ex-

change 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 con-

trol over monetary policy, but also imposes restrictions on their fiscal

policy discretion. The surrender of such important powers by govern-

ments 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 rep-

resents 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 bewilder-

ing array of governments, including three one-partymajority governments

of the Bulgarian Socialist Party (BSP) (until April 1990, Communist), a one-

party 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


272

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 econ-

omy, 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 signifi-

cant of which was the introduction of a currency board. The board, created

at the proposal of the InternationalMonetary Fund, represented the ultim-

ate recognition of the inability of Bulgarian governments to manage mon-

etary 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 govern-

ment. Governments could still finance the budget deficit by borrowing on

the international financialmarkets, but Bulgarian cabinets since 1997 have

been largely unable or unwilling to resort to that option. Thewillingness of

all themajor political parties to commit themselves to the board hasmeant

that the instability of the party systemand 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 Move-

ment 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 institu-

tions 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 institu-

tional legacies, actors’ choices, and crises, based on a historical institu-

tionalist 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


273

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 dom-

inated by one party, made it possible in some east central European

countries, such as Hungary and Poland, to develop centralized delega-

tion-type institutions. In the Czech Republic, relatively mild fiscal condi-

tions 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 configur-

ation. 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 out-

comes, 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 time-

frame. ‘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,


274

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 per-

formance. 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 Hun-

gary, 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’ para-

digm, 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 re-

inforcement 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 negoti-

ation 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 gener-

ally 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’ institu-

tions, 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


275

cabinet, but even in this case, Klaus’s unwillingness to develop the insti-

tutional powers of the primeminister and the financeminister 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 coher-

ent 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 Haller-

berg [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 cur-

rency 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,


276

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 Euro-

pean 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 post-

poning 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 establishedmember 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 two-

level game of ‘negotiating fit’, the national level is likely to remain pri-

mary in the area of fiscal policy.


277

Acknowledgements

This chapter is based on a research project on ‘Executive Capacity in Post-

Communist 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 HellmutWollmann (Hum-

boldt Universitat). Other researchers includedMartin Brusis and Radoslaw

Zubek. The project was assisted by Tereza Vajdova in the Czech Republic

and the Economic Policy Institute in Bulgaria.


278

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 EMUcreates 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 pro-

vides 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 pres-

sure 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

279

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 work-

ing age. In addition, the state subsidized food, housing, and transport, and

maintained formally free health and education systems. Welfare arrange-

ments 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 didmanage 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 1990–2was around 17–18 per cent, while elsewhere the collapse

was evenmoreprecipitous—23per cent in theCzechRepublic and28–32per

cent in Bulgaria and Romania. In 1990–4, economic growth and wages

declined rapidly,while inflation spiralled. Therewas a substantial transform-

ation 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 1989GDPs, andonly in theCzechRepublic andHungarydid realwages

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 themost dramatic social effects

of economic crisis and reform, and in particular, the loss of income through

unemployment (Fajth 1999; Kovacs 2002). Early retirement and disability

pensions were widely used for redundant workers and unemployment

benefit schemeswerewidely adopted as an immediate response to the crisis


280

(Nesporova 1999; Fultz and Ruck 2001; Muller 2002). In addition, all CEE

countries introduced a minimum wage and income-related social assist-

ance 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,

leadingto increasingpoverty,notonlyamongtheold,where itwas tradition-

ally concentrated, but also among the young and lowwage earners and their

families (Nesporova 1999). The number of people on pension-, unemploy-

ment- or social assistance benefits increased dramatically, driving up their

costs. This was especially true of the larger CEE countries. There, the share of

unemployment andpension benefits inGDP increased in the first half of the

1990s from6.6to14.6percent inPoland, from8.3to9.1percent intheCzech

Republic, and from9.1 to 10.6 per cent inHungary (Wagener 2002: 161).

Because state budgets were suffering from falling tax and social contri-

butions, 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, democ-

ratization 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). Eichen-

green (2003) notes that the larger CEE countries have become ‘western-

ized’ 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 coun-

tries (the Czech and Slovak Republics and Hungary) and increased in the


281

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 ‘moder-

ate’ 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 wel-

fare 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

Table 14.1. Social expenditure in the new CEE member states and the EU15, 2001

Structure of social expenditure (% of total)

Total socialexpenditure(% GDP)

Old ageandsurvivorpensions Sickness Family benefits

Disabilitypension

Unemploy-ment

Socialexclusion Housing

EE 14.3 42.6 31.0 14.6 7.8 1.3 2.2 0.6LV 14.3 56.4 19.1 10.1 9.6 3.6 0.6 0.7LT 15.2 47.5 30.0 8.3 8.8 1.9 2.3 1.2SK 19.1 38.2 35.0 8.2 8.1 3.6 6.5 0.4CZ 19.2 42.5 34.6 8.2 8.5 3.1 2.7 0.6HU 19.8 42.4 27.5 12.9 10.3 3.4 1 2.5PL 22.1 55.3 19.2 7.8 13.3 4.3 0.2 0.0SI 25.5 45.5 31.4 8.9 8.7 3.7 1.8 0.0Average 18.7 46.3 28.5 9.9 9.4 3.1 2.2 0.8EU15 27.6 46.1 28.0 8.0 8.2 6.3 1.5 2.1

Source: Eurostat.


282

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 ex-

ample of Hungary reveals a more general trend in the larger CEE countries.

Regardless of quite extensive reforms over the last decade (including a

stronger relationofpensions toemploymenthistories, an increasingpension

ageand the introductionof voluntary schemes), pensions spendinghasbeen

relatively stable while other benefits (e.g. unemployment benefits, family

support, and sick pay) have lost pace. As Lelkes (2000) explains,muchof 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 anddisability pension schemes, from19 to30per 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 mid-

1990s, only Poland and Hungary devoted a significant portion of their

spending to the labour market. This was related to some extent to un-

employment 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 Lithu-

ania, the long-term unemployed are likely be left entirely without income

support (Paas et al. 2003: 56 ff.; Vodipec, Worgotter, and Raju 2003).


283

These developments reveal an interesting ‘pathology’ in the larger post-

communist 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 conse-

quences 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 partici-

pation 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 adjust-

ment to EMU in Western Europe. Social expenditure in west European

countries did not necessarily decrease during the EMU convergence dec-

ade of the 1990s (Rhodes 2002). The political and/or distributive difficul-

ties of welfare retrenchmentmeant 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.


284

In some cases they increasedwelfare 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 conver-

gence and welfare state retrenchment, EMU was certainly used as an

occasion and excuse for tackling some long-standing social policy prob-

lems, 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 ‘prob-

lem load’ triggered some interesting institutional responses. These some-

times 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, althoughmany 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


285

Poland but also (though less dramatically) in Hungary and Slovakia. Thus,

these countries face the double constraint of low contributions and rev-

enues 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 infla-

tion. 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 con-

strained 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 prob-

lem 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, unemploy-

ment, the old age dependency ratio, and poverty after social transfers. We


286

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, wagemoderation 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 wagemoderation. 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 employ-

ers and unions has been of little importance in most cases, and that other

factors—the political orientations of governments and the type of execu-

tive—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’ organ-

isations 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 bargain-

ing 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 mem-

bership are low (25 per cent in the Czech Republic and 15 per cent in


287

Lithuania, Estonia and Poland in 2002), as are levels of bargaining cover-

age, 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 struc-

tures 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-em-

bedded 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’ organiza-

tions have not played an especially significant role in wage setting, the

importance of wage centralization and coordination indicators and argu-

−4.00

0.1

0.2

0.3

Co

ord

inat

ion

of

wag

e b

arg

ain

ing

ind

ex

0.4

0.5

0.6

0.7

−3.0 −2.0

SK

PL

LT

EE

LV HU

CZ

SI

Average real wage growth minus average productivity growth1997-2003

−1.0 0.0 1.0 2.0 3.0 4.0

Figure 14.1. Wage coordination and wage moderation 1997–2003

Source: OECD, Eurostat and European Commission (2004f ).


288

ments is diminished, and our attention is directed elsewhere. Wage devel-

opments 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 coordin-

ation 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 coun-

tries and welfare states requires some methodological innovation. As dis-

cussed above, it is not obvious that EMU will have a direct impact on

welfare systems. Moreover, the exogenous shock of joining EMU is noth-

ing compared to the shock created by the shift from the command econ-

omy 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 coun-

tries, 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


289

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 rela-

tionship—which we refer to as ‘welfare stress’—is illustrated in Figure 14.2.

Table 14.2. Old-age dependency ratio,2003–20*

Czech republic 25.6Estonia 25.0Hungary 25.6Latvia 24.8Lithuania 23.3Poland 21.7Slovakia 19.7Slovenia 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

2003LV 41PL 46LT 46EE 49SK 52HU 61CZ 69SI 77

Sources: Eurostat.


290

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.

Table 14.4. Social risk indicators: absolute values

Non-employmentrate 2003

Old-agedependency ratio

Poverty aftertransfers

GDP percapita in PPS, EU25 ¼ 100

Czech Republic 35.3 25.6 8 69Estonia 37.1 25 18 49Hungary 43 25.6 10 61Latvia 38.2 24.8 16 41Lithuania 38.9 23.3 17 46Poland 48.8 21.7 17 46Slovakia 42.3 19.7 21 52Slovenia 37.4 25.4 10 77

Source: Eurostat and own calculations.

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

Non-employmentrate 2003

Old-agedependencyratio

Povertyafter transfers

GDP/Capita PPS

Social riskindex

Czech Republic 0.723 0.962 0.381 0.443 0.157Estonia 0.760 0.940 0.857 0.729 0.205Hungary 0.881 0.962 0.476 0.557 0.180Latvia 0.783 0.932 0.762 0.843 0.208Lithuania 0.797 0.876 0.810 0.771 0.203Poland 1.000 0.816 0.810 0.771 0.212Slovakia 0.867 0.741 1.000 0.686 0.206Slovenia 0.766 0.955 0.476 0.329 0.158

Source: Own calculations.


291

Group 2: Poland and Slovakia—High Risks and Medium—HighDebt

For this group, EMU public expenditure constraints pose a more signifi-

cant 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 andMedium—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 ex-

penditure 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.

0.1300

10

20

30

40

50

60

70

80

0.150 0.170

Social risk index

Pu

blic

deb

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0.190 0.210 0.230

CZ

HU

SK

LT

LV

EE

PL

SI

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


292

Group 4: The Baltics: Lithuania, Latvia, and Estonia—HighRisks 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 improv-

ing 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 polit-

ical and institutional capacities for adjustment. It is to those issues that we

now turn.

3. Social Policy and Fiscal Adjustment Dynamics under EMUConvergence

Extending the Model

We begin to tackle the issue of social policy spending dynamics by exam-

ining 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 contribu-

tions 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


293

countries) but the weight in revenue of social contributions has signifi-

cantly 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 conver-

gence, 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 contribu-

tions in revenue. This may have an impact on its otherwise good employ-

ment 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 con-

cealed 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 Repub-

lic should be relegated from its pole position alongside Slovenia. Orban

and Szapary (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

Table 14.6. Social security contributions and social transfers

CZ HU PL EE LT LV SK SL

Share of socialsecuritycontributions1995 36.3 32.7 27.5 28.9 31.8 21.7 25.8 37.82000 38.4 27.9 34.5 24.8 27.0 26.1 28.0 31.7Share ofsocial transfers1995 41.3 55.8 55.9 58.6 57.1 56.8 34.4 41.62000 52.7 49.1 57.3 54.0 52.9 59.8 50.4 40.2

Note: As a percentage of total current revenues and total spending, respectively.

Source: von Hagen (2004).


294

of Poland (one of the worst case countries in our ‘welfare stress’ assess-

ment) 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 trajec-

tory 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 andHungary 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 pre-

accession 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 countriesmost 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


295

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 diffi-

cult 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 mak-

ing 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 decen-

tralized budgetary institutions led to a deteriorating fiscal performance.

But deficit developments since 1999 (see Table 14.7) reveal poor fiscal


296

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).

Ylaoutinen (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 aggre-

gates 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. Ylaoutinen

also points out that the majority of countries do not discuss deviations

between the objectives laid out in the multi-annual plans and actual out-

comes, 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 con-

clusion (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

Table 14.7. Fiscal imbalances in the new CEE member states

Fiscal deficit average 1999–2003 Fiscal deficit 2004 Debt 2003

Poland �3,0 �6,0 45,4Hungary �5,7 �4,9 59,1Slovak Republic �6,9 �4,1 42,6Latvia �2,8 �2,2 14,4Lithuania �2,7 �2,8 21,6Estonia 0,3 0,7 5,3Slovenia �2,4 �1,7 29,5Czech Republic �6,8 �5,9 37,8

Source: Eurostat.


297

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 diffi-

culties 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 under-

taxed (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 pres-

sures (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 con-

sensus 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 substan-

tial 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


298

longer-term sustainability noted above have led the European Commis-

sion 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 en-

gagement with welfare recalibration and retrenchment (Jedrzejowicz

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 grow-

ing similarities between the larger CEE welfare states and their counter-

parts 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

interventionmuchmore important than inWestern Europe. The ‘problem

load’ facing the CEE countries is also, at least on the surface, less of a

burden than was the case for theWestern 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 coun-

tries—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 Maas-

tricht 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 pen-

sions 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 labourmarket, where spending priorities—on

both active and passive policies—have been low. More generally, for the


299

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 inWestern 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 EUmember 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 await-

ing 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 fund-

ing 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 do-

mestic 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 pro-

vides a better means of addressing the central question of domestic room

formanoeuvre; 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,

301

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 bemet for Euro Area entry and

for the deeper reason of informal conditionality. Conditionality is a power-

ful 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 andmacro-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 andpolicy arrangements. For this reason, a ‘bottom-

up’ 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 negoti-

ation. 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 dif-

ferences shape domestic policy preferences and institutional arrange-

ments, notably for fiscal policy (see country chapters). These policy

preferences and institutional arrangements, in turn, mediate how domes-

tic policymakers negotiate EMU accession. They help to explain the par-

ticular 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

Domestic Transformation, Strategic Options and Soft Power

302

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 prefer-

ences, 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 gate-

keepers. 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 coord-

inate positions on the reform of the Stability and Growth Pact (SGP) in

2004–5. ‘Pacesetting’ does not translate into increased ‘uploading’ cap-

acity. 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 DomesticNarratives 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 conse-

quence, it poses a challenge to domestic political and technical elites—

how to construct a persuasive narrative for domestic audiences, a legitim-

ating 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 op-

tions—providing an external discipline, reinforcing a domestic discipline,

and deferring entry. From the perspectives of existing studies of European-

ization 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


303

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 conver-

gence of living standards consequent on deferred entry and/or the domes-

tic 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 import-

ing and providing an external discipline through early ERM II entry be-

cause 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 cal-

culate—especially in the Czech Republic and Poland—that there is a sig-

nificant potential for Euro-scepticism to take root and spread from the Left

and Right of the political spectrum into the centre (Taggart and Szczcer-

biak 2001; Kopecky and Mudde 2002). Britain’s brief and painful experi-

ence 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 prefer-

ences. 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 re-

inforce (as opposed to provide) domestic discipline suggests that the prime

catalyst for domestic economic policy transformation is not Europeaniza-

tion 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 ser-

vant’ narrative. Delay offers a means of accommodating the narrative of

‘sound’ money and finance with narratives that privilege ‘real’ conver-

gence in living standards and infrastructure and the preservation and

enhancement of welfare states. In short, competing and potentially


304

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 continu-

ing 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 inter-

ests 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 trans-

form into a populist domestic critique of EMU as ‘harshmaster’: 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 im-

ages 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 eco-

nomic potential of a huge and rich market, and enhanced capacity for

projecting political profile. In addition, accession states could leap frog


305

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 significantmembers 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 prob-

lems. 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 conse-

quent 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, espe-

cially 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

EUinstitutions,notablyover thedirectiveonfreedomofserviceprovision

. 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 cred-

ibility were deepened by evidence that public opinion in leading Euro Area

member states was less than supportive for the kinds of domestic eco-

nomic 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 EUwas 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 fa-

tigue’ in accession states to actual domestic ‘reform blockage’ in Euro Area

member states. The central question was not simply whether new acces-

sion 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 acces-

sion. 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 en-

largement threatened to sharpen problems of competitiveness and diver-

gence 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 develop-

ment 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.


307

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 flexibil-

ity 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 ofEast 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 lowmaterial 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 inabil-

ity 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 incen-

tive 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 Europeaniza-

tion is sustained by the incentive to keep ERM II membership as short as


308

possible through having put in place the conditions for sustainable nom-

inal 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 exploit-

ing 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 surveil-

lance 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 polit-

ical elites in east central Europe have domestic party and electoral incen-

tives 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 mem-

bers.

EMU accession is also a process of exposure to, and learning about, the

‘hidden’ side of conditionality (cf. Jacoby 2002). Scandals about the cred-

ibility 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 independ-

ence, 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


309

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, sin-

gle 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 Euro-

peanization 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 pol-

icies, where they are greater inmonetary 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 be-

comes more specific and constraining with ERM II accession. In turn, a


310

tightening exchange-rate constraint acts as an added discipline on domes-

tic fiscal policy.

The extent to which domestic policy transformation represents Euro-

peanization reflects, first, the complex relationship between EMU condi-

tionality and domestic macroeconomic policy capacity. Macroeconomic

policy capacity has two components: intellectual understanding of formal

and especially informal conditionality, and institutional leadership. Euro-

peanization 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 tech-

nical elites in the Czech Republic, Hungary, and Poland made faster pro-

gress 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 confi-

dence 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 inter-

national 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 central-

ized or decentralized, the degree of administrative professionalism, and

whether party political competition focuses on defending and extend-

ing 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 admin-

istrative organization and behaviour tended to persist (cf. Page 2003). For

this reason domestic policy transformation consequent on EMU condi-

tionality remains sporadic and limited rather than comprehensive and

systematic. Thenature of EMUconditionality 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


311

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 op-

portunities 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 institu-

tional innovation to strengthen leadership and ensure appropriate tech-

nical 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 transi-

tion, 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 con-

clusion 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 compli-

ance 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 rele-

vance to domestic economic policymaking.

Though the effects of EMU accession on domestic polities are less ap-

parent, they repeat this pattern of differentiation. The main effect on

domestic institutional configurations is observable in shoring up national


312

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 be-

tween centralized (Hungary) and decentralized (Czech Republic) in ways

that either facilitate or impede EMU compliance by their effects on do-

mestic 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 na-

ture, scale, timing, and tempo of reform. The key incentive for structural

reforms comes from the incentive to establish a strong competitive pos-

ition 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 acces-

sion were of limited political salience, though national central bank inde-

pendence 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 chap-

ters on Hungary and Poland). These choices were eased by being nested


313

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 conver-

gence 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 Europeaniza-

tion 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 statis-

tical 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’ para-

digm was hedged by loyalty to domestic political leadership. Hence, cen-

tral 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. Pol-

itical 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 theWorld Bank in the

transition process (norms that in any case were anchored in EMU) and,

above all, in domestic political developments.


314

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 condi-

tionality 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 European-

ization 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 domes-

tic 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 Europeaniza-

tion. However, by its nature Europeanization is embedded in processes

that transcend the domestic. Crucially, formal EMU conditionality relat-

ing to EU, ERM II, and Euro Area accession gains its coherence, persua-

siveness, 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 interpret-

ation 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 exchange-

rate criterion means a period in the narrow 2.25 per cent band of fluctu-

ation 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,


315

it implies strict compliance with EMU institutional templates. This com-

pliance is clearest and most specific in monetary policy.

Despite this constraining framework, the mechanisms of Europeanisa-

tion 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 uncer-

tainty. Though theMaastricht 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 flexi-

bility 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 accompan-

ied 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 gov-

ernments 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 prioritiza-

tion 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 import-

ance 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 infra-

structural improvements and EU structural fund spending. Compliance


316

with Maastricht nominal convergence criteria may seem less urgent than

investing in capacity building in the economy, for instance, communica-

tions, 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 con-

tagion that reflect market behaviour in the euro time-zone (of which they

are part) and the policy behaviour of each other and of Euro Areamembers

and institutions. These dynamic processes cut across boundaries and

highlight how domestic transformation is linked to indirect Europeaniza-

tion, especially the single European market and the use of the euro in

financial markets and trade. This mechanism of Europeanization is cap-

tured 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 subse-

quent 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 experi-

ence of current members?

. What is being measured. Institutional, monetary, fiscal or real conver-

gence?

. 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. Euro-

pean Commission Progress Reports since 1998 and its Convergence Report


317

2003; EBRD Transition Reports; IMF Transition: Experience and Policy

Issues 2000; the Deka Converging Europe Indicator (DCEI) Scoring Model

formeasuring convergence; also Piazolo 2002). The EuropeanCommission

Progress Reports andConvergenceReport took theMaastricht convergence

criteria as the point of reference and focused on nominal convergence

(monetary andfiscal),with someattention to institutional convergence. By

November 2001 the Commission was stressing the ‘considerable progress’

by all ten states. In contrast, the EBRD Transition Reports prioritised insti-

tutional 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 compre-

hensive 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 con-

vergence and offers a different categorization of convergence.

TheDCEI 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 con-

vergence. Poland and Slovakia had particular problems in real convergence,

leading to respective scoresof 72per cent and67per cent,withLithuania 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 themid-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


318

the cases of the Czech Republic, Slovakia, and the Baltic States and sug-

gests 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 amuch 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 differ-

ence in GDP growth rates could be sustained, it would take some twenty-

eight 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 agricul-

ture (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 thanmarket 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 sys-

tems to these new members in favour of a policy—especially in agricul-

ture—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


319

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 insti-

tutional capacity, especially at regional and local levels, or the fiscal cap-

acity, 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 differ-

entiated 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 andmonetary 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 meas-

ures 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 con-

vergence; 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 ofmonetary convergence (Holtemoeller 2004).

Hungary, and to a lesser extent, the Czech Republic, exemplify how acces-

sion 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, Lat-

via, 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,


320

pressures for nominal convergence are at their strongest in ERM II acces-

sion 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 con-

vergence 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 ‘dele-

gation’; 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 tomonetary 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 Euro-

peanization to treat east central European states as exceptional and dis-

tinct in sharing certain governance and institutional characteristics. They


321

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 pre-

accession 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 transi-

tion 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 Europemight

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 Kaza-

mias 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 themwith external incentives to economic, political, and admin-

istrative 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 inte-

gration 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 cross-

cutting 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


322

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-Ger-

man 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, thoughmore 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 lead-

ing 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 insti-

tutional guarantor. Notably, reform of voting rights in its governing coun-

cil to accommodate an enlarged Euro Area was based on a principle (GDP

size and financial assets) that gave extra weight to the central bank presi-

dents of the core members. Also, external incentives to comply with the

SGP gave to prime ministers and finance ministers, especially of Mediter-

ranean Euro Area member-state governments, opportunities to shift do-

mestic 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 Mediterra-

nean 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 diver-

gence 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 andGermany (for flexible application). Germany

in particular had fewer gains from EMU than other members (who bene-

fited from lower real interest rates) and underwent a protracted and pain-

ful 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


323

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 repre-

sents 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 institu-

tional and governance characteristics and to their roles as pacesetters or

laggards in euro entry. They differ in central institutional traits and char-

acteristics 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 domes-

tic politics asmembers of the original core and of theMediterraneanworld.

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 pol-

icies, 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 execu-

tive 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) rankingsofqualityofgovernancecovermacroeconomicgovernance

(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 theoverall governance indexEstonia,

Hungary, and Slovenia form a top category. Bulgaria and especially

Romania appear as laggards (though Bulgaria scores better on macroeco-

nomic governance). However, this index has two limitations: it does not


324

allow a comparison with the old EU15 or the Euro Area; and it is based on

performance as perceived bymarket participants.

Gros and Steinherr (2004: 139–40) have produced a quality of govern-

ance index based onWorld Bank figures that permits more useful compar-

isons. On the indicator of political stability, again Hungary and Slovenia

lead, followed by the Czech Republic. On government effectiveness, Pol-

and, 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 rank-

ing by trade potential on the basis of casting a wide net to include geo-

graphic 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 aroundGermany. 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 exception-

alism. 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 fief-

dom and executive fragmentation were characteristic, with the Mediter-

ranean 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 mem-

bers, let alonemake them exceptional. There was, in other words, shape to


325

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 differ-

entiates 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 coher-

ence. 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 rep-

licating the Mediterranean world, in which EMU accession strategy has

been about importing an external discipline (though with far from con-

vincing 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 cul-

ture 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 inter-

ests; 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 govern-

ments 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 cen-

tral European exceptionalism by continuing to delay; or emulating the


326

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.


327

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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

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 decision-

makers 146

and ‘top-down’ Europeanization 147

Bod, Peter Akos 188

Bokros, Lajos 180, 266–7

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


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 (1997-

2005) 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

354


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


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

Index

355

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


governments 34

and Economic and Monetary

Union 32–5

and euro entry 2

and impact of derogations/opt-

outs 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 banking and financial sector:


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


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

356

and institutional 5

and Latvia 293, 295


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 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 macroeconomic policy 50, 52

and ‘rogue’ behaviour 309

Croatia, and banking and financial

sector:


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


convergence of 253

privatization 243

and budgetary crises 56

and convergence 296, 297, 298


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 euro entry 88, 89, 99

and Euro-Area Accession

Strategy 160, 169, 177

formulation of 171–5

implementation of 175–6

Index

357

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


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 labour market 314, 315

as laggard 69, 71, 160


criteria 161

exchange-rate 163


EMU effects 175

and political constraints on

reform 165–8


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

social risk/welfare stress 292, 293,

295

social transfers 294

Czechoslovakia:

and banking and financial sector

privatization 242


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


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


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

Demjan, Sandor 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

358

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


sector 86–7

and capital flows 83

and competitiveness 84–6

and contagion processes 10–11

and core-periphery rankings 325


domestic contexts 11

domestic impact 3, 9–10

good servant narrative of 41–3

harsh master narrative of 40–1


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


timing of 87–9, 92

and euro as parallel currency 35



context of 34–5


domestic contest over 33

factors affecting 33–5

party and electoral

competition 37–8

public opinion 38


interest 36–7

unofficial ‘euroization’ 35

vulnerability of 35

Index

359

East Asia, and liberalization (cont.)

and euro-centred financial

markets 4, 34–5

and European Union, fast-track

accession 222

and Europeanization 301–3


exchange-rate pegging 54

timing of Euro Area

membership 67–8

and fiscal policy 56, 64


criteria 56–8

and foreign direct investment 8, 49,

61

and free-trade agreements 48–9

and governance quality 302–3


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


criteria 56–8, 74–6, 117–18


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

and public debt 65, 81, 98

and real convergence 71


advantages of Euro Area 66–7

and structure of economic

activity 83–4

and trade 102


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




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 polities 312–13


countries 63–4

and eastern enlargement of EU 1

and evolution of fiscal institutions:

Bulgaria 272–3

Index

360

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




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


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

Index

361

economic governance, (cont.)

and towards optimal economic

governance 123–4

economic growth:

and Czech Republic 176


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:




convergence of 257–9

lender of last resort 249–50

privatization 243

and competitiveness 86



Union 63


140

and economic reform 132

and euro entry strategy 139

and exchange-rate policy 58, 59, 60,

103, 163

currency reform 133, 135


and flat-rate taxation policy 23


and labour market 314


criteria 138


as pacesetter 66, 69, 127

and stability culture 128, 133, 135–6

and weak Euro-scepticism 130–1

and welfare state:

debt positions 296

post-communist era 279–284



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


eastern enlargement 13


and enlargement of 90, 91


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 Mediterranean members 12


and policy behaviour of member

states 33–4

and structural reform 100–2, 103

exchange-rate policy 103

fiscal policy 103, 106


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


Index

362


party and electoral

competition 37–8

public opinion 38


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


indefinite postponement 71

issues arising over 87

reasons for delay 67–9, 73, 77

risks of early entry 77–8



Euro Group of finance ministers 5, 124,

198

Europe Agreements 60, 64


countries 49

European Bank for Reconstruction and

Development (EBRD) 49, 61

and Baltic States 128–32

and financial sector in east central

Europe 261


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


entry 32


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


entry 32


and excessive deficit procedure,

Czech Republic 175–6

and exchange-rate stability 95

Index

363

European Commission: (cont.)

and gate-keeping 31

and Poland 205–6, 240, 252–3, 265–6


and Progress Reports 317

and Regular Reports on accession

states 15, 16, 18

Romania 226–7



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 Stability and Growth Pact 116

European Economic Area 48

European Employment Strategy 109


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

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


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


and conditionality 302

and diversity of impact 217

and domestic transformation:



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

364

Euro-scepticism 38


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


countries 63–4

and fears of speculative attacks 163,

164



criteria 65, 71

and premature entry 80

as testing phase 27–8

and timing of entry into 66

exchange-rate policy:


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


criteria 160

volatility of rate 163


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


and inflation targeting 54

and Latvia 54, 62, 95

currency reform 133–4, 135

and Lithuania 54, 62, 73, 95, 105

currency reform 134


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 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


finance ministers, Euro Group of, see

Euro Group of finance ministers

Index

365

finance ministries:


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


countries 64–5

and economic adjustment 20


accession 148

conditionality 28–9

impact of 261–2

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


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


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

366

and Slovakia:



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


Union 82, 91, 306

economic aspects of 74



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


flat-rate tax policy 208, 209


and Romania 231

foreign direct investment:



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

(GATT) 49

Germany:

and fiscal indiscipline 58


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

Gyurcsany, Ferenc 193, 268

Hallerberg, Mark 149, 263–5, 267, 270,

272, 274

Hansson, Ardo 131

Hausner, Jerzy 209–12

Havel, Vaclav 170, 171

Helsinki European Council 223, 233

Heritage Foundation 86

Horn, Gyula 180, 188, 266

Hungary:



sector 240, 242, 260


bank portfolio quality 255

convergence of 240

privatization 243

and budgetary crises 56

and conflicting economic/political

interests 182–3



and Economic and Monetary Union

accession 63

explanation of failure of 179

favourable conditions for 178–9

Index

367

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


policy drift and volatility 185

and education sector 191


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



and fiscal policy:

Bokros package 180, 266, 268

boosting domestic economy 182

constraints on 303

evolution of delegation

institutions 272


177

and governance quality 302, 303

and inflation 180–1


as laggard 11, 69, 178

and Maastricht convergence criteria,

failure to meet 178


and National Bank of Hungary 160,

185

controversy over independence

of 186–90, 193, 196


and political party system 183–4,

194, 266–9


and social solidarity 37

and trade 102


economy 25

and wage levels 23

and welfare state:

debt positions 295

post-communist era 279

social risk/welfare stress 318–19,

321, 322


Iliescu, Ion 218, 222

Index of Economic Freedom 86

inequality 282

inflation:

and Balassa–Samuelson effect

106


and Bretton Woods system 52

and Bundesbank 52, 53–4



countries 62, 81

and European Central Bank 27

and Hungary 180–1



criteria 74, 75, 79

and Poland 62, 199, 202

and Romania 62, 216, 227, 228

Index

368

and ‘sound money and finance’ 20

and Stage 2 adjustment 79

and wage coordination 313

interest rates:

and currency area theory 20


countries 76

and inflation targeting 54


criteria 74, 75, 79

and Poland 199, 201

Intergovernmental Conference, and

economic governance 119–20

International Monetary Fund (IMF):





countries 48

and euro adoption 87


Ireland 13

Isarescu, Mugur 217, 220, 223, 225, 26,

228

Italy 12

and competitiveness 84, 86

and criticism of fiscal statistics 31


and Stability and Growth Pact 20

Jarai, 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

Kovacs, Laszlo 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

Laszlo, Csaba 187, 190

Latvia:


privatization 243

and convergence 299


Union 67


140




currency reform 133–4, 135


and inflation 62


criteria 138

as pacesetter 69, 127

and stability culture 128, 135–6

and weak Euro-scepticism 130

and welfare state:

debt positions 295




Latvijas Banka 133

liberalization:


and Bulgaria 222, 240


countries 309, 310, 322

and European Union 48

and importance of 91

see also structural reform

Lietuvos Bankas 137

Lisbon process 29, 307

Lithuania:


convergence of 240

Index

369

Lithuania: (contd.)

lender of last resort 250

privatization 243



Union 91

suitability for membership 120




currency reform 134

and fiscal policy 135, 136–7




criteria 138

as pacesetter 127, 137


and weak Euro-scepticism 130

and welfare state:

debt positions 295



Luxembourg Council (1998) 61

Luxembourg process 29

Maastricht convergence criteria 4, 56,

74, 79


and Bulgaria 154, 158

and central banks 99

and Czech Republic 161, 163


countries 149, 150

performance against 95, 98–9

and Estonia 138


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

and Poland 198, 208



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


fiscal rules 55

monetary rules 52


Malta 8, 13, 14

and cohesion funds 97



as pacesetter 69

market behavior, and contagion

processes 12

market reform, see liberalization;

structural reform

Medgyessy, Peter 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

370

and EMU conditionality 24–5

and Exchange Rate Mechanism 21

and exchange-rate policy 58, 60

and Germany 58


and monetary integration 103–4

and Poland 197, 199–203

and Romania 216



Nastase, Adrian 217, 221, 223,

224, 225

National Bank of Hungary 178, 181

and controversy over independence

of 186


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 suitability for monetary

union 76

Orban, Viktor 181, 189, 267

Organization for Economic

Cooperation and Development

(OECD) 101



countries 149

Papademos, Lucas 32, 101

Parragh, Ferenc 191

Poland:




convergence of 240

privatization 243




and criticism of Pre-Accession

Economic Programme 15


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





Index

371

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


175, 176, 177, 203

Kolodko’s stabilization

package 208

tax increases 205



and inflation 62, 199, 202

and interest rates 199, 202


as laggard 69


criteria 160, 185



challenge to monetary

convergence 199, 200


and National Bank of Poland:

challenged on monetary

convergence 202–3

independence of 206


pro-EMU policy 213


Programme 205

and public finances 204

budgetary crises 56, 204–6

constitutional constraints 210

public debt 292

and social solidarity 37

and structural reform 200, 207, 210

and trade 102

and transfer payments 319–20


economy 25

and welfare state:

debt positions 295


social risk/welfare stress 319, 321


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


poverty 299


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 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


sector 242–6

and Bulgaria 156

Index

372


countries 61


productivity:

and Balassa–Samuelson effect 104–6


countries 85

public finances:

and accounting standards 17

and conditionality requirements 16


countries 75–6, 80–1, 87



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:


countries 80

and Euro Area membership 71

public opinion, and euro entry

strategies 37

Repse, Einars 138

Reserve Bank of New Zealand 53

Romania 8, 13, 14




privatization 243

and capital inflows 230

and capture of state economic

policy 37

and communist-era economic

strategy 217–18



and domestic politics:

economic reform 219–20, 224

executive reform 224

resilience to change 220–1

and domestic weakness 215


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


failures of 232

influence of domestic politics 195

managed floating 231

opposition to currency

board 229–30

strong leu policy 228–9



and inflation 62, 220, 224, 27

as laggard 215


and monetary policy, failures of 213

and National Bank of Romania 215

capacity of 177

Index

373

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


Union 16


Slovakia:


260


convergence of 268

privatization 243







and fiscal policy:

constraints on 396, 303


and flat-rate taxation policy 23


and inflation 62


as laggard 69

and public debt 292

and welfare state:

debt positions 295


social risk/welfare stress 319, 321,

322


Slovenia:




convergence of 240

privatization 243




Union 91

and economic convergence 36




and inflation 105


as pacesetter 69

and welfare state:

debt positions 295

post-communist era 279, 309

social risk/welfare stress 319, 321


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

Spidla, Vladimir 160, 270

Stability and Growth Pact (SGP) 96,

303

and annual convergence

programmes 28

Index

374


and conditionality requirements 25,

26

and controversy over 186


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


Estonia 133

and Bulgaria 157


countries 62

and European Union 108


and membership of Euro Area

66–7


state identity, and Euro Area

membership 8

statistics, and national statistical

offices 31

structural reform:


and Bulgaria 150–1, 156–7


and eastern Europe ‘catch-up’ 18

and importance of 108

and monetary integration 100–2,

103

exchange-rate policy 103



and Poland 200, 208, 210

and reform blockage 32

and reform fatigue 31

and Romania 22, 24–5, 218–20,

221, 224


reforms 31

and trade creation 106–7

and trade-off over time 103

see also liberalization

Suranyi, Gyorgy 187, 188

Sweden 13

and derogation from Euro Area

membership 34, 87

Swiss Institute for Management

Development 85

Szeles, Gabor 186, 187

Taiwan, and liberalization 48

Tosovsky, Josef 166, 169

trade:


countries 101–2

and Euro Area, growth within 67, 83,

106–7

transfer payments 319, 320

transnational policy networks:


and informal conditionality 19

Tuma, Zdenek 171

uncertainty:

and compliance/capacity

tensions 12

and conditionality requirements 10,

11–12, 25

and domestic transformation

301–02

and EMU accession 277

unemployment:


countries 98–9

and welfare state spending 306, 311

United Kingdom 53

and opt-out 34, 96

and privatization 48

Vasile, Rudu 225

Verheugen, Gunther 223

Videnov, Zhan 151

Index

375

Viksnins, George 131

Visegrad countries 49, 61


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


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

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



countries 48, 49

and Romania 224

World Economic Forum 85

World Trade Organization 49, 61

Yugoslavia, and privatization 243

Zeman, Milos 167, 270

Index

376

Documents

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