THE WARSAW INSTITUTE REVIEW

Date: 1 August 2018    Author: Łukasz Czernicki

Let’s not hurry with Poland’s Eurozone membership

Since the outbreak of the crisis in the Eurozone, the enthusiasm of Central and Eastern European countries, including Poland, to join the European Monetary Union has been significantly weakened.

However, in the face of growing international tensions in recent years, some opinions have emerged indicating that the adoption of the common European currency could contribute to the increase in Poland’s geopolitical security. This analysis is an attempt to answer the question about the rationale of Poland’s accession to the monetary union, taking into account the current dynamics in the geopolitical situation.

At the heart of the Eurozone crisis

Before presenting arguments for and against Poland’s accession to the Eurozone, it is first necessary to understand the nature of the crisis, which affected mainly the peripheral countries of Europe, i.e., Greece, Spain, Portugal, and Ireland.

First of all, we must be aware that the economic turbulence that has occurred has not been caused directly by the over-inflated spending of the state apparatus. Of these countries, Portugal alone saw a slight increase in its public debt-to-GDP ratio in the decade before the crisis, Greece remained relatively stable, and Spain and Ireland even managed to reduce it.

The root cause of the crisis was the credit boom that started in the Eurozone peripheral countries a few years before the introduction of the single currency. The excessive credit expansion at that time was due to several factors Firstly, the creation of the single currency area coincided with a substantial reduction in interest rates around the world. Secondly, the deepening of European integration created a wave of optimism at the periphery of Europe: entrepreneurs and consumers were keen to borrow, and banks were keen to lend. Thirdly, the economic recovery and increasing demand for credit encouraged financial institutions from other countries, in particular, Germany and France, to invest in the southern and western borders of Europe. The credit boom, therefore, had strong external financing[1].

The dynamic change in global market sentiment at the end of the last decade contributed to the slowdown in the periphery of the Eurozone.

The significant slowdown revealed the illusory nature of economic growth, especially in southern countries. It turned out that a significant part of the capital in the period of economic boom was spent there for consumption, often on purchases in the housing market. The bursting speculative bubbles and the worsening general economic situation contributed to the crisis in the financial sector. Problems of financial institutions combined with the recession subsequently undermined the financial credibility of individual countries (e.g., Ireland’s public debt-to-GDP ratio increased several-fold, due to the country’s takeover of banking liabilities). The unemployment rate increased dramatically. There were two main reasons why it was not possible to quickly resolve the problem. The peripheral countries, stuck in the Eurozone, could not reduce their currency exchange rate in comparison with other countries. Such a move could have had a beneficial impact on their economies, as the robust credit expansion in the 2000s made the countries of the South and Ireland relatively expensive. The so-called internal devaluation, i.e., manual price cuts and wage reductions, without changing the exchange rate, is always a long and painful process. Besides, attempts have been made at all costs to avoid the official bankruptcy of individual countries by supporting them financially, fearing a contagion effect on the countries using euros and the consequences for the financial sector. A declaration of insolvency and profound debt restructuring would help to alleviate the financial pressure exerted by the governments of countries in crisis, which has further reduced economic activity.

Less than a decade after the outbreak of the crisis, some say it is a thing of the past. Even the countries most affected by the economic turmoil are starting to see positive economic growth; the interest rates on their bonds are steadily decreasing. However, the road to returning to a stable path of economic development in the southern Eurozone countries seems to be still long and challenging. This is particularly evident in the tiresome recovery of employment in the south of the monetary union. For example, the Greek economy had approximately 4.5 million employees before the crisis. Nowadays this figure is almost one million less. Also, it should be remembered that for a decade now, interest rates on world capital markets have been at a record low level. Accelerating their increase could efficiently suppress the recovery of economic activity at the periphery of the Eurozone.

Economic arguments

Before the crisis broke out, two arguments were quite often used in the media and political debate on Poland’s accession to the Eurozone, probably because they were easily accepted by ordinary citizens who did not have much knowledge of macroeconomics, one for and the other against the adoption of the common currency. On the one hand, joining the Eurozone was supposed to eliminate transaction costs related to the necessity of exchanging national currency for transactions within the monetary union. On the other hand, it was feared that replacing the Polish zloty with the euro would contribute to a rapid increase in prices in Poland. The importance of both arguments in considering the advisability of joining the Eurozone is, in fact, marginal. The experience of many countries shows that price increases after the monetary union, if any, have been modest. The transaction costs associated with currency exchange, especially at a time when the financial sector is becoming increasingly digitalized, are in fact negligible.

Before the crisis, the main line of reasoning put forward by supporters of the adoption of the euro, was that joining the monetary union was supposed to lead to a decrease in interest rates in the economy. From today’s perspective, however, we can say that the reduction in the cost of loans following joining the Eurozone entails a severe risk of the economy overheating, which may result in the outbreak of another crisis.

The most important arguments in the debate on joining the Eurozone in the post-crisis economic reality are related to the experiences of the peripheral countries, described in the first part of the text. They argue in favor of preserving the Polish zloty. Firstly, the adoption of the euro increases the risk of a credit boom in a given country. Having its own currency makes it easier to limit the inflow of foreign capital, which is often the primary source of financing for credit expansion in the local market. The very fact of the existence of exchange rate risk seems to be a real obstacle to the external money inflow. The speculative bubbles on the real estate market in the last decade and the economic slowdown after the outbreak of the global crisis in the Baltic States maintaining a constant exchange rate of their own currencies against the euro were much larger than in Poland, where the central bank allows the zloty exchange rate to be shaped by the market. It is worth mentioning in this context, for the sake of justice, the fundamental change that has taken place in the area of macroeconomics over the last few years. After the crisis, economists’ confidence in financial markets has significantly weakened, and more emphasis has been placed on effective regulations. The so-called macroprudential policy introduces mechanisms limiting the probability of credit booms, regardless of the exchange rate regime in a given economy. However, these seem to be far from sufficient at the moment.

Secondly, being in a monetary union, in the event of a crisis caused by excessive credit expansion, a given country is exposed to the risk of a deeper economic recession. Recent economic studies show that the decline in GDP per capita in those countries most severely affected by economic turbulence in the Eurozone, i.e., Greece, Portugal, Ireland, Spain, and Cyprus in the years 2010–2015 was, on average, several percent higher than during the standard global crisis that has occurred over the last 50 years[2].

Currency adjustment is the simplest and most effective way of restoring international competitiveness following an inflation boom[3] described in the first part of the text on the basis of the Eurozone peripheral countries. It is well-known that such an operation is not possible in a monetary union.

Conversely, there is an assumption that accession to the Eurozone would entail entering a club of countries with a strong currency, the effect of which would be an increase in salaries in Poland[4]. Since the political transformation, wages in the Polish economy have been growing in comparison with the EU average, much slower than the Polish GDP, so it would undoubtedly be a desirable effect of the accession to the Eurozone. Moreover, greater appreciation pressure could encourage Polish enterprises to make more courageous optimization investments or even to change their business models, the latter of which are often based on relatively low labor costs in Poland. However, the validity of this argument is weakened by several factors. Firstly, the strengthening of the zloty – to some extent – is also possible outside the Eurozone. It is a matter of conducting the right exchange rate policy or the appropriate economic policy. Secondly, it seems that the situation on the Polish labor market already shows signs of a strong revival (the unemployment rate is the lowest in years), which results in dynamically growing salaries. Entering the Eurozone could, at this point, trigger an additional wage spiral. Thirdly, when having its own currency, it is possible to control the whole process of salary growth by increasing the currency exchange rate. Excessive wage increases, combined with high demand for consumer credit, are a simple way to lose competitiveness on the international stage and, eventually, to start a crisis. An example of this is most visible in the southern countries of the Eurozone.

Political arguments

A full account of the benefits and potential losses of adopting the euro also requires consideration of political arguments. The reasoning that joining the monetary union will increase our security in the international arena revived the debate about the euro in Poland.

It should be stressed at the outset, following Professor Grosse, that the Eurozone is not a military alliance[5]. The current shape of the monetary union does not guarantee that, by joining it, a country is given additional protection in the event of geopolitical turmoil. The crucial point of accession to the Eurozone is the transfer of monetary policy decisions to the European Central Bank. It can, therefore, be said that the impact of Slovakia’s adoption of the euro on its security is now the same as that of Montenegro, which unilaterally euroized itself years ago, i.e., practically none.

Following the outbreak of the crisis, new ideas were put forward for the reform of the European Monetary Union, the aim of which is deepening the integration of countries with a common currency. However, changes in the institutional architecture of the Eurozone will have a real impact on the security of its members, as long as they lead to the communitarization of costs, including those related to the activities of third countries.

There are two main proposals now on the table, the adoption of which could contribute to the distribution of financial responsibility between the Member States, for example in the event of aggression against a particular country from abroad. The first one is the idea of communitarizing the debt of the Member States of the Eurozone. This idea is currently being pushed forward in European high society mainly by French President Emmanuel Macron. The second one consists of the introduction of Community guarantees covering bank deposits for countries which have joined the so-called banking union. The problem is, however, that Berlin coldly receives both proposals. The approach to the role and the desired level of public spending in Germany is fundamentally different from the one in France, which is why it is doubtful that our western neighbors will take responsibility for the debts of other countries in the Eurozone. This is in direct conflict with their culture of maintaining strict budgetary discipline.

The Berlin’s agreement on the implementation of the third pillar of the banking union (i.e. the Community deposit guarantee), in addition to the Single Supervisory Mechanism and the Single Resolution Mechanism for financial institutions, is dependent on ordering the situation in the banking sector. This mainly concerns solving the problem of risky loans, the amount of which in the banking systems of the Eurozone countries is estimated at a considerable amount of almost one trillion euros[6]. It, therefore, seems that this issue will continue to block for years to come Berlin’s acceptance for the completion of the banking union. Besides, it should be remembered that participation in the banking union is also open to countries that are not members of the Eurozone.

It is better to wait

On the basis of the above analysis, it can be said that the current economic arguments are in favor of preserving the zloty. The highest potential risk associated with membership of the Eurozone is, on the one hand, a possible increase in the likelihood of economic overheating and, on the other hand, a deeper recession than would be the case if a country had its own currency. At the same time, the political analysis has shown that there are plans for reforms to strengthen integration within the Eurozone involving communitarizing public debt and providing pan-European guarantees for deposits held in banks in the monetary union. However, these proposals are being blocked by Germany – the most powerful economy in the Eurozone. Without effective mechanisms charging costs to the other Member States of the monetary union, in the event of economic problems caused, for example, by the aggression of third countries, it is merely an illusion to expect that the adoption of the euro will contribute to Poland’s geopolitical security. Therefore, Warsaw should refrain from joining the Eurozone, at least before institutional reforms in the European Monetary Union are completed.

 

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