EURO question

05.06.2023

History shows that various monetary and exchange rate regimes can work well or poorly, depending on the countries’ circumstances and policies.

Very similar beginnings but many different outcomes today – that is how one may sum up the history of monetary and exchange rate policy in the postcommunist countries of Central and Eastern Europe. Yet the colorful history of the last 30-plus years of profound economic transformation, despite its long duration and rocky character, does not provide a clear answer to whether it is worth pursuing a fully independent monetary policy at the national level in the context of an integrating Europe, or better to merge the national currency with its nearest monetary hegemon as quickly as possible – in this case, join the euro area.

The 30-plus years of “laboratory experiments” in Central and Eastern Europe with various exchange rate and monetary regimes have provided both rival camps with good arguments. The debate on the wisdom of embracing the European Union’s common currency remains open. So let us revisit this history in more detail.

Every country is a separate story

The former Soviet bloc countries in Europe had a common denominator after the bloc’s disintegration (1989-1992): they were all looking for a fundamental macroeconomic anchor, a fixed point in the period of transition to a market economy with free pricing, liberalized foreign trade and private ownership. That anchor was most often, usually at the advice of international monetary institutions, a fixed exchange rate – a system in which the value of one currency is tied to another.

While former East Germany avoided inflation and instability, the strong exchange rate drove much of its industry and labor force west.

Rates were most often fixed to the German mark – the monetary hegemon of Western Europe – or the United States dollar. Alternatively, it could be a basket of hard currencies containing the British pound, the Japanese yen and the Swiss franc, along with the abovementioned currencies. The Baltics, Bulgaria, Hungary and Poland chose this route. Before they could start, though, they had to devalue their artificial communist-era exchange rates, which did not correspond to reality.

Within a few years, however, the countries’ paths began to diverge. Former East Germany merged with West Germany, adopting the latter’s deutsch mark at a one-to-one ratio. The idea was to unite the economically disparate parts of the country through a hard currency union like Italy had done in the 19th century. While former East Germany avoided inflation and instability, the arbitrarily strong exchange rate drove much of its industry and labor force west, necessitating mammoth fiscal transfers that continue to this day.

Reluctance to go it alone

Several countries stuck to a fixed exchange rate in the form of a currency board: an extreme form of the pegged exchange rate in which a country’s money stock can be no larger than its forex reserves.

That means an absence of autonomous monetary policy and reluctance to pursue it. Such was the case of Estonia and Lithuania and partly also Latvia. These countries took a fixed currency peg to the West as an economic and geopolitical insurance policy against their giant eastern neighbor. Bulgaria, too, embraced the strict currency board regime in 1997 after the chaos and hyperinflation of the 1990s and has succeeded in remaining in it to this day.

It is no coincidence that these countries were most interested in adopting the euro as quickly as possible in their integration process. They had “outsourced” monetary decision-making anyway, typically to the Bundesbank or the U.S. Fed. When a country passively takes monetary policy from outside, it stands little to lose by joining the euro area. And so, between 2011 and 2015, all three Baltic states adopted the euro. Had it not been for the post-2008 crisis, that would have happened even earlier.

The only country that rushed into the eurozone just before the crisis was Slovenia in 2007. It, too, had a managed floating exchange rate. By quickly adopting the euro, Slovenia also wanted to show that it did not belong to the chaotic Western Balkans. It was followed two years later, in 2009, by Slovakia, which, after the breakup of Czechoslovakia in 1993, had remained the smaller and poorer part of the former federation and struggled with the distrust of international markets during the authoritarian governments of Prime Minister Vladimir Meciar (1990-1991; 1992-1994; 1994-1998). The Slovak koruna was unstable. Replacing it with the euro was seen as the completion of the radical economic reforms introduced after the democratic overthrow of the Meciar regime.

Two Western Balkan countries, Montenegro and Kosovo, use the euro as their currency unilaterally, without the European Central Bank’s (ECB) direct permission, as they are not EU member states. The two states desired political and economic emancipation from Serbia, which, after 1989, had experienced a dreadful episode of hyperinflation.

The existing eurozone member states do not want Bulgaria among them.

Croatia, Serbia’s archenemy in the Balkan wars of the 1990s, was also in a hurry to join the eurozone following its accession to the EU in 2013. The degree of euroization of its economy was so high that any independent monetary policy would be just an illusion. And as of January 1, 2023, Croatia adopted the euro and became the 20th member of Europe’s single currency club.

Demonstrably, each of the post-communist euro area member states had its own accession story and its reasons for joining – historical, romantic and geopolitical instead of purely economic. A particular category is Bulgaria. Despite its exemplary compliance with the Maastricht criteria, for long it was not even allowed to enter the ERM II exchange rate mechanism, the antechamber to the euro area. It still does not have the euro, even though it began its journey toward it simultaneously with Croatia. Why? The existing eurozone member states do not want Bulgaria among them.

From a fixed exchange rate to other systems

More interesting exchange rate and monetary developments occurred in the countries that are in the EU but have not introduced the euro and are not planning to do so. The EU countries that have not negotiated a currency opt-out are Poland, the Czech Republic, Hungary, Romania and Sweden; Denmark has an opt-out.

The Swedes voted in a 2003 nonbinding referendum not to join the eurozone and the country is not under pressure to do so today, even though it remains formally obliged under the treaties to seek membership. Sweden is, however, a global benchmark of independent, self-sufficient monetary policy. It is one of the pioneers of inflation targeting and has a freely floating exchange rate. The world has been learning from its central bank. The post-communist EU countries are looking up to the Riksbank too.

Denmark, in turn, represents a paradox in this respect. It has an opt-out clause from the euro, yet it has had a strict fixed exchange rate to the euro and conducts no monetary policy of its own, only issuing its banknotes and coins.

Denmark had followed a fixed exchange rate policy since 1982, when, for macroeconomic stability, it introduced a peg to the German mark. In 1999, it merely switched to a peg to the euro, thus replacing its subjection to one institution in Frankfurt, the Bundesbank, with another in the same city, the ECB. In its reluctance to make monetary decisions, Denmark is historically reminiscent of Austria with its historical fixed link to the German mark and its perceived need to be in the euro area as soon as possible.

Poland and Hungary tried this strategy for years, only to find that it sustains high inflation and embeds it in wage and price contracts.

In contrast, the countries of Central Europe have been groping for approaches through turbulent times. After short periods of experimentation with fixed rates, Poland and Hungary moved to a crawling peg system in which a fixed-exchange-rate currency can fluctuate within a bracketed range. Under such a managed devaluation design, the region’s reforming economies could seek to stabilize their local currencies’ exchange rates against the hard currencies in a high-inflation environment.

Macroeconomics teaches us that if one country (say, Poland) has a higher inflation rate than another (say, Germany) and has a fixed exchange rate with it, the former will gradually lose price competitiveness against the latter. That leads to a currency crisis and the need for an abrupt exchange rate adjustment. Managed devaluation is intended to prevent such disruptions.

Poland and Hungary tried this strategy for years, only to find that it merely sustains high inflation and embeds it in wage and price contracts. Both countries eventually took the sensible course of trying to float freely and stabilize domestic inflation on their own.