Divergence Criteria?

Graph.jpgThe European Central Bank’s Convergence Criteria are supposed to signal that a country can, and should, take further steps towards European monetary integration. They are rooted in the Theory of Optimum Currency Areas proposed by Robert Mundell, a 1999 Nobel Prize laureate. In light of his theory, countries considering sharing a currency should have strong economic links and a degree of symmetry in shocks which affect their economies. This is relevant when it comes to the ECB’s monetary policy – a single interest rate can only be successful for a group of convergent countries.

Yet, generally, the ECB’s criteria focus more on the economic performance and the sustainability of public finances than on convergence. The first two demand low levels of inflation and a low long-term interest rate. The reference values of debt- and deficit-to-GDP ratios should not be higher than 60% and lower than -3%. In addition, the currency of a eurozone candidate country should be pegged to the euro for two years prior to euro adoption without severe tensions. This is the only criterion signalling the symmetry of shocks between the Eurozone and a candidate country, but it can only be tested once a country fulfils the first four criteria and joins the European Exchange Rate Mechanism.

As of now, there are seven EU countries obliged to join the eurozone through their EU Treaties of Accession. The expectation is that they should join the European Exchange Rate Mechanism upon the fulfillments of the first four criteria. However, this is proving not to be the case. Sweden has resisted pegging its country to the euro despite having fulfilled the first four convergence criteria in 2012, 2013, and 2014, citing incompatible legislation. November 2015 was the fifth consecutive month in which Poland fulfilled four of ECB’s Convergence Criteria. The Poles, nonetheless, have been reluctant to join the Eurozone since the Great Recession, as the country’s floating exchange rate helped it maintain positive GDP growth rates throughout this period.

Taking a closer look at the Convergence Criteria may make one ponder the question, ’With whom are these candidate countries converging?’. The ECB’s own measure of convergence fails to demonstrate economic cohesion among countries already in the euro area. The graph shows that there were more countries missing the first four convergence targets than meeting them every year since the euro’s inception. Austria, Belgium, Malta and Portugal violated these criteria every year since they have joined the eurozone. While the eurozone has been steadily expanding, the number of eurozone countries fulfilling the criteria has been declining. Unsurprisingly, the debt criterion is most problematic; the number of countries satisfying it has markedly decreased in the aftermath of the Great Recession.

The violation of the ECB’s rules does not rule out convergence in the eurozone, as convergence can be measured in a number of ways. However, it gives eurozone candidate countries more reasons to doubt that it is time to abandon their national currencies.

A few words on the data behind the graph

Data was sourced from the European Central Bank. As debt-to-GDP ratios were not available for Greece and Estonia until the mid 2000s, the countries were excluded from the analysis.

Reference values used to determine if a country fulfilled the inflation and long-term interest rate criteria were not copied from the ECB’s Convergence Reports. Instead, I calculated them using the methodology outlined in the reports. In this analysis average yearly inflation in a given country was calculated using monthly data. Subsequently, the average was taken from the values of inflation for the three countries with the lowest inflation in a given year, which yielded 16 reference values. The same methodology was used to calculate the reference values of the long-term interest rate.

This is because Convergence Reports span across various time frames. For example, sometimes the reference values were calculated for a one-year period, and sometimes they were calculated for a period of a few months. The yearly reference values were not copied from the reports when a report contained a reference value for a given year. Instead, all of them were calculated in STATA and cross-referenced with those from the reports. I disregarded the exchange rate criterion, as countries already in the eurozone are using the euro.

 

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Divergence Criteria?

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