Friday, November 28, 2014
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Poland’s Eurozone Tests

WARSAW – The European Union’s new member states from Central and Eastern Europe are required to join the eurozone as part of their accession agreements. But deciding when to adopt the euro is a matter of heated debate.

At stake is not just an economic calculation, but also a judgment about the outlook of the single currency itself. For many, the benefits of membership have diminished since the financial crisis, and prospective members, such as Poland, can derive maximum advantage from joining only if they are clear about the economic conditions that must first prevail in their own countries.

The formal criteria for entry are contained in the 1992 Maastricht Treaty, which sets targets for government debt, budget deficits, inflation, interest rates, and exchange rates. But merely hitting these targets (or, worse, just approaching them) at any given point in time has proved to be an inadequate foundation for membership. Indeed, the malleability of the Maastricht criteria has caused many of the eurozone’s problems. As long as eurozone debts continue to rise and member economies diverge rather than converge, prospective members should also be stress-tested to see if they can withstand external shocks and sustain the membership criteria over the long term.

Before Poland decides to share a currency with its main trading partners, it should consider three vital economic conditions: its international competitiveness, the flexibility of its labor market, and the health of its public finances.

Poland’s export markets are growing steadily. But this is not because the country trades mainly with other dynamic emerging economies, or because there is huge global demand for uniquely Polish products. Rather, Poland simply combines low costs (including wages) and high-quality production. For this reason, Poland is sometimes called the “China of Europe.”

But competitiveness based on cost, rather than brand value or innovation, makes the Polish economy vulnerable. Poland lacks the deeply rooted competitiveness of, say, Germany, the Netherlands, Austria, Sweden, or Switzerland. Polish exports are sold under non-Polish names (Italian for shoes, for example, or English for clothing). Its machinery exports are part of larger multinational networks run by German, Dutch, or other global companies. And Poland’s cost advantage would disappear if the złoty were to strengthen sharply.

Although Polish companies are working hard to build brands abroad, this can take decades. In the meantime, the country must be careful about joining the exchange rate mechanism (ERM II) – the narrow band within which applicant currencies must operate for at least two years prior to adopting the euro. Doing so could cause the złoty to strengthen, as it did to the Slovak koruna, and wipe out Poland’s competitive advantage.

Another important aspect of Poland’s competitiveness is its flexible labor market. One in four employees is on a fixed-term contract or self-employed. A quarter of the typical Polish wage comprises variable elements, making it easy to freeze, or even lower, compensation during tougher economic times. This means that firms can hire workers on short-term contracts when they are unsure of the business outlook; more generally, such flexibility helps the economy withstand external shocks.

But flexible labor markets have disadvantages, too. Companies tend not to invest in talent or develop new skills, and the quality of existing skills can suffer. In the longer run, flexible labor markets also increase structural unemployment and fuel the informal economy.

Furthermore, shortages in Poland’s residential rental market restrict workers’ ability to move to where the jobs are. Arguably, Poland’s labor market is more akin to Spain’s than that of Scandinavia, where generous social protection allows for extensive employee training.

Finally, Poland needs sound public finances – that is, fiscal space for automatic stabilizers during economic crises. By saving money for hard times, the government can implement countercyclical measures, while ensuring stable finances throughout the economic cycle.

Such a policy was successfully implemented in 2009 and 2010, but the government lacked the funds it needed when economic conditions subsequently deteriorated. Sound public finances require not only low public debt, but also appropriate budgetary policy, which includes cutting spending (or raising taxes) during boom times, not during downturns, as was recently the case.

Broad-based competitiveness, truly flexible labor markets, and prudent budgeting are not beyond Poland’s reach. In each case, there are other national examples to emulate: Switzerland’s competitiveness, Denmark’s labor markets, and Estonia’s public finances, for example. Before Poland joins the eurozone, its economic policy should be directed toward these three criteria of long-term economic success.

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    1. CommentedDanuta Huebner

      You remark that competitiveness based on cost, as opposed to innovation, makes an economy vulnerable. If the national currency appreciates, cost competitiveness is lost. From this, you conclude that Poland should be very cautious before it joins the ERMII, as the zloty might appreciate.

      If what we want is genuine competitiveness however, based on true structural change and a leap to new innovation frontiers, then maybe joining the euro area is exactly what we need. Once inside the single currency, we are not tempted to use exchange rate policy to artificially become more 'competitive'. Instead, we have a commitment device which makes us go for genuine structural reforms. The challenge is of course to navigate the ERMII period successfully. If the right timing is chosen however, I don't see why this should be a problem.

      Taking an excessively long-run view of joining the ERMII and then the euro can be dangerous. The risks abound, from becoming being left behind by current euro area reforms, not having a say in the change of the economic monetary union, to potentially losing the confidence of investors and not to mention a lack of access to the ECB's non-standard monetary policy measures. These are risks we cannot afford to take.

    2. CommentedVal Samonis

      Well, what will deal a devastating blow to Poland's competitiveness are not rather minor negative circumstances that the Author mentions. There are two BIG problems:

      1. A total absence of any longer-term strategy for Polish economy (e.g. based on less vulnerable advantages, etc); and
      2. A frightening worsening of the dependency ratio in a very rapidly aging society (bad tax prospects) beset by huge emigration of young, bright, relatively educated.

      No amount of further currency manipulations will alleviate the above problems. A different sort of effort is needed.

      Val Samonis
      Royal Roads University, Canada
      Vilnius University, Lithuania

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