Slamming the Euro Door

LONDON – Last week, central bankers from around the world assembled in Frankfurt to bask in the glory of the euro’s first ten years. But for those coming from euro candidate countries, the event was a cold shower. Just as the global financial crisis has made euro membership seem more urgent and necessary than ever, euro incumbents have started floating proposals that would raise the bar for entry.

Under the proposal that was openly discussed in Frankfurt, in addition to the macroeconomic Maastricht criteria that have been in place since the euro’s launch, the quality of a country’s banking system would be used as an additional criterion for euro entry. Leaving aside the hypocrisy of Western governments pontificating on this topic while they are bailing out banks after massive regulatory failures, the proposal is seriously flawed.

To fully appreciate the proposal’s absurdity, consider the extraordinarily successful East European growth model of the past two decades. The model advocated by Western Europe and embraced by Eastern Europe has been based on the idea that capital should flow from capital-rich to capital-poor countries. Economists have to go back to the nineteenth-century United States to find a similar textbook example of successful growth, with large current-account deficits financed mainly through foreign direct investment. Financial flows have been accompanied by unprecedented financial integration, with most East European banks now controlled by Western parents.

This model has worked remarkably well not just in generating growth, but also, as documented in the European Bank for Reconstruction and Development’s 2008 Transition Report , in improving the institutions that support markets and democracy in Eastern Europe. But it has also left these countries vulnerable to the twists and turns of global financial markets. Over the last year and a half, they withstood these pressures remarkably well; but, as the global crisis hits them with full force, they are now seeking help from the International Monetary Fund.