Both Austria and Slovakia are located in the Central European region – they are part of the Central European family. As a matter of fact, Austria has made effective use of this location in the two decades since the fall of the Iron Curtain. It has become one of the most important investors in its Central European neighbours. Austria's economic links to Slovakia are especially strong, not least because of the short distance between the two capitals, Vienna and Bratislava. Today both countries are also members of the euro area, which strengthens their relationship even further.

The euro was a milestone of European integration (Nowotny, 2010). Against the background of the global financial crisis, it seems to be the right time to discuss and reflect on the euro's development from both a European perspective and from a global angle. In the early stages of its existence, the euro was under heavy criticism. The well-known argument of proponents of the optimum currency area (OCA) theory associates the costs of joining a monetary union with the loss of domestic monetary policy, the well-known argument that ‘one size cannot fit all’. Certainly, a currency union becomes costly if the business cycles of its member countries are not synchronised and if domestic adjustment capabilities are limited. In the absence of country-specific monetary policies, an idiosyncratic shock cannot be absorbed through the real exchange rate but has to be digested via flexible wages, fiscal transfers and mobile factors of production.

Introduction

When euro notes and coins were originally introduced in January 2002, consumers in the member states of the Eurozone experienced a sharp spike in perceived inflation, which translated into a permanent perception that the switch to the new currency was associated with a one-time inflation shock. As evidence of this, the synthetic indicator of perceived inflation over the previous twelve months compiled by the European Commission from consumer surveys showed a jump from 27 in December 2001 to 60 in September 2002 and remained above 50 for most of 2002. The most succinct summary of this view was coined in Germany, where the euro was promptly dubbed ‘teuro’ (from teuer, meaning ‘expensive’ in German).

For consumer prices as a whole, the perception was largely disproved by the actual data on the development of consumer prices during the relevant period. Prices in January 2002 rose by 0.09 per cent in the Eurozone according to the harmonised index of consumer prices (HICP) and the annual inflation rate during 2002 was also similar to 2001 and 2003, oscillating between 2 per cent and 3 per cent (although there was an unusual jump at the beginning of 2002, attributed mainly to the weather). Therefore, the explanations of discrepancies between the perceived and the actual inflation tended to focus on either purely psychological interpretations of how individuals could experience higher inflation at the time of a change in currencies without any basis in reality, or interpretations combining higher-than-normal changes in specific prices, which are likely to form anchors of consumer experiences, with psychologically based misconceptions.

Introduction

Since the early 1990s many European countries have introduced fiscal rules and procedures which are aimed at either preventing or reducing fiscal imbalances. This development reflects three main factors: the experience of the previous decades, characterised by large imbalances, public debt growth and the implementation of pro-cyclical policies; the creation of the Economic and Monetary Union (EMU) and the introduction of fiscal rules at the European Union (EU) level; and the challenges of ongoing demographic changes.

The reforms have involved three main lines of action: (1) the introduction of numerical fiscal rules; (2) the modification of budgetary procedures, in particular with a view to strengthening the role of the Ministry of Finance and to making budgetary policy more medium-term oriented; and (3) the creation of independent fiscal institutions, which can contribute to macro fiscal forecasting, fiscal analysis, policy design and even implementation.

In this chapter we argue that the attractiveness of the euro for CEE economies has always depended on (1) their willingness and capacity to invest in an independent stabilising monetary policy, and (2) the credibility of the euro project going forward. These are not new criteria, but it is worth recalling that the last decade has dispelled as unfounded the hopes that the euro is a convergence-bringing panacea or a substitute for structural reforms and fiscal discipline. Besides, the crisis and the unfolding fiscal consolidation programmes are reducing the attractiveness of the euro further in the short term. However, it is also worth recalling that the euro has been successful in bringing an important degree of monetary stability to the euro area, and has sheltered its members from many shocks. The attractiveness of the euro project for the Central and Eastern Europe (CEE) countries thus depends on the euro area's ability to build on these achievements. For the CEE countries that have been fixing their currencies, an early euro adoption should be a priority.

The economic debate about euro adoption should be cast in terms of the stabilising role of monetary policy – other considerations may be misleading. At the onset the euro was hoped to improve the long-term macroeconomic performance of member countries, not only in terms of price stability but also in terms of long-term output levels and growth rates. And the arguments portraying the euro as a vehicle of real convergence began to dominate in rationalising the common currency project.

Introduction

After several years of very strong economic growth, the Baltic countries have witnessed one of the deepest recessions in the world. In an historical context, the expected cumulative output loss associated with this Baltic recession is almost twice the size of the losses suffered by the hardest-hit countries in the 1997–8 Asian crisis, and in the case of Latvia comes close to the size of the US output decline during the Great Depression.

Despite many similarities in structural characteristics (including fixed exchange rate arrangements) and macroeconomic developments prior to the crisis, the Baltic countries have shown clear differences in their ability to cope with the common negative shocks associated with the global economic crisis. Estonia has been more successful than its Baltic neighbours in withstanding the impact of the financial crisis, and will join the euro area from 2011. Resilience to the crisis has been weakest in Latvia, which is dependent on financial support from the International Monetary Fund (IMF) and the EU and has a more uncertain economic outlook.

The euro area's future is troubled because of the heterogeneity of its members. Beneath the surface of satisfactory performance for the euro area as a whole, its first decade was characterised by divergence in key macroeconomic indicators among member countries (e.g. inflation rates, current account positions and real effective exchange rates). This divergence points to the source of the problem. It does not lie with the credibility of the European Central Bank (ECB). Rather, it lies with the difficulties for a number of countries in operating with a single currency. These arise from persistent differences in how labour markets work in member countries and in how different governments have approached the problem of stabilising the national economy within a common currency area (CCA).

The euro area's first decade shows that the choice of monetary regime can affect economic outcomes on the real side of the economy. Expectations that private and public sector agents would change their behaviour once a single currency was adopted proved overoptimistic. Contrary to the expectations of many observers, in the private sector, wage- and price-setters did not modify their behaviour in ways consistent with sustainable growth within a CCA. In the public sector, the need to stabilise national bouts of excess demand was neglected. The markets failed to signal the build-up of these tensions: until the sovereign debt crisis emerged in early 2010, and spreads on the bonds issued by euro area governments remained until then very narrow.

This volume brings together the papers and panel contributions presented at the conference on ‘The Euro Area and the Financial Crisis’, held in Bratislava from 6 to 8 September 2010. The conference was hosted by the National Bank of Slovakia and jointly organised by the National Bank of Slovakia, Heriot--Watt University in Edinburgh and Comenius University in Bratislava. The event was characterised by intensive discussions between central bankers, academics and policy-makers from all over Europe, which contributed directly and indirectly to the authors’ revisions of their papers. The basic question was: What are the implications of the financial crisis and the great recession for the future of the euro area?

The book begins in Chapter 2 with the keynote contribution by Governor Athanasios Orphanides on the issues surrounding financial stability in Europe. Part I addresses the experience of the crisis. Thorvardur Ólafsson and Thórarinn Pétursson try in Chapter 3 to identify the factors that caused the depth and duration of the crisis to be larger in different countries. Philip Lane in Chapter 4 focuses on the Irish case. Angel Gavilán, Pablo Hernández de Cos, Juan F. Jimeno and Juan A. Rojas in Chapter 5 examine the Spanish case. Aurelijus Dabušinskas and Martti Randveer in Chapter 6 consider the varying experiences of the Baltic countries. Part II considers the issue of accession to the euro area by countries in Central, Eastern and Southeastern Europe (CESEE). Biswajit Banerjee, Damjan Kozamernik and L’udovít Ódor in Chapter 7 analyse the different strategies for entry to the euro used by Slovakia and Slovenia. Miroslav Beblavý in Chapter 8 investigates whether euro entry was associated with significant rises in prices (especially for non-tradable goods and services) in Slovakia. And in the first panel contributions Governor Ewald Nowotny in Chapter 9 and Zdeněk Tůma, together with David Vávra, discuss in Chapter 10 whether and how CESEE countries should accede to the euro. Part III looks at the future of the euro area. Francesco Giavazzi and Luigi Spaventa in Chapter 11 argue that much more attention needs to be paid to current account deficits within the European Monetary Union (EMU). Daniele Franco and Stefania Zotteri in Chapter 12 consider the role that national fiscal rules could play in avoiding future problems. Thomas F. Huertas in Chapter 13 discusses mechanisms for ‘bail-in’ as an alternative to future bail-outs of financial institutions. Laurent Clerc and Benoît Mojon in Chapter 14 review the conduct of monetary policy in the euro area since the inception of the euro and the challenges that the Eurosystem has faced since the financial crisis. Boris Cournède and Diego Moccero in Chapter 15 assess the contribution that a price-level (as opposed to an inflation) target could make to the operation and performance of monetary policy. This is followed by contributions by Wendy Carlin, Vítor Gaspar, Stefan Gerlach and Jacques Mélitz to the second panel (Chapters 16--19), on how to restore confidence in the euro project.

Athanasios Orphanides in his opening keynote address affirmed that the global crisis revealed fault lines in the governance of the euro area. He concentrated on the new architecture for financial stability in Europe. In my brief contribution I want to focus on fiscal sustainability and budget discipline.

Demographic transition, the global crisis and debt levels

Before focusing on the specific case of the euro area I want to comment very briefly on a crucial evolutionary driver that will shape budgetary trends for the next several decades: demographics. The world is experiencing a fundamental demographic transition: according to the latest demographic projections, made available by the United Nations (2009), world population will stop growing by 2050, when it will have reached about 9 billion people (compared to almost 7 billion in 2010). This will interrupt a trend of pronounced population growth recorded for centuries. This constitutes an epochal transition, with profound impacts on economic, political and social balances.

Introduction

The euro was ten years old in 2008. To celebrate this important birthday the European Commission produced a 350-page report (European Commission, 2008), accompanied by a string of research papers, to evaluate the European Monetary Union (EMU) experience after a decade. Lights and shades emerged from a careful and thorough analysis of the relevant issues, but the overall conclusion was that EMU is ‘a resounding success’. Though perhaps more soberly, most observers would have subscribed to this view, ready to shelve some issues that, hotly debated when EMU was first launched, seemed now to have lost relevance: the effects of asymmetric shocks when optimum currency area conditions are not satisfied, the dangers of uncoordinated fiscal policies, the Walters (1986) critique of a ‘one-size-fits-all’ single monetary policy. One of the questions examined in the report, and at first sight somewhat reminiscent of the issues raised by Sir Alan Walters, was that of persistent differences in growth and inflation between some countries and the rest of the euro area. Misgivings on the sustainability of these trends were expressed here and there, but on the whole the policy conclusion was broadly reassuring:

Introduction

Central banks are usually assigned two main goals: the most recent one, which has become their priority objective over the last three decades, is price stability; the second one, which is historically their raison d’être, is to ensure the integrity of payments. In modern economies, this takes the form of the smooth functioning of interbank exchanges on the money market, which contributes to and depends on the maintenance of financial stability.

In accordance with economic theory, central banks have assigned specific instruments to each of these two objectives. The short-term interest rate has emerged, over the last three decades, as the main instrument with which monetary policy pursues its price stability objective. Central banks support the functioning of the money market through a continuum of instruments, ranging from their marginal standing facilities to the granting of liquidity assistance to troubled money-issuing institutions or lender of last resort (LOLR) to the financial system as a whole. These operations can, however, be sterilised in order to insulate the stance of monetary policy. Looking back at the first twelve years of the euro, this separation in the pursuit of the two objectives, which is consistent with the Tinbergen principle, has not been challenged until recently when short-term nominal interest rates reached their (zero) lower bound in 2009. The Eurosystem then, along with many other central banks throughout the world, embarked on non-conventional policies. The circumstances of the financial crisis and the great recession blurred the separation between the means mobilised by the euro area central bank in the pursuit of its two objectives.

Policy positions and committee structures in the European Parliament

The fact that the European Parliament (EP) is the only directly elected legislative body in the European Union (EU) gives its policy demands considerable weight in the decision-making process. Under the co-decision procedure, which is now the ordinary procedure, the EP’s formal decision-making power equals that of the Council of Ministers. Even when the consultation procedure applies, the EP appears to influence decision outcomes via the influence it exerts on the Commission (Nugent 2006: 404; Thomson and Hosli 2006b: 414; Kardasheva 2009).

This chapter examines the relevance of two general theories of legislative decision-making to explain variation in the EP’s policy demands. The first theory is the informational theory of legislative committees (e.g., Gilligan and Krehbiel 1989; 1990; Krehbiel 1991). According to this theory, on any given issue the policy position of the chamber as a whole is an unbiased representation of the policy positions of all parliamentarians. The second theory is the distributive theory of legislatures, according to which legislative organization, in particular committee structures and associated procedures, bias the policy positions of legislative bodies (e.g., Ferejohn 1975; Shepsle and Weingast 1987; Weingast and Marshall 1988).

The following 125 legislative proposals are included in this study. See Chapter 2 for details of the selection criteria. Asterisks indicate the sixteen proposals on which Costello (2009) collected detailed data on the policy positions of European Parliament (EP) groups, data that are examined separately in Chapter 5. The dataset will be available at http://www.robertthomson.info.

Agriculture

Proposal for a directive laying down minimum standards for the protection of laying hens kept in various systems of rearing 1998/092/CNS