COSTS OF JOINING THE EURO AREA

Participation in the euro area entails the abandonment of an independent exchange rate and monetary policy, and importation of a monetary policy that takes into consideration economic developments within the entire euro area. In principle, monetary autonomy is a device which helps to manage certain kinds of shocks affecting the economy, thereby dampening business cycle fluctuations. Thus, the size of costs arising from giving up monetary autonomy broadly depends on whether there is an increase or decrease in the volatility of Hungarian business cycles following entry into the monetary union. This is because business cycle volatility also passes through to household income. In turn, strong volatility in national income will create lower welfare than stable income, even if the two income levels are identical on average. Recent research, relating in particular to the USA, suggests that the welfare costs arising from cyclical volatility may be high (see Box III-1). However, it is extremely difficult to quantify these costs in the case of Hungary. This is because such quantification would require not only knowledge of prospective changes in volatility but also that of such illusive parameters as the risk aversion preferences of Hungarian households and the cyclical vulnerability of resource allocation efficiency. Therefore, the noted difficulty of estimating an absolute measure of welfare costs has prompted us to apply a different approach based on a relative view. We have compared Hungary with the present member states of the euro area from the point of view of exposure to asymmetric shocks and the effectiveness of alternative devices available for the management of these shocks. The following analysis will prove that the state of affairs with regard to these factors is at least as promising in Hungary as in the currently less-developed euro area member states.

In addition to the above factors, there is a palpable and easily quantifiable cost associated with giving up autonomous monetary policy, namely the loss of seigniorage. Once a member of the euro area, Hungary will also have its share of seigniorage revenue from the use of euro notes and coins, but due to accounting rules, this share will be lower than if the National Bank retained its right of issue.

Box III-1

Measuring the welfare loss arising from cyclical fluctuations of the economy

The higher volatility of business cycles arising as a result of a country maintaining its own currency causes losses in welfare. This can partly be explained on the basis of the assumption that households are risk averse, in the sense that faced with future consumption paths with equal expected values they will prefer the more certain path (showing lower variance). Using US consumption data series, Lucas (1987) showed that given plausible parameters for risk aversion, welfare losses associated with the economic cycles are negligible; households would sacrifice only a tiny 0.1% of their annual consumption in order to reduce the variability of their consumption from the observed level to zero.

Recent research has, however, revealed that the welfare losses arising from business cycle fluctuations cannot be identified simply with losses arising from fluctuations in consumption. Galí, Gertler and López-Salido (2002) claimed that due to price and wage rigidities presumed to exist within the economy, business cycles cause inefficient fluctuations in resource allocation. They measure the efficiency of resource allocation in terms of the size of the wedge between the marginal product of labour and the marginal rate of substitution between labour and leisure, referred to simply as ‘the gap’.³⁵ Deviations of this gap from zero reflect an inefficient allocation of labour during the period reviewed. Based on US data, they demonstrate that this gap, which measures the inefficiency of resource allocation, shows strong correlation with the business cycle. However, its fluctuations are asymmetric, i.e. the losses incurred on inefficient allocation during a recession by far exceed the advantages arising from improved efficiency when output rises above the potential level. Hence, even if the fluctuations of economic activity are symmetrical, the bigger they are, the more strongly they will increase the losses caused by inefficient resource allocation. Based on research of post-war US business cycle data, Galí, Gertler and López-Salido conclude that the ensuing welfare losses are not negligible, perhaps even one order of magnitude higher than those estimated by Lucas.

35Put differently, the ‘gap’ denotes the difference between ‘reservation wages’ related to labour supply and labour demand existing at a given rate of employment.

The literature on OCA suggests that a final fixing of exchange rates cannot be optimal unless there is only a small likelihood that the participating countries are exposed to asymmetric shocks. For example, if demand for a particular country’s goods declines asymmetrically, autonomous monetary policy would be able to offset this fall in demand by lowering interest rates, that is by encouraging domestic demand and/or having a weaker exchange rate make domestic products cheaper relative to foreign goods. Within monetary union, however, the common monetary policy will not react unless the impact of the demand shock has an effect at the overall level of the union. Even then, the size of monetary easing might be smaller than if the country had an autonomous monetary policy, and would also affect the countries that had no need for it. Furthermore, changes in the exchange rate affecting the structure of demand will have to be given up altogether.

The probability of asymmetric shocks occurring depends primarily on the similarity, the degree of integration and diversification of production structures. Structural similarities will cause common shocks, especially when there is a high proportion of intra-industry trade. The markets for individual goods within monetary union will be linked by intra-industry foreign trade, making it unlikely that an asymmetric shock will only affect the goods produced by one particular country. On the other hand, provided there is a sufficiently diversified economic structure, the treatment of temporary shocks affecting one particular industry would not require the adjustment of the exchange rate even given an autonomous monetary policy. Such an adjustment would only be necessary if the industry involved were of crucial importance at the macroeconomic level.

To assess the probability of asymmetric shocks, the first two sections compare the production structure of the Hungarian economy, the depth of foreign trade and production integration with those of the euro area participating countries. The analysis of these two dimensions has not revealed a lag in respect of the real economic convergence of the Hungarian economy. As the Hungarian economy has implemented structural convergence towards the euro area over the past decade, there is not a single industry left that contributes to the Hungarian GDP with a weight unprecedented in other euro area member countries. As there has been a sharp rise in export diversification, a change affecting one single industry can now have only a minor impact on the evolution of GDP. At the same time,

there has also been a shift in the structure of exports, with a considerable fall in the share of goods with high price sensitivity and an increase in the weight of goods requiring high technological standards and greater human capital.

The third section will look into the question of whether the Hungarian economy has been subject to asymmetric shocks in the past. Our findings suggest that industrial production is in close cyclical correlation with that of the euro area. As far as demand shocks are concerned, even the past decade has been characterised by a high degree of synchrony. By contrast, the supply side has not historically exhibited such a high measure of harmony, due to structural changes in the Hungarian economy concomitant with the economic transition. Nevertheless, as a production structure similar to that of the European economies is in place now, the Bank believes that the significance of prospective asymmetric supply shocks has declined.

A common currency may be optimal for a country even in the presence of asymmetric shocks, if there exist some adjustment mechanisms that can substitute for the exchange rate changes and smooth the production and consumption fluctuations.

Based on the OCA theory, we will look at some potential adjustment mechanisms such as wage and price flexibility, factor mobility and fiscal policy.

Historical analysis paints a favourable picture as far as price and wage flexibility are concerned. Available data show that the repricing period is short by international comparison. It calls for caution, however, that empirical studies on the issue were conducted when inflation was still in the double-digit range, and a lower inflation environment is likely to increase the duration of the repricing period. Wages have also adjusted rapidly in the past, but lower inflation is expected to lead to higher nominal wage rigidity as well. It is promising, however, that in view of the institutional features determining wage and price flexibility over the longer term, Hungary is in a better position than the majority of the euro area countries.

Just as the other EU member states, Hungary faces low labour mobility and permanent regional differences. International mobility is hindered by linguistic and cultural barriers, restricted mobility of social insurance, pension schemes and other social benefits, and temporary restriction on the free flow of labour in respect of certain members. In addition, even national mobility is low, attributable to a number of factors including regional differences in housing costs. Nevertheless, this low labour mobility is not viewed as an obstacle to Hungary’s entry into the monetary union, as even for the present euro area

member states the free flow of labour plays a negligible role in adjustment to shocks.

Fiscal policy’s role of regulating aggregate demand may be restricted in the coming years by the need to adjust in order to meet the Maastricht criteria and the Stability and Growth Pact. Nevertheless, the present structure of the budget also enables a certain degree of smoothing of aggregate demand to be made, partly via the automatic stabilisers and partly via the funds earmarked for extraordinary expenditures. From another perspective, participation in the euro area will even facilitate compliance with the SGP, as real interest rates of forint-denominated public debt are expected to decrease inside the monetary union (for more on this, see Chapter IV.4).

The Bank believes that Hungary has achieved a stage of integration where the real economic costs of fixing the exchange rate are low. However, the costs are also influenced by the extent to which autonomous exchange rate policy can be an efficient means of managing asymmetric shocks under the Hungarian economic conditions. Providing that certain conditions are met, exchange rate policy may assist economic policy in its efforts to restore and maintain domestic firms’

competitiveness. The main question is whether the exchange rate has preference over other objectives within a particular country or economic region’s monetary policy. Under an inflation targeting regime the primary objective of the central bank is to meet the inflation target, while the exchange rate may be used to enhance competitiveness to the extent that it does not pose a threat to meeting the inflation target. In the past, nominal exchange rate fluctuations could not permanently influence the evolution of the real exchange rate. Any change in the exchange rate passed through rapidly to consumer prices, thereby absorbing any increase in competitiveness caused by devaluation. It is common knowledge that the more open a country is, the less capable it is of influencing its real exchange rate on a permanent basis by changing the nominal exchange rate (McKinnon, 1963). And Hungary is one of the most open economies in Europe.

The most important question in the presence of asymmetric shocks is what structural weight the sectors hit by negative shocks hold within the economy. Unless the afflicted sectors have a crucial share, exchange rate policy may predominantly improve the position of sectors that have not suffered, triggering an upsurge in nominal profits, which may soon exert inflationary pressure. The share of transnational companies in the afflicted sector’s output should also be taken into consideration,

a measure reflected in the high proportion of FDI within the sector as a whole. This is because this set of economic agents tends to focus on the profitability of the entire corporate group, making the factor of prices governed by the exchange rate not necessarily of paramount importance to them.

The exchange rate can also influence aggregate demand by affecting incomes and economic agents’ wealth. The literature on the sustainability of currency areas does not deal with the role which exchange rate devaluation and the resulting rise in inflation play in the conduct of economic policy, focussing as it does on the effect of the exchange rate on relative prices. Nevertheless, the importance of this channel must not be neglected from the Hungarian perspective, as the nominal imbalances of the past ten years, originating from the preceding period, have been typically corrected by devaluing the forint. In the early 1990s, the pegged exchange rate in principle represented a nominal anchor for the economy. However, this announced anchor lacked credibility and economic agents had expectations of an exchange rate adjustment. Indeed, wage growth was not in line with the announced exchange rate, making a devaluation of the

Chart III-1