Monetary and real convergence
The Pros and Cons of the Maastricht convergence criteria
Nigel F.B. Allington
Gonville and Caius College Cambridge and Cardiff University.
Introduction
At the May 1998 Brussels Summit meeting of Heads of State confirmation came that eleven countries,
the entire European Union (EU) bar Britain, Denmark, Greece and Sweden, would join the euro in January
1999. That decision rested upon interpretation of the Maastricht convergence criteria for inflation, interest
rates, exchange rates, and government deficits and debts. The deficit and debt figures were known in
advance, those for inflation (2.7%) and interest rates (7.8%) where determined in January of this year.
Table 1 reproduces the key table from the Report and in particular shows how eight of the eleven qualified
under the debt criteria, although they were above the reference value, because it was shrinking in each
case. Greece alone did not qualify, Denmark and Britain exercised their opt-outs and Sweden chose not to
enter although it did fail to meet the exchange rate criterion. Greece expects to join in January 2001 and in
the following year euro notes and coins come into circulation.
Thus in spite of the siren voices of the Eurosceptics, and luke-warm public opinion in Europe in general,
the single currency has arrived and the (independent) European Central Bank (ECB) will shortly be setting
interest rates and monetary targets with a view to maintaining price stability as a primary objective. This
will cause friction in France, (where traditionally low inflation has received less weight than high
unemployment) but also surprisingly in Germany, following the recent change of government there. In the
future, in fact, the Euro XI (committee of euro-country finance ministers) might well become the focus of
economic policy dissent to the ECB.
The expectation is that the euro-area will enjoy currency stability and low inflation. At the
microeconomics level, transaction costs will be considerably reduced, and the single market re-energised as
price transparency emerges that will encourage arbitrage and competitive efficiency. Euro-area capital
markets will also receive a boost and entrepreneurs should find the cost of capital lower because low
inflation should produce low interest rates. However, the loss of independent national monetary and
exchange rate policies may impose counter-balancing costs. These will be large if the members of the
currency union are subject to asymmetric shocks (shocks that affect one country but not the others) that
cannot be accommodated through capital and labour mobility between countries and fiscal transfers from
Brussels to depressed regions. Ultimately, however, fiscal transfers simply camouflage the fundamental
problems within national economies that can only be addressed via wage, and hence price adjustments, to
raise competitiveness. But in the EU wages are quite inflexible and labour markets outside Britain and the
Netherlands are far too rigid to offer the level of adjustment required. The Stability Pact, which imposes
strict fiscal constraints after the single currency has been adopted, also limits the extent to which national
governments can use fiscal policy and could result in fines up to 0.5% of GDP for transgressors.
Thus observance of the convergence criteria should have minimised these problems for the euro-area
as economies within it became more integrated through trade, and policy making more centralised through
the ECB. Given their critical position therefore this article examines the criteria in detail and whether other
(real) criteria might not have been more useful.
Table 1
Current performance of the Member States in relation to convergence
Inflati
on
HICP
(a)
Janua
ry
1998
Government budgetary position
Existence of an
excessive deficit (b)
Deficit (% of
GDP) (c)
1997
Exchange
rates
Debt (%) of GDP
1997
Change from
previous year
1997
Reference
value
Belgium
Denmark
Germany
Greece
Spain
France
Ireland
Italy
Luxembourg
Netherlands
Austria
Portugal
Finland
Sweden
UK
Europe
2.7 (e)
1.4
1.9
1.4
5.2
1.8
1.2
1.2
1.8
1.4
1.8
1.1
1.8
1.3
1.9
1.8
1.6
3
yes
no
yes
yes
yes
yes
no
yes
no
no
yes
yes
no
yes
yes
(g)
(g)
(g)
(g)
(g)
(g)
(g)
(g)
(g)
2.1
-0.7
2.7
4.0
2.6
3.0
-0.9
2.7
-1.7
1.4
2.5
2.5
0.9
0.8
1.9
2.4
1996
ERM
participation
March 1998
January
1998
1995
60
122.2
65.1
61.3
108.7
68.8
58.0
66.3
121.6
6.7
72.1
66.1
62.0
55.8
76.6
53.4
72.1
Longterm
interest
rates
(d)
7.8 (f)
-4.7
-5.5
0.8
-2.9
-1.3
2.4
-6.4
-2.4
0.1
-5.0
-3.4
-3.0
-1.8
-0.1
-1.3
-0.9
-4.3
-2.7
2.4
1.5
4.6
2.9
-9.6
-0.2
0.7
1.9
0.3
-0.9
-0.4
-0.9
0.8
2.0
-2.2
-4.9
7.8
0.7
2.9
4.2
-6.8
-0.7
0.2
1.2
3.8
2.1
-1.5
-1.4
3.5
3.0
yes
yes
yes
yes (h)
yes
yes
yes
yes (j)
yes
yes
yes
yes
yes (k)
no
no
5.7
6.2
5.6
9.8 (I)
6.3
5.5
6.2
6.7
5.6
5.5
5.6
6.2
5.9
6.5
7.0
6.1
(a) Percentage change in arithmetic average of the latest 12 monthly-harmonised indices of consumer prices (HICP) relative to
the arithmetic average of the 12 HICP of the previous period.
(b) Council decisions of 26.09.94, 10.07.95, 27.06.96 and 30.06.97
(c) A negative sign for the government deficit indicates a surplus
(d) Average maturity 10 years; average of the last 12 months
(e) Definition adopted in this report: simple arithmetic average of the inflation rates of the three best performing Member
States in terms of price stability plus 1.5 percentage points.
(f) Definition adopted in this report: simple arithmetic average of the 12-month average of interest rates of the three best
performing Member States in terms of price stability plus 2 percentage points.
(g) Commission is recommending abrogation
(h) Since March 1998
(I) Average of available data during the past 12 months
(j) Since November 1996
(k) Since October 1996
Source: Adapted from The Convergence Report, European Commission, January 1998.
2
The Maastricht convergence criteria
At Maastricht in December 1998 the EU governments agreed that Economic and Monetary Union
(EMU) would start on 1 January 1997 if enough member states qualified, but failing that on the 1 January
1999 with no fallback strategy even contemplated. The politicians were so certain that the project would
achieve launch velocity, even if it was twenty years late.
Membership depended upon four tests of purely nominal convergence that included: inflation, longterm interest rates, fiscal positions and exchange rate stability (see Table 2 below). Real convergence that
would include variables such as growth, unemployment and external balance received only cursory
mention, although arguably these should have been of paramount importance. However, of the nominal
criteria chosen, only inflation makes any kind of intuitive sense and has implications for monetary union 1.
Low interest rates certainly follow on from low inflation, although the risk premia associated with deficits
would remain. And the inclusion of exchange rate stability simply makes conversion of currencies into the
euro easier (although the possibility of a 30% variation in bilateral rates for several countries since 1993
the fiscal ones: a government deficit-GDP ratio below 3% and debt-GDP ratio below 60%. While neither has
any bearing on the economic theory of currency union, it is easy to appreciate the (mainly) German
reasoning behind the adoption of measures of fiscal rectitude, that would exclude (mainly Mediterranean)
EU countries renowned for their profligacy.
Table 2: The Convergence Criteria in the Maastricht Treaty
1.
Price stability: a sustainable price performance and an average rate of price inflation over the
previous year no more than 1½ percentage points above that of, ‘at most, the three best
performing Member States in terms of price stability’; price inflation measured by the ‘consumer
price index on a comparable basis, taking into account national definitions’.
2.
Sustainable government financial position: that the member state is not the subject of a Council
decision that it has an excessive deficit, on the basis of the following criteria:
 A planned or actual ratio of general government net borrowing to GDP no greater
than 3 per cent, unless it has ‘declined substantially and continually and comes close
to’ 3 per cent or the excess is ‘only exceptional and temporary and the ratio remains
close to’ 3%; and
 A ratio of total general government gross debt to GDP no greater than 60 per cent
unless it is ‘sufficiently diminishing and approaching’ 60 per cent at ‘a satisfactory
pace’.
3.
Exchange-rate stability: participation in the exchange rate mechanism of the EMS, ‘respecting the
normal margins of fluctuations’, for at least two years without the Member State concerned
devaluing ‘on its own initiative’ the bilateral central rate for its currency against the currency of any
other Member State.
4.
Convergence of interest rates: durability of convergence and of ERM participation being reflected
in an average nominal long-term interest rate over the past year no more than 2 percentage points
above ‘that of, at most, the three best performing Member States in terms of price stability’;
interest rates measured on the basis of long-term government bonds or comparable securities,
‘taking into account differences in national definitions’.
The first part of this article appraises the integrity of the fiscal criteria, since so much weight is placed
on them, to gauge their economic relevance. Second, the more important real convergence criteria are
considered, which would yield an entirely different group of eligible countries for EMU from those chosen
in 1998.
1
As Mundell (1961) interpreted the necessary conditions for it in his classic 1961 article.
3
Fiscal convergence
The importance of fiscal convergence as a desirable goal can be traced back to the 1989 Delors Report.
The Maastricht Treaty merely confirmed this stance and in outlawing excessive deficits held member states
individually responsible for eliminating them and explicitly excluded any central bank financing of deficits.
But despite the fact that excessive deficits are ruled out and precisely defined, temporary and exceptional
government budget deficits that arise from the operation of automatic fiscal stabilisers in a recession are
permissible. So are those arising from adherence to the golden rule of public finance whereby government
borrowing finances only capital investment. Similarly, a higher debt ratio would not rule out membership
of EMU providing it too could be shown to be moving towards the limit through government saving: a
caveat of considerable importance to Belgium, Italy and the Netherlands in particular.
There consequently remained plenty of scope for political intervention to ensure sufficient members
qualified for EMU, but given that inflation rates had to converge, countries would not be able to use doses
of excessive inflation to erode debt. Also, in order to meet the interest rate criterion and avoid risk and
default premiums, those with unsustainable deficit/debt ratios would still have to engage in serious fiscal
restructuring. The belief was that once deficits and debts were under control, then issues like bailouts and
possible contagion effects from fiscal profligacy would not arise.
The actual figures chosen for the deficit-GDP ratio and for the debt-GDP ratio appear totally arbitrary,
although close to the EU average for 1991, the year of Maastricht. But the relationship between them can
be demonstrated with the following formulae:
 t 
d t  d t 1   
d t  def t
1   t 
Here, dt = Debt-GDP ratio in period t, t is the growth of nominal GDP in period t and deft is the DeficitGDP ratio in period t. Larger deficits therefore increase the Debt-GDP ratio and growth in nominal GDP
reduces it. More particularly, given deficits and debts can only be sustainable at one rate of growth of GDP
the specific Maastricht convergence figures are consistent with real growth of 3%, or nominal growth of 5%
and inflation of 2%. Beyond this, a 3% deficit would be consistent with the golden rule of public finance.
Considering the data produced for the 1998 Convergence Report (see Table 1), only Greece failed to make
the deficit criterion whereas only France, Luxembourg, Finland and the UK made the debt criterion.
Belgium (112%), Greece (108%), and Italy (121%) had particularly high debt-GDP ratios. However, deficits
were falling in all cases as most governments maintained primary surpluses so that the caveat mentioned
earlier could be invoked to allow all to qualify for EMU membership, except Greece, that failed under both
the inflation and interest rate criteria. Thus although the targets set were severe, through deflation and
various questionable measures to massage the debt downwards, the targets were met. To meet the 60%
debt GDP ratio precisely, however, would have meant serious economic retrenchment for some countries.
Adjusting the deficit and debt criteria
The integrity of the debt criterion might have been questioned in the first place on a number of
grounds. For example, non-monetary debt rather than gross debt should have been considered so that
explicit account could be taken of the monetary base which, for historical reasons, might be large thereby
penalising some countries more than others. Differences between gross and net debt can also be large if
financial assets are netted out of gross financial liabilities. Indeed, liquidating readily saleable financial
assets could reduce debt. Privatisation receipts could also easily be used to reduce government debt
further, although on an economic interpretation they should be viewed as equivalent to government
borrowing. But of course liquidating financial assets and selling businesses (even if this occurs for reasons
of efficiency) does not change the fiscal stance of the government and it would still be necessary ultimately
to raise taxation or reduce expenditure.
Finally, differences in the funding of pensions should also have to be taken into account and
government debt adjusted accordingly. In the EU the two extremes are the Netherlands, where civil service
pensions are fully funded and France and Germany where there is no funding of public sector pensions.
Social security pensions, on the other hand, tend to be totally unfunded throughout the EU. When
adjustments are made for the varying ways in which pension contributions and benefits are taxed to
achieve comparability, the debt figures for the Netherlands and the UK are adjusted downwards
4
significantly and those for France and Germany marginally, but in terms of meeting the criterion, by useful
amounts.
Of equal importance, those who framed the Maastricht criteria seem to be oblivious to the distinction
between nominal and real interest rates, a critical omission while interest rates differ. For many EU
countries, a large nominal interest burden does not translate into an equally large real interest burden.
Consequently, until a single currently has been adopted and a single inflation rate has been established, it
makes sense to apply different deficit criteria to different countries according to their different interest rate
positions.
Also growth rates of real GDP differ significantly amongst EU countries and convergence under this
heading forms no part of the Maastricht project. Poorer countries within the EU will have to grow much
faster to catch up with the richer and this process may extend over a considerable period of time.
Nevertheless, given that countries with faster growth rates can sustain higher deficit-debt ratios, the Treaty
ought to have made allowances for this factor too.
Interpreting the fiscal criteria
Interpreting the deficit has been crucial in assessing how rigidly it should be applied for convergence
and similar interpretative issues will arise later for stability. For example, the fiscal deficit will rise
automatically in a recession. Thus counter-cyclical automatic stabilisers such as: unemployment benefit,
social welfare expenditure, early retirement benefits, job retraining costs and subsidies for ailing firms
should be viewed as beneficial despite their implications for future taxation. However the precise extent to
which deficits in excess of 3% attributable to these causes would be permissible would be the subject of
political debate and the interpretation of a key phrase in the Maastricht Treaty “the medium term
budgetary position [of the country]”.
The Treaty also quite clearly invoked the golden rule of public finance without actually using the term, but
the Germans, and Gordon Brown (Labour Chancellor) in the UK, are keen on it. Defining consumption and
investment for this purpose would be important. A classic example of the problem involved is whether
teacher’s salaries should be counted as consumption or investment. Other economists would argue that
the rule makes little sense since both the permanent income and life cycle hypotheses demonstrate the
benefits to be derived from stable consumption when current income is unstable. Not only this, many
socially useful government investment projects (for example road building) have failed to generate a
stream of new revenue for government. Either directly through user payments, or indirectly by raising
productivity and hence the tax take, so that ultimately policies to raise extra revenue or cut expenditure
have to be pursued to pay for them.
Excessive deficits may lead to unsustainable debt and a solvency crisis and the Germans have insisted
there should be no bailout. The market itself of course will help to militate against this since a country
issuing excessive amounts of debt will be subject to credit rationing and a risk premia will be factored into
interest rates even with a single currency. In this case other countries interest rates will be unaffected.
And any government that reneged on its debt would be the subject of sanctions irrespective of whether it
was in a currency union or not. Only if financial institutions held large amounts of this debt would the ECB
become involved as lender of last resort, although not, it must be stressed, by taking over the debt. Hence
no monetary externality arises since the constitution of the ECB denies it the option of monetising
excessive deficits.
Finally, fiscal discipline would prevent spillover affecting interest rates, exchange rates or economic
activity elsewhere. Without this, uncoordinated national fiscal policies could lead to sub-optimal spending
levels and a deflationary contagion. When there are market distortions like taxes, transfers, technological
consumption (the introduction of new goods independent of consumer preferences), production
externalities (pollution), non-competitive behaviour, incomplete markets and so on, or government policy
created distortions, fiscal policy co-ordination becomes essential. Fortunately, empirical evidence suggests
that the size of spill-over effects are small and that even their sign is ambiguous because member states of
the EU, other than Germany, are too small to have large effects. Roubini (1991) found that a German
expansion of 2% would raise German GDP by 1% in the first year and reduce GDP in France, Italy and the UK
by 0.25%. Yet other economists have found the contraction to be as high as 2% elsewhere and still 0.5%
below the baseline five years later. Should Germany contract its money supply by 1% this reduces GDP by
0.8% in the other EU countries in the first year and the effect does not tail off for seven years.
5
Political necessity for fiscal convergence
Purely political motives could explain the fiscal criteria in the absence of convincing economic ones, but
even if this were to be the case, national legislation rather than mechanistic Maastricht rules might be a
more appropriate corrective. History has shown that governments in the EU have a tendency to
accumulate large deficits. The political business cycle and the policy contortions associated with the
election process also help to explain large deficits. Consequently political factors might make fiscal rules
desirable in the absence of adequate constitutional checks and balances.
In conclusion, therefore, the fiscal criteria are badly designed and would require higher unemployment
in many countries if they were to be mechanistically applied. Certainly there can be no case for uniform
rates across fifteen so obviously heterogeneous countries. And the criteria are not necessary to meet the
inflation, interest or exchange rate criteria. In the event, the debt level has been ignored; except that its
direction has been invoked, and the deficit has been met by creative accounting with longer run difficulties
likely to emerge when the Stability Pact test is applied.
The need for real convergence
An important opportunity for convergence was missed when real criteria were marginalised. The only
reference to real convergence occurs in Article 109 of the Maastricht Treaty.
“The European Union Commission and European Monetary Institute shall also take account of the results of
the integration of markets, the situation and development of the balance of payments on current account
and an examination of the development of unit labour costs and other price indices”.
A more robust application of real convergence criteria may, with the benefit of hindsight, come to be
viewed as a serious omission and one likely to lead to severe asymmetric shocks. In particular, the absence
of convergence in long-term productivity growth and a reasonable degree of correlation between EMU
members’ business cycles, both of which exhibit considerable divergence, would be critical.
The benefits of fixing exchange rates and adopting a single currency outweigh the costs if participating
countries constitute an optimum currency area. The impact of asymmetric shocks in such an area is
minimised if factors of production are mobile and/or fiscal transfers are possible between regions
experiencing difficulties. At the present time in the EU the abolition of capital controls and the completion
of the single financial market has made capital highly mobile. However, labour remains quite immobile
mainly because of problems associated with language, culture and housing tenure and budgetary
constraints mean substantial fiscal transfers are impossible. Also, the Stability Pact will constrain fiscal
policy, and given the low level of labour mobility considerable wage flexibility will be required if high
unemployment is to be avoided. To accommodate such rigidities now, therefore, large price changes
inevitably become necessary (and a single currency makes less sense), although their extent can be
minimised if counties follow the same growth path, are similarly affected by exogenous shocks and tend to
use similar policy strategies to deal with them. Changes in relative prices, in the short-term, are very
difficult to achieve within a fixed exchange rate regime or, indeed, a monetary union.
It follows therefore, that long term growth convergence and asymmetry in response to external shocks
are important factors in determining whether a currency area could be designated optimal or not. A high
degree of real convergence would be indicative of similar growth levels and symmetric responses to
external shocks. Only if the absence of real convergence were due solely, or primarily, to monetary
divergence or asymmetries, would adherence to monetary or nominal criteria be sufficient to create an
optimal currency area.
Productivity growth
Whilst real exchange rates (nominal exchange rate adjusted for price level differences between
countries) do exhibit stability over a 10-20 year period, in the short run they do not: the real exchange rate
tends to appreciate if productivity growth is fast. Since exchange rates are fixed in a monetary union, real
appreciation will occur as prices rise and the extent of such rises will be greater the stronger is productivity
growth. If prices cannot fall in low productivity countries in the union, then prices generally will have to
6
rise. Hence if productivity differences between member countries are large relative prices must change
and the ECB would be forced to pursue more lax monetary policy to accommodate this.
In actual fact there are significant differences in productivity growth in the EU. Although differences
did narrow in the 1980s, during the 1990s these have widened again. And the Bundesbank reports that if
German productivity rises 1% faster than that of its trading partners then the D-mark appreciates 1%. In
the case of Ireland, for example, this would imply that, where productivity has risen 2% above the level of
its trading partners, relative prices would have to rise by 2%. Whilst some productivity rises are
undoubtedly a response to previous poor performance, if this acceleration continues for any lengthy period
of time, an inflationary bias within the EMU would emerge.
Business cycles
Asymmetric shocks are likely to lead to diverging business cycles. These cyclical differences can be
easily accomplished if exchange rates are flexible, so that any necessary relative price changes are
minimised. However, in a monetary union relative price movements are wholly dependent upon inflation
differentials and any attempt to militate against them would increase unemployment. The extent to which
European business cycles diverged can be ascertained by correlating real GDP growth, output gaps and
changes in unemployment rates over the period 1973-96. The more bilateral correlations between these
variables in excess of 0.5 there are, the greater the convergence of member countries’ business cycles. In
fact only a small core, consisting of Austria, Belgium, France and Germany, demonstrated highly correlated
cyclical development, while Sweden, Finland and Netherlands showed the greatest divergence. Without
the ability to adjust exchange rates, therefore, the adjustment costs arising from EMU for the majority of
member states are likely to be large: and the more members the higher those costs will be.
This can be demonstrated by considering German reunification as an asymmetric demand shock that
originated within the domestic economy. Nominal exchange rate adjustments were ruled out in the ERM,
so that for real appreciation of the D-mark, German prices should have risen faster than those of other
member states. Given, however, that the Bundesbank pursued a tight monetary policy, other member
states had to deflate their economies with all the negative consequence that flow from that in terms of
increasing unemployment. During this period the UK and Italy where forced out of the ERM and France
restored to expanding demand.
It might be the case that asymmetric shocks within a monetary union could originate from divergent
monetary policy, so that if EMU eradicates this through the introduction of both a single currency and a
single controlling authority, real convergence would be improved. To establish whether monetary policy
might be the destabilising element, short-term interest rates were correlated with indicators of real cyclical
divergence, but the direction of causation could not be ascertained. Consequently, (an admittedly weak)
test was conducted by examining whether monetary trends are correlated between countries. And the
evidence does suggest that monetary trends are closely correlated over the period 1980-1996. Greece
alone shows unambiguous divergence, while Portugal, Spain and Finland show a small degree of divergence
and the rest are closely correlated. Consequently monetary divergence cannot explain cyclical real
divergence.
In summary therefore, there appears to be little real convergence within the EU and its absence cannot
be ascribed to monetary asymmetries. Hence the inclusion of eleven countries in EMU in 1999 will
undoubtedly increase the costs of adjustment to asymmetric shocks except in Germany, Austria, France
and Belgium. Given that the ECB will set monetary policy after 1999, the only policy instrument available to
counter shocks will be fiscal policy in the absence of greater labour market flexibility. However, the
continuing need to observe the Maastricht fiscal criteria in EMU and the possibility of fines under the
Stability Pact will leave many governments with limited policy responses. An accommodating monetary
policy from the ECB, following a shock like the 1970s oil price rises, would run the risk of raising inflation.
Consequently there remains a real need for higher levels of price flexibility, particularly in the labour
markets, as an appropriate response to divergence growth and business cycles. Without this, higher
unemployment and lower growth are inevitable.
7