External pressure in CEE

First, it has to be examined whether similar tendencies regarding external pressure/incentives can be detected in CEE. Here mainly two issues need to be

addressed: (1) did the pre-accession period, the period of preparation for EU membership, mean similar external disciplining effect for the CEE countries as did the preparation for EMU membership for current EMU members? (2) Does EU membership provide protection from market forces for the CEE countries? The short answer for both questions is: “no” or “very modest” at best

Soon after the regime changes in 1989/91 all of the eight CEE countries have declared their intention to join the EU. The accession procedure meant close monitoring by Brussels on the progress of meeting the membership criteria. Theoretically this could have evoked a strong incentive for fiscal discipline in a similar way the EMU membership preparation affected the performance of its 12 prospective members.

However during the accession period the EU’s main concern was to ensure that crucial structural reforms are taking place even if this means (temporarily) higher budget deficit for these countries. (Berger et al [2004] p. 10-11) In the words of the Commission:

“CEECs are not required to fulfill the Maastricht nominal convergence criteria, but rather to comply with the Copenhagen criteria. The primary fiscal concern in the pre-accession period is medium-term budgetary sustainability, rather than achieving any particular target for the government balance. […] Setting of specific budgetary targets could be misleading and the priority should remain on improving the functioning of the budgeting process, carrying out structural reforms, implementing the acquis communautaire, and supporting catching up.” (Commission [2002]) Not insisting on sound macro economic performance as a criterion for membership, Brussels could not effectively impose fiscal discipline on the accession countries.

By becoming members of the EU these countries agreed to eventually join the monetary union as well. However the lack of a clear, binding deadline for EMU accession combined with weak enforcement mechanisms of the EU against members that are persistently breaching the 3% budget deficit level deprived the system of any disciplining effect. Berger-Kopits-Székely [2004] offers a game theoretic model to explain differences in fiscal performance among countries of region, wherein fiscal behavior of these countries influences each other’s conduct of fiscal policy. In line with the model it can be argued that as more and more new member states are adopting the Euro the incentive will gradually increase for the remaining new-members to meet the criteria avoiding the obvious embarrassment of being the last country to join. At the

same time recent developments somewhat amended the overall picture and it is now questionable whether EMU membership is still unequivocally attractive option for new EU members. The not in every aspect positive experiences of Slovenia and particularly Slovakia with the Euro moreover the fundamental problems of the Euro-area becoming very visible due to the Greek crisis increased voices in CEE that question whether it is still in the best interest of these countries to adopt the Euro as soon as possible.

Regarding the protective effect of EU membership: since EU membership – at least theoretically – also means eventual Euro adoption (which – again theoretically – requires sound macroeconomic fundamentals), EU members might enjoy slightly higher market confidence than non-member states. This was reflected in decreasing long-term interest rates of new members, also in cases (i.e. the Visegrad countries) where this was not justified by fiscal performance. (Gyırffy [2007] p. 102) Nevertheless mere EU membership does not provide as strong protection against market forces as EMU membership.

Moreover it has to be noted that the above external factors affected all eight countries in the region to a similar degree: all of them have existed in the same international environment equally exposed to market forces, all of them had the strong intention to join the EU (which they did at the same time) and officially all of them aim to introduce the Euro as soon as possible, thus the observable large differences in their fiscal performance can be ascribed to differences in domestic factors.

Gyırffy’s work however has one important statement regarding external incentives / constraints in the CEE region. Evidence from the EMU countries seems to support the theory’s assumption, about the importance of domestic factors namely that the degree of public support is an important domestic factor in determining a country’s fiscal discipline. In case of EMU member states Gyırffy has found strong correlation between the level of satisfaction with democracy and a country’s budget deficit level.

The same test however fails to give supportive results in the CEE region: Unlike in the case of EMU member states, for the eight new EU members no correlation could be detected between the level of public trust and the level of budget deficit. Gyırffy gave the following explanation for this phenomenon:

“Unlike EMU member states, which face similar external incentives with regard to fiscal policies, the new member states have rather different constraints. In the Baltic States the widely known dangers of pursuing profligate policies with a currency board arrangement ensure the maintenance of consensus over different governments. At the same time the Visegrad countries do not face such constraints […]” (Gyırffy [2007] p.

196)

The above statement is crucially important from the perspective of my research therefore it has to be carefully examined. The statement has two elements:

(1) A currency board creates substantial external incentives for fiscal discipline (2) This external incentive overrides the effect and importance of domestic factors

(hence the impossibility to recognize similar correlation concerning public trust and fiscal deficits as in the case of EMU countries)

Before discussing these two points in detail, it is necessary to see what a currency board arrangement (CBA) is and how it affects fiscal policy.