The EU Economy After Enlargement

Speech by Chris Huhne MEP delivered to the European Liberal Democrat and Reformist Special Bureau on Tue 26th Nov 2002

I am an optimist about the economic effects of enlargement. Economics is never a zero sum game where one person loses what someone else wins. It is usually a positive sum game where everyone can win (and, if the policies are bad, everyone can lose). Both enlargement and the euro are two large structural changes that tend to increase competition in the European economy, and therefore tend also to increase productivity. And in time, once all the structural changes that this extra competition brings about have worked through, these underlying rises in productivity will mean higher living standards.

I believe that the economic advantages of enlargement have been seriously underestimated. There is a seductive view that enlargement does not really matter for the ten early candidate countries, because they have all the benefits of industrial free trade already. And I am the last person to denigrate the importance of free trade, or to suggest that the growing economic integration between the fifteen and the ten is unimportant.

But free trade alone does not encapsulate what is happening. Many investors invest in central and eastern europe because of access to the single market, and that would not be affected. But they also invest because they believe that the candidate countries - these low income countries - are fundamentally different to the low income countries of Latin America or Asia: they are committed to the Copenhagen criteria and hence to the rule of law. That commitment to due process and property rights is the first condition that any foreign investor insists upon.

So politics and economics inevitably overlap: I always preferred the old description of the subject in English as 'political economy'. Political economy matters. Just remember what happened in Slovakia when the government of Vladimir Meciar undermined the civil rights of the Hungarian-speaking minority. It was EU pressure - and most importantly the threat that membership would not proceed - that protected that minority. It was EU pressure that put Slovakia back on the right track. Without that pressure, Slovakia could easily have tumbled into the ethnic strife that was such a disastrous feature of Bosnia and Kosovo. And foreign investors would have run a mile.

Without EU membership and all the political guarantees that it brings - with only free industrial trade - the candidate countries would be substantially less attractive to investors. They would lose foreign direct investment, and the cost of borrowing on the financial markets would increase sharply. As it is, the interest rate spreads over bunds for the candidate countries to borrow are far lower than the spreads for similar countries in other regions. And those lower interest rates feed through into easier access to domestic capital, and to more assured capital flows. Astonishingly, the Czech government is currently able to borrow long term money in korunas at an even lower interest rate than the German government can borrow in euros.

It may be that some of this reflects an asset price bubble fed by relative scarcity, and that it may unwind as the Technology Media Telecoms bubble unwound. However, I think there are sound fundamental reasons to expect interest rates to be lower in central and eastern europe than in similar countries, and the EU's guarantees are essential to that case. After all, look at the impact of EU membership on the now thriving democracies of Spain, Portugal and Greece, and think that the last attempted coup d'etat in Spain was as recently as the eighties. Look too at the subsiding support for Jorg Haider in Austria, certainly partly self-inflicted but perhaps accelerated by the clear collective disapproval of the European democratic family.

If the ten can join the euro soon after EU membership, the possibilities of locking in a very rapid catch-up would be great. The Euro removes the exchange rate risks of investment and therefore increases cross border investment dramatically: so far cross border direct investment is up nearly fourfold in the euro-area countries since 1998 against a rise of just a half in the EU countries that have not participated in the Euro-area. In other words, the euro effect is to boost cross border investment by a factor of eight.

Moreover, euro membership would bring another unalloyed benefit for catch-up. Because rapidly growing economies tend to have higher inflation rates than slower growing ones - the famous Balassa-Samuelson effect - it also follows that a unique nominal interest rate is lower in real terms in the higher growth parts of a monetary union. That means that real interest rates would regularly be lower in the ten than the fifteen, providing a market means for the acceleration of the catch-up in living standards to which we all aspire and which of course would resolve any residual tensions between new and old members. High growth means high employment growth and a repeat of the experience of the southern member states when they joined: people stay at home to prosper rather than migrating.

These positive economic effects do not in any way depend on budgetary transfers, which is perhaps just as well. The existing members have been notably cautious about the budget as it affects the new members. There is a limit on structural and regional fund spending of 4 per cent of GDP in each new member - reasonable given the absorption capacity of any economy. There is also purely a phase in of the agricultural support policies and there will be a likely cap on total structural fund spending of 0.45 per cent of GDP of the EU as a whole.

There is even the possibility that some of the new members could, without special offsets, be net contributors to the budget which in my view would be an obscene outcome for countries at a much lower than average level of income. However, all these budgetary issues must be seen in the context of the relative size of the new members. In market price terms, the ten new members amount together to an economy the size of the Netherlands. If you add Romania, Bulgaria and Turkey, you have an economy the size of Spain. So these are manageable problems. We can ensure flows of finance to the new member states that are substantial for you, without being unduly burdensome for the richer and older member states.

I have said that economics is not a zero sum game whereby one person wins what another person loses. The increased prosperity that enlargement can bring to central and eastern europe will also create markets for us in the old member states: after all, almost all the candidate countries now have balance of payments deficits with us so that they are buying more from us than we are buying from them. The faster your growth, the more attractive your investment opportunities, and the greater your balance of payments deficits and the positive demand effects on the old member states.

However, these demand effects go side by side with a substantial increase in supply capacity and hence in competitive pressures, ensuring that they are benign and that the environment in the old member states remains non-inflationary. Enlargement, like the Euro, is another essential catalyst for economic change in our countries as well as in the east.

Enough now of the rosy spectacles. There are of course substantial challenges, not least in the high unemployment you and other candidate countries now suffer as growth slows down in your main markets and structural problems prove to be persistent.

An obstacle to the prospects of early euro membership are also the widening fiscal deficits in so many of the new members, including here in Poland and in Hungary. I suspect that the 6.9 per cent government deficit that the Commission forecasts this year for Hungary and the 4.4 per cent for Poland may prove to be under-estimates. Both of these numbers, of course, mean that Euro membership is some way off. But the prize of free trade, political stability, currency union, low interest rates and investment is not one that policy makers in the new member states should ignore. Fiscal tightening may prove an investment with great rewards.

Nor do I underrate the political challenges. Many of the candidate countries have to navigate referenda on membership, some of which may prove more difficult to win than currently seems to be the case. In Poland, indeed, you will need half of those entitled to vote or two thirds of the votes in the Sejm. In general the political consensus among central and eastern european elites is impressive, but we know from my own country and elsewhere that elites are not always good at communicating their own enthusiasms.

Nor is it always easy in a country like Poland with vivid nightmares of past experience with foreigners - Russian and German tanks on the Vistula - to lay old ghosts. I remember being here in Warsaw when a former prime minister, much to the shock of some foreign investors, disparagingly talked about the dangers of such investment turning Poland into a 'white colony'. If so, by the way, I have to say that my own country was colonised a long time ago: more than half of the assets of the British banking system are controlled by foreign banks mainly from our european partners.

I am confident though, now that we on the home straight, that you will surmount these challenges in the same way that you have surmounted so many others in the deeply impressive reconstruction of a market economy since 1989. Together, we face an economic and political future that is free and liberal, and which offers a vision of stability and prosperity. That will benefit us as much as I am sure it will benefit you.