Erkki Liikanen: Comment to Prof Gérard Roland: After enlargement -
institutional achievements and prospects in the new member states
Comment by Mr Erkki Liikanen, Governor of the Bank of Finland, to Prof Gérard Roland: After
enlargement - institutional achievements and prospects in the new member states, at the Central
Banking Conference, Frankfurt, 21 October 2004.
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1. Introductory remarks
Professor Roland's paper raises some essential issues regarding institutional development of the new
member states and prospects as to how enlarged European Union will work. The paper looks at
various institutional indicators compiled by ERBD and the World Bank. By the use of these indicators,
the paper aims at answering the following specific questions i) Have new member states achieved
their institutional transition in a stable and satisfactory way, ii) Has EU played a positive role in this
process, iii) Is there anything that EU can learn for its needed structural reforms in labor markets,
pension and welfare reform and iv) How will EU work with 25 members.
2. Summing up the main results of the paper
The paper provides some tentative answers regarding the first two questions. It argues that
institutional problems in the future are not going to be essentially worse than those facing existing
EU-member countries. Furthermore, the paper argues that EU has been playing "fundamentally
positive role in anchoring the institutions of the new member states to sound market system". As a
general message, the paper suggests that fundamental market institutions and the basics of market
institutions are well established and solid.
The last two questions get understandably less attention in the paper, given the wide scope of the
paper.
First I want to comment two questions;
1. Hypothesis on external anchor and enforcement powers vis a vis the governments of
Member states
2. Stable and satisfactory institutional transition
3. External anchor and enforcement powers
Regarding the first point, Prof. Roland argues that prospects on EU membership has enforced an
institutional reform, but that once inside, incentives to fulfil future reforms will be weaker. The paper
builds analogy to weak implementation of the Stability and Growth Pact (SGP) and argues that EU
does not have appropriate (very strong) enforcement powers.
While to some extent it is rather easy to agree with this point, one may also recognize that SGP -
similarly to Maastricht criteria - has improved fiscal prudence within the EU markedly over the last
decade. And this in spite of all the difficulties.
On the other hand the SPG is still a relatively new instrument. The Commission has even stronger
powers in the field of the internal market and competition policy. And there is a long tradition and case
law. By these tools the commission has accelerated the liberalisation in member states, controlled the
state aids and promoted competition. I am sure the commission will not hesitate to use these
competencies in the new member states.
And there are two more incentives:
Most of the new member countries are working towards joining the European Monetary Union (EMU).
Maastricht criteria and associated institutional reforms required will certainly foster future reforms, and
not just those required in Maastricht criteria explicitly. For instance, some studies show that structural
reforms in the labour markets may be associated with implementation of new monetary regimes, such
as inflation targeting.
And secondly there is and will be a lot of healthy competition between new member states about new
foreign investments. A successful reform process will be an asset in this field.
4. Stable and satisfactory institutional transition
Regarding institutional transition, we need to define "stable" or "satisfactory" institutional transition.
The paper seems to take a view according to which "stable" institutional transition means a process
that has evolved progressively without major disruptions or reversals. By looking how the number of
interesting indicators that the paper has compiled has evolved, this indeed seems to be the case: most
of the institutional indicators show a steady pattern of improvement. Yet, as can be observed from the
same indicators, there are also rather large differences between the countries.
One may also want to assess stability and satisfaction of institutional transition by analyzing its
consequences on economic, political and societal development.
One may use indicators such as fluctuations in inflation, public sector deficit, interest rates, exchange
rates, different measures of political stability, number of strikes, etc to measure stability from this point
of view.
Looking some important macro indicators to convergence, the economic stability has improved as
regards to inflation. As an average in the new member countries, the harmonized index of inflation
declined from close to 10 % in early 1997 to around 2 % in mid-2002, where it remained until early
2004.
On the contrary, progress with fiscal consolidation has generally been too slow and majority of
countries have yet to achieve a situation which, in broader view, might be judged as sustainable in the
medium term.
One may also assess the satisfactory element of an institutional transition by looking at some more
indirect measures. For instance, extent to which there has been reversal or drastic changes in inflow
of foreign direct investments gives rather good indication as to how foreign investors judge the
institutional transition. There are indeed rather large changes as regards inflow of foreign direct
investments in many of the new member countries.
In many countries high foreign direct investments have supported high output and investment growth
rates. However, maintaining a steady inflow of FDIs will constitute a major challenge in the future
because FDI inflows have tended to decrease in many new member states partly linked to reduced
privatisation activity. The decrease in FDI inflows have accompanied by a net outflow of portfolio
investments, with loans and trade credits becoming the main source of financing of the current
accounts.
All in all institutions has developed to right direction during the last decade and as paper argues, they
are mostly compatible with market driven economy. Of course, institutions as such are not important
but they provide necessary conditions for creating environment for future growth and prosperity. But
reforms are needed, in particularly as regards to corruption and legal system.
Professor Roland also raises a question: What can we learn from reforms in labour markets, pension
and welfare reform? Not much, is his conclusion.
I would like to put the question differently: What will the impact of the new member states on the
regulatory development in the EU of 25?
I think that the new member states will be very sensitive with new regulation which will add costs on
European. They compete directly with Asian countries about FDI's. They don't want to weaken there
position. There will be less new regulation.
5. How will EU work with 25?
Let me finally, turn to the most important and topical issues on How will EU work with 25?
I agree with Professor Roland that the new member states will be active and enthusiastic members.
They have not come to use a veto. And the larger is the Union, the more difficult it is to prevent a
decision by one veto.
I would like to discuss also on growth and productivity prospects of European economies during the
years to come. As already argued, for Europe to work as a stable political entity, and build room for
enlarged EMU it is necessary to close the income gap between the new and the old member
countries. Probably the best way to achieve this is to facilitate competition and thus enhance
productivity growth in all the sectors of the economies.
The rationale for, and success of, the single market is that it reinforces a principle of market economy
of the European economies. The market economy is reinforced by subjecting otherwise closed sectors
to greater competition and by the prospect of wide range of cross-border exchanges of goods and
know how. In doing so, it improves resource allocation and provides both dynamic and static efficiency
gains that, in turn, offer the promise of improved economic performance.
As for the new member states, many of above mentioned positive features have already been felt as
can be seen from faster economic growth and productivity in all of the new member countries.
The new member countries will in the future benefit also from greater markets for their products [and
thus scale economies], while the old member countries are facing stiffer competition in many industrial
sectors. Stiffer competition is likely to enhance productivity in Europe as a whole.
Large part of the productivity growth in the new member countries has been associated with inflows of
foreign direct investments as well as restructuring of the domestic companies.
In this process, large internationally operating companies have been playing an important role by
importing capital, but also by transferring business management skills and know how and thus
decreasing the knowledge gap to rest of the Europe. Indeed, a large proportion of trade is
intraindustry and intra-company trade where a significant proportion of global trade runs through
international production and distribution networks.
Increases in intra-industry and intra-company trade reflects the motives of large companies for
diversifying their supply chain and deepening economies of scope in the world market, rather than just
reflecting the differences in costs of inputs at different locations. Moreover, due to stiffer competition
and complexity of the products, companies concentrate on their core competencies.
This has a tendency to reinforce the development of a more concentrated, but spatially diverse
economy. In the short run, there can be significant employment losses and unbalanced regional
development, yet in the medium term European economies will be more efficient. Nevertheless, spatial
agglomeration across territorial boundaries is a real challenge for Europe, as there is a need to find a
right balance between strengthening the European most productive areas and their competitiveness
globally, yet to develop policies that minimize a risk of excessive regional diversification. Policies that
enhance exchange of know-how across borders are of crucial importance to minimize such a risk.
Especially for small new member countries, key to success is to be attractive and adaptive. In the
medium term, this requires further strengthening of those business areas with comparative advantage
and aiming at attracting foreign direct investment to those areas. This requires also continuing with
institutional and legal reforms that strengthen ownership rights, reduce corruption and provide with
favourable business environment in general. Otherwise, there is a risk that some countries lock-in to
low-wage/low productivity production. This would lead into rapidly widening income differences
between the EU countries.
In the longer term, know how, business management skills, and capital imported through FDI need to
be "rooted" in the societies such as to build up domestic capacity and ability for further increases in
productivity. As static comparative advantages based on lower labour costs has been deployed, the
new member countries need to base longer term industrial strategy on dynamic comparative
advantage and policies that enhance productivity through innovative activities of the firms. Once more,
competition combined with appropriate renewal of institutions would be essential.