w 109 long-run economic aspects of the european union's eastern ...

EMU, EURO AND ENLARGEMENTIf the ECB were to follow a policy of never intervening, the ERM-II would function ina similar way as these links to the DM. However, if the ECB were to deviate even alittle from a policy of ‘benign neglect’ it would immediately dominate the relationship.Even unlimited intervention by the ECB in favour of any currency of the candidatecountries could never endanger price stability in the Euro area. If marketsunderstood this they would not even test the resolve of the ECB. But how the ECBwill handle this issue is not yet clear.6.4.4 INFLATIONOne of the criteria in Article 109j (original numbering) is ‘the achievement of ahigh degree of price stability; this will be apparent from a rate of inflation which isclose to that of, at most, the three best performing members in terms of pricestability’. The numerical ceiling of 1.5 per cent is fixed only in an accompanyingprotocol. This is important because in the case of the CEECs one could argue that ifthey grow fast enough to catch up within a reasonable period they should have aninflation rate, as measured by the consumer price index (CPI), that is substantiallyabove that of the Euro area.This is suggested by the so-called Balassa-Samuelson (B-S) effect which is basedon the empirical regularity that productivity grows faster in the traded goodssector (essentially industry) than in services (many of which are not traded). If thecandidate countries maintain a stable exchange rate against the Euro the prices oftraded goods should increase in line with prices in the Euro area. But prices ofservices are likely to increase faster since wage increases are determined, at leastpartially, also by the high productivity industrial sector. A fast growing countrycould thus have a substantially higher inflation rate than the Euro area even whilepegging tightly to the Euro, and without running up external imbalances. It isoften objected that this idea is inconsistent with the experience of Ireland, whichover the last decade achieved very rapid catch-up without noticeable higher inflation.This argument is analysed briefly in box 6.1, where it is found that Irelandconstitutes a special case which seems unlikely to repeat itself (see also Annex 1containing a formal exposition of the theoretical underpinning of the Balassa-Samuelson effect).119Although the B-S effect is often mentioned, there are few reliable estimates of itsmagnitude. The ECB’s Monthly Bulletin of October 1999 dealt with this issue fromthe point of view of the Euro zone. The ECB does not provide a precise estimate ofthe B-S effect, but it claims there is a close association between absolute pricedifferentials and the inflation rate (measured over the period mid-1998 to 1999).However, the differences are not very large within the Euro zone. For example,Portugal, whose price level stands at close to 70 per cent of the EU average, had aninflation rate that was about 1.5 percentage point higher than that of the Eurozone’s core, whose price level corresponds roughly to the average.