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

LONG-RUN ECONOMIC ASPECTS OF THE EUROPEAN UNION’S EASTERN ENLARGEMENTThe price levels of the candidate countries are generally even lower than that ofPortugal – as one would expect given their even lower level of income per capita.Would this lead to much larger inflation differentials? Annex 1 provides a briefeconometric investigation of this issue. The main results is that if one uses theexperience of the countries in the Euro zone, one finds that given the very low levelof prices in the candidate countries the equilibrium inflation differential could bearound 3.5 to a full four per cent. This is considerably above the 1.5 per centthreshold of the Maastricht inflation criterion.A more thorough empirical analysis is needed to see whether the orders of magnitudefound here are confirmed by other approaches. If this were the case, onecould argue that the B-S effect could be strong enough to warrant derogation fromthe inflation criterion. Such derogation would not require a change in the Treaty,but only a change in the protocol (or its interpretation, which should be teleological,not literal).120However, even if the ceiling of 1.5 per cent is not changed, the B-S effect is unlikelyto represent an absolute obstacle. As the catch-up process continues it is likely thatthe price level of Estonia will increase towards the EU average over the next year(which implies higher inflation in Estonia), but the effect should diminish overtime. Moreover, the B-S effect should operate on average, over longer periods oftime. Actual inflation will fluctuate around this trend. It is thus likely that therewill be years during which actual inflation is below the trend, providing an opportunityfor candidates to 'squeeze in' (as happened with Portugal, Spain andGreece).An alternative to a re-interpretation of the inflation criterion would be for theapplicant countries to engineer a trend appreciation against the Euro (so thattradable prices decline and service price can remain stable). While this is veryattractive in theory it would be difficult to engineer in reality. Experience hasshown that using the exchange rate to steer domestic inflation along a narrow pathis very difficult because it can sometimes lead to overshooting and thus to largeimbalances.