BOSTON UNIVERSITY GRADUATE SCHOOL OF ARTS AND SCIENCES DEPARTMENT OF INTERNATIONAL RELATIONS

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1 BOSTON UNIVERSITY GRADUATE SCHOOL OF ARTS AND SCIENCES DEPARTMENT OF INTERNATIONAL RELATIONS RETHINKING THE ROLE OF CAPITAL MARKET LIBERALIZATION IN EUROPEAN UNION ACCESSION: ROMANIA, A CASE STUDY Tania Tzelnic Master s Research Paper Advised by Dr. Kevin P. Gallagher Submitted April 17, 2012

2 I would like to thank my advisor, Professor Kevin Gallagher, for his support, advice, and occasional talks about the Celtics. I would also like to thank my friends and family for their love and patience. I would especially like to thank Greg Dunlap, who managed to put up with me for two years of graduate school; Mori, Percy, and Alex Tzelnic, who were always there for me; Kodokan Boston for keeping me sane; and Sabrina Klein and Momoko Ichikawa for keeping me entertained throughout class. 2

3 TABLE OF CONTENTS Abstract... 5 Chapter One: Introduction Chapter Two: Literature Review 10 European Capital Market Liberalization..11 The Financial Crisis.16 Chapter Three: The Development Gap..21 Romanian Poverty, Infrastructure, and Development..22 EU Accession...27 Political Reform...28 Economic and Legislative Reform...29 Chapter Four: Watching the Crisis Unfold...38 The Sequence of the Crisis...38 The Political Economy of the European Union s rescue mechanisms.44 Front-loading of Structural Funds 44 EFSF/ESM: European Financial Stability Facility/European Stability Mechanism 45 ECB swaps and securities 46 The Vienna Initiative 47 Within the Euro Zone: The North-South Divide..49 The euro zone/european Union Divide...51 Economic Effects.51 Social Effects Political Effects 54 The social and economic effects of the crisis, in Romanian words.55 Support for democracy and free markets.57 Chapter Five: What Can Be Done..59 Re-ordering the Emphasis in the Acquis..60 Euro-for-All..61 Capital Account Regulation.61 Bibliography.63 Appendices 71 3

4 LIST OF FIGURES Figure 1. Convergence between Romania and the euro zone area, , current US$...24 Figure 2. Percentage of Population at Risk of Poverty or Social Exclusion in the European Union, the Eurozone, Bulgaria, Romania, and Hungary.24 Figure 3. GDP per Capita at Purchasing Power Parity, EU 15 = 100, Graph from Darvas, Figure 4. Average government debt as a percentage of annual GDP for the European Union. Note the lower levels of debt in Eastern Europe relative to Western Europe Figure 5. Net Private Financial Flows as a % of GDP, Figure from Becker et al, Figure 6. The structure of Romania s credit institutions by structure of shareholding and by capital country of origin. Figure From Vogiazas and Nikolaidou, Figure 7. Breakdown of select European bailout packages by contributor. Graph from Marzinotto, Sapir, and Wolff (2011).41 Appendix 1: Convergence between Romania and the euro zone, GDP per Capita, PPP, Constant 2005$..71 Appendix 4: Sectoral Breakdown of Capital Flows to Eastern Europe 74 LIST OF TABLES Table 1. GDP per capita, current US$, euro zone, European Union, Hungary, Romania, and Bulgaria, select years..23 Table 2. Breakdown of global creditors to Hungary, Latvia, and Romania by percent of contribution. Table recreated from data in Lutz and Kranke, Table 3. Greece, Portugal, Italy, Ireland and Spain and Germany in Table 4. Greece, Portugal, Italy, Ireland, Spain and Germany in

5 Abstract This paper investigates the role of capital market liberalization in EU accession by examining the role of capital flows in the 2008/2009 financial crisis, using Romania as a case study. While the focus of this paper is Romania, lessons from this paper can be more broadly applied to Eastern Europe. The arguments in this paper are three-fold: 1) that capital market liberalization contributed to the depth of the crisis in emerging Europe; 2) that the European Commission pursued policies that aggravated or deepened the crisis in emerging Europe; and 3) that divergence within the euro zone between winners and losers, and divergence between the euro zone and the new European member states have exacerbated fault-lines based on inequality and have resulted in a weakening of democratic institutions across the region. 5

6 You have to go far in Western Europe to find such enthusiastic Europeans that is, supporters of a supranational community called Europe as you will find at every turn in Eastern Europe. Traveling to and fro between the two halves of the divided continent, I have sometimes thought that the real divide is between those (in the West) who have Europe and those (in the East) who believe in it. Timothy Garton-Ash, The Levantine type in the areas between the Balkans and the Mediterranean is, psychologically and socially, truly a wavering form, a composite of Easterner and Westerner, multilingual, cunning, superficial, unreliable, materialistic and above all, without tradition. This absence of tradition seems to account for the low intellectual, and to a certain extent moral, quality of the Levantines...In a spiritual sense these creatures are homeless; they are no longer Orientals nor yet Europeans. They have not freed themselves from the vices of the East nor acquired any of the virtues of the West. Marcus Ehrenpreis (1928) as quoted in Todorova (1994). Chapter One: Introduction 2012 marks the fifth year of Romania s membership in the European Union. Romania is the EU s second poorest nation, with a GDP per capita nearly five times less than the average for the 17 nations that use the euro. Coming off of a steep recession and winding down commitments to the International Monetary Fund, Romania is doubling down on the development model that it followed pre-recession. This model, the one enshrined in Europe s acquis communautaire, or community laws consists of development based on liberalization: the opening borders to goods, services, capital, and people. Because new European Union members are required as a condition of accession to join Europe s shared currency, the euro, much of this liberalization program is meant to prepare nations for the competition pressures of Europe s single market and common currency. Therefore, a major component of this liberalization processes is liberalization of capital markets. Capital market liberalization occurs as one of the first steps towards accession, rather than at the end of the process, despite evidence that rapid liberalization 6

7 of capital can prove unstable to countries below a certain developmental threshold (i.e., Mexico in 1994 and East Asia in 1998). Many countries in emerging Europe are at developmental levels closer to countries in previous crises, and further from other European nations. The global financial crisis and Europe s subsequent sovereign debt crisis revealed deep rifts both in the political underpinnings of the euro zone, and in the advice offered to nations negotiating a path to euro-membership. For Romania, as well as other countries part of the European Union but not yet members of the euro zone, before doubling down on liberalization it makes sense to take stock of the recession, the ways in which it was exported to the East, and the weaknesses it revealed in the structure of the European Union. The requirements in the acquis communautaire were applied in a one-size-fits all manner to ten countries with very different political, institutional, and economic histories. The financial crisis and recession exposed common vulnerabilities across these ten nations, nearly all revolving around capital inflows. Where this is true, the acquis itself might need reform. The crisis also exposed some country-specific weaknesses. The latter are too divergent to investigate in detail across each of the ten countries. Rather, this paper will use Romania as a case study. This paper investigates the financial crisis from the perspective of the European periphery and asks, after the crisis, if capital market liberalization ought to be embraced wholeheartedly or with caveats. The arguments in this paper are three-fold: 1) that capital market liberalization contributed to the depth of the crisis in emerging Europe; 2) that the European Commission pursued policies that aggravated or deepened the crisis in emerging Europe; and 3) that divergence within the euro zone between winners and losers, and divergence between the euro zone and the new European member states have exacerbated fault-lines 7

8 based on inequality and have resulted in a weakening of democratic institutions across the region. The following chapter, Chapter Two, provides a review of the history of capital market liberalization in Europe, explaining how, from a global system of fixed currencies and controls on capital flows, Europe became the most liberalized region of the world. Chapter Two then discusses the impact of capital market liberalization on the financial crisis in emerging Europe in general, and Romania specifically. Chapter Three discusses the development gap between Romania and the rest of the European Union, as well as the gap between Romania and its closest neighbors. These differences are crucial to understanding why capital flows have been so destabilizing. The focus on Romania is not meant to detract from the general case that capital market liberalization has deeply affected all new European Union member states; rather, the focus is meant to explore in depth one case, from which further generalizations may be drawn. The fourth chapter looks at the sequence of the crisis, and policies implemented by the European Commission, often in conjunction with other partners to mitigate the effects of the crisis. Chapter Four then examines the effects of the crisis across the euro zone, as well as across the euro zone/european Union divide. This chapter concludes with an investigation into the way the crisis has lead to an erosion of faith in democracy across Eastern Europe. The final chapter, Chapter Five, offers some suggestions for how to deal with the underlying cause of the crisis, capital market liberalization. These suggestions, while unlikely to be politically tractable within the European Union, are indeed possible and pragmatic solutions. Europe, still in the grip of a severe debt crisis, must come to 8

9 terms with the idea that some aspects of its governance may need to be reconsidered in order to set the Union on more sustainable terms. This paper presents some possibilities. 9

10 Chapter Two: Literature Review The European Union, which in its original form came into being after World War II as the European Coal and Steel Community, initially existed in a global community of fixed exchange rates (the dollar-gold peg) and controls on capital flows, designed to allow nations autonomy over their own macroeconomic policies (Abdelal, 2006, 2007; Chwieroth, 2010; Vreeland, 2007). Over the course of the next half-century, European ideas about how to manage capital shifted, partially in response to changes in global thinking, partially in response to the needs and requirements of creating a single market, and partially in response to bargaining between nations on the terms of accession (Abdelal, 2006, 2007; Chwieroth, 2010). The role of capital market liberalization within Europe was hotly contested during debates surrounding the formation of the European Union and its transition to a single market (Eichengreen, Tobin, and Wyplosz, 1995; Eichengreen, Rose, and Wyplosz, 1996; Kenen, 1995). The European emphasis on capital market liberalization, and its eventual inclusion as one of the four freedoms guaranteed by the Union had long-term repercussions. Some of these repercussions have only become evident today, as the 2008/2009 financial crisis exposed asymmetries between European nations and weaknesses exacerbated by capital market liberalization. This section examines the history of capital market liberalization within Europe, and the ways in which this liberalization effected and drew the emerging Economies of Eastern Europe into crisis. 10

11 European Capital Market Liberalization In the Treaty of Rome, signed in 1957 by six countries 1 now considered part of core Europe, three freedoms were delineated: Freedom of movement of goods, freedom of movement of people, and freedom of movement of services (Abdelal, 2006, 2007). These three freedoms were to form the foundation of a common economic community. At that time, with embedded liberalism firmly ensconced in global economic thinking, it was a given that capital was to be regulated by the state (Abdelal, 2006, 2007; Chwieroth, 2010). On a global scale, capital controls were par for the course as nations fit their macroeconomic policies around a system of fixed exchange rates. This was largely a reaction to the destabilizing power capital flows had wrought during the interwar period (Kindleberger, 1978); as well as in response to an emerging synthesis between labor and capital which recognized the necessary role of the state to provide a stable environment for growth (Rodrik, 2011). In Europe, capital controls were not considered antithetical to the common market. Indeed, the first challenge to capital controls came in 1981, when an Italian national residing in Germany returned to Italy carrying 24,000 German marks with which to purchase ice-cream making equipment (Abdelal, 2007). After deciding not to purchase anything, he ran afoul of an asymmetrical control, allowing capital in to Italy without declaration, but not allowing capital out. He was arrested, and faced a fine and prison. His lawyer argued that such movements of capital aligned with the principles of the common market. The case made its way to the European Court of Justice, which decided the complete freedom of movement of capital may undermine the economic policy of one of the member states or create an imbalance in its balance of payments, thereby impairing the proper functioning of the common market (Casati, as quoted in 1 Belgium, Netherlands, Luxembourg, Italy, France, West Germany 11

12 Abdelal, 2007, p. 55). The European Court of Justice, in 1981, had decided that not only were capital controls consistent with the implementation of a common market, but that freedom of capital had the potential to be detrimental to the European project. Europe had three freedoms, and the countries joining the European Union would only need to adjust to these three for the next twenty years. The addition of capital as the fourth freedom guaranteed by the European Union came out of an idiosyncratic set of negotiating positions between France and Germany in the run up the Maastricht treaty of The inclusion of capital movement as a fourth guaranteed freedom opened a debate on how unregulated capital flows harm the larger European project of creating a single currency, and what might be done to mitigate that harm. This paper will first provide a historic overview of the bargaining that lead to capital freedom, and then discuss the debate that arose in response. The debate itself is noteworthy because at the time (early 1990s) many of the proposed solutions, had they been enacted, could have created a firebreak that would have halted the progression of the 2008/2009 financial crisis in Eastern Europe. In the late 1980s, under the guidance of its Finance Minister, Jacques Delors, France had come to view financial austerity and capital freedom as the only plausible levers to be pulled in order to stay within the European system of fixed exchange rates, or EMS (Abdelal, 2006, 2007). EMS itself was a system of fixed exchange rates, pegged to the deutschemark, with narrow bands around which other currencies could float (Jabko, 2006). This system had emerged as a necessary precursor step to the creation of a single currency, and a way of dealing with exchange rate risk in the single market. The system was highly unstable, however, and nations found themselves under frequent speculative 12

13 attack as their willpower to remain pegged to the deutschemark was questioned by markets. As explained by Eichengreen, Rose and Wyplosz (1996, p. 320): Consider a country willing to endure high interest rates and other forms of austerity now in exchange for qualifying for EMU [European Monetary Union, the creation of a single currency and monetary system] later. Its past and current policies may be entirely consistent with the maintenance of exchange rate stability. If a speculative attack occurs, however, it will be forced to raise interest rates. The cost of austerity now rise relative to the benefits of EMU membership later, which may lead the government to conclude that the cost of qualifying for EMU is suddenly too high. Once it forsakes the lure of EMU membership, it has no reason to resist shifting policy in a less austere direction; and the markets aware of its incentives, have reason to attack. This precise logic lead to significant pressure exerted on France, through a series of speculative attacks against the French currency. The bet was that France could not stand the rigors of EMS, largely because its exchange rate had become overvalued (Goodman and Pauly, 1993), however a sharp devaluation would have meant disqualification from EMS (Goodman and Pauly, 1993). France could respond in one of two ways: to seal its borders, float its currency, and leave the European project, or to follow a path of financial austerity and liberalization (Abdelal, 2006, 2007; Jabko, 2006). Initially, France s newly elected Mitterrand government chose a modified version of the former, allowing for three devaluations and establishing controls on capital outflows so severe that Goodman and Pauly refer to them as draconian (Goodman and Pauly, 1993, p.73). The heavy emphasis on capital controls came from a desire, on the part of the Mitterrand government to keep domestic interest rates lower than those generally prevailing in the rest of the world without abandoning the objective of exchange rate stability (Goodman and Pauly, 1993, p.73). After the third devaluation and large levels of capital flight due to evasion of capital controls by the wealthy (Abdelal, 2006, 2007, Goodman and Pauly, 1993), France shifted its policy. Acknowledging that controls were 13

14 not working, France moved towards capital market liberalization. This move was largely credited with stabilizing France (Goodman and Pauly, 1993). However, capital market liberalization meant that France lost autonomy over its monetary policy (for more on the open economy trilemma of fixed exchange rates, open capital markets, and domestic monetary policy, see Obstfeld and Taylor, 1998). France s loss of autonomy over its own policy lead directly to the push for European Monetary Union after all, if the German Bundesbank (the German Central Bank) was to set monetary policy for the entire set of countries pegged to its exchange rate, the least these countries could do was ask for a seat at the table. That seat at the table became the impetus for the single currency. Meanwhile, Germany, already adhering to financial liberalism, was skeptical of monetary union so long as such a union lacked a stalwart, independent central bank to guide it (Abdelal 2006, 2007). With a strong currency of its own, and the Bundesbank considered highly credible by financial markets, Germany had little reason to capitulate to France (Jabko, 2006). France, with a much less credible central bank and much less stable currency, viewed and framed EMU as an integral part of the European Project. Delors, leading the project for deeper integration, envisioned capital freedom within Europe as a cornerstone of European cooperation. For Germany, capital freedom was a given; EMU without credibility, however, was the most dangerous potential outcome (Abdelal 2006, 2007; Jabko, 2006). The debate, therefore, became one of the extent to which capital freedom would be part of EMU (Jabko, 2006). France wanted capital freedom within Europe, and Germany insisted on the principle of erga omnes, or the freedom of capital movement with third parties (Abdelal 2006, 2007). This meant that rather than creating a market of free capital movements within Europe, Europe was 14

15 liberalizing capital movements with the whole world. For the Germans, this was the one way to ensure credibility. According to Hans Tietmeyer, president of the Bundesbank, if you can withstand the test of the market, you have proven your stability. Only this way could we create a strong European monetary union and a strong currency (Abdelal, 2007, p. 80). With the Maastricht Treaty of 1991, erga omnes became the defining principle of European capital freedom, the fourth freedom guaranteed by the European Union. These freedoms were listed as the first four chapters of the acquis communautaire or the European body of community law. Given that Europe, as a common market, enforces customs and tariff barriers on trade at its own external borders, the requirement to liberalize capital with third parties outside of Europe is asymmetric requirement, demonstrating the degree to which Europe s model rests on the liberalization of capital. Indeed, while the global financial crisis is credited with a tarnishing and fall from favor of the Washington Consensus 2, some have claimed that that consensus merely shifted East, from Washington to Brussels (Lutz and Kranke, 2010). As freedom of capital movements was enshrined in the acquis and as the Maastricht criteria were negotiated, several scholars began to voice concern that the combination of the two sets of requirements would lead to speculative attacks and instability if a country pegged its currency, but had not yet been accepted to EMU. This concern arose from the sequence of events required for a nation to join the single currency. The relevant criteria, outlined in Maastricht, established that in addition to meeting certain requirements for debt, deficit, and price stability (outlined later), a country must also maintain a currency peg to the euro for two years, within fluctuating 2 The Washington Consensus is: a model of development based on fiscal discipline, trade and capital market liberalization, privatization and deregulation. The emphasis of the Washington Consensus is on the power of the free market to maximize outcomes (Bird, 2001). 15

16 bands of +/- 15% to the euro. This last stage, know as the European Exchange Rate Mechanism (or ERM) was to be conducted while capital markets remained open, in order to allow for capital freedom. The two requirements of open capital and a pegged currency were likely to be considerably unstable. So unstable, in fact, that in a series of articles, Eichengreen, Kenen, and others advocated for allowing some capital market regulations during this two-year period. In particular, Eichengreen proposed that investors be required to set aside a percentage of their investment in a non-interest bearing account at the home central bank of the nation in which they were investing. As Eichengreen, Tobin and Wyplosz (1995) point out the opportunity cost of the interest forgone would move with the interest rate and thereby rise automatically in periods of speculative pressure (p. 167). That is, in times of low interest rates, the difference between what an investor loses in potential income due to such a zero-interest deposit is minimal; however, in times of high interest rates, which typically coincide with speculative attacks, this difference grows. An investor or trader looking to make a large amount off of a speculative investment attracted to the high interest rates of a country in crisis must account for the percentage of their investment that will gain no interest. This opportunity cost changes automatically with interest rate fluctuations, and is therefore one way to address speculative attacks. The Financial Crisis The financial crisis affected emerging Europe 3 more deeply than any other region of the world (Becker et al, 2011; Darvas, 2009b, 2010), despite that this region had 3 Emerging Europe is the term loosely used for the former Soviet satellite countries in Europe and the countries in Central Asia that regained independence with the collapse of the USSR. This paper uses the 16

17 higher growth rates and lower government debt than Western Europe, and therefore ought to have been in a better position than Western Europe to ride out the crisis. Emerging European economies, however, were dependent upon growth based on trade and capital market liberalization (Berglof, 2009; Sanfey, 2010). The first of these pathways exposed Eastern Europe to precipitous drops in exports, but it s the second of these that presented Eastern Europe with destabilizing vulnerabilities that precipitated the ensuing depth of the crisis. During the boom years, the Eastern economies had re-created themselves as export powerhouses: together they comprised a region of low-cost, lowskilled manufacturing within Europe s common market (Becker et al, 2011, Heringhaus, 2008). As Western Europe entered recession, exports to the West dropped deeply (Sanfey, 2010). For nations such as Romania, Western Europe accounted for as much as two-thirds of its export market in 2008 (Sanfey, 2010). The sudden drop-off had immediate macroeconomic effects. Emerging Europe contains a mix of pegging and floating currencies, and the floaters, such as Romania, devalued their currencies in order to remain competitive. As a small economy, such devaluation could have led to a short recession and then quick recovery. However, capital market liberalization had seeded the ground for deeper instability. Eastern Europe s second vulnerability was in capital flows. In order to encourage investment in capital-starved Eastern Europe, capital accounts were quickly liberalized. This process began as soon as the 1990s, at the encouragement of the International Monetary Fund (IMF) (Abdelal, 2007; Chwieroth, 2010), with the active participation of the Romanian government after 1996 (Ban, 2010). As the IMF began to rethink its term to refer to the set of 10 countries in Europe that were Soviet satellite states and are now part of the European Union. 17

18 policy on capital market liberalization after the 1998 East Asian Crisis, the push for Eastern European liberalization came from the European Commission (EC) itself, as part of accession proceedings (Abdelal, 2007; Chweiroth, 2010). Greenfield and portfolio investment were encouraged, state-owned enterprises were privatized, often with foreign investors as the primary buyers, and foreign banks opened subsidiary offices in order to deepen financial markets (Becker et al, 2011). When the crisis hit the West, capital flows to the East came to a sudden stop (Calvo, 1998; IMF, 2009). Capital flight caused deep devaluations in countries maintaining floating currencies, such as Romania, and a depletion of reserves in countries maintaining a peg to the euro, such as Latvia (IMF 2009, IMF 2012a, 2012b, 2012c; NBR, 2010, 211). As banks began weighing their exposure to Greece and other heavily indebted European countries, they recapitalized, drawing liquidity out of subsidiary branches in Eastern Europe (Arvai, Driessen, and Okter-Robe, 2009; Darvas, 2009b; Vincent, 2011; Vogiazas and Nikolaidou, 2011). The threat of a liquidity crunch in Eastern Europe was so severe that the EC, in a joint venture with the IMF intervened, establishing the Vienna Initiative to maintain subsidiary bank liquidity in Eastern Europe for the duration of any IMF intervention (Darvas, 2009b). In a pattern to be repeated over and over throughout the financial and subsequent sovereign debt crisis, a rift emerged in treatment between the euro zone and European Union nations still maintaining their own currencies. Where a euro zone member needed a bailout, EC, the European Central Bank (ECB), and the IMF together addressed issue, under the name the Troika. When a non-euro 4 member needed a bailout, the IMF became the major partner, and the EC the junior. While some non-euro countries such as 4 There are 27 nations which use the Euro, 3 nations which do not use the Euro and have secured opt-outs from ever using the Euro: the UK, Sweden and Denmark; and 10 nations which maintain their own currencies but are expected to join the Euro area as soon as they meet appropriate criteria: list. 18

19 Sweden and the UK were offered ECB swaps at the height of the crisis, no Eastern European countries were offered access to ECB credit lines (Darvas, 2009b). Political rifts also appeared: the euro-only nations began separate meetings, much to the consternation of EU member-states indirectly contributing to bailouts 5 (newspaper article on this?) and required as a condition of EU accession to become euro-members themselves in the near future. Several authors have examined the effects of the crisis on emerging Europe in the context of returning to growth (Becker et al, 2011; Sanfey, 2010); the possibility of continued economic convergence with the European Union (Darvas 2009b, 2010; Heringhaus, 2008); the role of banks or capital market liberalization in exporting the crisis East (Becker et al, 2011; Berglof, 2009; Vogiazas and Nikolaidou, 2011); and the ways in which European integration has meant significant forward progress on institutional and legislative reform (Cameron, 2009; Vachudova, 2005). Other authors have examined the historical legacy of this region. Communism left a recent and deep developmental scar (Amsden, Kochanowicz, and Taylor, 1994; Brown 1994, 2001; Demetropoulou, 2002; Heringhaus, 2008), while the older footprint of the Ottoman Empire is often cited as the basis for this region s culture of endemic corruption (Todorova 1994, 2009). This paper is not situated against any of these arguments. Rather, it draws upon this literature in order to describe why European models of development left this region vulnerable to the crisis. This paper, then, argues that development within the European Union, even though positive, is fraught with vulnerabilities. The European Union can do much to remedy this, mainly by encouraging 5 While not expected to provide funding to Euro-area bailout mechanisms, non-euro countries within the European Union were required to vote on measures establishing such mechanisms. They, however, were not included in the set of nations at the table in terms of how these bailout mechanisms then operated. 19

20 a slower, steadier developmental path for its Eastern neighbors. In addition, while many policies, such as capital account liberalization, are allowed on paper to proceed at a pace set by the acceding country, they are de facto encouraged to be completed as rapidly as possible (Ems, 2000). This encouragement comes not only from the European Union, but also from citizens within acceding countries, desperate to be acknowledged as an indelible part of Europe. This rush, however, magnifies vulnerabilities inherent in the process of development. For Eastern Europe to catch up to the West, it must slow down. 20

21 Chapter Three: The Development Gap Romania s development gap vis-à-vis its closest neighbors and vis-à-vis Western Europe is illustrative of one of the major fault-lines between East and West. This gap, present in everything from differences in infrastructure and industrialization to degrees of poverty, social exclusion, and the presence of a culture of bribery is a result of the tumultuous history of this region. This difference, this gap between East and West, is in many ways the reason that Romania and Bulgaria have pushed so hard to become part of the European Union. For Romania, with deep historical trade ties to Western Europe, and France in particular, yet divided between the Ottoman, Russian, and Austro- Hungarian Empires, being on Europe s periphery was synonymous with a loss of sovereignty. Romania itself has been an independent state since 1848; it spent the years since 1946 behind the iron curtain as the USSR s neighbor. It is worth noting that Romania and Bulgaria have experienced only 23 of independence as nations since 1989; much of those years have been spent preparing their economies for accession, at which point, they became irrevocably part of Europe. This section lays out a picture of the development gap, both between Romania and its closest neighbors as well as between Romania and the European Union. This section then explains the European model for Eastern European development, and the ways in which the development model itself made this region vulnerable to the effects of the 2008/2009 financial crisis. The development gap and its historical narrative are also helpful in understanding why Romanians have responded to the crisis with increasing wariness of democracy and of free markets. 21

22 Romanian poverty, infrastructure, and development Romania s per capita GDP is $7,538 6, the second lowest in the European Union. The average per capita GDP of the 17-Euro using nations is $36,618 7, nearly five times higher (see Table 1 for a comparison of GDP rates across select European Union nations and Figure 2 for a graph of Romania s convergence against the euro zone). With this income gap comes a whole host of other issues: in 2006, during the peak of the boom years, Romania s poverty level was 13.8% 8 percent; by 2007, 18% 9 of Romanians below the poverty line were employed, the highest rate of employed at risk of poverty" in the European Union (Eurostat, 2010; see Figure 2 for a comparison of poverty rates). In addition, nearly a third (32%) of Romania s poor fall below 70% of the national median income, the highest rate in the European Union (Eurostat, 2010). These low numbers are not just emergent properties of the financial crisis. The year that Romania joined the EU (2007), its per capita GDP was 7, Despite years of receipt of structural funds, foreign investment, and investment by the government, certain capacities necessary for development are startlingly substandard. In 2010 only 30% of Romania s roads were paved. Bulgaria, Romania s poorer neighbor boasted a rate of 92% 11. As a whole, 91.6% 12 of roads in the European Union are paved. The lack of infrastructure or the poor quality of existing infrastructure is so bad that Nokia, when it placed a plant near the Cluj-Napoca airport, at the intersection of two major highways and on the rail system, insisted upon the building of a second highway, directly from the plant to the airport , current US$, World Bank Development Indicators , current US$, World Bank Development Indicators , poverty headcount ratio at the national poverty line, World Bank Development Indicators 9 Combating Poverty and social exclusion, a statistical portrait of the European Union 2010, Eurostat Statistical Books , Current US$, World Bank Development Indicators , 1998, and 1999 respectively. World Bank Development Indicators , 1998, and 1999 respectively. World Bank Development Indicators 22

23 (Heringhaus, 2008). The Global Competitiveness report, compiled by the World Economic Forum ranks the quality of Romania s infrastructure 13 at 136 out of 139 nations surveyed, with Romania s road quality 134 out of 139. While Romania presents some impressive numbers and some progress (Romania is ranked 36 th in mobile phone subscriptions, 22 nd in tertiary education enrollment rate), the overall condition of infrastructure is a major impediment to Romania s development. Table 1. GDP per capita, current US$, euro zone, European Union, Hungary, Romania, and Bulgaria for select years 14. Year Euro zone European Hungary Romania Bulgaria Union ,667 15,419 3,186 1,650 2, ,291 26,869 10,084 3,418 3, ,695 34,133 13,534 7,856 5, ,618 32,310 12,851 7,537 6, Infrastructure includes mobile connectivity, landlines, rankings for ports, roads, air transport, and quality of electric supply. Romania s range on the infrastructure indicator ranges from 36 (for mobile connectivity) to 134 (for quality of roads). 14 All data from the World Bank Development Indicators 23

24 Figure 1. Convergence between Romania and the euro zone area, , in current US $ Convergence Figure 2. Percentage of Population at Risk of Poverty or Social Exclusion in the European Union, the Eurozone, Bulgaria, Romania, and Hungary. Data from Combating Poverty and social exclusion, a statistical portrait of the European Union 2010, Eurostat Statistical Books. % of Total Population at Risk of Poverty or Social Exclusion European Union Euro zone Romania Bulgaria Hungary See Appendix 1 for a graph of convergence at purchasing power parity, 2005 constant US$ 24

25 In contrast, Romania s Northern neighbor, Hungary, boasts a per capita GDP of $12,852, almost a third of the EU average. To the south, Romania is bordered by Bulgaria, the poorest nation in the EU. However, Bulgaria s rate of poverty is 10.6% 16, and only 6% of those below the poverty line are employed 17. This uneven distribution across countries is largely an effect of history. In Hungary, as in much of the rest of the former Soviet satellite states, institutional and industrial reforms began as early as the 1960s (Brown 1994, 2001; Heringhaus, 2008). In Bulgaria, industry was a significant sector of the economy under COMECON while Romania was assigned the role of agricultural powerhouse (Amsden, Kochanowicz, and Taylor, 1994, Brown 1994, 2001). However, by the 1970s, Romania s dictator, Ceausescu, shifted development from a heavy agricultural basis to forced industrialization (Ban, 2010; Heringhaus, 2008). Ceausescu achieved impressive industrialization. By 1989, 53% of GDP generated by industry, a number higher than any other European nation and achieved through forced urban migration and hefty borrowing from abroad (Ban, 2010). The result was a highly planned but deeply dysfunctional economy where dogmatic principles were taken to their utmost extreme. Throughout the 1980s, Ceausescu had ordered nearly all agricultural and industrial production exported in order to pay the full amount of Romania s foreign debt (Ban, 2010). This decision lead to severe shortages of the most basic goods, including food and medicine. By the late 1980s, the calorie intake of the average Romanian was one third below minimum standards (Ban, 2010). Romania, therefore, entered the revolution of 1989 with a highly dysfunctional industry, a highly dysfunctional market economy, and little contact with the outside world (Brown, 1994, , poverty headcount ratio at the national poverty line, Worldbank Data 17 Combating Poverty and social exclusion, a statistical portrait of the European Union 2010, Eurostat Statistical Books 25

26 2001; Heringhaus; 2008). Then, it suffered the steepest recession of all ten ex- Communist nations (Darvas, 2010). By 2008, its GDP per capita barely recovered to 1989 levels. Figure 4 below demonstrates the severity of Romania s recession. It gives GDP per capita standardized by purchasing power parity 18 from 1980 to On this scale, the European Union nations would be represented by a value of 100. The closest nation to the European Union standardized GDP is Lithuania, which in 1988 had a per capita GDP of nearly 60% of the standard met by the European Union. This graph demonstrates both the depth of the recession in Romania, but also the degree to which it is just now, approaching the same standard of living as in In 1980, Romania s GDP per capita was just under 40% of the EU standard; by 2010, it has reached to just over 40% of the EU standard. Figure 3. GDP per Capita at Purchasing Power Parity, EU 15 = 100, Graph from Darvas, 2010 The development gap between Romania and the euro zone will be difficult to surmount; so will the gap between Eastern Europe and its Western neighbors. This inequality is one of the fault-lines within the euro zone, something this paper will address later. However, Romania has close neighbors in terms of development. Reaching their 18 PPP = the amount of money which buys an equivalent basket of goods across nations. 26

27 level, in terms of GDP, modernization or lack of poverty should be possible. Historical asymmetries are to blame for some degree of difference. Romanians, however, are responsible themselves: between 2007 and 2013, Romania absorbed between 4% and 5.5% of EU development and structural funds for which it was eligible 19 (EBRD 2011; IMF, 2012). The reason the absorption rate is so low is that Romania consistently fails to meet development benchmarks or to set aside funds for co-financing necessary to access funds (EBRD, 2011). In order to retain a similar level of structural fund support during the next phase of transition, the Romanian government would have to spend on approved projects at a rate of 30 million euros a day for the next year (news article). Such an influx of capital into the country would be likely to fuel consumption booms and drive the inflation rate even higher than its 2011 peak of 8% 20. EU accession All ten ex-communist nations were given the same script from which they were supposed to develop into nations capable of joining the European Union. The script was based upon, institutional anchoring to the EU, integration of product markets through trade in goods and services, unfettered capital mobility including through large-scale foreign direct-investment flows, and...labour mobility (Becker et al, 2010, pg. 144). Specific criteria for entry to the European Union include meeting all the Copenhagen criteria 21, or common standards for alignment in political, legislative, and economic spheres. The political criteria include respect for human rights, implementing a 19 The EBRD 2011 reports 4%; IMF 2012a reports 5.5% of structural funds absorbed so far in the pay period. 20 Eurostat Statistical Database 21 See Appendix 2 27

28 functional democracy, and respect for minorities. Legislative criteria include a full implementation of the acquis communautaire, the body of all EU legislation and court decisions, ranging from environmental regulations to taxation to policy dealing with educational standards. Because the acquis deals extensively with regulatory policy, it forms the basis of the shared market structure new nations are expected to adopt. The acquis is divided into 31 such chapters, each chapter covering a different area of legislation 22. A nation must complete each chapter in sequence; a chapter is considered closed when all its reforms are implemented. However, any chapter can be re-opened by the European Commission if circumstances change. Until all chapters are considered closed, the nation cannot move forward with accession. While the focus of this paper is economic development, because the common market depends upon a degree of institutional and political stability, this section will briefly outline non-economic progress within Romania. Political Reform Nations entering the European Union must have functional democracies, protect human rights, and acknowledge and provide representation for minority groups. For the former Soviet satellite states and former members of the Soviet Union proximity to the European Union has deeply impacted the level of reforms. The closer a country is to Brussels, the more likely they are to have implemented reforms transforming their political environments into ones that mirror the West (Cameron, 2009). Other correlates of Europeanization include the results of the first free election, percentage of GDP in 22 See Appendix 3 28

29 the private sector, and a history of democracy prior to communism (Cameron, 2009) 23. These reforms do not happen in isolation. For Eastern Europe, in part due to the cultural footprint of the Hapsburg, Russian and Ottoman Empires, the ability of these countries to implement reforms varied greatly (Demetropoulou, 2002). The eight nations that were part of the Hapsburg or Russian Empires reformed rather quickly, and were admitted as a group into the European Union in Of those eight nations, Slovakia, Slovenia, and Estonia have already joined the Euro. The two nations, Romania and Bulgaria, that were part of the Ottoman Empire, with its historical legacy of corruption, were the last two be admitted to the EU, three years behind the other eight. Already starting with lower levels of development and higher levels of corruption, these two nations had significant difficulty implementing each stage of reform. Unique to these two nations is Europe s Cooperation and Verification Mechanism, the anti-corruption monitoring scheme. These two nations are also the only two currently excluded from the European Union s Schengen zone (the area of free travel between member-nations), because of concerns of corruption related to border security. Economic and Legislative Reform While much of the acquis deals with areas outside of economics, many of its chapters deal explicitly with regulation and policy issues that shape markets and development. The acquis itself has been criticized because its cumulative nature means that each newest candidate for the European Union must add more areas of compliance than the acceding members before it. The acquis of the 2004 enlargement (which saw the 23 The strongest correlates of a high score on the EBRD transition indicators in 1992 were: the result of the first free election (.82), a history of democracy prior to communism (.82), percentage of private sector GDP (.82). 29

30 inclusion of Estonia, Latvia, Lithuania, Poland, Czech Republic, Slovakia, Slovenia, and Hungary 24 ) and 2007 enlargement (Romania and Bulgaria) consisted of 31 chapters; the next enlargement, which now includes Serbia, Croatia, and Turkey, will consist of 35 chapters. Since each chapter represents a different area of legislation, these are major demands in terms of implementation and regulation. The asymmetry also means that older member states which acceded under less lengthy acquis were held to less rigorous accession criteria than newer states. In areas such as environmental regulation, new EU states have struggled to meet regulatory requirements that do not match the typical requirements of countries with similar GDPs. The argument for this, of course, is that once a country belongs to the common market, advantages in terms of less stringent requirements might spark a race-for-the-bottom. However, it is undeniable that these requirements place an asymmetric burden on newer, developing member nations, often in ways that are considered superfluous by the nation meeting the regulations 25. These evolving criteria are especially difficult when it comes to the Maastricht criteria for euro zone membership, originally established as an arbitrary set of criteria in order to ensure some degree of uniformity across the first six euro zone states. These criteria are: Price stability (consumer prices at no more than 1.5 percent higher than the 3 best performing euro zone nations); Public/government debt sustainability (deficit not more than 3% of GDP, total debt not more than 60% of GDP); Long-term interest rates not more than 2% higher than the 3 best performing euro zone nations; 24 This enlargement also included Cyprus and Malta; these countries are not included in the grouping for this paper because of the differences between their histories and that of Eastern Europe. 25 For example, all indoor markets in Romania must have refrigerators for cheese. The addition of refrigerators imposes a significant cost in terms of installation, upkeep, and electricity. In many markets in Bucharest, once installed, they have simply been used as unrefrigerated display cases. 30

31 Two years in the ERM-II, with the home currency maintaining its value against the euro within narrowly fluctuating bands (+/- 15%). Because inflation rates within the euro zone are higher in aggregate than inflation rates outside of it, because euro nations benefit from the lower interest rates as a result of the common currency, and because interest rates have been artificially depressed as a consequence of the crisis, these targets have become progressively more difficult to meet since In addition, since these conditions do not apply once a country has entered the euro, many nations allowed their macroeconomic fundamentals to shift once they achieved membership. Current reforms such as the fiscal stability pact are attempts to remedy this concern, however, history has demonstrated that these mechanisms are prone to failure 26. One positive side-effect of the asymmetry between euro and non-euro requirements for macroeconomic fundamentals means that nations outside the euro but aspiring to euro zone entry have, as group and individually, lower debt-to-gdp ratios than nations within the euro zone that are allowed to ignore the Maastricht since their date of accession (see Figure 4). This quirk of Maastricht has led for many calls to reform the criteria or to simply grant euro zone membership to the European Union s newest members (Darvas, 2008). Since Maastricht criteria can be amended without running into the EU s unanimity rules, some put forward full euroization as one possible solution to end speculative attacks against Eastern European currencies at the beginning of 2009 (Darvas, 2008, 2009b). 26 The mechanism meant to control government debt and deficit is the Stability and Growth Pact. For a review of the SGP, its crisis, and potential reforms, see Schuknecht et al (2011) 31

32 Figure 5. Average government debt as a percentage of annual GDP for the European Union. Note the lower levels of debt in Eastern Europe relative to Western Europe. Map from CNN; Source data from Eurostat ( In addition to reforms indirectly impacting economic policy through regulation of industry, the acquis requires the opening of borders to trade in goods and services, and to capital flows. For the capital-starved countries of Eastern Europe, these flows were highly attractive during the boom years of Capital flows provided funds for building new factories, and in some cases, new roads and modernized ports; they were also part of the massive effort to privatize state-owned enterprises 27. The presence of foreign firms meant that Romania could capitalize on technology transfer, and the low cost of production meant that items could be manufactured for export to the EU. Increased money also went to wages, boosting imports. By 1999, Romania had its first foreign supermarket, located in Bucharest. By 2008, Romania s openness index (a 27 The latest IMF review of Romania, published in Month, Year, counts 154 state-owned enterprises left to privatize. 32

33 measure of the size a country s imports and exports relative to its GDP) was 74% 28 ; twothirds of its exports went to Western Europe, and two-thirds percent of its imports came from Western Europe (Sanfey, 2010). Romania s economy had become highly dependent on Western Europe (EBRD, 2011). Figure 5. Net Private Financial Flows as a % of GDP, Figure from Becker et al, In addition to foreign investment, Romania s open capital markets meant an influx of foreign banks. Romania became reliant upon foreign-owned banks and so did little to develop their own home banking sectors. By 2008, 30% of banks were Austrianowned, an additional 22% were Greek-owned, and the ownership of the remaining 48% included a smattering of other European countries such as Spain, Portugal, Italy, and France (The Economist, Eastern Approaches Blog, DATE 2011; Forster, Vasardani and Ca Zorzi, 2011; Vogiazas and Nikolaidou, 2011). Romanian-owned banks made up just 14% of the total banking presence in Romania (see Figure 6). This was not considered 28 Calculated using World Bank data from Romania; (X+M)/GDP 29 For a further breakdown of financial flows by sectoral composition, see Appendix 4 33

34 problematic during the boom, with the country dependent on foreign capital in order to expand. The new banks provided credit and financing, and Romania s private debt escalated from 20% to 60% of GDP (Becker et al, 2011). Because Romania was not yet a member of the euro zone, there was a currency mismatch between loans (typically made in euros, and the home currency, the leu). By 2008, 50% of loans to Romanians were made in euros or in Swiss francs (Radulescu, 2010). With Romania destined by treaty to join the euro zone, this mismatch did not raise many alarms. One of the few warnings, however, came from the IMF, which in 2003 warned both the European Commission and Romania that capital market liberalization would pose a severe threat to Romania s economy (Abdelal, 2007). This warning was triggered by a difference between inflation (10 to 11%) and interest rates (17%) that could have lead to destabilizing capital flows. In order to minimize speculative hot flows, the IMF suggested that Romania maintain some of capital controls it was in the process of phasing out, namely a rule prohibiting foreigners from open bank accounts in domestic currency. Romania, at that point, tried to back away from full capital market liberalization. Despite that European Commission rules allow for a timeline to be set by the acceding state for full liberalization (Ems, 2000), the EC threatened Romania that it would re-open the acquis at Chapter 4 unless full liberalization took place (Abdelal, 2007) 30. Under significant pressure from the EC, Romania ignored the IMF s warning and fully opened its capital account. 30 Romania had provisionally closed Chapter 4 negotiations in 2003; it was supposed to phase out all capital controls by 2004 and postponed the date until After this postponement, the EC threatened to re-open Chapter 4 negotiations. This would mean significant delay of Romania s accession (Abdelal, 2007). 34

35 Figure 6. The structure of Romania s credit institutions by structure of shareholding and by capital country of origin. From Vogiazas and Nikolaidou, From 1989 through to the end of the boom years, Romania saw dramatic improvements in political reform, decreases in corruption, and significant market changes. The export industry was completely revamped, and low-skilled manufacturing for export became a major sector within Romania s economy. Open capital markets meant new European banks, new debts denominated in Euro, and the implicit backing of European nations invested deeply in Romania s success. In contrast to the private sector boom, the public sector remained muted. Public debt never escalated beyond 20% of GDP until the crisis. In 2007, the projected budget deficit was 2.7% of GDP, and the 35

36 total debt to GDP was 12.8% of GDP 31. The criteria for Euro zone membership, the Maastricht criteria, specify that countries cannot project a deficit of more than 3% of GDP, or total debt of 60% of GDP. On both counts, Romania in 2008 was not far off of the mark. Before the crisis, then, Romania was a developing country, gradually improving across many aspects of political and economic life. Winners of Romania s membership in the EU were export industries and foreign banks; citizens, in terms of improving quality of life, more democracy, less poverty, and better access to credit; and government, in terms of the political backing of EU, and inclusion in Europe. In addition, the inclusion of Romania in the EU had beneficial side effects in the European Union itself. For each year between 2000 and 2008, the new members states added 1.75% to the EU s overall growth rate (European Commission, 2009); foreign winning bidders of the Romanian privatization process, large businesses establishing export bases in Romania, and foreign banks opening subsidiary offices in Romania were also all winners on the EU side. During the boom, there was very little downside to EU membership. Romania had lost some macroeconomic sovereignty because it was working to reach the Maastricht criteria. The difficulty of this should not be underestimated: with capital inflows and rising wages, Romania was trying to keep inflation as close to 3.5% percent as possible (IMF, 2009; NBR 2010, 2011). In addition, the surge of capital increased imports, and rising FDI lead to instability in terms of Romania s capital account. The flood of capital did put upwards pressure on Romania s exchange rate. However, with a floating currency, policymakers had room to devalue if necessary. There was also an erosion of sovereignty in terms of increased dependency on 31 Eurostat Statistics Database 36

37 European markets and European banks, but with the ultimate goal being a shared currency and a common market, the transition did not appear threatening, and little was done to develop the home banking market. Tighter and deeper integration with the European Union was the name of the game, and each step appeared to build in sequence, increasing integration and decreasing risk. The IMF warning appeared to be unnecessary. 37

38 Chapter Four: Watching the Crisis Unfold While the 2008/2009 Recession and European sovereign debt crisis are sometimes described as separate events, one fast-moving and one slow and ponderous, for the countries in Eastern Europe, these events unfolded simultaneously. Most Eastern European countries were deeply effected by the 2008/2009 Recession, but not only were these crises caused by a loss of exports, they then quickly transformed into debt and banking crises of their own. While most of Western Europe was still depending on the strength of its automatic stabilizers to get through the recession, Eastern Europe was contending with deep devaluations, a liquidity crunch, and the possibilities of bank runs. In a pattern repeated throughout the crisis, Eastern European bailouts were spearheaded by the IMF, a move that counter-intuitively has lead to a return to growth in this region. However, the return to growth masks deep and growing inequalities between Eastern and Western Europe. These inequalities, in turn, have lead increasing Eastern skepticism of democracy and free markets. This section examines the timeline of the crisis, the rescue mechanisms put in place by the IMF and the EC, and then examines the social, political, and economic effects of those mechanisms. The Sequence of the Crisis Europe s sovereign debt crisis began with a Standby Agreement, negotiated between the IMF and Latvia on July 27, 2009 (IMF, 2012c), with the support of the European Commission. This event, little noticed in the rest of the world (at the time focused on the possibility of default by Dubai 32 ), followed a 23% contraction in Latvia s 32 While concerns about Dubai reached a peak in November, 2009, articles in the Financial Times and other journals began as early as April and May of

39 economy from the end of 2008 (IMF, 2012c). The bailout itself was a source of contentious disagreement between the IMF and the EC. Latvia was presented the option of following a more austere program, advocated by the EC, or a less austere program, advocated by the IMF (Lutz and Kranke, 2010). While the less austere program would allow for using some of the bailout funds for social spending rather than debt payments, it would cut Latvia s debt more slowly and require devaluation. With the lats pegged to the euro in order to meet the last stage of the Maastricht criteria, Latvia could not devalue without dropping out of Europe s Exchange Rate Mechanism 33. Within Latvia, a coalition developed, primarily led by the Latvian Central Bank, to advocate for the more austere options that would keep the lats pegged to the euro. This was supported on the outside by the EC, which had championed Latvia as a model for Eastern Europe, and by Swedish and Nordic banks, which summed to 80% of the Latvian banking sector (Lutz and Kranke, 2010). The banks were concerned that a devaluation of the lats would substantially harm their bottom line. The IMF, on the other hand, having absorbed lessons from previous crises, cautioned the Latvian government that adjustment would be onerous without devaluation. Given the choice between severe austerity and failing to meet ERM-II criteria, Latvia chose the more austere option. It maintained its currency peg and opted to reduce its deficit from 12.5% of GDP to 4% of GDP within two years. Unemployment soared to 20%, and an additional 1.4% of Latvia s population dropped below the national poverty 33 The first and last nation to drop out of the ERM was the UK in 1992, which re-negotiated its terms of accession, allowing it a permanent opt-out from the shared currency. Since then, only two other nations (Denmark and Sweden) have secured opt-outs, neither one of these on the Eastern side of the continent, and both of which secured opt-outs without ever entering the ERM. After Denmark and Sweden secured their opt-outs, accession treaties were amended, closing all loopholes. Since then, as a requirement of accession, all new member states are obligated by terms of accession to join the euro. This includes the ten ex- Communist nations in Eastern Europe. 39

40 line. The IMF, in its most recent review, has cautioned Latvia that cuts to meet deficitreduction goals still appear to be too steep and unsustainable (IMF fifth review). The IMF intervened in a few of these cuts, for example preventing an across-the-board cut in education spending for 5-and-6-year-olds. The alternative, less-severe plan proposed by the IMF would have allowed Latvia s debt to remain at 12% of GDP for the first year in order to preserve social spending. This plan would have then allowed for a cut to 6% of GDP so long as at least 1% of GDP was earmarked for continued social spending (IMF, 2012c; Lutz and Kranke, 2010). That the IMF has allowed the severity of cuts enacted by Latvia in acknowledgement of Latvia s political aspirations is a nod to the IMF s new 34 commitment to country ownership of IMF programs (Vreeland, 2007). That austerity measures undertaken were so severe that they triggered objection from the IMF was harbinger of the way Europe would deal with its evolving sovereign debt crisis. Seven months later, Greece s newly elected government announced that the previous administration had manipulated figures regarding Greece s deficit, reported as 2.9% of GDP in order to meet the Maastricht cut-off of 3% of GDP. The true amount of Greece s annual deficit, determined later through a Eurostat report, was 13.6% of GDP. In the wake of Greece s announcement, investors began to look seriously at other European or European periphery nations. Romania, suffering from a steep drop in export earnings as a result of the crisis, came under attack next. GDP dropped by 8.5% in a single quarter, and its stock market lost 65% and the leu depreciated by 15% within a few months. Despite reasonably sound fundamentals, Romania had no alternative but to go to the IMF for aid. The IMF was the major partner in the bailout, providing 64.9% of funds; the European Commission the junior player, providing 25.1% (Lutz and Kranke, 2010). 34 Since

41 Other institutions such as the European Bank for Reconstruction and Development, and the World Bank also contributed 5% of the bailout (see Figure 7 for bailouts by funding sources for Greece, Ireland, Portugal, Hungary, Latvia, and Romania). As the crisis escalated, Hungary, the Ukraine, and then Iceland went to the IMF. Of the three, only Hungary was a member of the European Union, and yet the IMF provided it with the lion s share of bailout funds. Figure 7. Breakdown of select European bailout packages by contributor. Graph from Marzinotto, Sapir, and Wolff (2011). 41

42 Table 2. Breakdown of global creditors to Hungary, Latvia, and Romania by percent of contribution. Table recreated from data in Lutz and Kranke, 2010 Hungary Latvia Romania IMF EU World Bank EBRD Individual Countries 25.3 Greece, reeling from speculative attacks since its announcement of its new deficit numbers, approached the IMF on May 10, Initially, European Union officials had wanted to deal with the Greek deficit without the assistance of the IMF. The Greek government itself initially tried to cut expenditures; because of elections in Germany, Europe was reluctant to enter the fray (Schmidt, 2010). Maastricht and German constitutional law forbade one European nation from bailing out another, and German voters were concerned that their own government might spend its money to assist profligate Greeks (Schmidt, 2010; Dullien and Geurot, 2012). Because of the election, German rhetoric revolving around Greece was primarily concerned with the moral hazard of a bailout (Schmidt, 2010, Dullien and Geurot, 2012). Sensing reluctance on the part of Europe to implicitly back its own, the markets again began speculative attacks against European nations. This time, however, the speculation shifted to indebted euro zone countries rather than European Union members maintaining their own currencies. Within the next 6 months, Spain s credit rating was downgraded, and Ireland and Portugal approached the IMF. A distinct pattern began to emerge: countries that were 42

43 part of the euro zone or with currencies pegged to the euro received bailouts in which the EC was the major partner, with funding supplemented by the IMF and other outside investors. For European Union countries outside of the euro zone, however, the IMF played the role of major partner. Within this pattern, a secondary set of circumstances began to repeat. Where the country in need of a bailout was a member of the euro or pegged to it, severe austerity measures were imposed by the troika of the EC, the IMF, and the ECB. This was largely because fears that the credibility of European Monetary Union, itself, was at stake. However, the cost of these measures is such that of the six nations with the EC as primary partner (Spain, Portugal, Italy, Greece, Ireland, Latvia), four have returned to recession. In the periphery countries, however, the sharp downturn and dependence on IMF lending has led to a slow return to growth. In contrast to its typical role as enforcer of the Washington Consensus, the IMF included protection for social spending, and slower, steadier deficit reduction in its bailout packages (Lutz and Kranke, 2010; IMF 2009, 2012a, 2012b, 2012c). The Eastern European countries, however, needing to pass the market s test of credibility, tended towards the austere measures prescribed in Western Europe. That these countries found an advocate in the IMF has helped their prospects throughout the recession. Estimates for growth are 1.5 percent in Romania,.1 percent in Hungary, and 1.3% percent in Latvia. However, these nations are still nearly 10% below pre-crisis levels (Darvas, 2010), and their growth is highly dependent on Western Europe. As Western Europe has re-entered recession, largely due to austerity measures, Eastern estimates have been revised downwards by as much as 1-2%. In addition, the depth of the recession in Eastern Europe is likely to have 43

44 permanently altered these nation s development trajectories (Becker et al, 2010; Darvas, 2010). The Political Economy of the European Union s rescue mechanisms. In response to the crisis, the European Union initiated several mechanisms to stabilize nations coming under speculative attack and to bailout nations with debt burdens were great enough to threaten the European Union with the possibility of default. Since a nation cannot leave or be expelled from the euro zone without also being expelled from the European Union (Athanassiou, 2009), the threat of default by any nation could potentially undermine the credibility of the euro. Indeed, the pattern of speculative attacks followed this logic, which largely explains why Spain, with reasonable debt levels but with an unsustainable unemployment and growth crisis is typically lumped in with the rest of the European South. If one small nation (Greece) were to default and leave the euro, the logic goes, then the credibility of the entire European project will have been undermined. This section will examine the mechanisms for aid initiated by the European Union, and ask to whom the benefits of this intervention accrued. Front-loading of structural funds Nations receiving structural and cohesion funds for development from the EC were able to receive more of these funds and on a more rapid schedule than originally planned. This front-loading was targeted at on-going projects unrelated to the crisis (largely infrastructure projects) in an attempt to boost liquidity and maintain employment in the European periphery. The total amount of funds front-loaded in this manner was 11 44

45 billion euro, 7 billion of which went directly to new European Union states (Darvas, 2009b). However, in order to absorb EU funds, countries must have projects approved by the EC, and set aside money for co-financing of projects to be undertaken (Darvas, 2009b). Both of these have been raised as reasons that absorption of EU funds is so low, especially in cash-strapped states. Recall that throughout the entire period of , Romania has only been able to absorb 4% - 5.5% of structural funds allotted to it. Of the 20 billion euro the EC contributed to Romania s bailout, 5 billion euros were channeled through structural and cohesion funds, meaning that those moneys cannot be spent without project approval and co-financing (Darvas, 2009). While these additional funds must have added a component of stability, data is not yet available regarding the degree to which any nation receiving these front-loaded funds was able to take advantage of them. EFSF/ESM: European Financial Stability Facility/European Stability Mechanism The mandate of the EFSF is to safeguard financial stability in the euro zone by raising funds on capital markets to finance loans for Euro area member states ( Established by the 27 European Union member states on May 9, 2010, the EFSF was considered first line of European defense in the sovereign debt crisis. This is despite that by the date of the EFSF s establishment, Latvia, Hungary, Romania, Iceland, and the Ukraine had already signed standbyagreements with the IMF, which were all supported by the European Commission. The EFSF, backed by the euro area member states and with a lending capacity of 440 billion 45

46 euro, could 1) buy bonds of nations within the euro zone on secondary markets 35, 2) issue loans to euro area member nations, or 3) recapitalize financial institutions in euro area member nations through government loans. The EFSF provided funding for the Irish and Portuguese bailouts, and the bulk of the costs of Greece s bailout were financed through this mechanism. However, the EFSF was not large enough to cover the cost of a bailout to Spain or Italy. Because of the political difficulty in creating a permanent European bailout mechanism (this would require a German constitutional change in addition to ratification by all 27 European Union member states), the EFSF was designed as a temporary mechanism, to be phased out by Seizing on the dual potential weaknesses in the EFSF s design (its temporary nature and its inability to cope with Spain or Italy), markets increasingly focused their attacks on Spain and Italy. These concerns led to the creation of the European Stability Mechanism, or ESM, a permanent European bailout fund. The ESM will not be established until 2013, and its activities will be confined to the euro-area only. ECB swaps and securities At the height of the crisis the European Central Bank opened swap lines to European nations in need of liquidity. These swaps went to euro zone nations. The United Kingdom and Sweden, two nations not part of the euro zone, also received swaps (Darvas, 2009b). No new European Union member, however, received swaps or any other vehicle that would provide them access to ECB liquidity, despite the fact that a credit crunch loomed larger in these periphery countries than in the core, due to their 35 The EFSF could not buy bonds directly without modification of the language in the Maastricht Treaty stating no transfers take place between European Union nations. Such modification would require unanimous vote. 46

47 higher levels for foreign banks (Darvas, 2009b). Ultimately, Sweden, Switzerland, and a few other Western European nations used their ECB swaps in bilateral deals with some Eastern European countries, largely to shore up their own banks in these nations (Darvas, 2009b). For example, Sweden provided swaps to the Baltic states in order to support Swedish banks with a large presence in the Baltics (Darvas, 2009b). In addition to offering swaps, the ECB opened its list of securities eligible for refinancing to include non-euro denominated securities issued in the euro area. This applied to instruments denominated in US dollars, British pounds, and Japanese yen. However, this program was not expanded to include local-currency denominated bonds of non-euro European Union member states, despite pleas by central bankers from Poland, Hungary, and the Czech Republic (Darvas, 2009b; Euroweek, 2009). This request resulted in so much tension between member states, that when the ECB Executive Board discussed it, central bank governors from new European Union member states were asked to leave the room (Euroweek, 2009). Such an extension could have provided much needed liquidity to Eastern Europe; the main concern was that doing so would create currency risk beyond the capacity of the ECB to control (Darvas, 2009b). With interest rates to this region rising, and with foreign banks cutting loans and withdrawing liquidity from subsidiaries outside of the Euro zone, Eastern Europe was all but cut-off from European liquidity and interbank markets (Darvas, 2009b). The Vienna Initiative As the crisis intensified in Western Europe, banks in these states began to recapitalize. Fearing exposure to Eastern Europe, especially in case of devaluation, many 47

48 banks began to cut loans and credit to host countries. Since many of these banks had subsidiaries in Eastern Europe, and since together these Western banks were the majority banking presence in most Eastern European states, there was a real danger that recapitalization would draw liquidity out of the East. Since Eastern Europe was largely cut-off from ECB liquidity (with the exception of bilateral swaps extended through Sweden or Switzerland), recapitalization could have meant the sudden exit of all liquidity in Eastern Europe. Foreseeing this danger, the EC in a joint venture with the IMF, conducted a meeting with international banking groups, and home- and host-country authorities to make commitments to maintain exposure to Eastern Europe for the duration of any IMF intervention. Nine banks in Romania agreed to the terms, which included maintaining capital-adequacy ratios above ten percent (Darvas, 2009b). Given the degree of exposure these banks had to Romanian markets, this highly successful initiative prevented the escalation of the crisis in Eastern Europe. The four mechanisms used by the ECB and the IMF to stabilize countries within the European Union asymmetrically assisted euro zone nations over nations maintaining their own currencies (see Darvas, 2009b for an analysis of the euro shelter in a comparison of Hungary ad Greece). There is some rationale for this asymmetry: the ECB s primary concern ought to be the euro, and it is not shocking that its primary efforts went to support the single currency. However, the lack of other means to address the crisis in Eastern Europe, with the exception of the Vienna Initiative, meant that Eastern Europe suffered far more than Western Europe. This next section illustrates the degree of difference between Eastern and Western Europe in the degree of social, political, and economic effects of the recession and debt crisis. The first section outlines 48

49 the divide that emerged between euro zone nations, and the second section examines the more politically incendiary divide between the euro zone and the European periphery. Within the Euro zone: The North-South Divide The crisis revealed several deep fault-lines with the European Union. Some of these, such as cleavages between nations using the euro and nations using there own currencies were predicated on real differences between economies in the common market. Other divides, such as the North-South rift which groups Ireland, Spain, Italy, Portugal, and Greece into the European South are less easily explicable. Greece and Italy each had low growth rates and unsustainable or close-to-unsustainable levels of debt prior to the crisis (see Table 3). Ireland and Spain, however, entered the crisis with low debt levels, high growth rates, and low rates of unemployment. Portugal entered the crisis somewhere in the middle, with high unemployment but government debt close Germany s as a percentage of GDP. These nations were certainly not profligate or lazy, and yet that characterization has accompanied the grouping, reflected in the acronym PIIGS typically used to describe them. Regardless of their differences prior to 2009, each of these nations suffered drastic effects once the crisis took hold. Spain, the first nation in this grouping to be downgraded by credit-rating agencies, is facing 24% unemployment in Ireland, which had transformed itself into the Celtic Tiger during the years preceding the crisis, found itself needing a bailout as a result of providing guarantees that the government would back its banks. 49

50 Table 3. Greece, Portugal, Italy, Ireland and Spain and Germany in Gross Gov t Debt as a % of GDP Annual Surplus/Deficit as a % of GDP Unemployment Rate *Corrected Value Greece Portugal Italy Ireland Spain Germany 107.4* * Table 4. Greece, Portugal, Italy, Ireland, Spain and Germany in Gross Gov t Debt as a % of GDP Annual Surplus/Deficit as a % of GDP Unemployment Rate Greece Portugal Italy Ireland Spain Germany Unable, because of their membership in the euro, to devalue their currency, each of these countries has had to subject itself to an internal devaluation, dropping wages and government expenditure in order to reach criteria of the Stability and Growth Pact (e.g., deficit of not more than 3% of GDP, total government debt of not more than 60% of GDP). Three years into the crisis, this has left these nations reeling from severe austerity, and has seen a return to recession in many of these nations. On the other side of the divide, Germany has maintained an average unemployment rate of 7% throughout the 36 Eurostat Statistics Database 37 Eurostat Statistics Database 50

51 crisis, with 2012 unemployment at 5.7%. With low interest rates and well-regarded automatic stabilizers in the form of unemployment insurance, 49% of German households that lost a job successfully applied for benefits 38. As of April 2, 2012, the unemployment rate in Italy was 9.3%, the unemployment rate in Spain was 24%, and the aggregate unemployment rate across the euro zone reached a 15-year high of 10.8%. The difference in experience between Germany and the rest of the European Union explains much of the German reluctance to assist during the crisis. With its economy humming along, the crisis happened largely outside Germany s borders. The euro zone/european Union Divide The second cleavage revealed by the crisis is the difference between nations part of the euro club (or pegged to the euro) and nations in the larger EU. These effects are broad and intertwined, and reach into several related aspects of civic life within the euro zone. However, in order to disambiguate them, this section will deal separately with the social, economic, and political effects of this divide. Economic Effects In perhaps the most counterintuitive effect of the crisis, the countries in emerging Europe with the IMF as their major creditor have returned to growth, albeit slow growth. These countries will leave the crisis highly dependent on Western Europe for recovery, with public debt burdens much higher than those they carried in 2008, and yet, they are expected to grow. In Western Europe, however, the story is far bleaker. Many countries in Western Europe are not expected to recover for ten to twenty years almost an entire 38 Compared to 2% of households in Central Asia and the Caucuses (ERBD report). 51

52 generation. In this environment, it is unclear whether the outcome might be gradual convergence across Europe, at a dampened level of growth and development, or whether the outcome might be a Europe that pulls itself apart at the seams (Becker et al, 2011; Hundson, 2000; Sanfey, 2010). Social Effects The most striking difference of the sovereign debt crisis between the euro zone and the larger European is the diverging experiences of those trying to cope with the effects of the crisis. In the euro zone, for example, automatic stabilizers such as unemployment insurance, work-sharing schemes, and large social-safety nets protected most citizens from entering or re-entering poverty. In the new European Union member states, however, social safety nets are shaky at best. Data from the European Bank for Reconstruction and Development s 2011 Transition Report 39 speaks to the depth of this divergence between East and West. In Western Europe, for example, 11% of households had to reduce staple food consumption in response to the crisis. The rate in emerging Europe was 38%, more than three times higher. In Western Europe, only 4% of people reported delaying or skipping doctor visits. This rate was 13% in emerging Europe. Eurostat data from 2007 suggests that baseline rates in Eastern Europe were very high relative to Western neighbors even prior to the crisis. For example, in 2007, 47% of Romanians reported that they could not afford to eat fish or meat every 2 nd day, in contrast to the European Union average of 22%. Similarly, housing deprivation, infant 39 Data in this report is aggregated, with the transition region of emerging Europe including Eastern Europe, Russia, Turkey, and Central Asia. These states had very disparate outcomes during the crisis, with some, such as Turkey and Central Asian countries reporting growth rates of % above 2008 levels. 52

53 mortality rates 40, and other measures of poverty and social exclusion were highest in the new European Union states prior to the crisis; when new data becomes available, it will likely to reveal rates rising throughout the crisis. As was argued before, whether the IMF or the EC took the lead on intervention had significantly divergent effects in Eastern and Western Europe. Western European nations and nations pegged to the euro faced severe austerity measures, which have largely sent these nations back into recession. Latvia, an Eastern European nation pegged to the euro and receiving the majority of its funding from the European Commission and other European sources is still over 10% below its pre-crisis peak in terms of growth. Divergence in economic effects is not just limited to gross measures of growth. In response to the crisis and especially in response to job loss, many in across the European Union tried to establish their own businesses. Striking out as an entrepreneur is a long established way to deal with dissatisfaction or unavailability of jobs in the formal sector. In Western Europe, approximately 16% of the population tried to start a new business during the recession. Of those, 85% succeeded (EBRD, 2011). In Romania, only 8% of the population tried to start their own businesses, and the success rate for those entrepreneurs was 65% (EBRD, 2011). An analysis of reasons for failure in Romania elicits, in order of magnitude: 1) lack of access to credit, 51%; 2) too much bureaucracy, 25%; and 3) inability to afford the cost of bribes, 10%, one of the highest levels of failure due to bribery in Eastern Europe (EBRD, 2011). In addition, many of the fiscal consolidation requirements included in bailouts with the IMF and EC required raising the VAT, cuts to pensioners, and across-the-board 40 In 2007, over 30% of Romanian households reported living in a situation corresponding to severe housing deprivation, defined as a household that is overcrowded and without an indoor toilet or bath/shower; in 2007, the Romania reported an infant mortality rate of 15% per 1,000 live births. 53

54 wage cuts. The IMF has argued that in Romania, these measures led to a sharply procyclical stance, effectively delaying the economic recovery (IMF report). In response to these social pressures, Eastern European nations experienced massive out-migration throughout the crisis. Twelve percent of Romania s entire population emigrated since 2002, the majority young people in search of work, and the majority of moves concentrated during the crisis (Patran and Cage, 2012). For the most part, those who left were those with the education or assets to pursue careers elsewhere. These social effects of the crisis are likely to effect long-run development in emerging Europe. Political Effects The crisis proved to be a destabilizing force for governments throughout the European Union. Throughout the crisis, X governments within the Euro zone, and X governments in new European members states collapsed in the face of sometimes violent protests found their positions weakened, or had their representatives cursorily replaced by the EC. Prior to the crisis, there had been plenty of academic concern that Europe suffered from a democratic deficit (Moravcsik, 2002; Follesdal and Hix, 2006). The concern largely referred to Europe s unique structure of representation, in which individual citizens have only indirect representation in governance of the European Union. In addition, while there was some concern that there was a mismatch between the democratic ideals espoused by the European Union on one hand, and its imposition of requirements through the acquis on the other, this mismatch was chalked up to the price of entry into the union (Vachudova, 2005). The crisis brought about a new type of democratic deficit on in which the will of the people was directly thwarted by the EC in 54

55 support of its view of the greater good of the European Union. The most flagrant examples within the euro zone are the replacements of Italy s Berlusconi and of Greece s Papandreou. Outside the euro zone, citizens engaged in widespread protests in the leading to a number of riots and violent deaths. These protestors were objecting to the severe austerity measures, imposed by their own governments at the behest of the European Union. The social and economic effects of the crisis, in Romanian words A search of the archives of the three Romanian financial newspapers, Ziarul Financiar (Finance Newspaper); Saptamana Financiara (Finance Week); Captial (Capital); and the search of the first twenty pages hits on Google for each year of the financial crisis for the terms criza economica (economic crisis), and criza economica si Comisia Europeana (economic crisis and the European Commission) returned series of hits reflecting rising concern for the crisis. In 2008, before the effects of the crisis took hold in Romania, these searches resulted in 33,000 articles. By 2009, as Romania began feeling the crises, the number of articles returned more than doubled, to 81,300. Embedded within these is significant dissatisfaction with the status quo. For example, a 2008 article in Revista 22 (Magazine 22) says: Voi sintetiza mai jos obiectivele si cele 15 masuri concrete pe care Guvernul Federal al Germaniei si le stabileste, respectiv efortul bugetar la care este expus. Cert este ca te face sa-ti doresti sa fii neamt in aceste vremuri tulburi. [Summarized below are the 15 concrete measures that the German federal government established. The fact is, these measures make you want to be a German in these troubles times] 55

56 Other newspaper articles push against austerity. For example, from Capital, in a 2009 interview with Sorin Dimitru, the President of the Chamber of Commerce and Industry of the City of Bucharest: Criza economica poate reprezenta o oportunitate pentru Romania, insa masurile autoritatilor nu trebuie sa fie axate pe austeritate, ci pe dezvoltare si programe de investitii. [The economic crisis can be an opportunity for Romania, but the measures authorities take cannot be focused on austerity but on development and investment programs] Work by Romanian academics has also focused on the importance of development over austerity. For example, a paper by Eugen Dijmarescu, the Romanian Secretary of State for Economic Policies and Foreign Trade, published in the Romanian Journal of Economic Affairs argues: the way the crisis has been handled internationally, including by the Euro zone, remembers of double standard: with strict market rules to be applied by the emerging markets and temporary interventionist measures applied by major players, more or less co-author of the crisis (Dijmarescu, 2009). All these authors describe dissatisfaction with the handling of the crisis by the EC and by the Romanian government. More striking, however, were the violent protests that brought down the government after the Romania s President, Traian Basescu, announced reform of the health service. These protests, in which 34 people were killed and hundreds arrests, became an avenue through which the people protested austerity measures imposed on Romania. The New York times describes that protestors cited cuts to government salaries, frozen pensions and an increase in the value-added tax, as well as what they said was deep-seated corruption and a broader sense that the government served only its own interests and those of its richest constituents" (Kulish, 2012). The protestors forced the 56

57 resignation of Basescu, and the next set of elections may see the rise of a coalition government elected to oppose EC policies. Support for democracy and free markets Of particular concern to the EC ought to be the 2011 EBRD transitions report that demonstrates widespread rising sentiment against democracy and against market economies in all of emerging Europe. In the new European Union nations, 10% fewer people support democracy than they did prior to the crisis. In Romania, roughly 40% of the population support democracy, down from 50% before the crisis. Across all of the new European member states, no state records support for democracy at higher than 60% of the population; this is in contrast to the roughly 80% who support democracy in Western Europe. Support for market economies also fell significantly from pre-crisis levels. In Romania, support for markets was roughly 50% in 2006, matching the Western average. By 2010, it had dropped by 10 percentage points. Interestingly, for Western European member states, only in Sweden and in Germany is support for markets above 60%. The new European Union member states have only shallow experiences with both democracy and market economics, and their inclusion under the European umbrella has been noted as one of the victories of Europeanization. While it is encouraging that where governments in emerging Europe collapsed or were voted out of power, democratic actions were taken to transition to a new government, this trend is in danger. Recent developments in Hungary, and the authoritarian tendencies of its new government have suggested that non-democratic leaders and non-democratic institutions still receive 57

58 significant amounts of public support (Charlemagne s Notebook, 2011, The Economist, 2011). With a fragile relationship to democracy and market economics, consisting of two deep recessions in thirty years, Europe may find that there is trouble brewing on its periphery for many years to come. 58

59 Chapter Five: What can be done? This paper addressed the effects roots of European capital market liberalization, the legacy of this liberalization on the 2008/2009 crisis in Eastern Europe, and the ways in which asymmetrical responses by the EC and IMF lead to a divergence between old and new European Union member stats. Prior to the crisis, Eastern Europe was transforming but had not yet attained levels of development on par with Western Europe. The entire model of European development, based on integration of markets, the freedom of movement of people, goods, services, and capital, largely assumed that convergence would happen as an emergent property of integration. For nations near the EU-average in terms of GDP per capita, infrastructure, and other markers of development, convergence may indeed be epiphenomenal. However, for the nations well below the EU-average, integration, especially capital market liberalization, has proved to be more trouble than anyone (except for the IMF) anticipated. This section outlines three possible solutions to close the development gap between Eastern and Western Europe. The first of these, and the briefest, is simply to change the order of steps in the acquis. While the steps in the acquis are preformed in parallel 41, emphasis is often placed on the four freedoms. Simply moving capital market liberalization to the last step, to be undertaken after al other chapters have been closed might be an option. While this would not help new member states affected by the crisis, it might assist Croatia and Serbia, two countries that just entered into accession talks with the European Union. The second option, proposed at the height of speculative attacks against new member currencies is to grant euro entry to all new member states, regardless of their completion of Maastricht criteria. This option, while it presents a solution that ends speculative attacks, does not necessarily address 41 Personal Communication, Tereza Novotna 59

60 underlying imbalances. The cases of the euro zone South make it clear that adjusting to Germany inside the euro zone is just as (if not more) difficult than adjusting outside of it. The third solution is to re-introduce some form of capital account regulation to Eastern European countries below a pre-specified developmental threshold, akin to the proposals by Eichengreen, Kenen, and others in the early 1990s. This would allow for a system of rules that govern the countries are eligible to introduce regulations, therefore addressing concerns that exceptions to the rules undermine the normative aspects of the European Union. In addition, introducing capital account regulations based on development level highlights a destabilizing aspect of the current EU, and provides a possible solution. Imbalances across the EU are the reason that Europe s sovereign debt crisis took hold, and the reason that recovery has been so difficult to achieve. Surely addressing one major source of imbalances ought to fall within the scope of EU governance. Re-ordering the Emphasis in the Acquis The most common-sense solution might be to shift some aspects of liberalization back to the end of the acquis. This would provide nations with breathing room while reforming other regulatory aspects of their economies, allowing them to keep a temporary firewall between themselves and capital inflows. This solution is unlikely to gain any acceptance. Perusal of websites relating to EU-policy, such as Bruegel or voxeu finds no mention of a re-ordering of the acquis or at least delaying capital market liberalization to the end of the process. 60

61 Euro-for-all Another option, floated by Zolt Darvas at Bruegel at the height of the crisis, is to change Euro-entry criteria, allowing all new member states to join the euro without passing through the Maastricht criteria. Advocates of this argument point out that the original Maastricht criteria were arbitrary, were not observed by EU member states after accession, and require much tighter fiscal and monetary policy for new nations than were required for the old European Union. In addition, these criteria can be changed without unanimous vote, making them a possibility in a policy world governed by very few options in terms of policy. The concern, however is that discrepancies between euro using nations on macroeconomic fundamentals was one of the core cause of the European sovereign debt crisis. Given dynamics of the crisis, then, it makes little sense to include more heterogeneity to the mix. In addition, there is no evidence to support that an internal adjustment (i.e., adjustment once inside the euro zone) is any better at mitigating social, political, and economic effects than adjustment outside the Euro zone. While unilaterally allowing the new member states to adopt the euro would protect these countries from speculative attacks on currency, it might do little or nothing to stem the rest of the effects of a financial crisis. Capital Account Regulation Abdelal, in his 2007 book cites a conversation with EC officials on the issue of Romanian capital market liberalization. According to Abdelal, despite IMF advice directly contradicting the EC on liberalization, Romania followed the EC because, if Romania were not ready for the acquis, then membership ought to wait as well (Abdelal, 61

62 2007, p.211). Similarly, Croatia, at the suggestion of the IMF established a type of capital inflow control known as an unremunerated reserve requirement (URR), similar in design to those proposed by Eichengreen, Tobin and Wyplosz, 1995; Eichengreen, Rose, and Wyplosz, 1996; and Kenen, 1995). These types of controls allow capital to flow into a country, but require than a certain percentage of any transaction be held in reserve at the host-nation s central bank for a specified length of time, at zero interest. Because Croatia has become one of the next nations to begin accession proceedings with the European Union, this sets up another potential clash between the EC and the IMF. As Abdelal describes it, this presents the unexpected scenario of Croatia s accession to the free-capital EU being blocked because it followed the illiberal IMF s advice to rely on capital controls (Abdelal, 2007, p. 210). It seems, then, that allowing capital controls, even only under certain thresholds of development, or re-ordering the acquis such that capital market liberalization is the last step of accession proceedings are unlikely to be supported by the EC. Circumstances, especially in regards to political instability both within the Euro zone and across the euro zone/european Union divide may eventually push Europe to reconsider. However, there is no way to tell how long it might take for Europe to undergo a process of revaluation similar to that of the IMF. In an environment were no options appear to be on the table, then, it is the position of this paper that re-ordering the acquis and allowing for URRs and other forms of capital controls below a certain developmental threshold (such as 50% of the EU average GDP) are a sensible place to begin. Periphery countries struggling to meet accession criteria across 30-odd domains of legislation or regulation should not have to contend with the unpredictability of hot capital flows. Countries already part of the 62

63 European Union but below 50% of the EU average GDP are unlikely to find that their economies are converging with the West simply because they share market rules. These economies must still undergo significant changes, and it should be acknowledged that the process takes time. Certainly, some degree of capital flows ought to be encouraged. Foreign Direct Investment and other long-term flows can help these countries learn the standards and norms of Western Europe. It is not the position of this paper that all capital flows be discouraged, or that capital account liberalization be isolated from other reforms. Rather, the process must be carefully titrated, with the development of a cohesive European Union as the end-goal of the process. To do less risks magnifying and exacerbating differences between East and West. 63

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71 Appendix 1: Convergence between Romania and the euro zone, GDP per Capita, PPP, Constant 2005$ Convergence Convergence

72 Appendix 2: Copenhagen Criteria COPENHAGEN EUROPEAN COUNCIL ex_en.htm Membership criteria require that the candidate country must have achieved stability of institutions guaranteeing democracy, the rule of law, human rights and respect for and protection of minorities; the existence of a functioning market economy as well as the capacity to cope with competitive pressure and market forces within the Union; the ability to take on the obligations of membership including adherence to the aims of political, economic & monetary union. 72

73 Appendix 3: Chapters of the Acquis Communautaire 1. Free movement of goods 2. Free movement of persons 3. Freedom to provide services 4. Free movement of capital 5. Company law 6. Competition policy 7. Agriculture 8. Fisheries 9. Transport policy 10. Taxation 11. Economic and Monetary Union 12. Statistics 13. Social policy and employment 14. Energy 15. Industrial policy 16. Small and medium-sized enterprises 17. Science and research 18. Education and training 19. Telecommunication and information technologies 20. Culture and audio-visual policy 21. Regional policy and coordination of structural instruments 22. Environment 23. Consumers and health protection 24. Cooperation in the field of Justice and Home Affairs 25. Customs union 26. External relations 27. Common Foreign and Security Policy (CFSP) 28. Financial control 29. Financial and budgetary provisions 30. Institutions 31. Others a_country_join_the_eu/negotiations_croatia_turkey/index_en.htm 73

74 Appendix 4: Sectoral Breakdown of Capital Flows to Eastern Europe. Figures from Becker et al,