symposium article can we expect convergence through

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Symposium Article

Can We Expect Convergence throughMonetary Integration? (New) OCA Theoryversus Empirical Evidence from EuropeanIntegrationHELMUT WAGNER

University of Hagen, Hagen, 58093, Germany.E-mail: [email protected]

It is argued that the European Union and the Eurozone in particular are only able tosurvive if they succeed in avoiding and/or overcoming real divergence and excessivemacroeconomic disequilibria. The mainstream view in economics is that a monetaryunion is only efficient or rather sustainable if either there is a certain degree ofstructural homogeneity, that is if there has been real (institutional-structural) con-vergence among the member countries before accession (Optimal Currency Area (OCA)Theory), or – alternatively – this real convergence is going to occur soon afteraccession (‘endogenous’ convergence hypothesis: New OCA Theory). This paper firstpresents a theoretical foundation and a discussion of this endogenous convergencehypothesis and then offers an empirical analysis on whether or not such an endo-genous real convergence has occurred in the European Monetary Union (EMU). Theanalysis shows and explains that – and why – after EMU accession several (particularlyemerging market) member economies have experienced real divergence instead of thedesired/hoped for convergence. Finally, the paper draws some political implications.Comparative Economic Studies (2014) 56, 176–199. doi:10.1057/ces.2014.8;published online 27 March 2014

Keywords: OCA theory, monetary integration, convergence, European integration,euro area, institutional development

JEL Classification: E02, F02, F55, O43

Comparative Economic Studies, 2014, 56, (176–199)© 2014 ACES. All rights reserved. All rights reserved. 0888-7233/14

www.palgrave-journals.com/ces

http://dx.doi.org/10.1057/ces.2014.8

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INTRODUCTION

What can a new entrant into the EU/European Monetary Union (EMU) expect,convergence or divergence? This has always been a decisive question for new(or potential) entrants, a question that is grounded in the original goals ofEuropean integration. A major goal of the European integration process from thebeginning was to achieve convergence in institutions/structures and in per capitaoutput level among member countries. This was formulated in the preamble ofthe EC Treaty of 1957, namely to ‘strengthen the unity of [the] economies [of themember states] and to ensure their harmonious development by reducing thedifferences existing between the various regions and the backwardness of the lessfavoured’ as well as, later on, in the preamble of the EU Treaty of 1992, namely to‘achieve the strengthening and the convergence of their economies’.

Thus, convergence (in institutions/structures and in GDP per capita level)was often expected in accession countries.1 What makes the analysis ofconvergence so important is the fact that the non-attainment of this originalgoal, or even a divergent development within the union, would lead todisappointment within those countries that were falling behind, and couldhurt the European integration process as a whole. Furthermore, it may producethe continuing need for bailing out (providing financial aid to) these countries(so creating a so-called ‘transfer union’).2 This would lead to an increasingresistance and unwillingness in the financing member countries to stabilizethe union in this way. In the end, this could lead to a destabilization, and in theworst case, to dissolution of the European Union.

This danger manifests itself in the current so-called ‘Euro Crisis’. Since theoutbreak of the global financial crisis in 2008, increasingly divergent develop-ments and an increase in macroeconomic imbalances have appeared in theEuropean Union. In particular, in the so-called GIPS countries (Greece, Ireland,Portugal and Spain) severe contractions have led to an increasing variance(across Eurozone member countries) not only of unemployment, economicgrowth, current account imbalances, government debt and, especially, interestrates but also in measures of institutional and governance quality (see Wagner,2013, Estrada et al., 2013, and Schönfelder and Wagner, 2014). This hascreated political and social tensions within the EMU. The question arises as towhether this endangers the survival of the European Union, or, at least, of the

1 Institutional and structural convergence is here regarded as a precondition for sustainableconvergence in real GDP per capita level towards the level of the richest member countries (seehereto, eg, Acemoglu and Robinson, 2005; Beck and Laeven, 2006).

2 Particularly transition and emerging market economies have relatively weak institutions andstructures that make them more vulnerable to common shocks so that they more often have to bebailed out by the other member countries.

H WagnerOCA Theory versus Empirical Evidence

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EMU. In fact, it has nourished doubts in the public about the stability of theEurozone or its ability to survive. These doubts are not new and are groundedin the so-called Optimal Currency Area (OCA) literature.

The paper argues that the OCA theory led to the establishment of the euro,or the specific kind and timing of the European monetary integration process.Between the Maastricht Treaty and the introduction of the euro in 1999, it wasclear that not all OCA conditions would be met. However, a new OCA theorywas developed (inside and outside the EU-Commission) as an explanation orrationalization why the euro was a good idea anyway. But the developmentsexpected by the new OCA theory have not come about, witness the sovereigncrisis. Therefore one may argue that the early introduction of the euro in manycountries was a bad or too ambitious an idea.

The paper is structured as follows. The next section describes the OCATheory and asks why its lessons have been disregarded or downplayedin the European integration process. A main role in this downplaying hasbeen played by the so-called ‘New OCA Theory’, particularly its endo-geneity hypothesis. The following section critically analyzes this endogeneityhypothesis. The subsequent section looks at the lessons from the history ofEuropean integration and examines the facts with respect to convergence anddivergence in the EU/EMU. The penultimate section highlights some politico-economic interpretations and draws some implications. The last sectionconcludes.

OCA THEORY – OLD AND NEW

The old or classical OCA Theory of the 1960s analyzed the conditions underwhich a currency union can function. The core of this theory can be describedas follows: only if a high degree of institutional and structural convergenceamong the countries has occurred is a currency union a reasonable option. Inother words, according to the OCA Theory, a currency union only makes senseor is efficient and sustainable if beforehand certain structural and institutionaladjustments among the countries have occurred. OCA Theory articulated byRobert Mundell (1961) focused on a high degree of factor mobility (includinglabor) as the main criterion for a successful currency area. Later on, otherauthors added other criteria, such as a high degree of openness (McKinnon,1963), product differentiation (Kenen, 1969), fiscal integration (Kenen, 1969),financial integration (Ingram, 1973), etc. Here I interpret the OCA criteria toimply that there is a certain convergence of institutions and structures within aunion.


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In the 1970s (when Europe dared make a first attempt to implement amonetary union)3 there was soon evidence to suggest that the EU was still faraway from being an optimal currency area and the project was stopped in1977. Even at the beginning of the 1990s (when a second attempt to implementa monetary union was started, known as the Maastricht process) severalstudies indicated that the European Union had not yet developed into anoptimal currency area. That is, the institutional adjustments among thepotential member countries still left much to be desired. Against this back-ground, the EU backed away from the requirement of fulfilling the OCA criteriaas a precondition for entrance into the Eurozone. Instead, in the secondattempt to implement a monetary union (which led to the Maastricht Treaty),it chose the fulfillment of some ‘nominal’ convergence criteria (inflation,government debt, household deficit, interest rate and exchange rate stability)as a precondition for entrance into the Eurozone (see, eg, James, 2012).4 Thesecriteria were devised to ensure convergence on monetary, fiscal and structuralpolicy.

The reason for this refocusing and hence deviation from classicalOCA Theory was mainly political.5 The principal goal was to establisha stable euro, which would emulate the stability of the Deutsche Mark (DM)6

and ensure the preservation, stability and enlargement of the Europeanintegration. This in turn was regarded to be an instrument for achievingpolitical stabilization (through economic integration) and the securing of peace(ie, avoiding future political and military conflicts) in Europe (see, eg, Sapir,2011, p. 1221).

In contrast, focusing on the classical OCA criteria would have meant that abinary division within the European Economic Community (EEC)/EU wouldhave occurred creating a small northern ‘core’ of the EMU and a growing

3 In the late 1960s, the EEC Commission launched its first major political initiative aiming at thecreation of a monetary union. The result is usually referred to as the ‘Werner Plan’, named after thechairman of the committee that produced the document. This Plan is frequently regarded as a failuredue to the insufficient structural-institutional convergence among the envisaged members at that time(see, in more detail, eg, James, 2012, Chapter 3). Nonetheless, it was ‘a remarkably similar blueprint’to the plan of the Delors-committee in the late 1980s, which provided a basic draft of the successfulmonetary integration process during the 1990s in the European Union (Verdun, 2001).

4 I differentiate in this paper between the so-called Maastricht or ‘nominal’ convergence criteriaand the ‘real’ convergence criteria, which include the institutional and structural convergence criteriadiscussed in the early OCA literature. This differentiation between nominal and real convergence isstandard in the European monetary integration literature, see, for example, Papademos (2006).

5 Furthermore, there were also arguments in the union then that the early OCA Theory was too‘static’ and did not fit the dynamic process of the European integration (although it was not regardedas useless or ‘irrelevant’; see, eg, Mongelli, 2008, pp. 5–8).

6 The Bundesbank and the ‘DM’ currency issued by it had a kind of a role model function inEurope and beyond during the 1980s and 1990s.


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south-east periphery (outside of the EMU), which was then regarded asdangerous for the expandability and the stability of the EU (see Sapir, 2011,pp. 1221f.).7 During the 1980s and 1990s various empirical studies (see, eg,Bayoumi and Eichengreen, 1993, 1997) demonstrated that only a smallsubgroup of the EU then fulfilled relevant OCA criteria.

However, this focus on nominal criteria in the Maastricht Treaty and thedeviation from the original OCA Theory was later justified by a new hypothesiscalled the ‘New OCA Theory’. This hypothesis was developed inside andoutside the EU-Commission (see, eg, Emerson et al., 1992, Frankel and Rose,1997, Mongelli, 2002, 2008). It suggested that a real and/or nominal conver-gence before an entry into the EMU was not necessary because convergencecould occur endogenously once a currency area was put in place. (This wouldalso mean that nominal convergence criteria are not at all necessary.) How thisfits together will be analyzed in what follows.

NEW OCA THEORY AND THE ENDOGENEITY HYPOTHESIS

This hypothesis of the New OCA Theory implied the idea of an ‘endogenous’convergence, that is, that by and following entry into the EMU, incentivemechanisms become effective, which themselves lead to a nominal and (orvia) real convergence.8 In other words, a prior convergence is thus arguablynot necessary; see, for example, Frankel and Rose (1997, p. 754): ‘countrieswhich join EMU, no matter what their motivation may be, may satisfy OCAproperties ex post even if they do not ex ante!’9

In other words, an entry into the EU and into the EMU as well wouldsupport the institutional convergence among the member countries, since theaccession countries are encouraged to adjust or adapt their institutions andstructures to those of the present member countries. If that is true it wouldmean – as is central to today’s view of the Eurozone sovereign debt crisis – thatthere is a possibility of an endogenous fiscal adjustment, meaning that waitingto satisfy the formal (fiscal) constraints as entry criteria may be superfluous.The Maastricht fiscal adjustments would be unnecessary constraints for the

7 Today (ex post as a lesson from the Eurozone debt crisis) such a division might appear to havebeen the better way to go.

8 In principle this idea was already prevalent in 1992 (when the Maastricht Treaty came intoforce) and even in the 1970s (see Moravcsik, 2012, p. 56).

9 Already at the beginning of the 1990s such endogenous tendencies were being discussed. Itwas then argued that the waiver of the exchange rate as a stabilization instrument would not be asrelevant since the exchange rate instrument would in any case not be as necessary within a monetaryunion because the typical cases for its application would endogenously tend to disappear or bereduced. See hereto in more detail, for example, Emerson et al. (1992, p. 24).


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acceding countries.10 The reason is that accession to the EU/EMU maycreate incentives that might induce endogenous (fiscal) adjustment processesanyway.

In what follows, I describe the basis for the hopes for endogenoussolutions implied by the New OCA Theory. In addition, I will also brieflymention some (potential) counter-arguments.11

First, the most commonly identified benefit of euro adoption is theincrease in trade and investment that a common currency might induce.Expectations with regard to the euro’s trade effect were partly based on a studyby Rose (2000) that examined the experience of post-war currency unionsthroughout the world. This study suggested that currency unions increasedtrade by 300%. Such an increase in trade would also foster economic growthand create government revenues that may solve the fiscal consolidationproblem in the acceding countries after euro adoption. However, theseexpectations have been dampened by the results of several follow-up studies.These studies find much lower trade benefits of euro adoption (see, eg, Miccoet al., 2003, Baldwin, 2006, and Santos Silva and Tenreyro, 2010).

Second, it has sometimes been contended (see, eg, Darvas and Szapary,2008, or, in more detail, Wagner, 1998, pp. 91ff.) that the flow of foreign directinvestment into the acceding countries (of central, eastern and south easternEurope in particular) will increase after accession to the EU/EMU. This flow offoreign direct investment would generate technology spillovers and learning-by-doing and induce institutional reforms. This would produce positiveproductivity and growth effects (Wagner, 1998). However, it may be arguedthat if the initial infrastructure conditions in the acceding countries are weak,12

the potential for learning effects and technology spillovers induced by foreigndirect investment is small (see, eg, Kose et al., 2009).

Third, it is expected by supporters of the New OCA Theory that, bytransferring monetary policy to the European Central Bank and thereby givingup the possibility of seigniorage financing, the acceding countries can hope formonetary and therefore political stability13 as well as a reduction of the risk

10 Unnecessary constraints insofar as these would induce a postponement and a rise in cost ofaccession to the EMU. This postponement or rise in cost could have reduced the interest in accessionin the public of the candidate or accession countries. This was then not desired against thebackground of the wish for quick European integration and enlargement (see, eg, IMF, 2002, p. 39).

11 These counter-arguments were first developed in a (unpublished) study conducted by theauthor for the International Monetary Fund (IMF) in 2005 (Wagner, 2005b).

12 As argued, an improvement of the infrastructure conditions may be prevented by therestrictive fiscal policy that may be necessary for fulfilling the nominal convergence criteria and forcomplying with the rules of the Stability and Growth Pact (Wagner, 2002a, b).

13 There is a positive correlation between monetary and political stability insofar as high inflationusually goes along with political instability. That is, by avoiding high inflation one can reduce the risk


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premium in the interest rate on government bonds. This, together with thecompetition arising from increased price and cost transparency, would be animpetus for institutional reform and have positive growth effects. Thisexpectation was usually substantiated by reference to the experiences of thesouthern member countries of the EU and Ireland before and immediately aftertheir accession to the EMU.

However, whether a reduction in risk premia is sustainable dependson the use of reduced financing costs. Recent experience in the GIPShas shown that lower financing costs were used to finance consump-tion and (often) unproductive investments as well as wage increases.This led to a decline in competitiveness and, once the global financialcrisis started, the risk premia returned (see Figure 2) and resulted in over-indebtedness and finally factual insolvency in, for example, Greece andPortugal (see EEAG, 2013). Furthermore, the extent of reforms and theimpetus for growth usually depend on initial institutional and structuralconditions (see, eg, Acemoglu and Robinson, 2005, 2012; Mohr andWagner, 2013).

Fourth, against the background of increasing competition after accessionto the EU/EMU, rigidities and inflexibilities in the labor market were expectedto decline so that the costs of disinflation particularly for countries entering theEurozone with a (too) high inflation rate may also decline (see, eg, Calmfors,1998).

In principle, this is possible; however, as explained in earlier studies(Wagner, 1998, 2002a, b, 2012), it appears to be equally likely that therewill be institutional incrustation.14 If this danger of institutional incrustation

of political instability. This reasoning was also a major argument for establishing a monetary union inthe EU with an ECB modeled on the German Bundesbank.

14 These earlier studies argue that there is a real danger that, after accession to the EMU, thedemand for a quick(er) adjustment to the living standards of the EU core countries increases in thenew member countries. This may occur (and has occurred) in the form of (a) higher wage demands(the demand for wage adjustment is stronger when the wages are directly comparable in the samecurrency and when labor flexibility increases within the EU, inducing threats to exit, ie, migration oflabor), and (b) demands to adjust the welfare legislation to that of the richer member countries. Thisobviously happened in some of the GIPS countries in the period between EMU entrance and thefinancial crisis of 2008. These demands are substantiated by expected club solidarity expressed intransfer payments and bail-out actions in economic crises (despite contrary agreements in theMaastricht Treaty). This solidarity may be enforced (c) through political pressure, that is, threateningto use blocking power (exercising veto rights and blocking decisions, which are in the interest of thecore countries), (d) through permanent dominance of EU summits with distribution debates, (e)possibly also through increased union power based on centralization of the unions beyond countryborders, enforcing adjustment to the more inflexible labor legislation in the EU core countries. Seehereto also in the section ‘Some Politico-economic Interpretations and Implications’.


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materializes, the real convergence process would be slowed down if notstopped.15 The development in East Germany (the new Bundesländer) afterthe currency union with West Germany can be (or could have been) used as awarning example. Even if the hopes for endogenous upgrading and greaterflexibility on the labor markets materialize, the implementation of betterstructures and institutions takes time. However, given sufficient time, thescenario of real divergence could then become a reality in the transition period.These counter-arguments have apparently been confirmed by the laterexperiences in the southern accession countries of Greece, Portugal and Spain,and partly also by those in Italy.

In earlier studies (Wagner, 2002a, b), I showed that the planned earlyentry into the euro area of the then emerging NMS-10 (the 10 post-communistNew Member States (NMS) that entered the EU in 2003) could have resulted inreal divergence. The growth model I presented provided one scenario of howattempts to satisfy the nominal Maastricht convergence criteria could have anegative impact on (envisaged) real convergence between the incumbents andthe accession countries in a monetary union.

The key arguments were based on the fact that

(1) ‘emerging’ accession countries have relatively high optimal public invest-ment levels in comparison to developed incumbents, and

(2) the nominal Maastricht convergence or entry criteria, which were elaboratedfor the original (developed or ‘emerged’) incumbents, would have putpressure on the ‘emerging’ accession countries to maintain the publicinvestment levels less than optimal.

This means, the optimal level would only have been achievable (underreasonable parameter values) if at least one of the Maastricht convergencecriteria was violated. In other words, the optimal public investment levels couldnot have been reached (in the emerging/transition countries of central andeastern Europe) as long as the Maastricht criteria were taken seriously. The realconvergence process could then have been slowed by negative growth effects.

15 The hope that the unions in the acceding countries would be content with lower wagedemands, since they are smaller relative to the monetary area and therefore have no chance ofinfluencing the ECB, is naive, as such demands can be made through political pressure. Moreover,one can argue that the unions have already taken into account the effects on the internationalcompetitiveness of the firms that have already been exposed to the international competition process.Therefore, union behavior should not change too much after accession to the EMU. Instead ofresulting in lower wage demands, the fact that the unions in the acceding countries become smallerrelative to the monetary area is even more likely to decrease their perception of the inflationaryrepercussions of their individual wages, thus inducing them to make more aggressive wage demands(Cukierman and Lippi, 2001).


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In principle, and this also supports the general conclusion of the discus-sion of the early OCA Theory,16 my results imply that a sufficient degree of realconvergence should be seen as a precondition for a promising accession to amonetary union and not as the hoped-for endogenous result of early accession.

Whether this theoretical result is correct is an open question, which has tobe answered empirically. The only test object that is available and we can useis the EU/EMU. Therefore we ask in the following section whether accession toEMU has fostered the institutional convergence process in the Eurozone. Wewill show that this cannot generally be confirmed.

CONVERGENCE AND DIVERGENCE IN THE EUROZONE – EMPIRICAL FACTSAND EXPLANATIONS

In this section I first present some empirical results on convergence anddivergence in the Eurozone and then give some macroeconomic explanations.

Empirical resultsThe empirical studies have shown so far a non-linear tendency17 towardsconvergence within the European integration process (see, eg, Christodoulakis,2009, Raileanu Szeles, 2011, Marelli and Signorelli, 2010, and more recently Gilland Raiser, 2012, Estrada et al. (2013), Wagner, 2013, and Schönfelder andWagner, 2014).

Christodoulakis (2009) estimated (in a parametric framework) theβ-convergence parameter for members of the EMU, and found that the speedof β-convergence in per capita GDP weakened between pre- and post-EMUperiods. On the same basis, the σ-income-convergence between EMUmembersslowed or even substantially reversed.18 The only sign of convergence that canbe observed is the synchronization of business cycles, which has improved theviability of common monetary policy. Thus, business cycles have becomemore symmetric and less intensive after the establishment of the EMU, at leastuntil 2008.

16 It also supports the so-called ‘coronation theory’, which functioned as the justification of theMaastricht convergence criteria and had already ‘played a key role in the debates of the early 1970s: amove to monetary union should take place only when there was a substantive economic convergence’(James, 2012, p. 215; see also Mongelli, 2008, p. 10).

17‘Non-linear’ here means that the dynamics of convergence has first increased and then

stagnated or slowed down in the European integration process over the last decades. See the followingexamples.

18 Simply speaking, β-convergence implies that poor economies grow faster than rich ones andσ−convergence means a reduction in the dispersion of income levels across a group of economies.For more details see, for example, Barro and Sala-I-Martin (1995).


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Marelli and Signorelli (2010) estimated β-convergence in productivitylevels and labor market performance indicators in the EU-27 (emphasizingthe role of alternative indicators for real structural convergence). The evidenceof convergence in industrial specialization is less clear for EMU members.Trade integration increased due to institutional integration in the EMU and EU.When the σ-convergence of these indicators and per capita GDP is assessed, astrong convergence can be found in labor market performance indicators, butnone in productivity and per capita GDP for the EMU-12. In contrast, the NMSexperienced strong σ-convergence in per capita GDP and productivity.

Raileanu Szeles (2011) applied a non-parametric framework for the NMS,which detects convergence clubs and distinguishes between long-term andshort-term absolute convergence in per capita GDP. Her findings indicated alack of real convergence in the long term in favor of short periods ofconvergence and divergence. By comparing these results with the standardparametric approach to detect β-convergence, the β-parameter is found to beweakly significant.

Estrada et al. (2013) studied the extent of macroeconomic convergence/divergence among euro area countries. They found (inter alia) that there was astrong convergence in unemployment rates across euro area countries duringthe first nine years of EMU. ‘With the onset of the financial crisis, however,that convergence process among euro area countries has been interrupted andlargely reversed, more so than in other non-euro economies’ (ibid., p. 2).

As a general tendency,19 significant institutional-structural convergencecould only be observed before accession to the EMU. After accession to theEMU, institutional-structural convergence appears to have slowed down oreven turned to divergence in some countries (see Figure 1). However, on theother hand, there has been a clear alignment of GDP per capita and thefulfilling of some Maastricht criteria in a majority of the E(M)U membercountries during the first 9 years of EMU before the financial crisis (see, eg, Gilland Raiser, 2012, and Wagner, 2013). In contrast, there was real divergencewith respect to institutional and structural alignment in some of the GIIPScountries (GIPS plus Italy) after accession to the EMU (particularly after theglobal financial crisis). Interpreted in the context of the OCA Theory, thisindicates that also the GDP per capita convergence tendency is likely not to besustainable (in the sense of an endogenous convergence process). Thetemporary alignment of GDP per capita (and the fulfilling of some Maastrichtconvergence criteria) seems to have been possible only against the backgroundof partly unconditional financial aid and non-credible commitments.

19 For a more detailed description of some of the above und the below-mentioned studies see, forexample, Wagner (2013: part 4).


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Figure 1: Development of institutional indicators in some EU/EMU countriesData source: World Bank. World Wide Governance Indicators* Percentile rank indicates the country’s rank among all countries covered by the aggregate indicator,with 0 corresponding to lowest rank, and 100 to highest rank (World Bank).


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Figure 1 indicates that after entrance into the Eurozone, institutionalconvergence ground to a halt and even reversed in some of the membercountries.

In Figure 1, the development of several World Wide Governance Indica-tors (WGI) is depicted. I compare the development of these WGI indicators inthe GIIPS countries (which have been Eurozone members since 1999/2001)with that of the NMS countries (here: Bulgaria, Czech Republic, Hungary,Latvia, Lithuania, Poland and Romania; which had not yet entered theEurozone within the considered period 1996–2012) and Germany (as a kindof benchmark member country).

To summarize, as a general tendency, one can interpret the data inFigure 1 cautiously as follows: institutional-structural convergence can only

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Figure 1: Continued...


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be observed before and until shortly after20 accession to the EMU. In particular,there was real divergence with respect to institutional and structural alignmentin some of the GIIPS countries after accession to the EMU, particularly after2009. On the other hand, there has been a clear alignment of per capitaGDP and the fulfilling of some of the Maastricht criteria in a majority of theEU/EMU member countries until 2009; see Wagner (2013).21 However, asalready mentioned above, the alignment of per capita GDP and the fulfillmentof some Maastricht criteria (before 2009) then were only possible againstthe background of partly unconditional financial aid and non-crediblecommitments. After 2008, as Gill and Raiser (2012) have shown in moredetail, even the original goal of (supported) income convergence could not beattained anymore; income convergence slowed and went into reverse in partsof Europe.

In Schönfelder and Wagner (2014),22 we investigated the speed anddirection of the institutional development of European countries. We testedthe following hypotheses (developed largely from the public-choice theory):

● The prospect of European countries joining the EU disposes them to strength-ening their institutions so that the speed of convergence is high.

● EU Member States preparing the introduction of the euro have incentives todevelop their institutions but the speed of institutional convergence is muchlower.

● As soon as Member States introduce the euro, institutional convergence grindsto a halt, or is even reversed, as there could be incentives to undo reforms.

To test these hypotheses, we estimate a dynamic panel data model, wherethe institutional convergence is measured by changes in WGI. The changes inWGI are explained by the ‘status’ of the European countries (ie, being amember of the euro area, Member State preparing to adopt the euro, accedingcountry, candidate country, potential candidate country or none of the abovementioned) and additional controls (level of openness and GDP per capita, allin the previous period).

20 The convergence effect shortly after the accession to the Eurozone can be interpreted as thelagged effect of earlier investment (in the time before accession) in institutional infrastructure.

21 There it is shown that there has been β-convergence in the NMS-10 countries until thefinancial crisis, insofar as the growth rates in the NMS-10 were higher than that in the EU-27 average,and that this applies also to the GIIPS countries, however to a lesser degree. Furthermore, it is shownthat there also has been σ-convergence in the EU/EMU in the decade before the financial crisis, butnot among the EA-11 (the first-round entrants).

22 This study is a follow-up study of Wagner (2013), as the latter one was based on simpledescriptive statistical analysis, whereas the follow-up study uses some more elaborated empiricalmethods, in particular a dynamic panel data model.


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Our descriptive analysis shows that there was an improvement of WGIfrom 1996 to 2012 in the least performing countries. Best performing countriesdid not improve further. The mean values of WGI increased with status. Andthere was a tendency that year-to-year changes of WGI are higher for countriesbefore and in early stages of accession. Our panel analysis showed that thelower the WGI, the stronger the positive impact of a country’s affiliation to theEU/EMU. Affiliation to the EU/EMU reduces the persistence of institutionaldevelopment. Although we could not find much evidence for institutionaldivergence, there was also none for convergence in the euro area.

To sum up the findings, we can confirm an overall positive effect ofprospective EU membership, and a smaller effect of preparation for theeuro. We find some indication of institutional divergence, but no evidence ofinstitutional convergence as soon as Member States introduced the euro.

In general, one can conclude from the recent empirical evidence that theincentive for countries that enter the Eurozone as an emerging market economyto go on investing in necessary institutional upgrading is reduced or wanes. Thismeans that institutional convergence tends to slow or stop within the Eurozone,so that the remaining gaps are not going to be diminished (something that canwork out disastrously for the emerging member countries as well as for theunion as a whole; the present euro crisis is an example of this).

Macroeconomic explanationsThe above empirical findings show that the expectations of the New OCATheory have not (or, not sufficiently) been met. One of the main reasonsbehind this, as I argued and described in another paper (Wagner, 2013), is thatentrants into the EU can choose between various alternatives (staying outsidethe Eurozone, delaying entrance or trying to rush into the Eurozone), which allhave potential economic pitfalls. These pitfalls are especially dependent on theinitial stance of development or convergence, and on the chosen exchange ratesystem. Over the recent decades these pitfalls have become even morecomplex and costly since globalization and the integration of financial marketshave fundamentally changed the environment in which the catching-upprocess for newcomer countries is managed (see also Wagner, 2005a).

Examples of the economic pitfalls that today’s newcomers may experienceif they join the euro area too early include (1) excessive imbalances,(2) endogenously enforced austere fiscal policy, (3) (fear of) contagion, and(4) business cycle asymmetries.

(1) Key risks and challenges, which all entrants face on the road to euroadoption and beyond, are based on exposure to large and volatile capitalflows and the danger of overheating due to credit booms.


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(2) Emerging economy entrants into the Eurozone23 face a danger of fallingbehind in real convergence when pushing too hard to attain the nominalconvergence criteria of the EU Treaty of 1992 as a precondition for Eurozoneentry. The main reason is that in order to fulfill these nominal convergencecriteria they are often forced to forego infrastructure investments, whichwould be necessary to attain the goal of real convergence (for a model-basedanalysis see Wagner, 2002a, b).

(3) Countries that want to join the Eurozone are forced to participate in theExchange Rate Mechanism (ERM-II) of the European Monetary Systemwithin the normal fluctuation margin, and without severe tensions, for atleast 2 years (see Hochreiter and Wagner, 2002). By doing this they willprove that they are strong enough to withstand severe exogenous shocks.During this transition period, the accession countries follow a type of ‘weak’currency pegging (soft peg), which implies the danger of severe speculativeattacks. If their institutions are not yet strong enough, they may experience asignificant capital outflow, which triggers the devaluation of its currency andtherefore an increase of their external (foreign currency-denominated) debts.Even if these newcomer countries follow a solid economic policy, they canrun into problems since unintendedly they can import big crises viacontagion from neighboring countries. As has been shown previously(Berger and Wagner, 2005), the increase in crisis probability in one countryalone may trigger currency crises elsewhere. Here fundamental weakness aswell as spontaneous shifts in market sentiment can play a role in thetransmission of currency crises.

(4) As described in Wagner (2013), ‘excessive credit growth and domesticdemand growth leads to inflationary pressures in emerging market econo-mies’ (p. 203). This can result in strong asymmetry in the form of realinterest rate differences within a monetary union. Since the ECB only targetsaverages, it cannot fight this asymmetry by reacting to national imbalancesin nationally optimal ways and thus cannot avoid a destabilization ofthe union as a whole. Optimal national levels will be missed the wider theasymmetry or variance is. Even if this may trigger transitory real or GDP percapita convergence, ‘it often ends up in bubbles and an eventual counter-development towards real divergence (currently seen, for example, in someof the GIIPS countries)’ (ibid.)

Table 1 shows the macroeconomic imbalances within the euro area in2011 and (in parentheses) as the deviation from the German value.

23Many entrants into the EU, and from 2001 on into the EMU, were emerging economies such asGreece, Spain, Portugal, Ireland (in the 1980s and 1990s) or the post-communist East Europeantransition countries (in the 2000s).


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To deal with such imbalances or disequilibria and with the associatedpitfalls, the EU Commission developed a set of rules, the so-called ‘six-pack’,which came into force in December 2011 (see European Commission, 2012).This package amends the Stability and Growth Pact by introducing strongerrules and specific sanctions for violations of those rules; and it automatizesthe implementation of sanctions. In particular, this package identifies

Table 1: ‘Imbalances’ within the euro area 2011

GDPgrowth

Unemploymentrate

Governmentdebt (% GDP)

Fiscal deficit(% GDP)

Long-terminterest rate

Current accountbalance (% GDP)

Belgium 1.8 7.2 97.8 −3.7 4.23 −1.4(−1.2) (1.3) (17.3) (−2.9) (1.6) (−7.1)

Germany 3.0 5.9 80.5 −0.8 2.61 5.7(0.0) (0.0) (0.0) (0.0) (0.0) (0.0)

Estonia 8.3 12.5 6.1 1.1 n.a.a 2.1(5.3) (6.6) (−74.4) (1.9) (−3.6)

Ireland 1.4 14.7 106.4 −13.4 9.6 1.1(−1.6) (8.8) (25.9) (−12.6) (7.0) (−4.6)

Greece −7.1 17.7 170.6 −9.4 15.75 −9.9(−10.1) (11.8) (90.1) (−8.6) (13.1) (−15.6)

Spain 0.4 21.7 69.3 −9.4 5.44 −3.5(−2.6) (15.8) (−11.2) (−8.6) (2.8) (−9.2)

France 1.7 9.6 86.0 −5.2 3.32 −2.0(−1.3) (3.7) (5.5) (−4.4) (0.7) (−7.7)

Italy 0.4 8.4 120.8 −3.9 5.42 −3.1(−2.6) (2.5) (40.3) (−3.1) (2.8) (−8.8)

Cyprus 0.5 7.9 71.1 −6.3 5.79 −4.7(−2.5) (2.0) (−9.4) (−5.5) (3.2) (−10.4)

Luxembourg 1.7 4.8 18.3 −0.3 2.92 7.1(−1.3) (−1.1) (−62.2) (0.5) (0.3) (1.4)

Malta 1.7 6.5 70.3 −2.7 4.49 −0.3(−1.3) (0.6) (−10.2) (−1.9) (1.9) (−6.0)

TheNetherlands

1.0 4.4 65.5 −4.5 2.99 9.7(−2.0) (−1.5) (−15.0) (−3.7) (0.4) (4.0)

Austria 2.7 4.2 72.4 −2.5 3.32 0.6(−0.3) (−1.7) (−8.1) (−1.7) (0.7) (−5.1)

Portugal −1.6 12.9 108.0 −4.4 10.24 −7.0(−4.6) (7.0) (27.5) (−3.6) (7.6) (−12.7)

Slovenia 0.6 8.2 46.9 −6.4 4.97 0.0(−2.4) (2.3) (−33.6) (−5.6) (2.4) (−5.7)

Slovakia 3.2 13.6 43.3 −4.9 4.45 −2.1(0.2) (7.7) (−37.2) (−4.1) (1.8) (−7.8)

Finland 2.8 7.8 49.0 −0.6 3.01 −1.6(−0.2) (1.9) (−31.5) (0.2) (0.4) (−7.3)

aThere were no Estonian sovereign debt securities that comply with the definition of long-term interestrates for convergence purposes. No suitable proxy indicator has been identified (ECB).Deviation from Germany in parentheses.Source: Eurostat.


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macroeconomic imbalances as a potential source of instability and establishesa surveillance mechanism and an ‘excessive imbalance procedure’. Thismacroeconomic imbalance procedure includes an early warning or alertmechanism, which is grounded in a set of indicators and in correspondingthreshold values for these indicators (see ibid.).24

The EEAG (2013, p. 58) found that ‘the introduction of the euro eliminatedthe exchange rate risk’ and that ‘the Eurosystem created optimistic expectationsregarding the rapid convergence of the periphery countries (Greece, Ireland,Portugal and Spain) with the core of the euro area’ (see, eg, Blanchard andGiavazzi, 2002). Furthermore, it found that ‘(T)he poorer a country was in 1995relative to the average, the larger its current account deficit was from 2002 to2007’, and that ‘the periphery grew via stronger investment at the expense of thecore, and thus brought about convergence’, accompanied by rapidly rising pricesthat led to the bubble that ultimately burst (EEAG, 2013, p. 59). Finally itsuggested ‘that there is a pronounced negative relationship between our (lack of)competitiveness indicator and current account deficit’ (p. 60).

SOME POLITICO-ECONOMIC INTERPRETATIONS AND IMPLICATIONS

Behind the above-described macroeconomic disequilibria and the asso-ciated divergence tendencies in parts of Europe lie some ‘deeper roots’,namely a politico-economic framework that triggers negative incentiveeffects to reform and thus leads to the described non-linearity of theconvergence adjustment. Certainly, one can argue that the current sover-eign debt crisis in the euro area was due to a flaw in the construction ofthe EU treaty, namely wrong incentive mechanisms to reform for acces-sion countries (see the section ‘Asymmetric incentive mechanisms foraccession countries’). A second interpretation is that the EU’s disregard ofthe effects of recent global reduction of trade restrictions (see the section‘Costs increase when globalization advances’) have favored divergencetendencies within the Eurozone. Another construction failure may beseen in the asymmetry between a common monetary policy and hetero-geneous diversified fiscal policies of the currently 18 member countries ofthe EMU.

24A similar set of indicators was considered by the IMF (2010). These early-warning indicatorsand their threshold values are often criticized as being arbitrary, leading too often to false alarm, andbeing endogenously affected by policy instruments (see, eg, Kaminsky and Reinhart, 1999, andWhelan, 2012).


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Asymmetric incentive mechanisms for accession countriesBefore entry into the EU, but particularly before entry into the EMU, thestructural adjustment requirements (partly for fulfilling the nominal conver-gence criteria) on the potential accession countries are high. If these require-ments are not fulfilled, an accession country can in principle not be admittedinto the EU/EMU unless the other member countries turn a blind eye to suchcases (as in the cases of Italy and Belgium at the start of the EMU)25 or do notlook at them very closely (as in the case of Greece).26 Hence there is a strongincentive for the potential candidate countries to implement these institu-tional-structural reforms before applying for admission, in order to be admittedin the EU/EMU. However, as soon as the goal of being admitted in the EU/EMUis reached, these reforms slow down (see also EBRD, 2014). The reason for thisis that the country cannot then be thrown out of the EU/EMU, even when itstops implementing reforms (which are costly and painful for the public andtherefore politically not easy to implement) and instead keeps relying on thesolidarity of the other member countries.27 The previously effective incentivemechanisms then do not work anymore, which has turned out to be a seriousdesign failure of the EU Treaty. Moreover, a country that enters the Eurozonegets an entry premium in the form of a decreasing risk premium28 and hence ofa lower interest rate on the capital market (see Figure 2). Figure 2 shows thatthe spreads of government bonds among the euro area member countriesbegan to level out from the mid-1990s.29

Therefore, after entry into the EMU, it becomes easier and less costly forthe country to run into debt. This can accelerate the convergence process ifthese bonuses are invested productively. If, however, they are (mis)used forconsumption and prestige (unproductive) investment projects and welfare/wage increases, converse effects can occur leading to real divergence. Inaddition, according to the ‘Political Economy’ literature (particularly theso-called ‘club theory’),30 newcomers often think that the incumbents willshow increased solidarity with them after their entrance into the Eurozone

25A major reason for this was the fact that these two countries were founding members of theEEC.

26 Later accession candidates were treated much more finickily: look at the example of Lithuania.27 Related arguments build on similar free-rider problems (see, eg, Calmfors, 2001, or Chari and

Kehoe, 2008).28 This convergence of interest rates contradicts the expectation laid down in the Maastricht

Treaty that interest rate differentials would or should function as a disciplinary force by showing riskdifferences. This expectation has not become true mainly due to the financial market’s anticipationthat the no-bail-out rule would not be binding or implemented.

29 The reason for this early leveling was the so-called ‘halo’ effect, that is the effect of the earlyannouncement regarding the participating countries.

30 See, for example, Sandler and Tschirhart (1997).


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(interpreted as a ‘club’). Thus they expect that the incumbents will help themif they get into severe imbalances. The reason for this is the often-heard beliefthat all member countries are ‘in the same boat’; thus, not helping failedcountries would have negative feedbacks on the other member countries andon the union as a whole. This thinking and corresponding behavior could beseen of the GIPS countries during the past decade.31

Therefore there are asymmetric incentives in the European integrationprocess. Before entry into the Eurozone the incentives to follow the rules arehigh (due to the specific structure of the EU treaties), whereas they decrease orslow down after entry into the Eurozone. Consequently, it is not surprisingif the institutional-structural convergence slows down after entry into the

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Belgium Ireland Greece Spain France Italy Netherlands Austria Portugal Finland

Introduction of Euro

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Figure 2: EMU convergence criterion bond yield spreads vis-à-vis Germany (EA12)Data source: Eurostat

31 Fernandez-Villaverde et al. (2013, p. 29) recently came to a similar conclusion: ‘Observersexpected the arrival of the Euro to lead to a modernization of the peripheral European economies.Lacking monetary and fiscal autonomy, governments would have to adopt structural reforms they hadbeen previously refused to implement. In fact, as we have shown in this paper, the steep financialboom derived from the drop in exchange rate risk and from the Euro wide financial bubble meant thatthe budget constraints that these countries faced were loosened, rather than tightened. Countries thatcould cheaply borrow delayed painful reforms. Moreover, accountability was lost during the bubbleas bad decisions have no negative short-run consequences when rising asset prices hide all mistakes.As a result, the financial bubble fueled the deterioration of governance and of the institutionalarrangements on the Euro’s periphery’.


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Eurozone and if the GDP per capita convergence bottoms out as well, althoughthe latter can still be positively driven by financial structural aid measures foremerging member countries.

Costs increase when globalization advancesThe occurrence of an economic and monetary union can be compared withregional globalization. The member countries are thus integrated morestrongly and become highly interdependent. To steer such a union under theseconditions without crisis through the structural change that accompaniesglobalization requires ongoing costly structural adjustment reforms in allmember countries. Withholding or delaying such reforms in single membercountries will not only be costly for the respective country (which may fall intoinsolvency) but can also drive the other member countries into a crisis.

A fall into insolvency or an exit from the EMU of a member country wouldalways be costly for the other member countries as well, because of theincreased (especially financial) linkage.32 It becomes even more costly if theglobalization occurs worldwide. Then severe contagion effects across borders(also of the union) will emerge, and these effects will be able to eventually leadto the collapse of the whole union, even of the world economy. (An example ofthis is the current debt crisis in the Eurozone, which has emerged during apending global financial crisis.) What matters here is that the costs of aninsolvency and a following exit of a crisis country could, due to the linkage ofthe relations across member countries, become so high for the other countriesthat a reform-unwilling country may hope that the other member countries arenot able to afford to let it go bankrupt.

Under such conditions, a currency union converts to a kind of ‘communityof fate’ in which even small countries, by behaving as freeloaders, can‘blackmail’ other countries since they can cause systemic contagion effects forthe union and the world economy as a whole. Not to have foreseen this andthus not to have established effective mechanisms to automatically penalizemembers that delay or decline to implement (agreed) necessary reforms is asecond construction failure of the EU Treaty that the then governmentsare responsible for. There are, or have so far been, no sufficient incentivemechanisms for the member countries to conduct the necessary reforms.However, there were credible expectations of a bail-out by the other member

32 Besides of producing direct economic costs, a euro exit would – as Olivier Blanchard (ChiefEconomist at the IMF) recently emphasized at the American Economic Association conference inPhiladelphia (on 4 January 2014; panel session ‘The Macroeconomics of Austerity’) – be ‘a logisticaland a legal nightmare’. I would add it could also be a political nightmare since it would trigger strongpolitical tensions among European states. This apparently let even factually insolvent GIPS countriesso far shy away from considering this option.


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countries in the case of insolvency risks in a member country (which wasreflected in the levelled spreads between 2003 and 2008 in the euro area). Atthe beginning of the 1990s, the EMU/EU Treaty still pursued a largely staticconcept since at that time globalization had not yet advanced very far. Sincethen, however, the world has changed drastically with the increasing globali-zation so that today institutional-structural reforms are more necessary thanthey were previously (at the end of the 1980s). Therefore these reforms werenot foreseen or considered then to be so relevant, also because, in contrast totoday, the consequences then seemed to still be manageable and limited. Themistake was the non-anticipation of the globalization process and its costlycontagion effects. Therefore a reform of the construction pillars and thus of theincentive mechanisms is urgently required in the EMU today.

CONCLUSIONS

Convergence is an original goal of European integration. The importance ofthis goal has been strengthened by the early OCA theory. This paper arguesthat the European integration and enlargement process has (from the 1980son) built on the illusion of endogenous convergence. In contrast to the oldOCA Theory, the so-called ‘New OCA Theory’ has included the idea of an‘endogenous’ convergence process, that is, that by and after entry into the EUand later the EMU, incentive mechanisms become effective, which lead to anominal and real convergence process within the union. Accession countriesthat have lagged behind in institutional and structural development wouldbe encouraged to steadily work on adjusting or adapting their institutionsand structures towards those of the most highly developed member countries.The paper shows that this illusion has not sufficiently manifested itself, at least notafter (emerging economies) newcomers entered the Eurozone. The paper gives anoverview of the empirical evidence of real convergence within, and induced by,the European integration process and highlights the fact that the lack of ex anteinstitutional convergence has induced or aggravated the debt crisis in theEurozone as soon as a large financial shock has hit the union. Finally, the paperhas given some politico-economic interpretations and political implications forsafeguarding the survival of the Eurozone and of the European integration processin general. The main challenge the European Union is confronted with is how torepair the construction failures in the EU Treaty and to induce the (particularlyemerging market) incumbents not to slow down their efforts to further upgradetheir institutions even if it is costly and painful for the public of these countries.Only such a successful repair process could result in a stabilization of theEurozone and sustain the European integration process.


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AcknowledgementsI would like to thank Oleh Havrylyshyn, Adrienne Bohlmann, Christian Haase,Nina Schönfelder and Paul Wachtel for their comments on previous versions ofthis paper. This paper is based on my presentations at the American EconomicAssociation conference in San Diego, January 2013, and at the 19th DubrovnikEconomic Conference, June 2013.

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