Euro adjustments

The debate about Malta's adoption of the euro as its currency from the coming just under 12 months is off the political agenda. This is something very positive as it has removed any political uncertainty that could have been surrounding the issue.

The remaining uncertainty is economic as Malta had not as yet met all the criteria for it to adopt the euro when the last Convergence Report prepared by the European Commission was drawn up last December. At that time the inflation rate was still a major obstacle, although the latest data shows that Malta does satisfy this specific criterion.

I believe it is critical that Malta does adopt the euro next January, albeit after it has achieved sustainability of its public finances, brought inflation to a level that is comparable to other EU member states, and implemented further reforms at a microeconomic level that would render the economy more flexible.

It is critical because we have already had one of the 10 member states that joined the EU in 2004 (namely Slovenia), adopting the euro at the beginning of this year, Cyprus is hoping to join in January 2008 and other countries are striving to comply with the required criteria. Getting the full benefits of EU membership requires us to adopt the euro as well and we cannot miss the boat.

In adopting the euro, we need to accept that we would be giving up two adjustment mechanisms that are used as part of a country's economic policy to counter any downswings in the economy or other external shocks such as the recent oil price increase. I am referring to the exchange rate of the Maltese lira and the interest rate.

Admittedly the developments of the last two years were such that we have already pegged the value of the Maltese lira against the euro, which means that we are already in a fixed exchange rate regime, while movements in local interest rates have essentially been in synch with movements of interest rates as determined by the European Central Bank.

These two steps have been taken to safeguard the value of the Maltese lira and to have price stability, and the Central Bank of Malta should be lauded that it has achieved these two objectives.

However, we would still be left with a number of other adjustment mechanisms. Some of the countries that have adopted the euro have recognised the importance and validity of these other mechanisms and have made full use of them.

This has enabled them to achieve better economic growth. Other countries have still to understand how they can use these other mechanisms for their own benefit. We would need to be part of the first group even before we adopt the euro.

One group of adjustments may be grouped under what the European Commission terms as market adjustment mechanisms. These would include changes in competitiveness.

Traditionally countries used to regain an element of competitiveness for firms operating in that country by devaluing the currency. Malta went through this experience at the beginning of the 1990s. This is no longer possible with the adoption of the euro. However, firms can still maintain their competitiveness if labour costs and the costs of other factors of production such as land are kept under check.

This is achieved through greater flexibility in the operation of the labour market, liberalisation of the services sector, better regulation in the area of property. The more flexible the labour market is and the more effective competition that exists in the services market, the less sticky costs are, and the more these costs will respond to downswings in the economy.

This would mean that the costs of the factors of production are directly linked to productivity, and such costs can only go up if there are productivity gains - a tall order but possible.

The second group of adjustments may be grouped under what the European Commission terms as policy-based adjustment mechanisms. These would include the use of fiscal policy to steer the economy in a particular direction.

It would mean using fiscal policy less for a redistribution of income (which is an important objective just the same) and more for the development of specific economic activities or for the furtherance of specific structural policies. In Malta we have not used fiscal policy for this purpose to any great extent. In fact the discussion on the budget is most often reduced to how public spending is being channelled into the various social initiatives.

The limited use that has made of fiscal policy to develop specific economic activities have not been unsuccessful; one of the most notable ones in the last couple of years is the benefits that have been given to companies to set up back office operations in Malta.

So mechanisms to address downswings in the economy will still remain even after the introduction of the euro. However, the soft options, like running up huge fiscal deficits or devaluing the currency, have been removed. This is not a bad thing in itself.

It only means that we would need to become more sophisticated in the way we use the economic tools at our disposal - this is an adjustment process in itself.