For the 10 countries poised to accede to the EU, the event will mark the culmination of a dramatic transformation from central planning to market-oriented economies. Membership in the EU and the euro in turn holds out the promise of an extended period of rapid real growth as these countries catch up with their EU partners.

To this point, the nominal convergence and structural criteria associated with the accession process have been a beacon for good economic policies and improved outcomes. They have imparted a clear market orientation to reform and buttressed this with a financial discipline that has materially helped these countries impose hard budget constraints on soft segments of the public sector. This has contributed to significantly stronger growth outcomes than in other transition economies.

However, while accession and euro adoption will likely provide an important boost to candidate countries, they will also impose important long-term constraints on macroeconomic policies. Despite the dramatic transformation that has taken place among accession countries, they remain at very different stages of economic development than current EU members. With per capita GDPs averaging only about one third of that of present EU members, these countries will require substantially higher rates of infrastructural investment, economic restructuring and institutional development over several decades if real convergence is to succeed. In this context, adopting the economic policies of current EU members will present difficult challenges, which need to be considered carefully by the accession countries as they approach euro adoption.

As befits requirements for entering a monetary union, the criteria are nominal ones focused on the extent of convergence prior to entry. The principal criteria are low inflation and a moderate fiscal deficit in the year prior to the decision on entry and limited exchange rate variability vis-à-vis the euro over the two prior years. Even leaving aside the fiscal criterion, which is a prelude to a tougher criterion to come, achieving the combination of low inflation and a stable exchange rate may prove fairly challenging for the accession countries where real-convergence-related productivity gains in the traded goods sector imply ongoing real appreciations and hence, in the context of a relatively narrow exchange rate band, higher inflation. The need to adjust administrative prices and to raise indirect taxes to harmonize with EU requirements will contribute further to continued inflation differentials.

While the entry criteria may prove challenging and involve short-term costs and longer-term risks, these will likely be seen as well worth the benefits of joining the euro club. Attempts to lower inflation to euro area levels in the near term could, in tandem with the fiscal consolidation effort, dampen domestic demand in the short run. This was the experience of many of the present euro members in their run-up to entry—despite their partial resort to "sleight of hand" measures, for example, the temporary removal of indirect taxes or decreases in administrative prices. Moreover, euroisation implies risks of credit bubbles, strained financial systems, and over-indebtedness. Nevertheless, it appears likely that accession countries will decide that such risks are acceptable given the strong financial (lower interest rates) and real (strengthened FDI) benefits associated with quick euro adoption. This also was the experience of earlier joiners of the euro, many of which experienced a significant strengthening of growth soon thereafter. For some accession countries, markets may have discounted euro entry to such an extent that countries will be spurred toward euro entry because of the risk of experiencing negative shocks if entry is delayed.

Euro membership places significant additional constraints on fiscal policy. In particular, once a country has adopted the euro, compliance with the 3% maximum deficit takes on added teeth—with potential penalties for non-observance. Moreover, and more important, countries must develop and commit to a medium-term plan to meet the SGP criterion of budget targets "close to balance or in surplus" indefinitely. This is intended to ensure compliance with the 3 % rule without resort to pro-cyclical policies during economic downturns, but also to curb the kinds of speculative excesses that euroisation might engender. The fiscal constraint will, in general, be binding: in their Pre-Accession Economic Programs (PEPs) only two countries, Estonia and Slovenia, project a close to balanced budget by 2004; the rest will require significant fiscal adjustment over the medium-term.

These constraints, which were designed for advanced countries, could prove problematic for two reasons. First, rapid real convergence in the accession countries is likely to require significantly higher rates of public infrastructure investment than presently achieved. The South East Asian tigers, for example, had rates of public investment averaging some 8% of GDP during their rapid catch-up years. While accession countries have achieved robust growth rates with much lower rates of capital accumulation—averaging about 4% of GDP for the period 1995-2000—this will become more difficult as the gains from restructuring are wrung from the economy. Second, rapid real convergence from per capita incomes that presently average only about one-third those of present EU members could—to judge from the EU (and other) countries' own histories—generate credit and asset price bubbles and a considerably more volatile growth performance than presumed by the SGP. As a result, to comply with the SGP, countries will face higher than average risks of running afoul of the 3% limit or of needing to run overall fiscal surpluses over the cycle in order to limit such risks.

The orthodox view is that the SGP framework will provide the incentive and the political cover to do what is optimal anyway. That is, the need to run fiscal balances and satisfy public investment requirements will force these countries to make major cutbacks in current spending. In general, such spending is already high in relation to GDP in these countries, and badly needs to be trimmed in order to strengthen supply side incentives. In a number of cases, subsidies remain high and the social safety net generous, while in others, public employment may be excessive. More broadly, it is noteworthy that the high growth and investment rates of the Asian tigers mentioned above went hand in hand with balanced budgets, the large amounts of public investment having been paid for by public saving (ie. low current spending). Correspondingly, international empirical evidence suggests that prudent fiscal policy is generally consistent with robust growth in the medium-term. On this view, therefore, the SGP will both limit the scope for the fiscal profligacy that was at the roots of many countries' boom-bust cycles and enforce the reductions in current spending that will spur a better use of resources.

Even supposing that economic case, however, effecting sufficient rationalization in low-priority spending to deliver such an outcome will not be a simple matter. First, reducing such spending will require accompanying structural reforms which are often difficult, both technically and politically. Second, competing objectives and requirements suggest that the need for cuts in current spending may be larger than is apparent from simply examining gaps between public infrastructure needs and spending. In this regard, accession-related spending, notably for the environment, is expected to cost an average of 2-3% of GDP over the medium-term, at least part of which will need to be borne by the general government.¹ At the same time, candidate countries are planning significant tax cuts over the medium-term, and many have already implemented such cuts, spurred on by tax competition from neighbors. In fact, the PEPs reveal that candidate countries are planning a decline of almost 2 percentage points of GDP in their tax burdens over 2000-2004.

Thus, despite some mitigating considerations, there is a risk that SGP constraints could delay productive public spending and real convergence. The mitigating factors include the EU structural funds, which may amount to perhaps 2% and as much as 4% of GDP, which will help the accession countries juggle their competing objectives. Moreover, some portion of infrastructure needs can be provided by the private sector—even if with some government involvement. However, history suggests that fiscal targets would be met at least in part by cutting investment or delaying supply-side oriented tax cuts—most significantly for direct taxation—with potential adverse effects on private sector incentives and activity.

It is entirely understandable, and may well be optimal, for accession countries to move as rapidly as possible through the various stages to euro entry. Indeed, in almost all countries in which a preference has been stated, there is a clear objective of adopting the euro in the minimum time possible. However, the accession countries, and especially those with relatively high fiscal deficits, need to weigh both the short run gains of accession and euro adoption and the long-term challenges that the associated policy requirements will present. Countries aiming for early euro adoption should develop plans for reducing inflation and for moving to a balanced budget over the medium-term that makes adequate allowance for both envisaged tax cuts and infrastructural investment spending. It should also ensure that the political support exists to take the difficult steps that will be required to put that plan into action.