Eastward Enlargement of the European Union

Author(s): Bruno S. Sergi

Source: Russian & East European Finance and Trade , May - Jun., 1999, Vol. 35, No. 3
(May - Jun., 1999), pp. 41-56
Published by: Taylor & Francis, Ltd.

Stable URL: https://www.jstor.org/stable/27749483

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Russian and East European Finance and Trade, vol. 35, no. 3, May?June
1999, pp. 41-56.
? 1999 M.E. Sharpe, Inc. All rights reserved.
ISSN 1061-2009/1999 $9.50 + 0.00.

Bruno S. Sergi

Eastward Enlargement of
the European Union

Game-theory methodology (Hamada 1976; Kydland and Prescott

1977) describes the economy through rules of conduct, inter
actions, and conflicts between the public and the private sectors in
any individual economy or among interdependent economies.
Although the "games" have generated numerous controversies
concerning results that look sometimes conflicting, the theory is
supposed to settle the question as to whether countries either
undergoing monetary integration or proceeding on the road of
transition from central planning to a market economy may
benefit from joining together in a common area.
The earlier literature is concerned with the costs and benefits
arising from the coordination of economic policies in a fixed
exchange-rate arrangement (Hamada 1976). The role of fiscal

Bruno Sergio Sergi is Contract Professor of Institutional Economics at the

University of Messina, Faculty of Political Science. The author thanks Ali
Kutan, an anonymous referee, and the participants at two international con
ferences held in Sofia (1996) and Prague (1998) for comments and criticisms
on earlier drafts of this paper. He also thanks Bojka Hamernikova, Roman
Matousek, Milan KHma, and Richard Hirschler for interesting discussions and
exchange of views. The author is also grateful to the Royal Economic Society
(RES Small Budget Scheme Grant) and the Public Finance Department at the
University of Economics in Prague for support. The author takes responsibility
for the views expressed and possible errors and mistakes in the paper.

41

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42 RUSSIAN AND EAST EUROPEAN FINANCE AND TRADE

policy (see Kehoe 1987; Chang 1990) has been a key issue in the
more recent literature. The widely shared belief is that, as long as
policymakers move without a binding agreement, a one-shot
game will result in an inefficient outcome. With economic coor
dination, each country would be better off by playing a non
cooperative game. A cooperative monetary policy (Hamada
1976) together with a cooperative fiscal policy (Kehoe 1987)
lead to higher levels of welfare, and this does not prevent a
government from having a certain degree of domestic fiscal
autonomy.
Following the game-theory methodology, this paper extends
the literature by examining the feasibility of integrating the
eastern and the western sides of Europe into a common area.
Besides discussing the implications arising from competition and
the conduct of future economic policies, the paper addresses the
fact that such a "joining" may imply either a political union,
where domestic policies are independently set, or a single-currency
union, where monetary policy is designed by a common monetary
authority. While the first type of union represents the first stage
of the European enlargement to the East, the single-currency
union would be the second stage.
The present study is organized as follows. After a definition of
the trade-off in game theory and the role of surprise inflation in
the conduct of monetary policy, the next section uses the frame
work of policy optimization and explains how the Phillips trade
off is adapted to our purpose. Section II reports data on the
economic structures and inflation rates of some European countries.
Then, the simple model developed in the article on inflation rate
and service sector as a percentage of GDP ranks seventeen
economies versus Germany, which we assume to be the lead
country in the conduct of monetary policy in Europe. One of our
conclusions about the European Union (EU) enlargement toward
the inclusion of the Central and East European economies is that
the enlargement issue will probably take into account the economic
conditions prevailing in the less wealthy EU countries and not
the EU's income average. Also, other Central and East European

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 MAY-JUNE 1999 43

countries are becoming increasingly similar to EU economies in

terms of level of development, and this could be a solution to
Europe's euro "dilemma" in allowing entrants to take part in the
political and economic union first and then in the single currency.
Our approach clarifies that the current EU may be divided into
two groups of almost homogeneous economies, whereas a
broader Europe that includes transition economies would be
grouped into three. Finally, Section III presents conclusions.

I. A Simple Approach

Game-theory methodology helps study the interactions among

economies and show costs and benefits arising from "imposing"
a coordination onto the conduct of economic policy. To this end
this section follows three steps.
In the first step, our exercise studies the EU and the eastern
countries of Europe with respect to specific inflation "strategies"
that may tempt policymakers and describes the rule of conduct of
monetary policy through a basic game-theoretical process. It
builds up a market structure characterized by a trade-off between
inflation and the unemployment rate above its natural level. The
latter is brought about by friction in the labor market and un
matched levels in the economic development of the EU and
Eastern Europe. A successful economic strategy (such as a lower
unemployment rate by speeding up production) would hinge on
an expansion of money supply engineered in such a way as to
surprise economic agents and affect their expectations about
future inflation or by the unexpected changes in the money stock
and thereby the price level. Therefore, specific attention should
be paid to the inflation strategy, which might be viewed as a
game-theoretical policy-choice variable in Central and Eastern
Europe of the type described above, but not so in the EU. Put
simply, inflation is a policy choice both in the EU and in the
East, but it differs in the variance around the proper inflation
level.
The traditional model starts from the following:

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44 RUSSIAN AND EAST EUROPEAN FINANCE AND TRADE

y, = \|/? + 9(n,-nf) + e,, (1)

where \\fn is the prevailing structure of the economy (e.g., that at
a given real wage or compatible with the current level of produc
tivity in any individual country); the second term (cp[7if - nf]) is
the effect that a surprise rate of inflation might produce on the
economy; st is a real productive shock. The simple loss function
is of the type described in equation (2):

MinLt
\J/,7l
= ViE a(y, - y?)2 + ?(n,)2 (2)

where E is the expectations operator, a and ? are the two weights

policymakers place on (i) the deviation of the "domestic structure
of the economy" from that considered best and (ii) inflation
around the optimal zero percent or a rate so low as to generate
the least variance. It is worth noting the following: a and ? are
weights that reflect the relative importance that domestic authorities
attach to the path of the economic structure and inflation; ? is the
policy-choice variable in policymakers' hands.
The second step of this paper is devoted to the awareness of
the Phillips curve in describing convergence among economies
and the deviation of the economies in Central and Eastern Europe
from the situation prevailing in the West. We need to clarify the
importance of monetary policy as the policy-choice variable in
the policymakers' hands. In the usual Phillips curve trade-off,
policymakers might use money growth to manipulate labor markets
and trade off inflation for more employment. Inflation policy
might also serve to accommodate for shocks that, although
assumed to be almost identical across countries, involve different
"structural" economic situations and produce social outcomes in
countries that are either in transition or in a phase of integration.
Put simply, a binding constraint on the production of inflation
operates in the EU (from the European Monetary System [EMS]
to the European Central Bank). There are no constraints on the
use of inflation in the transition economies, at least formally, but
the usefulness of restrictive monetary policies is not denied, even

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 MAY-JUNE 1999 45

though the degree of tightness and especially its timing face

many uncertainties. A simple objective of zero inflation may be
damaging in the overall governance of transition, even though a
tighter monetary policy will lead to a much lower inflation rate
by the end of this century, promote convergence toward Western
standards, and expand competitiveness in the global market.
The third step involves the issue of convergence between the
EU and the transition countries. This paper's approach confronts
convergence by making a comparison between inflation and
GDP. There are some reasons for such a view, because it facilitates
our efforts in answering the question posed in the introduction.
The structure of the EU and East European economies is adopted
in such a way that, although not exhaustive, it enables us to come
up with some possible outcomes. The convergence of the
economy's structure as a ratio of the service sector in GDP to
inflation, which is also adopted in this paper, is advantageous for
analyzing available data because it permits us to compare countries
on the basis of one GDP component and not on the basis of
per-capita income or the deviation of unemployment from the
natural rate. The use of these two alternative convergence criteria
would have been the least convenient to illustrate whether a
"Western" enlargement to the "East" is at all possible.
In doing so, let us simply assume a framework where the
preferences of two blocs of countries over the trade-off between
a and ? are taken into account.
?Bloc 1 is the East = E, and bloc 2 is the West = W; they unite
into an economic union first and then into a monetary union.
?Although the two blocs may agree on the optimal inflation
rate, policymakers' preferences may differ in such a way that
those ruling the Western bloc (the European Central Bank) care
more about the "operative" attainment of price-change targets
relative to the other parameter.
?Bloc 2's central bank sets inflation for the combined area
(bloc 2's inflation is sensibly downward biased compared to bloc
1) in light of its own aw and ?^. Bloc 1 thus loses its mixture of
expand ??.

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46 RUSSIAN AND EAST EUROPEAN FINANCE AND TRADE

?External disturbances hit both blocs equally, and real shocks

are correlated and produce similar effects on each bloc. This
assumption is likely to hold better over time as higher labor and
capital mobility and more trading with one another take place.
The final step of this approach is to minimize the loss function
in terms of expected inflation to produce a solution for the inflation
surprise under the assumption that expected inflation is zero or
low and the parameters a and ? imply a Western-type economic
policy strategy:

1 (3)
1 + (?/a) 8'9

where the error term, as assumed before, represents perfectly

correlated shocks.
The question here is that we need to find the expected losses to
be incurred by bloc 1 under the alternative hypotheses of either
submitting or not submitting to the monetary choices made by
Western policymakers. Under the assumption that bloc 1 submits
to the West's choices, substituting the solution for inflation surprise
into loss function (2) and taking expectation produces the expected
loss to be incurred by bloc 1:

_[aE($w/aw)2vl + $Evl\ (4)

1 l+(?^/c^)
By contrast, the loss for bloc 1 if it retains autonomy in the
conduct of monetary policy is given as follows:

= , *f; , <5)
Returning to the definition of expected losses under the two
different monetary policy strategies, we can write down the out
come of joining for Central and East European countries as net
gains or losses where the alternative hypotheses are the inflation

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 MAY-JUNE 1999 47

set by bloc 2 (that is, the West) as in (4) or in a "political" union

where bloc 1 may strictly follow a domestically oriented policy
(5):

*W aE^
We observe that the outcome of equation (6), which represents
the loss function of joining and submitting to the Western infla
tion policy choice, is at a minimum when the deviation of the
ratio approaches zero. Equation (6) has the following properties:
?it is independent of the variance of the exogenous shocks;
?it is positive (at least in the short term) because low inflation
strategies are common and workable in Western Europe;
?as equation (6) approaches zero, the desirability of joining
the Union increases. If the outcome is far from zero, the differ
ence in a and ? would not provide a credible framework for an
enforceable union. Central and East European countries are better
off in a common area only if there is prior structural converge,
and under this hypothesis welfare losses would decrease and
efficiency gains would appear.
At the present time, any conclusion that West and East should
join in a single area soon or later is not easy to answer. In the
European type of economic union, monetary policy is centralized
and fiscal policies are "partially" independent. What matters
most in the policy of joining still depends on the prevailing a and
? parameters. Despite the fact that a and ? are supposed to be
comparable among the Western countries that already form the
EU, this is not always true. If the membership is to be broadened,
Central and East European countries then need to have a clear
notion of how this union would be created and how it would
work. The crux of the matter is that two aspects stand at either
extreme:
?enlargement to the East will come under consideration taking
into account the economic fundamentals prevailing in the less rich

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48 RUSSIAN AND EAST EUROPEAN FINANCE AND TRADE

Western countries, where the level of wealth is more comparable

with the transition countries seeking membership;
?successful membership of Eastern countries in the EU
would also require that they have greater economic relationships
with the neighboring deutsche mark-area countries, notably the
strongest in Europe. Therefore, and contrary to the previous
"extreme," the two Western parameters a and ? would be those
of Germany when applying equation (6). Therefore, the degree of
convergence of transition European economies to that of the
West is measured with respect to Germany's inflation rate (?w)
and economic structure (aw). Although data show that France,
Austria, and Belgium recorded lower rates of inflation in 1997
compared to Germany, we still use the German benchmark in
light of the predominance of the Bundesbank's reputation for
low-inflation strategy. Thus, the larger the inflation divergence
between Germany and the transition economies and the bigger
the difference in the fundamentals of the two blocs' economies,
the easier the rejection of joining. As long as there are distur
bances that force the Central and East European bloc to have
diverging economic fundamentals, the EU enlargement to the
east is unlikely.

II. Data and Interpretations

Some of the most insightful papers on the economic transforma

tion available in the mid-1990s (Brada 1994; Miller 1994; Portes
1994) emphasize that progress has been achieved at the macro
level but has not been matched by deep restructuring at the micro
level. In this respect, it would have been possible to consider
other angles of discussion?for instance, the existence of dissimilar
shocks and capital and labor mobility. But we have set aside such
aspects by "assuming" that disturbances are correlated among
countries because closer ties between "Eastern" and "Western"
Europe have already been established. One recent piece of evi
dence, even though limited to Western countries, shows that a
similarity between business-cycle patterns is possible despite

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 MAY-JUNE 1999 49

Table 1
Proxies for a: GDP Sectors and Demand in Selected Countries?1995
Production % GDP Demand % GDP
Country S MA E IG
Austria 63 34 2 38 27 19
Belgium 62 36 2 74 18 15
Germany 64 35 1 23 21 20
Greece 43 36 21 22 19 19
Portugal 62 34 4 28 28 17
Bulgaria 53 34 13 49 21 15
Czech Republic 55 39 6 52 25 20
Hungary 59 33 8 35 23 11
Poland 54 39 6 28 17 18
Romania 39 40 21 28 26 12
Russia 55 38 7 22 25 16
Source: The World Bank Development Report, various yea
Legend: S = services, M = manufactures, A = agriculture, E =
G = government.

significant differences in the conduct of m

policies and the terms of trade (Christodo
Besides this, stronger economic relationsh
diminish dissimilarities over time, spur the v
one another, and facilitate capital and labor
whole, the use of the economy's structur
measure looks reasonable.
The choice of our sample was determined
of data, and we recognized that different da
findings.2 However, apart from Russia, whi
this paper, such a shift would mean few si
Table 1 presents some data to explain our par
of the service sector in the overall econom
GDP will be adopted in our final calculations
As of 1995, the countries in Table 1 are
similar in terms of some data but to differ in t
The countries that are slow reformers, s
Romania, show the greatest differences. By c

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50 RUSSIAN AND EAST EUROPEAN FINANCE AND TRADE

are negligible and sometimes favor selected transition countries.

Over time, a positive trend may arise from the private sector that
amounts to more than 60 percent of both GDP and employment,
from which the latter will benefit. Bulgaria and Romania have a
smaller private sector in GDP (data are not reported in the tables,
but the private sector accounts for less than 50 percent of GDP),
although the share in GDP is likely to accelerate because new
privatization and deeper restructuring programs are expected to
be implemented soon. Another side of this story is that the ratio
of the shadow economy could reach up to 25-30 percent of
Central Europe's GDP and could be much higher in the countries
of the former Soviet Union.3 It is evident that estimates yield
striking discrepancies according to different techniques used, but,
even relying on the lowest estimates and assuming that these
figures are included in official GDP, the economic structure in
the transition economies could come close to that of the West,
especially for the Czech Republic, Hungary, and Poland.
As far as GDP growth is concerned, transition economies
continue to enjoy economic growth, which is high in Estonia,
Hungary, Lithuania, Poland, and Slovakia. The estimates for
1997 place Central Europe and the Baltic countries better in real
GDP growth than the EU, and it is expected that such a divergent
economic growth path will continue in the region throughout the
1990s. As for statistical figures, the IMF estimates a real GDP
growth of 2.9 percent and 2.5 percent in the EU countries in 1998
and 1999, respectively, and of 3.0 percent and 2.8 percent in the
euro-area countries. Relative to the advanced economies, they
grew by 2.1 percent and 1.9 percent in 1998 and 1999. World
growth is expected to be nearly 2.5 percent in 1999.
The parameter ?, expected inflation in the model, is proxied
by the actual inflation rates in 1997 (see Table 2). For Bulgaria
and Romania, inflation rates are estimates for 1997. The two
blocs recorded average inflation rates during 1990-94 of 4.3
percent (West) and 107.7 percent (East). Inflation has eased in
both sides of Europe, and it is expected to continue on a down
ward trend throughout the end of the century.

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 MAY-JUNE 1999 51

Table 2
Proxies for Actual Inflation Rates in Selected Countries

Country 1990-94 1997

Austria 3.5 1.3
Belgium 2.8 1.6
Germany 3.7 1.7
Greece 16.2 5.5
Portugal 9.1 2.1

Bulgaria 122.1 769a

Czech Republic 22.3 8.6
Hungary 25.5 18.3
Poland 149.5 14.9
Romania 154.8 1093
Russia 564 14.7
Sources'. National statistics and World Economic Outlook, various issues.
Estimated inflation.

Even if the inflation "gap," partially due to different monetary

strategies, is expected to decline over time, there are reasons for
this gap to widen in some cases. First, in the process of deep market
reforms from the previous system of artificially low prices, it is
possible that even in light of tighter monetary policies (more in line
with Western styles), cost-push factors may still cause inflation be
yond the rates compatible with the EU averages. Second, the con
sumer price index, no doubt, overstates the rate of inflation in the
transition scenario. An explanation of that is the better quality in
new goods and services from recent productions that goes par
tially or totally unmeasured in the traditional consumer price
index. A better cost-of-living index would take into account these
measurement issues and better state the true inflation rate.
The estimates of equation (6), obtained when considering the
comparative position of seventeen countries with respect to
Germany, are given in Table 3. The lower the values in the table
(i.e., close to zero), the closer is the end of the convergence path.
Table 3 includes countries that were already members of the EU,
those wishing to become new members, and Russia for comparison
purposes. It is worth listing some findings.

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 52 RUSSIAN AND EAST EUROPEAN FINANCE AND TRADE

Table 3
Convergence Rankings (equation 6)
Country Ranking
First group:
France3 0.000155
Austria3 0.000035
Belgium3 0.00000057
Netherlands 0.000011
Spain 0.000017
Denmark 0.000022
Italy 0.000027
Portugal 0.000053
Second group:
Slovenia 0.0051
Greece 0.010
Czech Republic 0.016
Estonia 0.026
Russia 0.057
Poland 0.062
Hungary 0.080
Third group:
Romania 7.65
Bulgaria 209
Notes:
aThis table places France, Austria, and Belgium in the first group even though they
rank better than Germany. According to the model, they should have been left out.
?The inflation rate is based on 1997 figures in Table 2.
?Service sector as a percentage of GDP as of 1995.

First, it should be noted that all the deutsche mark area countries
are "greatly" tied to Germany and hence form the first group.
"Exceptions" in the first group are France, Austria, and Belgium,
which rank better than Germany, having recorded rates of infla
tion that are 0.7 percent, 0.4 percent, and 0.1 percent lower,
respectively. These three countries are nevertheless in the first
group because it was assumed theoretically and for the conduct
of a common European monetary policy that Germany would
have the best comparative position among the Western countries
and so that it would retain the lead in Europe. Included in the
first group are other southern EU countries, except Greece, which

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 MAY-JUNE 1999 53

is the only "Mediterranean" EU country classified in the second

group. The second group includes Slovenia, which would have
the lead, the Czech Republic, Estonia, Russia (to our surprise),
Hungary, and Poland. Romania and Bulgaria are categorized
together in the third group; they stand little chance of catching up
in the near term either with Germany's or with the second group
of countries' standards.
Second, recent data for most Central and East European
countries show signs of improvement so that their comparative
position could look much improved by the end of this century
with respect to that shown in Table 3. Although the recovery is
fragile, the efforts of reconstructing a sound economic structure
can be amplified if new technologies and skills spill over into
these countries soon and so make it possible for them to adapt
their economies fully to market mechanisms.
Third, the policy of joining as described in the model might
suppose that transition countries do or do not join in a bloc. On
the contrary, joining will occur as bilateral agreements. Our own
a priori belief is that it might be more effective to have some
flexibility in joining and to allow membership to the best-ranking
economies in the EU first and in the euro-zone later. Although
there is no fixed final date for the eastward enlargement, the
Czech Republic's membership is possible in the next few years,
that is, by the turn of this century. Countries such as Hungary and
Poland, hopefully, will follow early in the first part of the next
decade (Gylfason 1995), and the others may secure member status
in the following decade. As far as the third group of countries
(Romania and Bulgaria) is concerned, although the prospect of
their membership seems to have faded, they will take a much
longer time to join unless there is an extraordinary income
growth combined with strong monetary stability.
Finally, there is no strong argument for preventing a speed-up
of the process of membership in the euro-zone soon after these
countries become new EU members. If an accelerated enlarge
ment to the east occurs, at that time Greece might still be out of
the euro-zone; then membership in the euro-zone would rely on

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54 RUSSIAN AND EAST EUROPEAN FINANCE AND TRADE

common criteria. Every effort must be made to keep this second

phase from proceeding at a snail's pace.

III. Conclusions

This paper presents some data on the ratio between inflation and
the services sector as a percent of GDP in seventeen European
countries and compared it with Germany. Our simple model put
together such a ratio and the role of monetary policy to evaluate
the accession of Central and East European countries to the Euro
pean Union. It is possible to observe that positive structural conver
gence within Central and East European countries has been
made; however, further changes in competitiveness are neces
sary for the long-run success of West?East integration.
Negotiations with countries aspiring to become new members
of the European Union may carry through a step-by-step enlarged
Europe by early in the next century. The Central and East European
countries may link with EU countries in the near future, providing
more close economic relations with Germany (this is especially
so in the case of joining into a broader euro-zone). The functioning
of a political union would still imply that the two parameters we
worked with, a (services sector as a percent of GDP) and ?
(inflation), would be chosen "within" the deutsche mark area
because it will retain the lead, although we believe that accession
will depend on the standing of Greece and the other "poor"
European Union countries.
The issue of timing is important, and the prospects are encour
aging. It is argued that a first step in this process may take place
relatively soon, and this is in contrast to other views (one for all,
Baldwin 1994) that advocate a two- or three-decade postpone
ment. The process of membership may take longer than we have
argued only if monetary and fiscal policies do not follow the
planned course of price stability and if negative supply shocks
affect the Central and East European countries' inflation rates in
a negative way, in that they diverge from the inflation-rate levels
shared by EU members.

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 MAY-JUNE 1999 55

Notes
1. The traditional optimum currency-area literature favors the existence of
real wage flexibility, mobility of labor, and fiscal integration before joining.
Mundell (1961) argued that two countries with nominal wage stickiness benefit
from joining if they have similar shocks or high labor mobility. Whereas a
high capital mobility has the effect of being a substitute for low labor mobility
(Froot and Rogoff 1991), benefits would arise if the two countries were to
trade heavily with one another (McKinnon 1963) or if a variety of industries
exists so as to cause a shock without severe effects (Kenen 1969).
2. Early drafts of this paper report that Germany's inflation was the lowest
in Europe before 1997. With data referring to 1997, the situation within our
first group, as in Table 3, is a bit modified, but the ranking of Central and East
European countries is unmodified.
3. For example, Russia, 40 percent; Moldova, 40 percent; Ukraine, 46
percent; Georgia, 64 percent.

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