President of the think-tank, the Observatory of the Managers' Association of Slovenia and full Professor of Finance at the School of Economics and Business of the University of Ljubljana, Professor Dušan Mramor, has been the Minister of Finance in two governments of the Republic of Slovenia: that of Anton Rop (2002-2004), during which Slovenia joined the EU, and that of Miro Cerar (2014-2016). Both terms coincided with the country's two historic breakthroughs: during his first mandate Slovenia joined the ERM2, the 'waiting room' to adopt the euro upon fulfilling the "Maastricht criteria", enabling the country to adopt the euro two years later, the first of the member states that joined the EU in 2004 to do so. During his second term, the government budget was brought back within the Maastricht criteria after years of economic downturn and struggles, while at the same time rescuing the banking sector. The Financial Times Banker Magazine named Professor Mramor the European Finance Minister of the Year 2016 for his contribution to Slovenia's path out of the great economic crisis. In his recent contribution to the quarterly edition of Outlook , Professor Mramor highlights the inappropriate economic policy at the EU level which is resulting in much higher volatility in the economic performance of the so-called peripheral and "new" EU countries. He recalls the crucial moves in the economic policy of Slovenia which, in contrast to the recommendations of the EU policy makers and country 'supervisors', allowed for a counter-cyclical economic policy that eventually restored stability and has resulted in sustained economic growth above the EU average for several years.

Harmful effects of a pro-cyclical economic policy

Professor Mramor's analysis of the economic policies across six Slovenian Governments (2000-2018) shows how a few governments reacted in a counter-cyclical way to conditions of economic crisis or overheating: to crisis by responding appropriately to stimulate economic activity and preventing the harmful underutilisation of existing human and material resources, and to overheating by adopting appropriate austerity measures. Twice, however, Slovenian economic policy caused a deepening of the crisis by pro-cyclical restrictive measures and once by expansionary fiscal policy that substantially contributed to the overheating of the economy. In these three cases, a pro-cyclical economic policy lowered GDP in the long run. An extreme example was the period of pro-cyclical economic policy during the highly overheated economy of 2005-2008, and its subsequent catastrophic consequences in the period 2009-2014 and beyond.

"Leaving aside the question of how appropriate the economic policy of the EU and the eurozone was for Slovenia and which instruments the state had at hand to lead an appropriate economic policy before and after the accession to the EU and the ERM2 and the adoption of the euro, this issue proved to be extremely important," states Professor Mramor.

"With the adoption of the euro, Slovenia 'surrendered' monetary policy to the European Central Bank (ECB) which implements monetary policy according to the state of the economy of the entire eurozone. Of course, the economic situation in the eurozone countries with the largest weight, like Germany, France or Italy, is crucial to the decisions of the ECB". 

"By joining the EU and the ERM2, Slovenia lost key effective economic policy instruments and was further affected by pro-cyclical fiscal rules and the pro-cyclical monetary policies at the beginning of the crisis. The result for the entire 13 year period was extremely poor, as the relative economic development of Slovenia in 2017 was at the same level (85% of the EU average) as at the time of the country's accession to the EU in 2004. Consequently, Slovenia did not converge to the EU average, in part as a consequence of the wrong decisions Slovenia made."

Has the monetary policy of the ECB been, so far, appropriate for Slovenia?

This depends, first, on whether the monetary policy of the ECB is appropriate for the whole eurozone. At the beginning of the last major financial and economic crisis, the ECB conducted an inappropriate, pro-cyclical monetary policy as it initially responded to the crisis by raising interest rates; monetary policy changed completely following the change of the governor. With 'quantitative easing', the economic situation of the entire eurozone was addressed more appropriately, causing sharp criticism from the strongest member of the eurozone, Germany. With the departure from tracking primarily its needs and taking into account the economic circumstances, for example in France and Italy, the ECB's monetary policy also became more appropriate for Slovenia.

Was Slovenia sufficiently harmonised at its entry into the eurozone?

On joining the ERM2 and the adoption of the euro, a number of analyses concluded that Slovenia's 'convergence' towards the EU, and the eurozone was successful and that the ECB's monetary policy was also suitable for the country. The crisis showed a completely different picture. One of Slovenia's most prominent economists, Velimir Bole, warned very early on that we were overestimating the appropriateness of EU economic policy for Slovenia, while underestimating the significant impact on the reduction of the country's ability to effectively conduct its own economic policy to address unsynchronised economic changes. So, we were unprepared to react appropriately.

Does the ECB's monetary policy affect the so-called peripheral EU countries differently?

The monetary policy of the ECB can be inappropriate for countries like Slovenia, even when it is appropriate for the eurozone as a whole, and even more so when it follows the needs of the most powerful members.

Economic shocks affect Slovenia differently. In most cases, the consequences are 'symmetrical', that is, in the same direction but much greater in Slovenia than in the eurozone, and in some cases, they are even 'asymmetrical', in the opposite direction. It turned out that the structure of the economy in Slovenia, characterised by the small size of the economy with industrial production comprising mainly components rather than finished products, the significant weight of tourism, and with an underdeveloped capital market, the country is much more exposed to the cyclical motion of the economy and various shocks.

Slovenia, according to its economic characteristics, belongs to the so-called peripheral EU countries which, in the case of large shocks, serve as a buffer for core countries. For example, core countries mitigate the overheating of their economies by capital outflows into real estate investments in peripheral countries. For the latter, this means additional demand in already overheated economies. In recession, investors from core countries cease to invest or even begin to sell real estate. Financial institutions in peripheral countries, which usually have headquarters in core countries, withdraw financial resources from peripheral countries. By doing so, they neutralise part of the negative economic changes at home, but they also cause major fluctuations in the economic activity of peripheral countries, or even a collapse of the real estate and financial institutions and a deepening of the downturn such as, for example, in Spain in the latest crisis. Table 1 shows the greater fluctuations in the economic activity of the 'old' peripheral and even more so, of the 'new' EU countries than of the core countries.

How can the peripheral and "new" EU countries mitigate such exposure?

In order to pursue an appropriate economic policy and achieve the greatest possible economic prosperity, such inadequacies of the ECB's monetary policy should be replaced by stronger measures of fiscal policy in each member country. This may imply the need for an even more flexible fiscal policy than that available before becoming a member of the EU. However, the rules and methods of coordinating public finances of the eurozone and EU countries not only do not allow this but even lead to a pro-cyclical fiscal policy.

What are the criteria for EU convergence?

In 1992, long before the introduction of the euro (1999), the EU had already identified the need to coordinate fiscal policies and introduced the Maastricht convergence criteria which a state must fulfil in order to join the eurozone. The Maastricht criteria were a response to the concern that an individual member of the European Monetary Union (EMU) might behave irresponsibly and other members would have to carry the burden. However, the financial and economic crisis of 2008 showed that these criteria were not a sufficient guarantee as a number of countries in the EMU became insolvent and needed help.

Were the Maastricht criteria too tight or perhaps dysfunctional, exacerbating the north-south divide and the fiscal policy of the EU?

The opinion in the EU was that troubled countries behaved irresponsibly. As most of them were from the south of the EMU, this deepened the distrust between the north and the south, also referred to as Protestant versus Catholic countries. The north came to the aid of the countries in difficulty in various ways, but not without strict conditionality which has also had long-term negative consequences for those countries. On the other hand, the northern countries exacerbated the situation by upgrading the EMU's institutions and its response systems to shocks by tightening the Maastricht criteria. The principle of medium-term balanced public finances was introduced, comprising a specific methodology for calculating the permitted maximum annual deviation from the balanced public finances. The allowed deviation depends on where the country is in the economic cycle: in recession, a calculated nominal general government deficit is permitted, and a certain surplus is required in the upturn. It was also determined how a country must achieve the medium-term objective with its annual 'fiscal effort', as well as the requirement of general government debt of less than 60% of GDP. All the key elements of these amendments were transferred to the EMU members' legal order.

It seems as if both monetary and fiscal policy are attuned to the core countries?

Indeed! Both monetary policy and the agreed fiscal policy limits in the EMU are mostly adapted to the needs of the core countries. However, these criteria do not address the relatively higher needs to respond to shocks and the larger fluctuations in the economic cycle in the peripheral and 'new' EU countries."

What were the consequences for Slovenia which found itself in the middle of a double-dip recession?

Because of the difficult political situation at the time, we were the penultimate country of the EMU to transfer a key part of the Fiscal Rule into the domestic legal order. This delay caused a tremendous amount of damage due to the loss of confidence in Slovenia's 'capability' to act. Therefore, to prove the opposite, Slovenia adopted the Fiscal Rule in the most restrictive form despite the need for flexibility. With the required two-thirds majority in the Parliament, the Fiscal Rule was written into the Constitution, the Fiscal Rule law was passed and the members of the Fiscal Council elected. Clear warnings concerning the inadequate formulation of the Fiscal Rule law were disregarded at that time.

If the Fiscal Rule had not been adopted, then the negative consequences for Slovenia would have been extremely high and the way out of the crisis would have been questionable. Slovenia was already considered a high-risk country by financial investors. The additional negative opinion of the European Commission and the credit-rating agencies would have triggered a resurgence of the crisis due to the restricted access to financial markets.

Did the Fiscal Rule have such an effect across the entire EU?

The public finance constraints determined by this methodology proved to work fairly well for the core countries, but did not for the peripheral and 'new' members of the EMU, and were the most damaging for Slovenia. For example, in 2016 Slovenia had deflation, stable labour costs, a huge surplus in the balance of payments and above-average unemployment. The methodology led to a completely incorrect conclusion that the Slovenian economy was heavily overheated and that Slovenia should respond with a very restrictive fiscal policy by decreasing public expenditures in nominal terms. The case was so obviously illogical that even the European Commission agreed that the calculations should be ignored. If such a decision has not been made, the rapid recovery of the Slovenian economy would have been halted. This was not the only completely erroneous result of the methodology for Slovenia, in the years before the crisis the errors were even larger, but in the opposite direction."

  

Could we say that Slovenia was even lucky to represent only a 'statistical error' in the EU accounts, allowing the country to go its own way?

We could say that! However, it was decisive that we, as policymakers, had our own analytical expertise to find the right answers.

Overall, at the least, I think we should not accept the criticism about irresponsible behaviour of peripheral and 'new' countries of the EMU. Slovenia successfully neutralised the significant economic impacts caused by the EU and EMU accession period before 2005, thus leading a responsible economic policy. You could even say that this is a textbook case. As Table 2 shows, at that time Slovenia achieved high GDP growth with significantly higher macroeconomic stability, complying with fiscal rules on low public finance deficit and public debt, and exceeding the performance of several core countries, some of which even violated the fiscal rules.

So, how should EU economic policy change so that divergences do not persist?

Together with other peripheral and 'new' countries, Slovenia should request that the current methodology, along with a number of other poorly designed rules regarding public finances which make it impossible for individual countries to conduct the necessary fiscal policy, are abandoned or substantially altered. Furthermore, a decentralised system of economic policy management in the eurozone needs to be developed in order to allow EMU members to neutralise non-synchronous changes of economic activity, independently, with effective economic policy instruments in a timely and appropriate manner. At the euro area level, however, it is necessary to strengthen the ability of the EMU to help member states in cases when, with full use of their available economic policy instruments, they cannot neutralise the shocks. This help should be immediate and unconditional. Before such a system is introduced some predetermined conditions should be met to avoid moral hazard."

**Dušan Mramor, born in 1953 in Ljubljana, is a full Professor of Finance and has twice served as the Slovenian Minister of Finance, and also in several prestigious positions. In the 1990s he was the first President of the Council of the Securities Market Agency and has been a council member of the National Bank of Slovenia, Vice-President of the Strategic Economic Council of the Slovenian government, and an adviser to the President of the Republic and to other expert academic and advisory panels. He has also served as a consultant to the World Bank and on the supervisory bodies of several companies and banks. Professor Mramor was the Dean of the Faculty of Economics (2007-2013) and Chair of the Board of the University of Ljubljana, as well as a Visiting Professor and has worked at several universities in the EU and the USA (for example, at Indiana University). An accredited senior appraiser with the American Society of Appraisers since 1995,Professor Mramor was also a Vice-President of the European Finance Association and the European Institute for Advanced Studies in Management. **

*** Outlook is an independent publication published by the Managers' Association of Slovenia intended to evaluate Slovenia's economic trends and economic policies in a European context and to position good managerial practices in the context of social development and welfare. ***