Paper delivered at a discussion “Strategy for Price Stability and Prospects for Euro Launch in Lithuania,“ organised by Parliamentary Committees on Budget and Finance and European Affairs at the European Information Centre of the Lithuanian Parliament.
Measures for the introduction of the euro: pluses and minuses
Dear participants of the event,
I thank the organisers of this discussion for an opportunity to present the Lithuanian Free Market Institute’s (LFMI) position on the introduction of the euro in Lithuania.
The Lithuanian Free Market Institute is of the opinion that the major goal to be followed in considering this issue is Lithuania’s long-term economic growth and vouchsafing its sustainability and competitiveness. The launch of the euro should be treated as a tool to attain these goals, rather than the goal itself. It’s unquestionable that the introduction of the euro in itself would present advantages, such as a freer trade with the euro-zone countries, investors’ potentially stronger confidence in Lithuania, bigger price comparability and an entirely eliminated risk of the exchange rate fluctuations. However, both the launch of the euro itself and measures intended to its facilitation may exert both positive and negative effects. These should be taken into account while debating the issue of the euro launch.
In my presentation I will focus on the measures for controlling inflation, laid down in the Medium-term Strategy for Price Stability, which will be employed while attempting to meet the Maastricht criterion of convergence. But first let me express a brief note on the National Plan for the Euro Launch and the means designed to shield consumers’ interests.
The National Plan for the Euro Launch and protection of consumers’ rights
It is emphasised in the National Plan for the Euro Launch that it is crucial to safeguard consumers’ interests. A number of measures have been envisaged to that end: publicizing the cases of abuse in the media, calling on businesses to sign plans of good business practice and the like. Although these measures may bring certain results and help avoid a likely chaos during the period of the euro launch, they would not pose any essential influence from the point of view of price stability. The most important and proper instrument to avoid increases in prices and to protect consumers’ interests is to allow natural competition among companies. In case a seller, in the competitive market, attempts at raising prices (abuse), his/her goods would not be purchased by consumers: he/she would be forced either to cut down prices or retreat from the market.
Practical experience of introducing the euro reveals that this step has provoked a slight rise in prices in the countries where it was launched. (According to Eurostat, the level of inflation went up from 0.12 to 0.29 percentage points after the launch of the euro). The main reason why prices climbed only insignificantly was the said competition among companies. It is therefore vital not to impose any restrictions on this type of competition.
I would also like to discuss the measures for controlling inflation anticipated in the Strategy for Price Stability.
Proposal regarding the personal income tax
The Strategy for Price Stability contains a proposal not to mould unjustified expectations in the market that the personal income tax (PIT) and other taxes will be cut rapidly, envisaging that a prompter reduction of PIT should be considered only after Lithuania’s macroeconomic situation and the implementation of the budget are evaluated. It is stated that a more rapid decrease of the personal income tax would stimulate internal demand and borrowing, increase the current account deficit and put pressure on price growth (in other words, it would menace the country with economic “overheating”).
Yet, this argumentation fails to encompass two important aspects. First, as a result of pressure of internal demand, costs of companies have been sharply on the rise recently, thus undermining their competitiveness – a factor that jeopardises Lithuania’s long-term economic development. A more rapid reduction of PIT would provide for companies a certain “safe zone” that would allow them to adjust to the fast changing labour market. This would render more opportunities to companies to attract workers for the same amount of money. Second, a decision to halt a reduction of the personal income tax does not take into account that taxpayer money, collected to the budget and spent later, also stimulates internal demand, shapes ungrounded expectations and drives the level of inflation up.
As regards the personal income tax, tax favours for housing loans, distorting market participants’ motivation, might be eliminated. A withdrawal of tax privileges might retard the growth of the loan portfolio.
Proposals to implement a strict fiscal policy and to eliminate the budget deficit
LFMI strongly supports these proposals. The best tool to not to form unjustified expectations and to diminish an inflationary pressure is to conduct a more disciplined fiscal policy.
For this reason, it is a welcome proposal to abandon the practice to update budgets of the government sector in the middle of the year in case factual revenues exceed those projected. The existing practise provokes irresponsible spending; in the years of a strong economic growth a national budget must have a surplus in order to manage trimming the state debt.
It is also a laudable proposal to eliminate the budget deficit by fixing this provision in the Law on Fiscal Discipline. It should be noted that LFMI has been calling on the authorities to adopt this decision long before that. The state deficit must be eliminated as soon as possible – this should be carried out as early as 2008, not 2009 as anticipated in the Strategy for Price Stability. In addition to that, the objective should be to eliminate the state budget deficit, rather than to balance the budget of the entire government sector (the state budget and the budgets of municipalities and the State Social Insurance Fund).
Apart from proposals put forth in the Strategy for Price Stability, it is worth to highlight other measures that would help cutting down budget expenditure and increasing its efficiency. First, elimination of various VAT exemptions would contribute to balancing the budget.
Second, it is an important measure to raise the efficiency of public expenditure by essentially revising the procedures of budget formation so that the principle of programme funding was implemented completely, in order to facilitate the evaluation and monitoring of the benefit drawn from financing individual programmes.
Proposals regarding curbing the growth of wages and salaries
In a non-central planning economy, the growth of wages and salaries can be restricted by administrative means only in the public sector. However, mere restriction of earnings in this sector will not solve the problem: workers of the government sector will either move to the private sector or go to work to foreign countries. It is necessary to alter the very principles of public sector funding so that better employees could be paid higher salaries, while those performing work poorly were remunerated less.
On the other hand, the provision stating that no legal background must be created for “automatic” indexing of salaries based on the level of inflation of the previous periods should be supported. Wages cannot be artificially tied to a specific indicator – their growth is determined by labour productivity and the ratio of labour supply and demand. This principle must be applied to the minimum monthly wage as well – the minimum monthly wage, which has been continuously and rapidly raised in Lithuania lately, augments labour costs and inflation.
Proposal to implement “an optimal excise plan”
The proposal to implement an optimal excise plan, i.e. to raise excise duties earlier than planned, must be evaluated taking into consideration all likely consequences of this move. As it is acknowledged in the Strategy for Price Stability, a more rapid increase in excise duties on tobacco products “may cause a complete disbalance of the domestic market and activate smuggling activities in particular.” Therefore, the Strategy for Price Stability includes a recommendation not to raise excise duties on tobacco earlier. But similar effects are also likely, if the excise duty on fuel is lifted earlier: smuggling activities and illegal sales of fuel would intensify, thus harming consumers and companies. Given these factors, it is highly questionable whether it is expedient to implement increases in excise duties earlier just for the sake of the euro launch. It should be highlighted that this may serve as an argument that will provoke citizens’ negative attitudes towards EU’s single currency.
Proposals regarding price control
A reduction of regulated prices may indeed help to decrease the statistic indicator of inflation but it would serve as a short-term measure. LFMI thinks that the principle of price regulation itself is defective, so if prices are set artificially low, this may bring deleterious effects to the regulated areas. In a situation when there are no abilities for prices to reflect the market information, incentives to invest are diminished, the quality falls, the market is perverted and competition comes to be hardly possible, which undermines chances that prices will go down in the future. Evidently, the balance of benefits and damage of this measure causes considerable doubts.
It would be a welcome step to liberalise regulatory regimes of economic sectors where prices are regulated (on condition that these were essential reforms of liberalisation, rather than re-regulation), since this move would allow to achieve an objective level of prices in the long run. Nevertheless, it should be heeded that the inflationary impact of such a reform in the short- and medium-term can be hardly projected.
Finally, I would like to discuss several measures that were not mentioned in the Strategy for Price Stability but which would help to reduce inflation and would be instrumental for the country’s long-term competitiveness.
Fostering a general growth of competitiveness
One of the main causes of inflation is that the demand for certain products is growing faster than their supply. Prime examples in this respect are the Lithuanian real estate market and climbing prices of agricultural products as a result of draught. If conditions to rapid development of production of the main consumer goods are ensured and their supply grows, the pressure for price growth will be diminished. Counterbalancing and liberalising the market, reducing bureaucracy and abstaining from levying new barriers to economic activity would serve as vital measures to build conditions for a more rapid expansion of production and establishment of new businesses.
Meanwhile, in the sectors with intense competition, the growth of prices in a general context of the growth of inflation is usually lower or even negative. The clothing and footwear market is a conspicuous illustration (prices of this group of goods plummeted by more than 4 percent in Lithuania in one year period).
Liberalisation of the land market
Liberalisation of the land market and simplification of territory planning would ensure conditions that a bigger supply of land plots suitable for residential and commercial construction will emerge. It would also create preconditions for prices to go down or at least would harness their growth. Currently, the existing complex land market regulation artificially reduces the supply of real estate – this determines the growth of real estate prices in Lithuania.
Eliminating subsidies for energy consumption
Surging prices of energy resources on the global market has a more significant impact on the level of inflation in Lithuania, compared to other countries, due to especially inefficient consumption of energy, heating in particular. The existing compensations for heating services discourages people from saving energy, while improper regulation of the activities of resident communities in apartment buildings and maintenance of apartment houses inhibits communities’ abilities to take needed decisions regarding these measures. Subsidies for heating and hot water must be integrated into a general social assistance benefit – thus socially supported individuals would receive a bigger social benefit that could be used to satisfy their most urgent needs, which would move all consumers’ interest in saving energy.
To sum up, precise forecasts of changes in the level of inflation are unfeasible on account of many factors. Even if all measures proposed in the Strategy for Price Stability are implemented, we still cannot be certain that Lithuania will eventually satisfy the Maastricht criterion. It should be also stressed that various artificial manipulations in prices may come to serve as a pretext for treating Lithuania’s indicator of inflation as “unsustainable.” For these reasons, LFMI believes that it is expedient to give effect to those instruments that would be beneficial not just with respect to reducing inflation and launching the euro, but that would also help enhance Lithuania’s competitiveness and increase welfare. In short, Lithuania needs to conduct a rigid fiscal policy, to eliminate its budget deficit, to remove various subsidies and tax favours that distort the market, to launch liberalisation reforms and to increase its overall competitiveness.