Blog Post

Latvia in the Eurozone: A Bet with No Upside

The euro does not help Latvia, but could hurt it. The Eurozone is not helped by Latvia, but Latvian entry could create new problems. The best scenario is that no one does worse than the status quo after Latvia joins the Eurozone. So why the rush for Latvia to become the 18th member of the Eurozone?

By: Date: June 13, 2013 Topic: European Macroeconomics & Governance

The euro does not help Latvia, but could hurt it. The Eurozone is not helped by Latvia, but Latvian entry could create new problems. The best scenario is that no one does worse than the status quo after Latvia joins the Eurozone. So why the rush for Latvia to become the 18th member of the Eurozone?

Latvia has just emerged from a wrenching experience. Having lived beyond its means for years—the current account deficit in 2007 was nearly 25 percent of GDP – a crisis was inevitable. From a peak in 2007, GDP fell 20 percent to the bottom in 2010 and the unemployment rate reached nearly 20 percent. Through this free fall, the Latvian authorities stuck to their commitment of maintaining the lats at a fixed parity with euro.  That decision was controversial. Many argued, on the basis of good evidence, that allowing the lats to depreciate would have been the better of the two unhappy options. But to the Latvian authorities, maintaining the exchange rate commitment was paramount. The strongest economic reason for staying with the parity was the fear of so-called balance sheet effects: the burden of euro-denominated debts may have been overwhelming for the holders of a highly depreciated lats. While it will be many years before output and employment recover to pre-crisis levels, the worst is over. Indeed, investors have been happy to buy Latvian debt at increasingly higher prices.

The argument for now adopting the euro is that the commitment to the fixed exchange rate would become irrevocable. And, presumably, access to the European Central Bank’s vast liquidity pool is a plus. Moreover, the European Commission’s assessment is that Latvia is ready to adopt the euro by virtue of its low inflation and low public deficit—and that these are durable achievements.

But the economics does not favor euro adoption by Latvia. The Latvian authorities are giving up the extremely valuable option of floating their exchange rate at a future time. And what may be the offsetting gain? Establishing policy credibility is not one of them. Having proven to the world that Latvia will endure the most intense economic pain to preserve its exchange rate parity, why is a further commitment needed? If the argument is that a future government may be irresponsible and the country may be faced with a new crisis, it is presumptuous to judge that the floating option will not be right one at that time. Binding a future government in this manner is particularly overreaching given how little Latvian public support there is today for a move into the Eurozone.

Two of the last five new entrants into the Eurozone are facing critical problems. True, every unhappy country has its own story to tell. But it is remarkable how entry into the Eurozone spurs reckless banking. Cyprus and Slovenia may each have their own history to blame, but it cannot be a coincidence that they share with earlier members the experience of banking sectors gone out of control—banking sectors that are now in the intensive care of the Eurozone authorities. Perhaps, it is the knowledge that the ECB stands behind them that induces such wanton behavior.

The admission criteria—low inflation and low public deficits—are poor guides to eventual performance in the Eurozone. Latvia got into trouble in 2008 because it failed the competitiveness test—Latvian demand for foreign goods galloped and was not matched by the world’s demands for Latvian goods and services. Why will that change now? Private sector wages have barely fallen and the current account deficit has disappeared mainly because consumption and imports have collapsed.

More importantly, long-term competitiveness requires a healthy pace of technical change and higher quality products. Olivier Blanchard has pointed out that Latvia’s best hope is its large productivity distance from the world technology frontier, a gap that offers the potential to grow. But Blanchard has also—only recently—chronicled the Portuguese experience, where such potential never blossomed into reality. If Latvia does successfully climb the technology ladder, it will do as well outside of the Eurozone as inside it; but if it fails that bigger competitiveness challenge, it will face an unpleasant rerun of its recent crisis. Again, Portugal offers a warning: the competitiveness problems that forced a painful adjustment under the Exchange Rate Mechanism in 1993 remerged less than two decades later.

Moreover, the Eurozone is itself largely dysfunctional. By the admission of its own stewards, the “monetary transmission mechanism” is inoperative. Put simply, when the ECB changes its interest rates, its member countries feel no impact. It is as if the countries were operating on their own. This may improve with time. Those in the Eurozone have no choice; but does Latvia need to rush into this setting?

Indeed, if there was a moment for Latvia to float its exchange rate, this would be it. Policy credibility is strong, the markets are reassured, and the risk of balance sheet disruptions is minimal. Countries with floating exchange rates in Eastern Europe have, on average, done much better than the fixed rate countries since the start of the crisis. Latvian trade with the Eurozone economies is not especially large and, similarly, it has extensive financial connections outside the Eurozone.

Are there reasons why Latvian entry will help the Eurozone? It is hard to think of any. At best, as a small country, Latvia will have no influence on ECB policy or on the economic and financial conditions of other Eurozone economies. But, Cyprus has only recently demonstrated that even a small country can cause tremors.

If policymaking is in large part the art of risk management, then the decision is simple. There is no evident upside to this initiative. The downside risks today appear small, but those could change quickly and the costs of that unlikely event could be large, especially for Latvia.

Latvia’s integration into Europe must be viewed through the lens of powerful historical forces. For Latvia and for Europe, deeper integration is the only right way to go. But the euro is not evidently the right symbol of that forward movement. The euro is often thought of as a political project, one that will bring the nations of Europe into a greater political union. But Latvia is joining the euro at a moment when history is fiercely contesting the architecture of that greater political vision. Over three-fifths of the Latvian population does not wish to join the Eurozone now. Does that not count?   


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.


Warning: Invalid argument supplied for foreach() in /home/bruegelo/public_html/wp-content/themes/bruegel/content.php on line 449
View comments
Read article More on this topic More by this author

Blog Post

The latest European growth-rate estimates

The quarterly growth rate of the euro area in Q1 2018 was 0.4% (1.5% annualized), considerably higher than the low growth rates of the previous two quarters. This blog reviews the reaction to the release of these numbers and the discussion they have triggered about the euro area’s economic challenges.

By: Konstantinos Efstathiou Topic: European Macroeconomics & Governance Date: May 20, 2019
Read about event More on this topic

Upcoming Event

May
21
10:30

Europe after Sibiu: Towards differentiated integration?

A comprehensive follow-up to the Informal European Council in Sibiu, Romania.

Speakers: Andrew Duff, John Erik Fossum, Paweł Karbownik and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read about event More on this topic

Upcoming Event

May
28
12:30

The Ukrainian economy: the way forward after a year of political turbulence

What can Ukraine do to foster economic growth? How can the EU and other international partners help Ukraine with this process?

Speakers: Olena Carbou, Marek Dabrowski, Elena Flores, Ivan Miklos and Hlib Vyshlinsky Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article Download PDF More by this author

Book/Special report

Bruegel annual report 2018

The Bruegel annual report provides a broad overview of the organisation's work in the previous year.

By: Bruegel Topic: Energy & Climate, European Macroeconomics & Governance, Finance & Financial Regulation, Global Economics & Governance, Innovation & Competition Policy Date: May 16, 2019
Read about event More on this topic

Past Event

Past Event

CANCELLED: Future of taxation in the EU

Due to a previously unannounced air traffic controllers strike in Belgium, the Prime Minister Morawiecki is unable to land in time for the event. We apologise for any inconvenience.

Speakers: Marie Lamensch, Mateusz Morawiecki and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: May 16, 2019
Read article More on this topic

Blog Post

Germany’s even larger than expected fiscal surpluses: Is there a link with the constitutional debt brake?

Germany is having a political debate on the adjustment of its budgetary plans due to revised forecasts, and an academic debate on the debt brake. Yet, since 2011, general government revenues and surpluses have been systematically and significantly higher than forecast. The German surplus reached 1.7% of GDP in 2018. This bias did not exist from 1999-2008 before the introduction of the debt brake. While the IMF also got its forecasts of German surpluses wrong, the extent of the bias is larger for the German government’s forecasts. These data suggest that the political debate should focus on the debt brake and its implementation rather than on how to close the budgetary ‘hole’.

By: Catarina Midoes and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: May 13, 2019
Read about event More on this topic

Upcoming Event

Jun
17
12:30

Role of national structural reforms in enhancing resilience in the Euro Area

At this event Gita Gopinath, Chief Economist at the IMF will discuss the role of national structural reforms in enhancing resilience in the Euro Area

Speakers: Maria Demertzis, Gita Gopinath and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More by this author

Blog Post

Spitzenkandidaten visions for the future of Europe's economy

What are the different political visions for the future of Europe’s economy? Bruegel and the Financial Times organised a debate series with lead candidates from six political parties in the run-up to the 2019 European elections.

By: Giuseppe Porcaro Topic: European Macroeconomics & Governance, Global Economics & Governance, Innovation & Competition Policy Date: May 8, 2019
Read article More on this topic More by this author

Opinion

When facts change, change the pact

“When facts change, I change my mind,” John Maynard Keynes famously said. With long-term interest rates currently near zero, the European Union should reform its fiscal framework to allow member states to increase their debt-financed public investments.

By: Jean Pisani-Ferry Topic: European Macroeconomics & Governance Date: May 1, 2019
Read article More on this topic More by this author

Blog Post

EU enlargement 15th anniversary: Upward steps on the income ladder

Since their accession to the EU 15 years ago, the incomes of most central Europeans have increased faster than the incomes of longer-standing members and, thereby, they moved upwards in the EU distribution of income. Yet the very poorest people have not progressed in some countries.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: April 30, 2019
Read article Download PDF More on this topic

Working Paper

What drives national implementation of EU policy recommendations?

The authors use a newly-compiled dataset to investigate whether and why European Union countries implement the economic policy recommendations they receive from the EU.

By: Konstantinos Efstathiou and Guntram B. Wolff Topic: European Macroeconomics & Governance Date: April 25, 2019
Read article Download PDF More by this author

External Publication

European Parliament

Taking stock of the Single Resolution Board: Banking union scrutiny

The Single Resolution Board (SRB) has had a somewhat difficult start but has been able to learn and adapt, and has gained stature following its first bank resolution decisions in 2017-18. It must continue to build up its capabilities, even as the European Union’s banking union and its policy regime for unviable banks continue to develop.

By: Nicolas Véron Topic: European Macroeconomics & Governance, European Parliament, Testimonies Date: April 18, 2019
Load more posts