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 European Macroeconomics & Governance Tags & Topics

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.

View comments
Read article More on this topic More by this author

Blog Post

Silvia Merler

Should we worry about Greek banks?

Earlier this month, the IMF and the European institutions clashed over conditions for sustainability of the Greek debt. One of the main disagreements seems to be the evaluation of the Greek banks’ health. Whose assessment should be trusted and are there reasons to worry?

By: Silvia Merler Topic: European Macroeconomics & Governance Date: February 23, 2017
Read about event More on this topic

Upcoming Event

Mar
9
12:00

The Belarusian economy: are real changes on the way?

At this event we will discuss where the economy of Belarus is heading, and what this implies for the EU.

Speakers: Kateryna Bornukova, Rumen Dobrinsky, Robert Kirchner, Dzmitry Kruk, Alexander Zaborovski and Georg Zachmann Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article Download PDF

Policy Brief

Screen Shot 2017-02-17 at 16.42.38

Europe in a new world order

In this paper the authors explore what the EU’s strategic reaction should be to US diminishing giant policies, and the EU’s role in a world of declining hegemony and shifting balances

By: Maria Demertzis, André Sapir and Guntram B. Wolff Topic: European Macroeconomics & Governance, Global Economics & Governance Date: February 17, 2017
Read article More on this topic

Blog Post

Zsolt Darvas
DSC_0798
dsc_1000

The Brexit bill: uncertainties in the estimate of EU pension and sickness insurance liabilities

Pension and sickness insurance liabilities for EU staff could be an especially contentious part of negotiations on an EU-UK financial settlement: the “Brexit bill”. This post looks behind the calculation of the alleged cost of pension benefits and concludes that it may be less than half of what it seems.

By: Zsolt Darvas, Konstantinos Efstathiou and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: February 17, 2017
Read about event More on this topic

Upcoming Event

Mar
22
11:30

Conversations on the future of Europe

On the occasion of the 60th anniversary of the signing of the Treaty of Rome, we will hold an event of four conversations between Bruegel scholars and European thinkers.

Speakers: Maria Demertzis, Emmanuel Mourlon-Druol, Johanna Nyman, André Sapir, Catherine Schenk, Guntram B. Wolff, Andre Wilkens and Ivan Krastev Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels
Read article More on this topic

Blog Post

Zsolt Darvas
DSC_0798
dsc_1000

The UK’s Brexit bill: could EU assets partially offset liabilities?

The ‘Brexit bill’ is likely to be one of the most contentious aspects of the upcoming negotiations. But estimates so far focus largely on the EU costs and liabilities that the UK will have to buy its way out of. What about the EU’s assets? The UK will surely get a share of those, and they could total €153.7bn.

By: Zsolt Darvas, Konstantinos Efstathiou and Inês Goncalves Raposo Topic: European Macroeconomics & Governance Date: February 14, 2017
Read article More on this topic

Blog Post

MariaDemertzis1 bw
unnamed

The impact of Brexit on UK tertiary education and R&D

In this blog post, we look at the impact of Brexit on UK’s education and research and development sectors in terms of students and staff, as well as funding.

By: Maria Demertzis and Enrico Nano Topic: European Macroeconomics & Governance Date: February 14, 2017
Read article Download PDF More on this topic

External Publication

Screen Shot 2017-02-13 at 12.31.18

Improving the Responses to the Migration and Refugee Crisis in Europe

What must be done to over- come the intra-European conflict and achieve a bal- ance that produces common ground allowing for a po- litical and social consensus on migration?

By: Massimo Bordignon, Yves Pascouau, Matthias M. Mayer, Mehrdad Mehregani, Demetrios G. Papademetriou, Meghan Benton, Pedro Góis and Simone Moriconi Topic: European Macroeconomics & Governance Date: February 13, 2017
Read article More on this topic More by this author

Blog Post

Zsolt Darvas

Questionable immigration claims in the Brexit white paper

The UK government's white paper on Brexit suggested that the EU's "free movement of people" has made it impossible to control immigration. This seems to rest on an assumption that EU citizens can "move and reside freely" in any member state. Zsolt Darvas finds these arguments problematic, and points out that it is difficult to infer public opinion about immigration from the referendum result.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: February 8, 2017
Read about event

Past Event

Past Event

Brexit and trade: what EU and WTO rules imply

Bruegel in collaboration with Leuven Centre For Global Governance Studies organizes an event at which we will discuss the options for redesigning trade relations in the post-Brexit era.

Speakers: Viktoria Dendrinou, Hosuk Lee-Makiyama, Petros C. Mavroidis, André Sapir and Prof. Jan Wouters Topic: European Macroeconomics & Governance, Global Economics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: February 6, 2017
Read article More by this author

Blog Post

ECB Board Members - Benoît Cœuré, Mario Draghi, Peter Praet, Sabine Lautenschlaeger, Vitor Constancio, Yves Mersch

Resolving Europe’s NPL burden: challenges and benefits

Keynote speech by Vítor Constâncio, Vice-President of the ECB, at Bruegel event: "Tackling Europe's non-performing loans crisis: restructuring debt, reviving growth", Brussels, 3 February 2017

By: Vítor Constâncio Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: February 3, 2017
Read about event

Past Event

Past Event

Tackling Europe’s non-performing loans crisis: restructuring debt, reviving growth

How can we connect the different initiatives for NPL resolution and identify an agenda that is shared between EU, national authorities and the private sector.

Speakers: Corso Bavagnoli, Iker Beraza, Arne Berggren, John Berrigan, Marco Buti, Vítor Constâncio, John Davison, Maria Demertzis, Sharon Donnery, Inês Drumond, Giorgio Gobbi, Piers Haben, Boštjan Jazbec, Gert-Jan Koopman, Alexander Lehmann, TJ Lim, Brendan McDonagh, Reza Moghadam, Ajay Rawal, Emanuele Rosetti Zannoni, Dirk Schoenmaker, Carola Schuler, Julien Wallen, Thomas Wieser and Guntram B. Wolff Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: February 3, 2017
Load more posts