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 by this author

Blog Post

Zsolt Darvas

Single market access from outside the EU: three key prerequisites

In relative terms, Norway’s current net financial contribution to the EU is similar to the UK’s. Switzerland and Liechtenstein pay surprisingly little, while Iceland is a net beneficiary. Relative to their population, Switzerland, Norway, Iceland and Liechtenstein received about twice as large an inflow of EU immigrants as the UK. These countries also have to adopt the vast majority of EU regulation to gain access to the single market.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: July 19, 2016
Read article More on this topic More by this author

Opinion

Guntram B. Wolff

The difficulties of defining EU-UK economic relations

Negotiations on the UK's exit from the EU have not yet begun, but the UK leadership needs to find a balance between single market access and free movement. There are also tensions between the demands of voters and what EU partners can plausibly agree. Guntram Wolff doubts the likelihood of a Norway- or Switzerland-style deals, and urges caution on all sides.

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: July 19, 2016
Read article More on this topic More by this author

Blog Post

Marek Dabrowski

Iran: from isolation to economic cooperation

With some sanctions temporarily lifted, now is the chance for Iran to reintegrate into the global economy and political system. But comprehensive economic and political reforms are needed.

By: Marek Dabrowski Topic: European Macroeconomics & Governance Date: July 15, 2016
Read article More on this topic More by this author

Blog Post

Zsolt Darvas

Brexit vote boosts case for inclusive growth

In the United Kingdom’s Brexit referendum, income inequality and poverty boosted ‘leave’ votes, in addition to geographical differences and larger shares of uneducated and older people in UK regions, according to my regression analysis. The actual presence of immigrants did not have a significant effect on the results. Disadvantaged people voted in smaller proportions. Turnout was also low among the young and residents of Scotland, Northern Ireland and London, who were more likely to vote ‘remain’.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: July 13, 2016
Read about event More on this topic

Past Event

Past Event

Does the euro area need a sovereign insolvency mechanism?

The sovereign debt crisis shook the Euro to its foundations. It soon became clear that there was no mechanism to allow a tidy insolvency of a state wishing to remain inside the euro area. To face future crises, does the EU need a sovereign insolvency mechanism?

Speakers: Jochen Andritzky, Lars Feld, Zsolt Darvas and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Bruegel, Rue de la Charité 33, 1210 Brussels Date: July 12, 2016
Read article More on this topic More by this author

Blog Post

Jérémie Cohen-Setton

The great risk shift and populism

What’s at stake: For many commentators, Brexit was the signal of a broad populist backlash and illustrated the need to articulate policies that address the grievances of those citizens who have been left behind by recent economic changes.

By: Jérémie Cohen-Setton Topic: European Macroeconomics & Governance Date: July 11, 2016
Read article Download PDF More on this topic More by this author

Policy Contribution

Cover

An Italian job: the need for collective wage bargaining reform

Italy’s current system of centralised wage bargaining needs to be reformed. The system was designed without regard for the underlying industrial structure and geographical heterogeneity of the Italian economy. This has fostered perverse incentives and imbalances within Italy.

By: Alessio Terzi Topic: European Macroeconomics & Governance Date: July 6, 2016
Read article More on this topic More by this author

Opinion

Guntram B. Wolff

市场与公投承诺不可兼得

未来几个月市场的动荡还将持续,直到英国与欧盟关系的条款最终敲定。英国与欧盟保持密切关联的政治可能性越高,市场反应将会越积极。相反,如果英国采取孤立主义,以及欧洲大陆的惩罚性情绪越高,那么英国和欧盟的股市下跌将会越严重。

By: Guntram B. Wolff Topic: European Macroeconomics & Governance Date: July 6, 2016
Read article More on this topic More by this author

Opinion

Schoenmaker pic

登录 注册 丢了“欧盟护照”伦敦金融城伤不起

 作为全球金融中心,伦敦一部分的吸引力来自于其窗口作用——在伦敦扎根可以直接打入泛欧洲经济区(EEA)的内部市场。这么说来,金融企业有一个英国经营牌照就如同有一本“欧盟护照”,境外机构可以在整个欧洲经济区提供金融服务,畅通无阻。

By: Dirk Schoenmaker Topic: European Macroeconomics & Governance Date: July 5, 2016
Read article More on this topic More by this author

Blog Post

Dalia Marin

Inequality in Germany – how it differs from the US

The pay gap between workers and CEOs in Germany is driven by a lack of managers. Income inequality could fall if there were more managers available for companies to hire. Firms should start hiring more CEOs who are women or from abroad.

By: Dalia Marin Topic: European Macroeconomics & Governance Date: July 5, 2016
Read article More on this topic

Blog Post

Alvaro Leandro
jaume

Spanish unemployment and the effects of the 2012 labour market reform

What’s at stake: Spain is currently the EU country with the second highest level of unemployment, after Greece. The high and persistent level of unemployment and the appropriate labour market reforms are a major topic of discussion in Spain. We review arguments made in the blogosphere and by international organisations on the reasons for Spain’s stubbornly high unemployment, and various assessments of the labour market reforms of 2012.

By: Alvaro Leandro and Jaume Martí Romero Topic: European Macroeconomics & Governance Date: July 4, 2016
Read article More on this topic More by this author

Blog Post

Zsolt Darvas

No Lehman moment on currency markets after Brexit vote

While the pound sterling has lost a lot of its value right after the Brexit vote, from a historical perspective neither the fall of the exchange rate, nor its current level, is unprecedented. The situation is not as severe as it was in the aftermath the collapse of Lehman Brothers.

By: Zsolt Darvas Topic: European Macroeconomics & Governance Date: June 30, 2016
Load more posts