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?