The Baltic Misery Needs a Solution

Writing for the European policy website Euractiv.com, Resident Fellow Zsolt Darvas proposes a solution for the Baltic states, based off his Policy Contribution The Baltic Challenge and Euro-Area Entry. Darvas argues that the economic rationale surrounding certain aspects of the criteria for entry into the Euro area are unsound and should be reformed, allowing for immediate Euro-area entry for the Baltic states.

The global financial and economic crisis has not turned into another global Great Depression. The Baltic situation, however, is very gloomy. After losing about 20 percent of GDP in the last two years, Latvia and Lithuania are still expected to contract by an additional 4 percent in 2010, while Estonia is expected to stagnate. There are also serious question marks about medium-term economic growth.
Their misery has various roots. Before the crisis, huge capital inflows, high inflation, a fixed exchange rate, and aggressive lending policies all led to substantial lending, housing and consumption booms and, consequently, very high current account deficits. Inflation and wage increases well above productivity increases eroded competitiveness.
The huge boom came with a huge toll. The correction already started before the crisis, but the crisis amplified its magnitude. While many observers advised and predicted devaluation, the three countries have so far managed to survive under their fixed exchange-rate strategy and have engaged in drastic budget expenditure cuts, including nominal wage cuts. Wages and prices have also started to fall in the private sector, and the previously huge current account imbalances have been turned into surpluses. The adjustment is having a severe social impact.
How to go forward? The dilemma around the lost competitiveness and the large stock of foreign currency loans can not be solved properly by any of the options (maintaining the pegged exchange rate, devaluation, introduction of a floating rate) that are at the disposal of the Baltics, as I point out in more detail in a recent paper.
For example, the current strategy of sticking to the peg and cutting prices and wages may not be sufficient to restore competitiveness. The uncertainty surrounding the peg discourages investment and hence delays recovery. The huge budget expenditure cuts (eg 40 percent in the case of Latvia) may lead to social unrest that could bring down governments and the peg as well. The recession and nominal wage cuts will lead to even more loan defaults, which may make banks exceptionally cautious in granting new credit, again delaying the recovery. The other readily available options (devaluation or a move to a floating rate) also have serious weaknesses.
Ultimately, the best option would be „immediate‟ euro entry at a suitable exchange rate supported by appropriate resolution to manage the debt overhang. This is not an easy solution.
Currently, in order to join the euro area, applicants must meet an absolute target for the budget deficit (3% of GDP) and government debt (60% of GDP). For the interest rate and inflation criteria, they are judged against the top three performing EU member-state economies. Applicants also have to have a stable exchange rate and compatible central bank statutes. Due to the exceptionally deep and lengthened recession, it has become very difficult for the Baltics to meet the budget deficit criterion of euro-area entry. And even if all formal criteria will be met, the Commission and the ECB also have to evaluate whether the criteria were met in a sustainable way. They may say not.
The Baltics problem aside, there were serious concerns about the economic rationale of the criteria even before the crisis, and those concerns have been amplified during the recession. In
each year before the crisis, more than half of euro-area members have violated the criteria, and all members are expected to violate in response to the crisis. There have also been previous admissions to the euro area in which the full adherence to the formal criteria was rather suspicious. It is crystal clear that the criteria, as they are measured now, are not a suitable way to judge „sustainable convergence‟. The Baltic dimension adds yet another reason in favour of reform.
Luckily, it is possible to change the current entry criteria without a formal treaty change. The EU Treaty itself specifies an obligation for the Council to lay down the details of the entry criteria and the excessive deficit procedure. In other words, the Council does have the ability to reform the measurement of the criteria. A good solution would be to relate the numerical values of the criteria to the average of the euro area.
It is a logical solution, as applicants are highly integrated into the euro area and affected by economic developments there.
It would alleviate the asymmetry of letting the automatic stabilisers run and helping the economy with discretionary stimulus in euro-area countries during a crisis but painfully doing just the opposite in applicant countries.
It would remove the highly unfavourable property of the current system that the capacity to meet the entry criteria depends on the business cycle.
It would abolish the peculiar possibility that non-euro-area countries or very small countries with which the applicant has virtually no trade may affect the criteria.
Finally, as countries in the euro area are declared to have achieved “a high degree of sustainable convergence”, the convergence of applicant countries towards the euro-area average seems a natural requirement.
Of course, even if the Baltic countries manage to adopt the euro (converted at the current exchange rate) in the near future, there will also be significant risks and challenges for the medium and long run. The case of Portugal provides a warning signal: it joined the euro area after a boom period with a weak competitive position and it had the slowest growth rate among euro-area countries since then.
But reforming the entry criteria and encouraging the Baltics to select a suitable conversion rate and to design debt resolution schemes jointly with lenders and the international community is still the best option.
The EU should be more than just a rule book. When everyone is aware that a rule has deficiencies, action is needed to change the rule. The suggested reform of the criteria would not undermine the stability of the euro area and would be in the interest of the whole EU. It is the right time for the Council to exercise its authority in making the criteria more sensible.

The piece was also published in the leading Lithuanian business daily Verslo Zinios.