Blog Post

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 […]

By: Date: December 10, 2009 Topic: European Macroeconomics & Governance

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.


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.

Read about event More on this topic
 

Upcoming Event

Sep
1
12:30

The EU recovery fund - state of play and outlook

Bruegel Annual Meetings, Day 1- In this session we will discuss the EU recovery fund, its state of play and outlook.

Speakers: Nadia Calviño, Karolina Ekholm 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

Sep
2
10:00

Conversation on the recovery programmes

Bruegel Annual Meetings, Day 2- In this session, we discuss the recovery programmes.

Speakers: Maria Demertzis, Henry Foy and Tadeusz Kościński Topic: European Macroeconomics & Governance Location: Palais des Academies, Rue Ducale 1
Read about event
 

Upcoming Event

Sep
2
13:00

European banks: under global competitive pressure?

Bruegel Annual Meetings, Day 2 - European banks have lost stature and remain generally low-profitability, low-valuation in comparison to their global peers. Is that a problem? If so, what can EU policymakers do to address it?

Speakers: José Antonio Álvarez Álvarez, Mairead McGuinness and Nicolas Véron Topic: European Macroeconomics & Governance, Finance & Financial Regulation Location: Palais des Academies, Rue Ducale 1
Read about event More on this topic
 

Upcoming Event

Sep
2
15:45

Blending physical and virtual: shaping the new workplace

Bruegel Annual Meetings, Day 2 - This panel will cover the changes the COVID-19 pandemic made to our workplaces, and what to expect in the near future.

Speakers: Nicholas Bloom, Michael Froman, Mario Mariniello, Sara Matthieu and Luca Visentini Topic: European Macroeconomics & Governance Location: Academy Palace
Read about event More on this topic
 

Upcoming Event

Sep
3
10:15

Conference on the Future of Europe: envisioning EU citizens engagement

Bruegel Annual Meetings, Day 3 - Panellists will discuss different options and what they may entail while revisiting the debates on the future of Europe at national and EU-level that have been conducted thus far.

Speakers: Caroline de Gruyter, Kalypso Nicolaïdis, Niclas Poitiers and György Szapáry Topic: European Macroeconomics & Governance Location: Palais des Academies, Rue Ducale 1
Read about event More on this topic
 

Upcoming Event

Sep
3
09:00

The role of the EU's trade strategy for an inclusive and sustainable recovery

Bruegel Annual Meetings, Day 3 - We are delighted to welcome Valdis Dombrovskis, Executive Vice President of the European Commission for An Economy that Works for People to talk about Europe's trade strategy.

Speakers: Valdis Dombrovskis, Alicia García-Herrero and Guntram B. Wolff Topic: European Macroeconomics & Governance Location: Palais des Academies, Rue Ducale 1
Read article
 

Blog Post

Will European Union recovery spending be enough to fill digital investment gaps?

The recovery facility will boost digital transformation, but questions remain whether it will be sufficient to achieve Europe’s digital ambitions.

By: Zsolt Darvas, J. Scott Marcus and Alkiviadis Tzaras Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: July 20, 2021
Read article Download PDF
 

Policy Contribution

A new direction for the European Union’s half-hearted semiconductor strategy

The EU needs a more targeted strategy to increase its presence in this strategic and thriving sector, building on its existing strengths, while accommodating its relatively low domestic needs.

By: Niclas Poitiers and Pauline Weil Topic: European Macroeconomics & Governance, Innovation & Competition Policy Date: July 15, 2021
Read article More by this author
 

Blog Post

Fit for 55 marks Europe’s climate moment of truth

With Fit for 55, Europe is the global first mover in turning a long-term net-zero goal into real-world policies, marking the entry of climate policy into the daily life of all citizens and businesses.

By: Simone Tagliapietra Topic: Energy & Climate, European Macroeconomics & Governance Date: July 14, 2021
Read article More on this topic
 

Blog Post

Fair vaccine access is a goal Europe cannot afford to miss – July update

European countries must do more to tackle the vaccine uptake gap. Vaccination data should be published at the maximum granularity level so researchers and local decision-makers can monitor progress.

By: Lionel Guetta-Jeanrenaud and Mario Mariniello Topic: European Macroeconomics & Governance Date: July 14, 2021
Read article More by this author
 

Blog Post

SPACs in the gap

Special-purpose acquisition vehicles could fill a gap in European equity markets and lure risk-averse investors off the sidelines.

By: Rebecca Christie Topic: European Macroeconomics & Governance, Finance & Financial Regulation Date: July 13, 2021
Read article More on this topic
 

Blog Post

A breakdown of EU countries’ post-pandemic green spending plans

An analysis of European Union countries’ recovery plans shows widely differing green spending priorities.

By: Klaas Lenaerts and Simone Tagliapietra Topic: European Macroeconomics & Governance Date: July 8, 2021
Load more posts