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Friday, January 17, 2014

Why did Latvia join the euro?

Following on from our #EUReform Conference, we will now begin to shift back to normal blogging which was slightly disrupted by the undertaking of organising such a huge event.

One topic which was discussed at the Conference – specifically in the panel on Lessons from Central and Eastern Europe – is whether Latvia has made the correct decision to join the euro at the start of this year.

Many people were understandably surprised that a country would even countenance joining the euro, given that it is still in the midst of a severe crisis. We laid out some of our thoughts in a recent interview with CNN Marketplace Europe, but will develop them further below.

Why did Latvia join the euro?

Political reasons
  • The key reason here is to cement ties with the EU and to protect itself further against influence from Russia. The Latvian Finance Minister, Andris Vilks, recently cited the example of the problems in Ukraine as a key reason why they chose to align closely with the EU through the euro. With the euro, the economic influence of Russia is reduced, while any uncertainty is backstopped by the security of the currency. With its own free-floating currency, any clash with Russia would likely cause fluctuations.
  • There is also a view that being within the euro may entitle a country to greater levels of support and ‘solidarity’, be this against political or economic uncertainty.
Economic reasons
  • As a small country in a world increasingly dominated by large central banks, many believe the euro still offers Latvia a level of protection and certainty. Many small countries in this area would have pegged currencies or de facto use other currencies in any case, so joining the euro may not be as big a choice as it first seems. It can also be very hard to realistically manage a free-floating currency for a small country these days, open to sharp flows of hot money or speculation.
  • With this in mind, Latvia has maintained its peg with the euro and endured significant pain to do so. This is an issue we looked at in our internal devaluation paper. In any case, after having endured the worst of having a pegged currency, Latvia may see now as the time to reap the benefits.
  • There are also the usual touted benefits of the single currency – notably reduced transaction costs. This is important for Latvia which sees around 30% of its exports go to eurozone countries. It is also likely to increase foreign direct investment and access to financing given the use of the much more liquid euro markets.
What are the potential downsides?
  • The biggest risk facing Latvia is that it will repeat the mistakes it made when it joined the EU and which countries such as Ireland, Spain and Greece made when they joined the euro. This would be huge inflows of money prompting significant rises in prices and wages, as well as being funnelled into industry bubbles rather than productive investment. It is hoped Latvia has learnt from its own mistakes and those of others but that remains to be seen.
  • The loss of tools to manage the national economy is also well known. Not only will Latvia lose control of its own specific monetary policy (something which we have seen can have perverse effects and potentially worsen he problem mentioned above), but it will also be subject to significantly more oversight and will have to sign up to the fiscal targets and structures set in the eurozone.
  • Another big downside is that it seems to be going against the will of the people. All the polls in the run up to the Latvian accession to the euro showed that the public did not want to join. Not only is this undemocratic, particularly given the importance of the issue, but it risks stoking uncertainty. This is especially true since Latvia's previous government, which was a key proponent of the move, resigned.
  • The final risk is one which all euro countries share. Latvia has now tied itself more deeply to a group of countries which continue to struggle, and for which the economic outlook remains mixed. It has also joined at a time when the exact structure of the eurozone remains in flux. Further integration seems likely, but what this will mean and cost is unclear.
In the end, only time will tell if this is the correct decision for Latvia. We are not going to pass judgement either way, although it is clear a more democratic approach would have been preferable. The most important point, though, is that Latvia does not repeat the same mistakes as before.


Anonymous said...

Speaking of solidarity, it'd be nice to see a photo of the then Greece minister of finance grinning upon their adoption of the euro... As a EU voter I wouldn't give a single cent to any member country in crisis.

Their biggest mistake was their decision to join the EU, but now that they're in, it hardly matters any more. Since their old currency was pegged to the euro they were already practically on the euro.

Your analysis forgets that they could have unilaterally adopted the euro to gain those supposed benefits (except the seniorage) without exposing themselves to sociopaths from Brussels and FaM.

I am certain that for a market minded country "advantages" of EU and eurozone membership are negative.

Jon Danzig said...

See my article about this subject: 'Latvia: From Soviet Union to European Union'


Rik said...

If Latvia could keep its economic house in order there seen the cases of Danemark, Sweden little would have to be feared from staying outside the EZ.
It could like Danemark de facto peg its currency to the Euro. Which basically has the same effect but gives room when things have to be done like a devaluation or stimulus of the economy. Especially seen the fact that the Euro is (and for good reason btw) relative to other major currencies pretty strong seen the economic mess most of its members are in. Strong currency but in a non-growing market not something to join.

Basically as far as export goes (which is by far the most relevant sector of its economy (as it pays for all the stuff Latvia itself doesnot produce, which is nearly everything) it is increasingly putting its eggs in the Euro basket. With the EZ being the world's biggest underperformer. It had in all honesty always been it largest trading-partner but spreading risk like the UK is doing now would have been a much wiser strategy. Normal economic/risk management simply demands seen the Zombie-growth status of the EZ a move away from there. In that respect this all doesnot make much sense.

Accepting Latvia basically as OE indicates against the will of its people is imho a huge strategic miss by the EU. At the moment it is a relatively small PR success.
However longer term it is a huge new risk that the EZ is putting on its back. Seen the structure of the Euro (and the EU) any exit is in potential a huge risk as there are simply no rules for it.
Every exit is likely a dirty one, as it looks now and with high uncertainty. A zone with 300+ million people should hardly feel problems caused by an economic midget like Latvia. But we have seen that even a country of that size (Cyprus) can put the whole thing under considerable pressure and Latvia's voters might actually do so. Nutshell bring in a new potential problem with no mechanism to solve it when it happens is simply a huge risk.

It would have been much better if membership would have been deferred. Simply wait till it becomes clear how things will develop. EU leaders might be firm in their defence, but every 4 year roughly other people decide and those people at the moment are in large numbers pretty Euro-sceptic. It would have had an call option which of course wouldnot have been used if the EZ would start to fall apart. Seen that basically nothing is solved in the EZ the (potential) volatility is still there. Which makes such an option very valuable and now they have thrown it all away. A road via a peg first would have been much less risky and kept most of the optionvalue intact. Especially seen the fact that very likley stockmarkets will take a big hit this year and very likley the whole Euro-thingy as a consequence thereof will come under pressure again.

For the UK pretty good news. The more potential rubbish the EZ put on its back the likelier some of those will materialise and the easier a reneg/reform will be after that.

Jim Kemeny said...

From the Swedish point of view there is a problem here that has not been mentioned. Sweden's banks are heavily dominant in Latvia. I can see the time coming when the next housing bubble exposes Swedish banks to yet another crisis like the ones in 1992 and 2008. Sweden does not have regional banks like Germany, Switzerland and Austria, it has a small number of banks that dominate the banking sector. In addition the taxation system in Sweden subsidises its banks by guarantees made to all banks from taxation.

I don't care how much profits they are making, it won't protect them from heavy investments in a country in which they dominate the mortgage market. Even the EU Commissars criticise Sweden for that (by Commissars I mean those in the hierarchy of commissioners who have the most power, like Barroso.)

Anonymous said...

So it is just a big game to protect themselves from Russian influence and exposure. And for the EU it is political and not benefit-based.

I thought that the EU was there to prevent conflict and war in Europe?

Yet another basket case joins the EU and Euro with begging bowl out ready for their free hand out paid for countries such as ours who are heavily in debt.

How does all of this add up either financially or socially?

Free trade. No sovereignty.


christhai said...

Why did Latvia join the Euro?

True Answer:

Because the EU bribed Latvian politicians to do so.

Anonymous said...

There was never any doubt that they would have to join the euro it was part of their accession deal.

Anonymous said...

When it Open Europe going to announce, in the interest of ethical reporting and full disclosure, that it is an agent (albeit informal) of the EUSSR?

It seems decidedly dishonest for Open Europe to continue to pretend that it is anything else.

Patrick Barron said...

Latvia has joined a currency that suffers from the "tragedy of the commons". The euro will fail. Latvia should have kept its currency and declared itself a free trade nation.