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.

Public support for the EU drops by 16% in one month: is popular support for the euro in Greece finally about to wane?

As we've noted in the past, a factor that will determine whether the eurozone can hang together in the long term is the extent to which the public in the South begins to see the euro and EU austerity as synonymous.

For example, despite everything that has taken place in Greece, this has not been the case, with a majority of Greeks consistently in favour of remaining inside the euro. The choice is instead perceived as being between austerity or some form of alternative. This is why we rightly predicted that Greece would remain inside the euro following its hectic dual elections last year (at a point when many analysts were predicting an imminent Grexit).

But is this now starting to change? 

Possibly.

A new Public Issue poll shows that 66% of Greeks now have a "negative opinion" about the EU. For a country that has traditionally has been staunchly pro-EU, that's bad enough. But extraordinarily, when the same question was asked only a month ago, 'only' 50% of respondents said that had a negative opinion  about the EU- a massive 16% increase in only a month, possibly owing to the handling of the Cypriot bailout and the renewed Troika push for civil service cuts in Greece. Those with a positive view dropped from 48% to 31% in the same space (see the graph below).

A separate poll by Marc for Alpha TV asked the question, “In case it’s not possible to improve the conditions of the loan agreement, what do you think we should do?” 53.8% answered "remain in the EU and the euro", while 41.3% said they wanted to "leave the EU and return to the drachma" (4.9% don't know). Note that this was a question about leaving the EU, not only the eurozone. Whilst still a majority in favour of sticking around, to our knowledge, there has been no Greek opinion poll to date with such a large share in favour of leaving the euro and the EU.

Incidentally, the Public Issue poll also asked who respondents wanted to see as Prime Minister. Top candidate? “None”. (see graph)

We're not drawing any firm conclusion from this, although if this trend continues it will be significant. Currently a majority of Greeks believe that things "would be worse" outside the euro. It's worth listening to our interview with leading German economist Hans-Werner Sinn, which we published today, on the prospects for Greece in the euro. One thing is clear: this won't be easy.

Celebrating the end of the eurozone affair ignores the heart of the matter

In today's Telegraph, Mats Persson seeks to answer this simple - and yet brutally complex - question: is the eurozone crisis over?

'We are in the middle of the beginning of the end. The crisis has really hit its peak”, former French economy minister and current IMF chief Christine Lagarde told a broadcaster when asked about the eurozone crisis. The only problem: that was in July 2010. Time and again, EU leaders have declared the crisis over – and been proven wrong. So with markets remaining cautiously optimistic about the euro, is the worst finally behind us?

There are well-rehearsed reasons to be cheerful. Borrowing costs are down for all crisis-stricken countries, exports are picking up in some and EU leaders have actually agreed on a forward-looking measure by turning the ECB into a single supervisor for eurozone banks. Just as eurozone leaders have celebrated prematurely, Anglo-Saxon analysts have consistently tended to overstate the immediate risk of a eurozone break-up. Famously, one major US bank last year assigned an 80pc-90pc risk of Greece leaving the euro – an assessment that Open Europe cautioned strongly against. In Europe, the safest money is always on another fudge. Germany and the ECB were likely to take a political decision to keep Greece inside the eurozone for now, given the fragile situation elsewhere.

But the news last week that the eurozone economy shrunk by 0.6pc in the last quarter of 2012 illustrated what was always the bloc’s greatest challenge: reversing chronic economic malaise. Most fundamentally, reconciling a supranational currency with 17 national democracies remains a challenge. The eurozone’s basic austerity-for-cash prescription continues to fuel tension within individual countries and between the hawkish north and the austerity-fatigued south, testing voters’ patience. The forthcoming Italian elections are turning into a bit of a referendum on EU-mandated austerity, just like the Greek elections last year. Five of the seven main political parties – together polling at around 50pc – have vowed to end cuts. Two parties, Lega Nord and the Five Star Movement, the latter led by comedian-cum-politician Beppe Grillo, even want a referendum on whether the country should remain in the eurozone. The everlasting Silvio Berlusconi is making last-minute gains, in part thanks to a promise to kill what he calls “austerity imposed by Europe”. Against all known principles of common sense, the man still could win. Thankfully, a broadly pro-reform, centre-left coalition led by Pier Luigi Bersani is the most likely outcome, but even then the hope of sweeping economic reforms will be tempered, not least due to those parties’ strong links to the unions.

The Italian elections show how the north and Club Med in many ways are locked into a Catch-22: one wants cash (“solidarity”) first, supervision or discipline second, the other the exact opposite. That dynamic is again evident in the ongoing difficulties in agreeing a bail-out for Cyprus: Germany is unwilling to put in cash for fear of rewarding the bloated Cypriot financial sector. Cyprus resists far-reaching privatisations or significant write-downs of its banking or sovereign debt. This north-south stalemate could become further entrenched if French president Francois Hollande continues to slide towards the Mediterranean bloc, both in terms of political temperament and growth rates (France registered zero growth in 2012). This would weaken the Franco-German axis.

And beyond politics, has the eurozone’s triple crisis – fiscal, banking and competitiveness – really been addressed in any fundamental way? Many eurozone countries are on the path to running a primary surplus – meaning income exceeds outgoings, excluding the cost of servicing a country’s debt. But the eurozone’s overall debt still stands at 90pc of GDP, compared to 70pc in early 2010. Greece, Italy, Portugal and soon probably Cyprus, have debt levels exceeding 120pc of GDP – double what is meant to be allowed under eurozone rules.

The banking sector, too, remains fragile. Thankfully, ECB action helped avoid a massive bank funding crisis last year, but there is a price: eurozone banks have become alarmingly reliant on artificial life support. Liquidity from the ECB to banks now tops €1 trillion (£860bn) – up €140bn on 2009. Even though some banks have started to pay back the cash they owed the ECB early, the eurozone is a long way off a back-stop to allow for wind-downs of bust banks or disentangling of bank and government debt. Overnight interbank lending – a key indicator of banks confidence in the system – remains only half of what it was in 2009 and a third of its peak in 2007. If the crisis were solved, this would surely not be the case.

Finally, by almost every indicator, the single currency is absolutely riddled with economic imbalances, but with no fiscal facility to compensate for them. Encouragingly, Spain, Portugal and in particular Ireland have cut unit labour costs relative to Germany – a key measure of competitiveness - but Italy and France are actually becoming less competitive in relative terms. And imbalances go far beyond labour cost. This year, Greece is expected to contract by over 4pc, Spain by 1.5pc and Cyprus by almost 2pc – while Germany, Finland and others are set for growth. Then there is unemployment. Shockingly, Greek unemployment hit 27pc towards the end of last year, with youth unemployment close to 62pc. Spain is not much better at 26pc and 55pc respectively – and all the scheduled reforms and cuts haven’t even been implemented yet. In Germany, meanwhile, unemployment is at record lows.

In a best-case scenario, the Mediterranean countries will follow the Irish example and continue to squeeze wages and cut costs at home. But in light of domestic political resistance, these imbalances could well continue to test the eurozone’s one-size-fits-all model for a very long time.

So, we have an election fought over EU austerity, political stalemate, a bail-out which no one wants to pay for, abysmal growth forecasts and massive unemployment. There may come a day when the eurozone bounces back and puts us all to shame. But to celebrate now the “end of the crisis” seems to be setting the bar exceptionally low.

The OECD, bearer of bad news at Christmas?

A quick post on a topic which we have already explored in our internal devaluation paper and plan to look at in more detail in the New Year: competitiveness in the eurozone.

The OECD released it latest assessment of unit labour costs (ULCs) in the eurozone a couple of days ago and they do not make pretty reading for Italy or France and only slightly better for Spain:

(The graph shows ULCs indexed to 100 in year 2000. Greece= light red, Spain= green, Germany= dark red, Italy= blue  and France = turquoise).

ULCs are often taken as a measure of a country’s competitiveness, it is by no means the only measure but it is a useful indicator of the situation. As the graph above shows Italy will have higher ULCs than Spain, Greece and, obviously, Germany at the end of this year. This trend will only get worse and France could well find itself in a similar position in 2013/14 if things continue on their current path.

This highlights a point which we have made previously – for all his good work on the fiscal side, Italian Prime Minister Mario Monti has failed to provide sufficient reform of the labour market or boost productivity and improve the business climate (other areas which would also help improve the country’s competitiveness). Elections in Italy in early 2013 mean there will be little opportunity for reform in the first quarter of the year. That may be irrelevant depending on the format of the new government – there is no guarantee of a stable pro-reform coalition in Italy.

The results are similarly worrying for France which can ill afford to fall behind other eurozone states, not least because many of these countries are also improving their budget and current account deficits, while making significant product market reforms and deregulating – all of which the French government has shown little willingness to do.

As for Spain and Greece the reading is a bit more positive with their adjustments clearly having some impact – although as the OECD notes much of this has come from cuts to employment and falling domestic demand rather than successful reform. It is also clear that there is some way to go before they reach the levels of Germany (or get firmly within the bounds of acceptable differences, as we have pointed out before). With unemployment already sky-high in both places this remaining adjustment is likely to be painful.

Plenty for eurozone governments to ponder over the festive period then.

What keeps the folks in Brussels and Berlin awake at night?

Possibly this graph - from our new report on the internal devaluation needed in the PIIGS for the euro to remain intact.

Source: Eurobarometer

It shows how trust in the EU amongst voters in the PIIGS has on average fallen from 55%  in 2001 to 25% in 2012, in the wake of EU-mandated cuts. On average, 66% of voters in these countries now mistrust the EU (up from 26% in 2001). And Spain still has half of its internal devaluation ahead of it (not to mention Greece). This won't be easy.