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.