Lessons from Latvia Joining the Eurozone

The Instytut Obywatelski has publised the Polish translation of my analysis on the lessons to be learned from Latvia joining the Eurozone. Here is the original English text I had written:

Latvia, just like Poland, is one of the eight countries obliged under the European Treaties to join the Euro. Only last week, its government officially requested entry to the Eurozone, presumably putting an end to a debate that is very much still alive in Poland.

The former Soviet republic paid a heavy economic price for its steadfast pursuit of adherence to the Maastricht criteria during the course of the financial crisis, namely for its strict adherence to the Lat’s peg to the Euro and radically bringing down inflation rates in 2009. Olli Rehn, Commissioner for Economic and Monetary Affairs and the Euro praised Latvia as a „success story“ (link) in his immediate response to the request, an assessment that will strike as ironic those familiar with the still difficult economic situation of the country.

The economic suffering of Latia, induced by this – politically and to some extent – self-imposed stringent adherence to the Maastricht criteria and paltry reaction to it, has been nothing but astonishing. Following a boom in the lead-up to the financial crisis marked by very strong growth figures, the government’s dedication to bring down inflation rates, which had been at 15% in 2008, contributed to a harsh recession peaking at negative 17.5% growth rates in 2009. In parallel, Latvia significantly reduced its annual budget deficit from -9.8% in 2009 to a measly -1.2% in 2012. It also adhered to its peg to the Euro at all times – even if it required a temporary EU-IMF bailout, it has since paid back, from 2008 to 2011 to achieve this.

Latvia thus refused itself the export-growth-inducing and debt-reducing benefits of higher inflation rates and a cheaper valued currency that, say, the United Kingdom currently engages in. It did so essentially exclusively in order to be able to apply for Euro membership as soon as possible.

The costs of this macroeconomics course, this „success story“, were harsh. Not only does GDP per capita still stand below its pre-crisis peak of 2007, unemployment also remains stubbornly high at 14% – even if it is admittedly down from its high point of 21% in 2009-2010. Latvia’s persistent population loss due to the emigration of its educated and young in the pre-crisis years also increased dramatically starting in 2009. While this brain-drain helps to reduce the unemployment rate, it also leaves the country with a formidable demographic problem, at the same time that those who do leave are the ones that could arguably contribute the most in high-productivity sectors.

Apart from this heavy past economic cost exacted on the country, Latvia’s expected strong, catching-up induced, GDP growth will in all likelihood make the ECB’s jointly-set Eurozone interest rate inadequate in the future. This had been a problem in the pre-crisis years due the Lat’s peg already, it is expected to become a problem once again in the near future, especially in light of the sclerotic growth rates elsewhere in Europe. Another potential danger for Latia is that the Baltic state with its asymmetrically high growth rates will be a prime-target for the development of „Spanish“ macroeconomic imbalances, a danger only amplified by developments in Cyprus and the accompanying flows of Russian moneys away from the island and into Latvia.

One may be tempted to wonder why the large majority of Latvia’s political leadership strongly supported – and supports – EMU membership then. Even societally there was limited backlash only against harsh austerity measures even when support for membership admittedly stands at a mere 33% of the population today and has been decreasing steadily. The answer to this question arguably lies with the peculiar economic and political situation of Latvia.

The country, first of all, is in fact a small, open economy mostly interconnected with EU member states – relatively – little affected by the Euro crisis, most notably it has virtually no trade exposure to any of the – Southern and Western – periphery states. In addition and quite ironically, its drastic loss of 24% of GDP in 2008-2009 could actually have been attenuated if the country had been a member of the Euro at the time, as that recession was to a large extent based on a sudden liquidity freeze that the ECB could have helped the country overcome. Latvia on its own could have only addressed it via a massive injection of liquidity – monetary expansion thus – that would have effectively ended its peg to the euro. Joining the Euro will then not result in the same austere economic difficulties parts of Southern Europe are being forced to go through currently. The Latvian budget is stable and sound, its general government debt at 42% is comfortably below the Maastricht criterium, and of course the country is back on the growth track ever since 2011.

Another peculiarty of Latvia is its limited size and emigration-prone young population. The country has in fact had a negative net migration rate throughout the 21st century. This moderate outflow which had edged upwards during the boom years exploded once the crisis really hit. At least some of the – relative – labor market successes must thus be put into the context of Latvians simply packing things up and leaving. This kind of adjustment is hardly feasible for bigger countries of course.

Finally, politically Latvia is dominated by a stark linguistic divide between Latvian and Russian native speakers as well as historic fears of Russia. The majority – Russian-speaker – party in parliament is thus shunned by a coalition of Latvian-speaker parties even with the Prime Minister Valdis Dombrovskis’ party having been trounced in elections in 2011. Deeper integration into the EU is as much a political question as an economic one for Latvia then.

It is questionable then to what extent lessons for Poland may be drawn from the seemingly rather peculiar outlier that Latvia is. Not only does Poland call a far bigger economy its own, it also barely suffered during the 2008 financial crisis and its aftermath even while its unemployment moderately has been rising since.