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.
Last week saw a flurry of relevant players weighing on the debate of how to escape from the crisis trap and shape Europe going forward. Lots of interesting ideas and proposals floating around.
The speech that arguably caused the biggest uproar was Radek Sikorski‘s (the Foreign Minister of Poland) in Berlin. He laid out a stark dystopian-utopian dichotomy of Europe warning of ‘disintegration with appalling human cost‘ (Yugoslavia) or federation, ‘deeper integration, or collapse‘. His choice is clear as he – in broad strokes – lays out what a reformed European Union could look like. His proposals effectively includes more majority-vote decision-making (even if he never explicitly says so), automatic sanctions to strengthen fiscal discipline, stronger roles for the Commission, the Council and the European Court of Justice, the European Central Bank (ECB) as a true lender of last resort (LoLR) and calling on it to act soon, a smaller (‘Member States should rotate to have their commissioner‘!), more effective Commission, an empowered European Parliament formed at least in part via ‘pan-European‘ lists. In other words a strong move towards a more federalized EU, spearheaded by the Eurozone but not taking place outside of existing community institutions and based on significant treaty changes. For this, in a striking statement, he calls for Germany to lead, to – finally – act. ‘I fear German power less than I am beginning to fear German inactivity.’
So much for Poland, in France two differing visions were put forward by President Nicolas Sarkozy in Toulon and the French Parti Socialiste‘s presidential candidate François Hollande in front of the Socialist Group in the European Parliament. Hollande attacks the German-inspired austerity model as a solution to the crisis and disdains the need for treaty change, he in turn proposes a pact of responsibility, governance, and growth (‘une pacte de responsabilité, de gouvernance et de croissance‘). Most notably this were to include an increase in the guarantees going to the EFSF, a partial European debt collectivization (maybe along the lines of the Redemption Pact proposed by the economic advisers of the German government), and the ECB as a true LoLR. He wants an investment program at the same time financed via Eurobonds (Me: ’cause that’s gonna happen…) even while promising to lower French debt in the short- and mid-term (‘un déficit de 3% du PIB en 2013, un retour à l’équilibre en 2017‘).
Sarkozy has less manoevure for campaign promises as the opposition candidate in his proposals on Europe’s future. He also wants to reduce French government debt, while also reforming labor market laws (‘la retraite à 60 ans et les 35 heures ont été des fautes graves‘). Sarkozy stresses the Franco-German partnership, ‘la convergence‘ between the two in a Europe of stability (‘une zone de stabilité‘). He puts forward the (Franco-German) company line of more European solidarity necessitating more (fiscal) discipline (‘L’Europe a besoin de plus de solidarité. Mais plus de solidarité exige plus de discipline‘). He wants to re-found Europe (‘Elle doit être refondée‘) not in a supranational manner though but in a (Gaullist) intergovernmental one. At the same time he wants to move more decision-making into qualified majority voting (QMV) procedures. He is in favor of a government of the Eurozone, essentially run or at least dominated by the heads of state and government. He wants to create a European Monetary Fund (EMF), which were to take its decisions under QMV. The ECB he considers an independent actor, while emphasizing his hope and conviction that it will intervene in the face of deflationary pressure. Finally, he is in favor of increased coordination on budgetary questions coupled with automatic and more severe sanctions for those states not adhering to the debt rules. All this should be reflected in a new treaty. One last add-on, in a typical Sarko populist move, he wants to revise Schengen to be able to deal better with immigration questions.
On to the Germans then, were Bundeskanzlerin Merkel laid out her vision in front of the Bundestag on Friday. Following Merkozy’s newly agreed upon decision to not lay pressure on the ECB anymore she also stresses the bank’s independence. What she stresses – little surprisingly – are automated actions against states in infraction of debt rules, these procedures should be controlled by the Commission or the ECJ. Merkel once again stresses that Eurobonds are not a viable solution right now (‘Euro-Bonds [können] jetzt nicht als Rettungsmaßnahme gegen die Krise eingesetzt werden’). She wants to empower the ECJ to allow it to take cases because of infractions against the debt rules. More generally she wants to create a -n ill-defined – Stability and Fiscal Union, including a strong ESM and reforms of labor laws in some member states. Does that mean her proposed treaty changes include labor and maybe social policy transfer to the European level, at least partly? She makes clear that the treaties need to be changed either within the EU 27 or within the Eurozone if not possible otherwise.
Last but most definitely not least, here is arguably the most important speech of last week (at least in the short term). Mario Draghi’s, the President of the ECB, statement in front of an apparently almost empty European Parliament. Draghi interestingly enough stressed the ECB’s goal ‘of maintaining price stability […] in either direction‘ and as applied to ‘both the setting of official interest rates and the implementation of non-standard measures‘. Will the ECB increase its – non-sterilized – intervention then? Secondary Market Purchases (SMP) 3.0? Draghi also calls for ‘fiscal compact‘ as the ‘most important signal from euro area governments for embarking on a path of comprehensive deepening of economic integration.’ He then answers to critics wondering how such a ‘longer-term vision can be helpful in the short term‘ by telling them that ‘other elements might follow‘. Ever greater, monetary expansionary union?
So what are we left with then? Sarkozy and Merkel are preparing treaty changes – intergovernmental one, much more federalist the other. Both are stressing the independence of the ECB, Sarkozy with the explicit hope of it intervening massively, Merkel – as insinuated by the opposition – only praying for it at night. Sarkozy wants more solidarity (Eurobonds!), Merkel believes they are the wrong solution as of this moment. Sarkozy wants to move ahead with tighter – again: inter-governmental – economic governance within the Eurozone, Merkel prefers treaty change for the EU 27 or at least with an opt-in for everybody interested (Poland! Sweden?). Lots of issues to work out before Monday’s episode of Merkozy running Europe. The German opposition wants the EFSF to become a bank, Hollande is looking for a European investment program based on Eurobonds – I think we can safely ignore both of these for the time being, the latter more so than the former. Sikorski is practically begging the Germans to finally put an end to this crisis, while effectively calling for a federation of Europe. Draghi, finally, hints at ECB intervention once a ‘fiscal compact‘ is underway.
It’ll be an interesting week once more to say the least.