Despite risks, Latvia (and all the Baltic states) still wants to join the eurozone

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Latvia was formally accepted yesterday as the 18th member of the eurozone, meaning that on January 1, 2014, it will join Estonia as the only former Soviet republic to have adopted the euro as its currency.latvia

That might be surprising given that, in the wake of the 2008 global financial crisis and, in particular, the ensuing eurozone sovereign debt crisis, the eurozone has not been the most popular club.

Malta and Cyprus joined at the beginning of 2008 (we know how well that worked out for one of them), Slovakia joined at the beginning of 2009 and Estonia followed in 2011.  But though Croatia recently joined the European Union to much fanfare, and though other Balkan nations are anxious to follow suit into the European Union, there’s little Balkan sentiment to join the eurozone, nor is there an incredible amount of appetite from other more established EU members, like the United Kingdom, Denmark or Sweden, or newer central European countries.

It’s a different story in the Baltic states, though, and it’s not hard to see why — for small states that were swept into the Soviet Union for much of the 20th century, eurozone membership is as much about geopolitical strategy as about economics.  It explains why the only other European country on target to join the eurozone anytime soon is Lithuania, the third and final Baltic nation, which hopes to join the euro in January 2015.

But the specter of Russian domination doesn’t explain everything — after all, Poland is gently backing away from joining the euro, and its history with Russia is also complicated (though perhaps balanced by an equally complicated relationship with Germany).  Moreover, even Latvian nationalism in the face of valid concerns about Russian influence hasn’t kept the decision to join the eurozone from becoming incredibly unpopular, and polls show that a majority of Latvian voters oppose the decision to replace the Latvian lats with the euro by a nearly two-to-one margin.

The current government, a coalition of broadly free-market liberal parties headed by prime minister Valdis Dombrovskis, has pushed ahead with euro membership, despite a dip in its popularity.  Dombrovskis’s own Vienotība (Unity) was trounced in last month’s local elections, with the anti-euro, relatively more Russia-friendly Saskaņas Centrs (Harmony Centre), Latvia’s major center-left party, winning a landslide share of the vote in municipal election in the capital, Riga.  Although the three governing center-right parties, taken together, widely outpolled Harmony Centre in Latvia’s most recent parliamentary elections in September 2011, Harmony Center emerged as the largest single party in the Saeima, Latvia’s 100-seat unicameral parliament, for the first time in Latvia’s post-Soviet history.

Dombrovskis, an economic whiz kid who was only 17 when the Soviet Union crumbled, took office in early 2009, the year that Latvia’s economy contracted by 18%, and he initiated a program of budget-cutting and an era of ‘internal devaluation’ – i.e., when a country makes its exports more competitive not by devaluing its currency, but by gradually (and painfully) lowering prices and wages internally.  Today, however, Latvia’s budget deficit is among the smallest in the European Union, and its public debt stands at around 44% of GDP.

Since then, Latvia has become a battleground for competing views of economic theory.  Keynesian macroeconomists argue that Latvia could have rebounded faster with even higher GDP growth and employment gains if it had lowering the value of its currency and postponed the most stringent budget cuts until the economy recovered.  More austerian economists argue that Latvia’s return to growth stems directly from its fiscal discipline, and that international markets have rewarded Latvia with access to cheaper credit as a result of confidence in Riga’s ability to adjust its finances.

I don’t want to revisit those fights — after all, Dombrovskis has already attacked economist Paul Krugman for disparaging Latvia’s economy.  Suffice it to say that the truth lies somewhere in between.  Latvia’s economy has recovered, with 5.5% GDP growth in 2011 and estimated 4.5% growth in 2012, and the unemployment rate has fallen from around 21% to 13%.  But the Latvian economy remains smaller overall than it was in 2008 when the crisis began, and unemployment has gone down in part because tens of thousands of Latvians have simply decided to emigrate.  Furthermore, many Latvians themselves argue that their approach has worked in part due to Latvian cultural values — after all, it’s a country that watched its economy collapse in the mid-1990s during the crucible of post-Soviet privatization.  It’s convincing to me that collective hardship, as an economic policy, has worked more successfully in some countries (such as Latvia and Ireland) than in others (such as Greece or even Lithuania).

Despite four very difficult years, Dombrovskis has remained prime minister, which makes him the rarest of public officials in Europe these days.

So given where Latvia now stands, there are other good reasons for it to want to join the euro.

With a population of just over 2 million that’s been shrinking from a high point of nearly 2.7 million in 1990, Latvia’s relatively small size means that much of the country’s debt is already denominated in euros and not in lats, so a currency devaluation would not have significantly lightened the country’s (mostly private) debt burden.

Through the Latvian lats has been pegged to the euro since 2005 through the European exchange rate mechanism (ERM II, to distinguish from the previous ERM that ran from 1979 until the introduction of the single currency) that allows it to float within 15% of the euro’s value – just like the Estonian kroon, Slovenian tolar and Slovak koruna prior to their own accession to the eurozone, and like the Lithuanian litas remains today.  That means that for the past eight years, Latvia’s already been saddled with many of the drawback of eurozone membership and, for example, it would not have been able to devalue its currency in 2009 without falling out of ERM II, potentially casting doubt on the Latvian government’s future credibility. (Latvia’s refusal to leave the euro peg is one of the reasons Krugman famously called Latvia ‘the next Argentina’ in late 2008, comparing Latvia to Argentina’s stubborn policy of ‘convertability,’ which pegged the Argentine peso to the dollar and which Argentina eventually abandoned in 2001 as economic pressures mounted).

Once it is part of the eurozone as a formal matter, the hope is that Latvia will reap even lower bond yields, lower interest rates and enhanced opportunities for investment as part of Europe’s economic and monetary core.

But that doesn’t mean there aren’t downsides to joining the eurozone.

One risk is that Latvia will join the eurozone with an exchange rate that’s too high, thereby leading to price inflation (a risk that Edward Hugh argues hurt Estonia following its entry into the eurozone in 2011).

But the two countries that have joined the eurozone since the sovereign debt crisis began have seen their economies grow — Slovakia is growing faster, in fact, than the Czech Republic.  And in the more immediate test case to Latvia’s north, Estonia’s GDP growth shot to nearly 8% in 2011, largely on the basis of a natural post-crisis bounce.  Though GDP growth fell back to an estimated 2.5% in 2012, that’s still relatively strong growth in comparison to the eurozone as a whole, especially in light of the significance of European exports as a component of Estonian GDP — Estonia is even more dependent on exports to other countries within the European Union than Latvia currently is.

Another more immediate downside is the  €320 million payment that Latvia will be expected to make to finance the bailout of countries that, despite their own half-decades of economic turmoil, are even richer than Latvia.  Though the payment will be spread out over five years, it’s in excess of 1% of Latvian GDP, not a small price to pay.

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