It’s now or never … not in a long time

 

Opinion polls on the currency provide some conflicting information. While some 80% would like to see the fixed exchange rate continue, only 30-something per cent are in favour of introducing the euro by 1 January 2014, although euro introduction is the ultimate fixed exchange rate for the lat vis-à-vis the euro.

But if people think that Latvia can “just” enter the Eurozone at some other time of its own choice they are quite wrong – there may be just a small window of opportunity that may not open again for several years to come. This has of course also been part of the debate here but I thought I would try to explore it in more detail in this entry.

Since September 2012 Latvia has met the Maastricht inflation criterion (see e.g. here or also Figure 2 of this entry) and it will continue to do so during the spring and thus through the assessment period but it is far from certain that it will continue to do so – rather, it is more realistic that Latvia will NOT fulfil the criterion and this for the following reasons:

1) The criterion is very strict – inflation must be lower than the average of the three lowest (non-negative) inflation rates in the EU plus 1.5 percentage points. In a union of 27 countries (soon 28; Croatia is about to enter) there will always be a handful of countries with very low inflation thus creating a low criterion value.

2) The so-called Balassa-Samuelson effect, that prices are lower in poorer countries than in richer ones. This effect is shown in Figure 1 below.

Figure 1: Price levels of the EU27 countries (2nd axis) against GDP per capita (1st axis), 2011 (Latvia is red, Estonia blue, Lithuania green)

Source: Eurostat

Note: Luxembourg is excluded – its GDP is exceptionally high partly because of many people working there but not living there while its price level is constrained by the proximity of Belgium, France and Germany.

The graph displays a clear relationship between the level of GDP per capita and the general level of prices. Latvia is relatively poor in the EU having a bit less than 60% of the EU average in terms of GDP per capita and its prices are lower, too, at less than 70% of the average of prices in the Union.

For those not familiar with the Balassa-Samuelson effect, here is a quick explanation. Think of a good or a service that cannot be exported or imported, e.g. my favourite example, a hair cut. Last time I had a hair cut in Denmark was some eight years ago. The price was around 35 lats and should explain why I choose to have what remains of my hair cut here. Why such a massive price difference? Denmark is a rich country (some 120% of the EU average in terms of GDP per capita) and thus wages are generally high, also for those who cut hair. But to pay such people a high salary the price of a hair cut must be high. A hair cut in Latvia is relatively cheap because wages by EU standards are relatively low, reflecting relatively low GDP per capita. If you want to experience the Balassa-Samuelson effect the hard way, just go to Norway and “enjoy” its prices…

But what happens when Latvia (hopefully) continues to converge towards the EU GDP average? If so, the country experiences productivity growth that is higher than elsewhere in the EU; this raises wages, also for the hair cutting people although their productivity can hardly increase – but it will do so; otherwise no one would cut hair anymore. When these wages go up the price of a hair cut has to rise, too, and will also start to converge to the EU average and in this process prices will rise faster here than in e.g. Denmark, or, in other words, inflation will be higher in Latvia than in Denmark or other richer EU countries. Please note that a) this effect is not dramatic – one-two percentage points per year but that may be enough to miss the Maastricht inflation criterion and b) this effect takes place when the country is growing i.e. when wages grow faster than prices due to productivity growth. Sort of “positive” inflation, if one might say so.

Just think about how Estonia managed to join the Eurozone. Estonia is richer than Latvia but still relatively poor in an EU context and thus with a relatively low price level and is also subject to the Balassa-Samuelson effect, see again Figure 1. How did Estonia pass the inflation criterion? In the midst of the economic crisis when there was no GDP growth, no convergence and thus no price pressure – as can be seen from Figure 2. Estonia fulfilled the inflation criterion from November 2009 until October 2010, just one short year of window of opportunity.

Figure 2: The Maastricht inflation criterion (in green) and comparable Latvian and Estonian inflation rates

Source: Eurostat and own (tedious) calculations

As mentioned before, Latvia does fulfil the inflation criterion right now but not least due to quite a bit of creativity: VAT was lowered from 22% to 21%; that is a one-off effect downwards on prices that will soon vanish from the inflation numbers, 2012 saw no tax increases that could have increased inflation and one can argue that although economic growth has resumed there is still so much left of the crisis in terms of unemployment that there has been no serious wage pressure to leave an impact on inflation. Yet…

In short: It is either now in terms of joining the eurozone or most likely not for several years.

Note: One often hears the argument that by joining the Eurozone, inflation will surge. Inflation indeed rose in Estonia (‘surged’ would be an exaggeration), see again Figure 2 but do note that a) inflation went up already before joining the zone on 1 January 2011 and b) that quite a bit of it could be Balassa-Samuelson related and c) due to e.g. some higher taxes that were simply delayed so as not to breach the criterion. Here is a dissection of Estonian inflation experience since joining the Eurozone (in Latvian).

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga