Latvia in the Eurozone: Lots of work ahead

For me one of the most important issues for Latvian economic policy should be to realize that being in the Eurozone does not imply automatic economic growth

At the moment of writing Latvia fulfills all five Maastricht criteria and should thus be set for adopting the euro on 1 January 2014. True, besides the five quantitative criteria (on inflation, exchange rate, long-term interest rates, budget deficit and government debt) a country is also supposed to be evaluated on the basis of ‘sustainability’ of e.g. low inflation but that never seems to have played a major role. (Estonia was invited to join at a time of negative inflation, which is hardly sustainable). For all the recent newcomers, Slovenia, Malta, Cyprus, Slovakia and Estonia, it seems to have been the case that fulfilling the five means you’re in and I do not envisage this to be different in the case of Latvia. And why should it be?

Many may feel that should Latvia join, it is cause for celebration after years of hard preparatory work. Rather, one should see it as a time when the hard work begins. The Eurozone offers some serious benefits but it also introduces some limitations to economic policy that should not be underestimated.

For me one of the most important issues for Latvian economic policy should be to realize that being in the Eurozone does not imply automatic economic growth. Rather, the ‘friendly straitjacket’ that the zone provides highlights certain demands from economic policy. I see three major issues here.

Firstly, fiscal policy has to be prudent – just witness what happens when it is not c.f. many Southern European countries. This should be under control – I hope – with the recent law on Fiscal Discipline.

Secondly, external competitiveness is essential and it is thus important that cost developments are kept in check – I cannot imagine anyone wanting a rerun of the cost explosion of 2004 – 2007 and the ensuing internal devaluation. One cannot make a law on ‘Competitiveness Discipline’ but I would like to see this issue highlighted much more than it was during the boom of 2004 – 2007.

Thirdly, and closely linked to the second issue, are continued structural reforms. These are good for the economy in general, helping it to grow and converge but they also help competitiveness by raising it via increased productivity.

OK, altogether easy to say, less easy to do but the evidence from the existing Eurozone highlights the importance of these issues. Figure 1 looks at the original Eurozone members from 1999 (plus Greece which joined in 2002). It displays the development in GDP per capita from the zone’s inception until 2012. What we see are very different developments indeed. Germany has benefited from its increased competitiveness while Greece and Spain (and Portugal) are reeling from lost competitiveness combined with harsh austerity to bring fiscal policy under control.

Figure 1: GDP per capita in EZ 12 increase (%), 2012 over 1999.

Source: Eurostat and own calculations

But the most interesting country in a way is Italy. It also lost some competitiveness since it entered the Eurozone and it is suffering somewhat from austerity but in no way or form as severe as in the other Southern countries. As an example of that I provide in Figure 2 unemployment rates for Greece and Italy – it is up in Italy but not at all dramatically. Yet, as seen in Figure 1 Italy is actually a poorer country now than it was in 1999.

Figure 2: Unemployment rates in Italy and Greece, 1999 – 2012

Source: Eurostat

This is a good (but sad) example of a country that has not managed to use the membership of the area of monetary stability in terms of inflation that the Eurozone is to pursue reforms of its economy.

Can Latvia be expected to be fiscally prudent from now on? I guess so. Will it pay sufficient attention to competitiveness? I imagine so. Will reforms continue? I hope so.

I know that the data presented here are very simple but they still tell an important story: The Eurozone may bring many benefits to the Latvian economy but economic development still rests with the Latvians and economic convergence is not automatically guaranteed by the euro. Thus the hard work does not end on 31 December 2013 – it begins on 1 January 2014.

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