The Euro Lottery

From what I understand, public support for joining the euro in 2014 is currently far from Lukashenko-type percentages but the process is nevertheless on track. I thought I would update with the most recent numbers plus a take on how realistic it is that Latvia will fulfil the Maastricht convergence criteria and actually join by 1 January 2014.

Of the five criteria Latvia has no problem with exchange rate, public deficit or public debt (see e.g. the September newsletter from Bank of Latvia – should soon appear here).

As for inflation Latvia currently (August 2012) does not qualify as is seen from Figure 1 – the average of the three lowest rates; those of Sweden, Ireland and Greece, plus 1.5 percentage points equals 3.0% which Latvia misses by a whisker.

Figure 1: Maastricht inflation criterion, August 2012

Source: Eurostat

But recent inflation development in Latvia indicates that, bar nasty surprises from oil and food prices, the country will fulfil the criterion by next spring when assessment will take place. As Figure 2 shows, year-on-year inflation (the rate that we most often associate with inflation) has come down again quite substantially and this will in the next half year feed into the longer Maastricht measure (which looks at inflation as price developments in the past year compared to the previous past year instead of the more volatile year-on-year measure that looks at the past month over the similar month of last year). There has been very subdued inflation pressure recently see e.g. here but some effect should also be evident from the, in my point of view, ‘excessively creative’ idea of lowering VAT with the sole purpose of lowering inflation.

Figure 2: Latvian inflation, monthly data, year-on-year and HICP (Harmonized Index of Consumer Prices)

Source: Central Statistical Bureau of Latvia

That leaves only the issue of the long-term interest rate and here it will be interesting to see how assessment will take place. In principle, the interest rate criterion should be based on interest rates of the three countries with lowest inflation but since Ireland and Greece with their very high interest rates are among those three, strict adherence to the criterion would make it a walk in the park for Latvia to qualify, see Figure 3.

Figure 3: Long-term interest rates for evaluation of the Maastricht criterion on interest rates, August 2012

Source: Eurostat and own calculations

And strict adherence is not what we should expect – already in the spring Ireland was discarded from the interest rate criterion in the EU Commission’s Convergence Report (page 5-6):

“At the current juncture, sovereign bond markets in some Member States are subject to severe distortions, which make their long-term interest rates not a meaningful benchmark for the assessment of convergence. Against this background, it would not be appropriate to include the long-term interest rate of Ireland one of the three best-performing Member States in terms of price stability, in the calculation of the reference value for the long-term interest rate criterion. Hence, the reference value is based on the long-term interest rates in Sweden and Slovenia” [Sweden, Ireland and Slovenia were the three countries with lowest inflation rates in spring 2012].

So Ireland and Greece may be kicked out but what then? Basing the criterion solely on one country, in this case Sweden, would be absurd (and not just because Sweden has a floating exchange rate and is outside the Eurozone)and unfair as it would make the interest criterion harder to meet than at any time before. Will it instead be based on the three lowest inflation rate countries not involved with the Troika? Currently that is Sweden, Bulgaria and Spain where the latter’s high interest rate would be a helping hand for Latvia – that is, if Spain might not be taken out of the equation, too, and for the same reason as Ireland and Greece.

But as can also be seen from Figure 1 several countries are very close to each other in terms of inflation so the three best might be a different bunch in the spring of 2013. The nightmare scenario for Latvian entry into the Eurozone should be if the three would be Sweden, Denmark and Germany (see Figure 3).

OK, a bit of speculation but what can be said now is that a) Latvia fulfils the exchange rate criterion, the deficit criterion and the debt criterion. It is almost certain that it will fulfil the inflation criterion by spring of 2013 but then we shall have to see which countries the interest rate criterion will be based on and how it will be interpreted and that is, as far as I can see, far from certain at the moment.

What can be said, however, is that currently the Maastricht criterion for inflation and interest rates are absurd: Low inflation in Sweden comes from an appreciating currency that has nothing to do with the euro while low inflation in Ireland and Greece come from high unemployment and austerity, neither of which should be criteria for entering the Eurozone – and some of the interest rates are influenced by risk of default and thus not reflecting sound, low-inflation economic policy.

Altogether pretty messy…..

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