17/6/2013: Latvia's Mistake

An excellent piece by ex-IMF Ashoka Mody for Bruegel blog on Latvia's bizarre, one-way (the wrong way) bet on entering the Euro: http://www.bruegel.org/nc/blog/detail/article/1108-latvia-in-the-eurozone-a-bet-with-no-upside/

Mody - having completed pensionable tenure at the IMF - is now going 'free agent' so political correctness can be set aside. He argues, quite correctly, that Latvia's membership in the Euro simply ties its hands on currency valuations and interest rates, without giving it anything tangible in return.

"But the economics does not favor euro adoption by Latvia. The Latvian authorities are giving up the extremely valuable option of floating their exchange rate at a future time. And what may be the offsetting gain? Establishing policy credibility is not one of them. Having proven to the world that Latvia will endure the most intense economic pain to preserve its exchange rate parity, why is a further commitment needed? If the argument is that a future government may be irresponsible and the country may be faced with a new crisis, it is presumptuous to judge that the floating option will not be right one at that time. Binding a future government in this manner is particularly overreaching given how little Latvian public support there is today for a move into the Eurozone."

"More importantly, long-term competitiveness requires a healthy pace of technical change and higher quality products. …If Latvia does successfully climb the technology ladder, it will do as well outside of the Eurozone as inside it; but if it fails that bigger competitiveness challenge, it will face an unpleasant rerun of its recent crisis. Again, Portugal offers a warning: the competitiveness problems that forced a painful adjustment under the Exchange Rate Mechanism in 1993 remerged less than two decades later."

Crucially, per Mody, "...the Eurozone is itself largely dysfunctional. By the admission of its own stewards, the “monetary transmission mechanism” is inoperative. Put simply, when the ECB changes its interest rates, its member countries feel no impact. It is as if the countries were operating on their own. This may improve with time. Those in the Eurozone have no choice; but does Latvia need to rush into this setting?

Indeed, if there was a moment for Latvia to float its exchange rate, this would be it."

Mody does not ask the other question: Why would the euro zone want so urgently for Latvia to join? The answer to this question is even less palatable politically and economically. Euro zone does need another country with a clearly divergent economy and no real dynamic of convergence (shallow growth across the euro zone and still crisis-driven dynamics in Latvia). Nor does Latvia suit the euro zone core - with slower growth and lower inflation targeted by demographically challenged Germany et al. Which means that the only reason for Latvia to be welcomed by the euro zone is geopolitical. Just the same as the only reason for Latvia to enter the euro zone is geopolitical as well. Both, the club and the entrant smell Russia in the distance and feel their early 20th century-stuck fears.