Europe Must Not Let Latvia Fall
Latvia and its Baltic neighbours Estonia and Lithuania are going through their most severe economic crisis since the Soviet Union disintegrated. Their troubles matter beyond their own borders: they could trigger a new wave of financial disruption across Europe, with politically perilous consequences.
Latvia’s tragedy is to be the victim of its own success. Eager to join the European Monetary Union, the government restrained deficits when it could have borrowed with abandon: at the end of 2008, public debt was less than 20 per cent of gross domestic product. Now it needs to borrow in order to combat Europe’s worst recession, but it is getting the cold shoulder.
Wednesday’s failed debt auction shows markets are punishing the government for the sins of the private sector which, encouraged by the exchange rate peg required for Emu entry, gorged on cheap credit denominated in euro or swiss francs. The halt in global financial flows last autumn abruptly ended the credit-fuelled boom. The private sector’s refinancing needs – frighteningly big at a time of scarce finance – are more challenging because of the steep fall in GDP, which exacerbates self-reinforcing fears of devaluation.
Is it realistic and desirable for Latvia to continue aiming for eurozone membership when the crisis is battering it on all fronts? Devaluation would put that process on indefinite hold, but could boost exports and cushion the economy’s fall – as depreciations have done for countries with floating currencies (an additional problem for those with currency pegs).
But the costs of a devaluation would outweigh the benefits. Once the peg went, a small adjustment would not quell downward pressure on the lats. And a large fall would do devastating damage to private sector balance sheets.
The costs to the rest of Europe of abandoning the lats peg would also be considerable. A devaluation could frighten markets enough to bring down other pegged currencies – Estonia’s and Lithuania’s in particular. The problems would spread through those countries’ creditors, such as Swedish banks.
The EU has supported rescue programmes co-ordinated by the International Monetary Fund and put up €50bn in balance-of-payments support. This may not be enough; it is small compared to the region’s external refinancing needs. Much more support would be needed to fend off a wave of fully fledged speculative attacks.
There is one sure way to avoid this outcome: accelerate the Baltic countries’ accession to the euro. Until the crisis, they were meeting the Maastricht convergence criteria better than most eurozone countries. Now those criteria entrench poor policies for the crisis. Latvia shows it is willing to make the painful adjustments that euro entry would entail, such as drastic wage cuts to make the country live within its means.
The highest stakes are political. The newest member states count on EU solidarity as Russia asserts its interests on Europe’s edge. The greatest casualty of a Baltic collapse would be European unity.
