Latvian Currency Peg: The Looming Divide Within Europe

Zsolt Darvas and Jean Pisani-Ferry published at voweu.org "The looming divide within Europe" today, as the financial crisis is highlighting the shortcomings of European Monetary Union. Read the full article.


Here are some key excerpts:

Membership in the euro area is regarded by some as the solution to the problem. True, those ten of the twelve new member states that joined the EU in 2004 could by now have joined the euro area, had they met the admission criteria. Indeed, four of them are already members of the euro club. The EU can certainly be criticised for clinging to criteria ill-suited to catching-up countries and the case for reforming them is strong (Pisani-Ferry et al., 2008, Darvas and Szapary, 2008).

Is there therefore a case for speeding up? External stability concerns would suggest early euro-area entry: being inside a large currency area considerably helps small open economies in times of crisis. But the experience of the Czech Republic (not in the euro) and Slovakia (a member since 1 January 2009), two countries that have both maintained macroeconomic stability, shows that euro membership is not the key to stability. Furthermore, the arguments for caution – essentially the need to avoid imposing too low real interest rates to catching-up countries – remain fully valid.

And now key message related to Latvia:

Countries operating fixed exchange-rate systems are caught in a trap now. Given the large share of foreign-currency lending, an abandonment of the peg followed by sharp depreciation would have a devastating effect. However, under a fixed exchange rate, the reduction in current account deficits made necessary by the reversal of private capital flows will probably imply severe recession, unless domestic prices and wages are sufficiently flexible. This macroeconomic dilemma is bound to dominate policy choices, and it would not be solved by early entry into the euro area. Countries in this situation may not need to introduce a floating exchange-rate regime because of the possibility of severe overshooting, but they should facilitate real exchange-rate adjustment – where feasible, a social consensus to cut nominal wages would be less painful than other available options.

Well, this represents one side of opinions. However, Edward Hugh, who represents very much the devaluation camp has this post today. Very interesting message, among other arguments, here:

Also, it only struck me this week how ridiculous it is to have all these Swedish banks giving the advice to stay on the peg, when Sweden itself is not pegged to the euro, and is able to "correct" in a way which Latvia isn't. Sweden again is a country with a substantial economic tradition. There is now quite a debate going on inside Sweden itself about the extent of that country's responsibility for what is going on in the Baltics (see the two differing points of view I have put up in the comments section to the last post). Also note (from the extracts from the IMF report I have also put up in
comments to the last post) the way in which it is now clear that it was pressure from the EU - who didn't want Latvia to throw itself at the mercy of the euro - which has created this ridiculous situation. The IMF seem to have favoured widening the band to + or - 15%, as a first step to entry into ERM2.

What is right?