Latvia Joins the Eurozone
On January 1, Latvia will become the 18th country to join the European Monetary Union (Eurozone).
The accession will beef up the region’s population by 0.6 percent and its GDP by 0.3 percent. A similar share will augment the Eurozone’s broad money stock. Latvia, the sixth poorest economy in the EU in 2012, will become the poorest member of the Eurozone upon accession.
The country made headlines when in 2008 its GDP contracted by more than 10 percent after a period of credit-fueled investment in housing while consumption rose well in excess of current income. Throughout the subsequent IMF-led adjustment, the central bank never broke the fixed peg of the lats (the currency) to the euro. As a result, wages plummeted, lowering the purchasing power of the population by double digits. The unemployment rate, at more than 22 percent by end-2009, was the highest in the EU at the time.
Latvia’s accession will add a strong voice for fiscal restraint and rules-based monetary policy at the European Central Bank (ECB). At least in the foreseeable future, its vote on the board of the ECB will weigh as much as Germany’s.
The banking system is largely owned by Scandinavian strategic investors. This makes it vulnerable to limited moral suasion and control in times of possible financial turbulence. Additionally, non-local deposits make up more than 30 percent of the total—not high enough to designate Riga an offshore haven but high enough to add an additional layer of risk to financial intermediation.
Overall, the decision to shed control of domestic money to an outside institution is as much political as it is economic. It can be seen as buying protection against possible foreign interference. In this respect, Latvia follows the pattern of the politically motivated foundation of the EMU itself in the early 1990s. In the end, this tradeoff between political benefits and economic costs is a type of social contract whose strength depends on the willingness and ability of all to underwrite it.