Presentation by Giancarlo Corsetti, Professor of Macroeconomics, University of Cambridge at International Conference: "Against the Odds: Lessons from the Recovery in the Baltics" organized by the International Monetary Fund and the Bank of Latvia. Riga, June 5, 2012

1. The Baltics and the euro
Giancarlo Corsetti
Against the odds: Lessons From the Recovery in The Baltics
Riga, Latvia, June 5 2012
Faculty of Economics NIAS Duisenberg Fellowship

2. Questions
A policy strategy pursuing integration in the euro area raises two
questions:
• What kind of union are the Baltic countries joining?
• How does/will the euro zone cope with macroeconomic and financial
stability at systemic level?
• How can a small open economy prosper in (and contribute to) a large
monetary and economic union (currently in a crisis)?
• A forward-looking assessment of the recent Baltic experience

3. ‘Good-bye currency risk, hallo sovereign risk’
Long-run government bond yields in Europe 1987-2012
30
1992-93 crisis
25
Madrid
Summit
Belgium
20
Ireland
Irrevocably
Fixed Greece
Parities Spain
15
France
Italy
Netherlands
10 Portugal
Finland
Germany
5
0

4. From currency to sovereign/jurisdiction risk
1990s: imperfectly credible fixed exchange rates created vulnerability to
confidence (self-fulfilling) crises.
• By eliminating currencies, the euro was expected to stem financial
instability in Europe.
Today: sovereign replaces currency risk as source of vulnerability to
confidence crisis.
• By eliminating domestic debt markets – the argument goes -- some
form of ‘eurobonds’ will reduce instability.
But weak fundamentals and confidence feed on each other.
• Eliminating markets may reduce room for confidence crises, but does
not rule out the emergence of imbalances.

5. A systemic and a country-specific challenge
Monetary union works if it can rely on institutions/policies that
(a) contain the emergence of imbalances and
(b) if imbalances materialize, can foster adjustment.
This is the key challenge for the euro area as a whole.
For the Baltic countries, the challenge is obvious:
• In or towards the euro, they reap the gains from eliminating currency
risk.
• The policy priority is to prevent/contain sovereign/jurisdiction risk
• But there is also a new responsibility: working cooperatively with the
rest of the union

6. Sovereign risk undermines macroeconomic stability
Preventing/breaking this
Negative
‘diabolic loop’ expected output
is a common objective growth
in a currency union
Lower demand Increase in public
debt
Higher private
borrowing cost Higher sovereign
risk
Banking fragility

7. The crisis of the euro: past and present
Beyond the current crisis, Europe suffered at least one other large
systemic monetary break up:
•the crash of the Exchange Rate Mechanism (the ‘hard ERM’) in 1992-93,
followed by a period of speculative waves and currency and financial
instability.

8. How does a euro crisis develop?
In 1992-93, as today, the crisis developed in 3 phases
(a)Imbalances may build up for different reasons (financial, fiscal, policy)
• market signals are socially-inefficient (underestimated risk)
result in large price misalignments (eroding ‘competitiveness’)
• typically exacerbated by a dollar slide (1992 and 2009)
yet remain long underestimated (no early action is undertaken)
(b)A large shock (German unification, the global financial crisis) makes
them unsustainable
(c)A policy conflict divides the Center from the Periphery (worsened by
faltering political support for a common currency)

9. The policy conflict in 1992-93
German unification caused domestic overheating requiring the D-mark to
appreciate in real terms. This was possible via either:
(a) Increase in German inflation
• ruled out by the Bundesbank, which hiked policy rates and thus
generated a contractionary shock for the rest of the system
(b) Exchange rate realignment
• ruled out by countries, investing their political capital on maintaining a
fixed exchange rate
(c) Deflation in the rest of the system
• painful, with uncertain political consensus.
.

10. Crisis erupts as cooperation grounds to a halt
• In 1992, proposals for a coordinated adjustment: small D-mark re-
valuation, matched by small devaluation of weak currencies…
• …rejected.
• Equilibrium vastly different without policy coordination: fewer countries
expected to devalue by more than in the proposed cooperative solution.
• Speculation sky-rocketed when agents realized they were playing
against countries in conflict with each other.
• Then, as now, the crisis was first and foremost a manifestation of (a
break down of) ineffective intra-European cooperation
The story is in Buiter Corsetti Pesenti 1998
.

11. Relative to today’s crisis, in 1992-93:
(a) Exchange rates could/did adjust
• low pass through, moderate inflation
• export growth helped by German demand and global recovery
(b) While no cross-border payment system provided automatic cross-
border financing…:
• Sudden stops of private capital forced depreciation, unless other
countries provided large discretionary support
(c) …debt in crisis countries was denominated in domestic currency

12. Relative to today’s crisis, in 1992-93:
(d) While countries undertook deep fiscal adjustment, their efforts were
fostered by moderate inflation (5%) over a few years.
• E.g. in addition to a large budget cut (5.8% of GDP) in 1993, Italy
produced large public saving by freezing part of nominal spending
over the following years
But here comes a crucial element…
(e) New policy models replaced ‘disinflation through exchange rate
stabilization’ and provided a sense of direction:
• Inflation targeting, embraced by the UK and SWE.
• Monetary unification.

13. The end of the crisis in 1995
It took a couple of years of policy adjustment, with trials and errors, for
• Europe to restore credibility of full cooperation (Madrid summit)
• markets then to settle on new equilibrium relative prices.
• Yes, some banks had to be rescued
Then, the euro was launched effectively under the presumption that no
fundamental imbalance would ever materialize.

14. Today’s crisis
Striking analogies in the development of the crisis.
But the euro
• rules out (a) exchange rate adjustment;
• softens (b) balance of payment constraint;
• but also kills (c): debt is no longer denominated in domestic currency;
• Undermines the possibility of a role for moderate inflation in fiscal or
relative price adjustment

15. Today’s crisis
Years into the crisis, still need to define a ‘sense of direction’
• The fiscal compact is only one element
• Hard to see any crisis resolution without strong cooperation in
banking (recapitalization, deposit insurance) and public debt
management (sinking fund or some form of eurobonds)
The prospects for a solid/effective agreement on banking and sovereign
debt, however, also depends on resolving the real side of imbalances.
• Uncertainty about the model of adjustment

16. How would adjustment via exchange rates work?
3 main channels:
1. Relative price of tradables/nontradables
• Competitiveness
2. Relative national wealth
• Domestic demand and net savings (transfer problem)
3. World price of domestic liabilities
• In domestic currency: portfolio view (Kouri, Tobin)
• In foreign currency: balanced sheet and valuation effects

17. How would adjustment via exchange rates work?
1. Relative price of tradables/nontradables rises in the short run
• Quickly setting incentive to reallocate resources towards exports and
domestic production.
2. Relative national wealth falls
• Reducing demand and imports for a given level of output.
• Composition/diversification of national portfolios matter
3. World price of domestic debt denominated in home currency falls
• In response to a rise in sovereign risk, the exchange rate instantly
adjusts the international price of bonds for a given nominal interest
rate --- see the recent UK experience in this light.

18. A realistic view
• The third (risk-pricing) channel is not operative in countries that borrow
in a non-national currency.
• With a large debt in a foreign currency, however, real depreciation
raises automatically its burden whether it occurs via a fall in prices
and wages, or via the exchange rate
• Primary and external surpluses need to respond flexibly to shocks
(e.g. banking crises) and fluctuations in the market perception of risk
• With the exchange rate, non-tradable prices falls more rapidly (arguably
causing output to contract by less)
• The hard truth: in the euro area, some form of fiscal devaluation is the
only instrument left.

19. The Baltic experiment
Front-loaded deep (fiscal) adjustment can force a quick turnaround of
market sentiments, and reduce vulnerability over time.
Special conditions eg:
• Low initial public debt
• But large private debt in foreign currency
• Large financial support by international institutions and foreign banks
• foreign-owned intermediaries willing to engage
• Strong boom preceding the crisis
• Size, openness, high labor mobility and migration (costly)
• Clear sense of direction -- joining the euro

20. Policy priorities now
• Temptation (for L&L): Final sprint to satisfy euro-accession criteria, if
only formally
• Beware: multipliers are high in crisis/economic slack period
• Opportunity (EL&L): Shape the economy with policies that are desirable
independently of monetary future, addressing
• Private debt overhang
• Persistent high unemployment and underutilization of resources
• Loss of skilled labor via migration
• Financial and fiscal stability

21. Fiscal adjustment is for the medium term
Cyclically adjusted surplus
2005-2008 and 2010-2011, % GDP
Lithuania
Latvia 2005-2008
2010-2011
Estonia
-6 -5 -4 -3 -2 -1 0 1 2 3

22. Competitiveness is a medium-term objective
Real appreciation before the crisis is driven by tradable prices (proxied by
the terms of trade), not by nontradable prices (CPI/PPI). It did nothing to
‘cool down’ the economy.
Latvia
1.15
1.1
1.05
Index, 2002=100
1
ToT
0.95 CPI/PPI
0.9
0.85
0.8
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

23. Competitiveness is a medium-term objective
Similarly, recent development mostly mirrors macro adjustment. Gains in
‘competitiveness’ are the ‘tail’, not the ‘dog’ in the story.
Real effective exchange rate
(Unit labor cost - 27 EU trading partners)
1.85
1.75
1.65
1.55
Index, 2002=100
1.45
Estonia
1.35
Latvia
1.25
Lithuania
1.15
1.05
0.95
0.85
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011

24. To conclude
The Baltics (no matter how small) will affect geography/identity of the euro
• Politically and historically, there will be a new spin
• Baltic as a region (with common interests) with strong connection to
Nordic countries, strong ties with the East, hard-earned reputation in
international organization.
• It will be interesting to see what the Baltics politics will be once in.
• Center, Periphery, and Baltics
The meaning of Baltic experiment for Europe is perhaps larger than its
details.