The Euro and Baltic currency overvaluation

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Baltic currencies are overvalued, which has led to hot money flows and unsustainable levels of consumption. A crash is all but inevitable. The Baltics want in to the Euro, Estonia and Lithuania in particular. They are willing to sacrifice their economy on the altar of the Eurozone’s fixed exchange rates because the Euro is a political union as much as an economic one

This reminds me of 1992. Remember when the Pound was kicked out of the European exchange-rate mechanism (ERM)? Well, it was obvious from the start that the pound was overvalued. In 1989, Margaret Thatcher’s personal economic adviser risked an open dispute with Chancellor Nigel Lawson over the pound, ERM and fixed exchange rates.

The current crisis, long festering between Mrs. Thatcher and her Chancellor of the Exchequer, Nigel Lawson, exploded when her personal economic adviser, Sir Alan Walters, sent a now famous manuscript to The Financial Times of London – in lieu of granting it an interview about his personal life and views. The document, headed ”A Life Philosophy,” had been written for an obscure American journal, The American Economist, 18 months earlier; it has not yet been published.

In one devastating paragraph, Sir Alan declared: ”For more than 35 years I have been convinced that the various forms of pseudo-fixed exchange rates, dignified by various names such as crawling pegs, reference zones, etc., had only deleterious consequences – especially encouraging overvaluation and repression (on the part of dependent currencies such as sterling, the French franc, etc.) and massive capital flight or inflow when the ‘realignment’ was imminent, which would in turn give rise to proposals for more exchange controls and trade barriers.”

So he urged Britain to resist the pressures from Europe and ”the British establishment” to put the pound into the Exchange Rate Mechanism and instead to maintain its system of flexible exchange rates. ”So far,” he said, ”Mrs. Thatcher has concurred.”

NY Times, 6 Nov 1989

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Yet, the political desire for unity with the rest of Europe won the day — Margaret Thatcher’s government fell and paved the way for John Major and Britain’s europhiles. This pushed Britain into an unwise economic decision. The recession of the early 1990s was made all the more severe by the economic policies used by the UK government to defend the Pound’s overvalued peg.

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So, here we are more than 15 years later with the same experiments in Euroland toward fixed exchange rates at unreasonable pegs. We have seen the Baltic States enter the Euro at unreasonably high exchange rates, causing their economies to overheat, risking a crash. Again, this was obvious from the start:

In its January report, the Bundesbank argued that the high current account deficits of east European countries could pose a risk if they were to enter the euro too fast. The Bundesbank said the problem is not the current account deficits themselves, which are normal for countries at this stage of economic development, but the impact of high current account deficits on the exchange rate. The biggest risk lies in the choice of a potentially wrong conversion rate when entering the euro. As we have seen in the case of Germany, which entered the euro with only a moderately overvalued exchange rate, it can take many years to correct such a mistake.
FT, Wolfgang Munchau, 29 Jan 2006

While there is considerable difference between the three countries of Estonia, Latvia, and Lithuania, in general, things are destined to end badly for the Baltics. The countries would be advised to look after their economies first and politics second. A nasty recession in the UK after its unwise ERM experiment so put the British off to joining the Euro that they are still outside the Eurozone 15 years later. This is a lesson in history that Estonia and Lithuania both need to take seriously. An economic slump because of poor economic management will set their cases for the Euro back even further.

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