Why Exchange Rates Matter in a Crisis: Latvia vs. the Czech Republic

The focus of economic crisis watchers has shifted to Europe. The European Union, and especially the core countries that comprise the euro area, are struggling with budget deficits, possible defaults, and the threat of a double-dip recession. One of the factors causing headaches for European policy makers is the fact that most EU member countries have fixed exchange rates relative to one another, either within the euro area or through other fixed-exchange rate arrangements. Only a few EU members have fully flexible exchange rates. A comparison of Latvia, with its fixed exchange rate, and the Czech Republic, with a floating exchange rate, can show why exchange rates matter in a crisis.

Latvia is not a member of the Euro area, but its currency, the lats, has been firmly pegged to the euro since the country joined the EU in 2004. The fixed exchange rate has helped promote trade and financial integration, but it has also created problems for stabilization policy. During the boom years from 2004 to 2007, Latvia enjoyed the fastest growth in the EU, but also suffered the most rapid inflation. With a fixed exchange rate, the central bank could not use monetary policy to cool the boom. Rising prices and wages undercut competitiveness.

In contrast, in the Czech Republic, the post-accession boom was accompanied by rapid appreciation of the Czech koruna, which strengthened from 33 per euro to 23 per euro in just 4 years. The strong currency kept import prices low and helped restrain inflation. Without the need to hold the exchange rate fixed, the Czech central bank was able to use monetary policy to avoid excessive wage increases or a housing bubble. When the crisis hit, the koruna depreciated as quickly as it had earlier strengthened, quickly restoring competitiveness. The recession in the Czech Republic was among the mildest in the EU.

The effects of the crisis on Latvia were entirely different. Without a devaluation, the only way Latvia could restore competitiveness was through deflation of prices and wages. This strategy, often called "internal devaluation," has been extremely painful. The unemployment rate has soared to 22 percent as prices and wages fall. Meanwhile, unemployment in the Czech Republic has risen only slightly and has remained below the EU average throughout the crisis.

The bottom line: During good times, the fixed exchange rate policy of euro area countries and others with pegs to the euro helps promote trade and integration. However, during a boom, a fixed exchange rate makes it hard to avoid dangerous overheating and bubbles. When a crisis comes, a fixed exchange rate makes adjustment slower and more painful.

The euro has been a bold experiment, but today, the currency bloc is fighting to remain intact.

Follow this link to download a free set of PowerPoint slides with charts and data comparing the experience of Latvia and the Czech Republic. If you like the slides, please post a comment to let others know how you have used them in your economics courses.