Thursday, June 24, 2010

Estonia Joins the Euro: What Can We Learn?

The economic news has been full of talk about a crisis in the euro area. Some observers are even taking bets on who will leave the euro first--Germany or Greece? Yet, in the middle of this crisis, Estonia has applied to join the euro area as its 17th member, and has been accepted, effective January 1, 2011. Why does the Estonian government think this is a good idea? What can we learn?

Start with the context. When Estonia achieved independence from the Soviet Union in 1991, it inherited the unstable Soviet ruble as its currency, and along with it, inflation of more than 1000 percent. To end the hyperinflation, in 1992 it introduced its own currency, the kroon, and pegged it firmly to the German mark using a currency board. When the euro was introduced, the peg moved from the mark to the euro. The currency board was highly successful in ending hyperinflation and restoring growth. It also helped Estonia shift its trade quickly from East to West. Today, more than 75% of its trade is with EU members.

After accession to the EU in 2004, Estonia began to see some of the drawbacks of a fixed currency. Under the currency board, it could not use interest rates or exchange rates to offset the inflationary pressures of financial inflows and a housing bubble. Similarly, when the financial crisis hit, Estonia could not use depreciation to soften the shock. Like its Baltic neighbors Latvia and Lithuania, Estonia went from boom to bust. In contrast, floating-rate countries like Poland and the Czech Republic were much less affected by the crisis. (See this previous post for more details about the impact of the crisis on fixed and floating-rate countries.)

A final lesson that can be drawn from Estonia's experience is the importance of sound fiscal policy to countries that choose a fixed exchange rate or membership in a currency block. Going into the crisis, Estonia had a solid budget surplus and the smallest debt-to-GDP ratio in the EU. In contrast to Greece, which entered the crisis in the worst fiscal position of all EU members, Estonia had much more room to maneuver. Yes, like Greece, it was forced to make some budget adjustments during the crisis, but the cuts were merely painful, not catastrophic. It appears that 2010 will see the beginning of economic recovery in Estonia, whereas Greece faces several more years of austerity and is still not certain to avoid default.

The bottom line: There are both pros and cons to fixed exchange rates and common currencies, but a small country like Estonia, with sound fiscal policy and strong trade ties to its currency partners, has the best chance that the advantages will outweigh the drawbacks.

Follow this link to download a free set of classroom-ready slides with charts, data, and lessons to be learned from Estonia's accession to the euro.

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