All nations have suffered in the financial crisis, but the most vulnerable have been smaller economies that are not part of a currency union. Iceland all but went bankrupt last October. Latvia is in an ominously similar state now. And it poses a particular dilemma for the member states of the European Union.
Should they help to bail out Latvia and thereby implicitly guarantee the debts of other nations? There would be huge costs to inaction. The collateral damage to the regional economy and banking system would be immense. But aid must not be a precursor to greater fiscal federalism. And in the interests of European taxpayers, it must be tied to better domestic policy by Latvia.
There are constitutional as well as economic implications of a bailout for the Baltics. The EU comprises independent sovereign states. The members states of the eurozone have pooled sovereignty in one area alone, monetary policy, while maintaining national control of public finances. There is an unresolved tension in that arrangement. Stabilising a financial crisis in Europe is urgent. But there are three crucial issues that must be addressed now: how to reach agreement among EU governments; how to pressure Latvia to make domestic reforms; and how to secure the agreement of voters to such a proposal. Germany is a crucial actor, having long opposed the notion of budgetary transfers to countries with weaker fiscal positions.
The essential problem of the Latvian economy is the story of the whole financial crisis: too much debt. Latvia and other Central European economies enjoyed strong growth in the boom years. Underlying it was a huge volume of lending from Western banks. This credit expansion fuelled domestic demand and a bubble in property prices. Inflation rose sharply. The current account deficit widened dramatically.
Latvia now faces a punishing economic adjustment. Its Government undertook this week to cut public spending by 10 per cent in a colossal recession (the economy is expected to contract by 18 per cent this year). Last December, Latvia received a €7.5 billion loan from the International Monetary Fund and the EU. It now urgently seeks to cut spending to qualify for a further tranche of the loan. The consequence of failure would probably be a default comparable to Iceland's. The contagion would spread to the other Baltic states and to those banks (notably in Sweden) that have lent heavily.
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In the advanced industrial economies, the crisis has been contained by aggressive monetary and fiscal easing and recapitalisation of the banks. A collapse of Central European economies might spark contagion across the continent's financial system once more. That is why stabilising the crisis is crucial to Europe's businesses and consumers. And action needs to be taken urgently precisely to forestall the introduction of a huge federal European system of cross-subsidy of profligate governments.
The pain for Latvia's economy will be excruciating. Policymakers and Western banks should acknowledge the necessity of devaluation of the Latvian currency, which is currently pegged to the euro. Otherwise it will be the European exchange- rate crisis of 1992 all over again, without the subsequent economic recovery, and with an alarming growth in centralised power in Europe.