Here’s Why Latvia’s Decision to Join the Euro Makes Sense

Last week’s convergence report from the European Commission gave Latvia the green light to become the eighteenth member of the euro zone as of next January. “The euro zone is again a club with a queue — not at the exit but at the entrance,” crowed Herman Van Rompuy, president of the European Council. “Joining the euro zone will foster Latvia’s economic growth, for sure,” Latvian Prime Minister Valdis Dombrovskis said in Riga. Yet Latvians on the street are less certain. Public opinion polls show that only about 35 percent of respondents favor the switch, and opposition parties that oppose the euro have done well in recent local elections.

Who is right? Is it really a good idea for Latvia to sign on for membership in Europe’s troubled currency union? Let’s look at some of the factors that would make the answer “yes” or “no.”

Criteria for an optimal currency area

We can begin by setting Latvia and the euro to one side to look at the broader question of which countries or regions might benefit from common currencies. Imagine that we sit down with a blank outline map of the world and try to fill it in so that countries and regions that are better off sharing currencies are assigned the same color. We ask questions like these: Should Maryland and Virginia both use the dollar? If yes, color them both green. Should Russia and Ukraine both use the ruble? If yes, color them both red, and so on. When our map is finished, the regions with the same color—whether they are sovereign nations, groups of nations, or regions that overlap national borders — are what economists call optimal currency areas.

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The theory of optimal currency areas can be traced back to a 1961 paper of that name by Robert Mundell.  Mundell emphasized that making the case for a common currency is a matter of balancing advantages against disadvantages. Economically, the advantages are reductions in the costs of trade — eliminating the need to buy and sell currencies, to hedge exchange rate risks with futures or swaps, and the like.

The economic disadvantages stem from the fact that a country with a shared currency cannot respond independently to external shocks by using monetary instruments like changes in interest rates or exchange rates. Mundell also recognized a role for political factors in the choice of currency arrangements. Interestingly, at that time, he saw the question of currency areas as purely academic, seeing it as “hardly within the realm of political feasibility that national currencies would ever be abandoned in favor of any other arrangement.”