January 8, 2014

By: G. Matiss Merkelis, Contributor

(Originally published January 1, 2014 at www.gmmerkelis.com)

Today the small Eastern European country of Latvia joins the Eurozone.

1 January 2014 marks the second time Latvia is losing its currency, the lats, to an outside entity.  The first happened back in 1940; then, the nation turned over its old lats to the Soviets and their ruble, at par.  Unwillingly.  Along with the rest of their sovereignty.  After the Cold War, in 1992, Latvia finally reinstated the lats, as the Russian tanks were moving out.

Today, it surrenders its money to the European euro, at a rate of 0.702804 lats to 1 euro.  The question of willingness this time is up for debate.

The following article intends to take a hard look at this and a variety of issues surrounding the euro.

(And yes, the lats was actually stronger than the euro, and US dollar, and British pound).

Please note that if at any time you need a break from the facts and figures, you can check out this catchy tune that was recently released about the lats and has been topping the local music charts.  The name of the song translates to “Thank you lats!”

You inferred right.  It’s actually an endearing ode to their nation’s replaced money.

A Mandate, Not a Choice

Today you will no doubt be privileged to many interviews with pensioners and cab drivers on BBC and Bloomberg debating the pros and cons of this news.  CNN will probably catch the central bank governor and country’s President delivering some cheery sentiments about this important milestone in the history of the small nation of 2 million.

This transition is, in many ways, the culmination of a slow progression of westernization for Latvia—all that is bad and all that is good—from independence and the breakup of the Soviet Union in 1991, through joining the EU and NATO in 2004, to acceding to the single currency bloc this day.

Expect little reporting, however, on the realities of the process.  One might start, for example, by asking the question—who took the decision to enter this thing called the Eurozone?

As late as March 2013, at precisely the moment when the Latvian parliament officially submitted its proposal to the European Central Bank (ECB) for Eurozone membership, a robust two-thirds of the country was against the currency.  This was the second-lowest approval rating ever by any country, one year out from the switch.  But that didn’t faze decision-makers like Olli Rehn, the monetary affairs commissioner of the EU.  “The Eurozone could have 18 members by 2014,” he said at the time.  “There are no criteria related to opinion surveys.  You can’t be disqualified because of opinion surveys and political criteria.”

So the people’s opinion doesn’t factor into the process.

Ironically, Mr. Rehn’s home country of Finland, continuously one of the most fiscally sound in the EU, took that top spot of lowest approval rating ever when his home country abandoned its currency, the markka, for the euro in 1999.

Or take Lithuania, Latvia’s neighbor to the south of 3.5 million, who will join the Eurozone one year from today.  Nothing official yet, but it will happen.  The EU needs the good press.  In fact, the Lithuanian bureaucrats have been working on their marketing for quite some time, as the proletariat there, too, has plenty of doubts.  Back in February 2013, Lithuanian Prime Minister Algirdas Butkevičius told the press, “Today a total of 52 percent [of the population] are in favor of adopting the euro in Lithuania.  However, we have a certain action plan which will involve several institutions that will be engaged not only in forming fiscal policy and in administrative issues but also will have to present the euro to society.”  Kudos to the Lithuanians.  Really going all Mad Men on the euro in an attempt to sell it to the public.

So it is.  One year from today, Lithuania will follow Latvia and abandon their currency, the litas.

If all goes to plan, the Poles, Czechs, Hungarians and other new EU members will follow suit in the years to come.

Behind the Marketing

If we were to sum up all the euro accession news today, in Latvia and beyond, all the analysis, the pros, the cons, the supporters, the doubters; we could say this: it just doesn’t mean a thing.  It was a foregone conclusion.  There is not, nor has there ever been, a real debate.

From the first German banker to salivate over a euro coin in 2002, to the last Estonian farmer who stumbled upon one in 2011 – the decision by each country to take on the euro was made not by the populace at large, but by the ever turning cogs of the growing, bloated, bureaucratic European system.

In an effort to illustrate how deep this history runs, a quote from Adam Lebor’s excellent history of the Bank for International Settlements—the central banks’ bank, may be in order.  The European Central Bank holds a seat at the BIS today.  In this excerpt from his book, Lebor analyzes BIS board member and technocrat (and also Nuremburg convicted Nazi official) Walther Funk’s convictions in 1940:

The Reichsmark would be the dominant currency, but the currency basis of postwar Europe was of secondary importance to economic leadership.  [Funk claimed,] ‘Given a healthy European economy and a sensible division of labor between the European economies, the currency problem will solve itself because it will then be merely a question of suitable monetary technique.’  Here Funk seems to anticipate the arguments of the euro enthusiasts who, fifty years later, claimed that a common currency, if properly constructed in the right economic conditions, could not fail.

Indeed, this philosophy of shared, common currency is nothing new.

If your aim is to address the democracy (for lack of a better word), or the freedom, or the choice, or the independence of any of the countries in Europe to chart their own path, it should first be stated loud and clear that there simply is no choice when it comes to the euro.

According to the Maastricht criteria on euro convergence, a critical part of any country’s quest to become a member of the European Union, since the 2004 enlargement of 10-countries (which Latvia counts among), is that it’s a requirement to join the Eurozone.  The timing is supposedly up to each member state and its decision-makers (and plenty of them down the line still doubt the currency), but it is a requirement nonetheless.  So we should set it straight, among the supposed “eagerness” or “dissent” of any new entrant to the euro: it is a mandate by those in Brussels and Frankfurt – for any new member of the European Union – to join the Eurozone.  It’s not even a George Carlin false choice.  There is no choice.

Of course, like any good self-contradicting governance, there are special exceptions to this rule.  The UK, Sweden and Denmark all have exemptions in which they are not obliged to join the currency bloc.  More on them in my next post.

Maastricht criteria: Who Actually Follows it?

Not very long ago, on 18 November, Latvia celebrated its 95th anniversary of independence.  “Anniversary” is a touchy term here, because it was interrupted for 50 years during WWII and the Cold War, when the Nazis and Soviets, respectively, occupied the place.

Though not a tremendously religious man, I found myself heartened by the sermon of Riga’s archbishop that day.  His message was paraphrased in the media as follows:

Until now the national targets have been to join the European Union, NATO, and the introduction of the euro.  It’s important now that the nation’s new plan be in the name not of Maastricht, but of Latvia; not of criteria and rates, but of the people; and not in the name of a currency, but of individuals.

Wise words.

In such a terribly, painfully and obviously mismanaged world, this kind of thinking makes good sense.  Yes, some might call it nationalistic.  There certainly is a vein of that which runs deep here.  Deportations to Siberia can have that effect.  But there is a lesson in this political skepticism for the Western world.  It has always been quite easy for Eastern Europeans to see the inequitable proclamations emanating from their leaders’ mouths.  Whether it’s Moscow’s apparatchiks past or Brussels’s bureaucrats present, Eastern Europeans have a healthy understanding that their overlord’s decrees from on high are rarely grounded in reality.

It is my hope that this skepticism will continue to grow in the West.  Is it not more important to focus on one’s local market… on one’s circle of friends… on one’s family?

With that in mind, let’s get on to Maastricht.

Signed in said city back in 1992 (the banquet dinner must have been a grand affair), the treaty was the basis for today’s installment of the European Union.  Among many laws and regulations which no one in Europe actually reads, it addressed a common currency, the euro, outlining five so-called “convergence criteria” for new entrants to the currency.  The spirit of each point is as follows:

1. Low consumer price inflation rate
2. Low government annual deficit to gross domestic product (GDP)
3. Low government debt to GDP
4. Stable exchange rate relative to the euro
5. Low long-term interest rates

Now it is fair to say that each point is a logical, healthy standard for any nation or economy to strive for.  And in fact, at one time, the ECB stringently enforced these metrics when reviewing new country applications for Eurozone entry.  See Lithuania’s failed bid in 2006, when they missed only the inflation benchmark, and only by zero point zero three percent.  Amazingly, and presumably out of principle, they were refused entry.

Of course, that was eight years ago, before people around the world began noticing their governments taking on much more agonizing judgments like closing lemonade stands and bake sales.  Oh yes, and there was a little hiccup in between you may have heard about called the Eurozone crisis.

In any event, as we well know, Latvia has hit all the benchmarks of Maastricht.  Ticker tape parade to follow.

Much more importantly, the Maastricht criteria are complimented for current, existing Eurozone members by something called the Stability and Growth Pact.  It’s also filled with a lot of nonsense and gets amended all the time by no one with a real job, but the key part of it is to ensure that existing members continue to follow the benchmarks of Maastricht, rather than becoming lax after entry.

So I would argue that this is the track record we need to look at: How have the existing members fared since the euro was introduced in 1999?

Yes, to ask the question is to already have answered it.  But please, indulge me…

Eurozone Rule No. 1: Low consumer price inflation

There is much to say about inflation inside the Eurozone.  We’re talking here of course not about the correct definition of inflation, which is an increase in the stock, or supply of money (most strict definition), but of an increase in consumer prices (less strict definition), which is measured by the government (therefore, terrible indicator).

Consumer price inflation is perhaps the most easily manipulated metric ever, demonstrated by the fact that it’s governments who are doing the measuring… of an unlimited combination of goods and services.  Many have written about this.  The methodology on food and energy alone should give anyone using their eyes pause for concern when they see a government report on the number today.

Nonetheless, the Maastricht benchmark on inflation essentially states that a member’s consumer price index cannot be higher than the arithmetic average of the 3-lowest inflation rate countries in the Eurozone, plus 1.50%.  So the benchmark is a moving target, and you have a buffer margin of 1.50% above the lowest three countries to still be considered in good standing.  Sounds exciting.  The actual results over the past 14 years?  They look like this:

On the whole one might say this table doesn’t look terrible.  If you believe the numbers.  And if you think two-thirds of the classroom passing is a good statistic.  Before even looking at freshman applicants.

The Eurozone average over the past 14 years was 2.1%.  Very close to the number central bankers throw around all the time to convince people they are doing their job and keeping prices in control, which according to them is about 2%.

Let’s drill down on what 2% means here.  To help understand how it could affect one’s wealth, we need the good rule of 72: divide 72 by a rate without the % sign, and you get the number of years a thing takes to double, roughly.  So, 72 / 2(%) = 36 years for prices to double at their target inflation rate.  But look at individual countries that may be quoting more realistic rates.  Spain, for example, averaged 2.8% using the euro, meaning prices are doubling every 25 years there.  Greece averaged 3.2% for its time in the eurozone, meaning a doubling of prices in less than 23 years.

Using the rule of 72 shows the power of compounding and how sensitive even 0.1% price inflation can be on price doubling.  And that’s still if you believe their publicized rates reflect realty.  Do you?

There is plenty of anecdotal evidence…

… which has suggested otherwise in the past.  Though introduced as an accounting currency in 1999, the first euro coins and banknotes started circulating in 2002.  According to people using their eyes in Germany, “vegetables increased…by 18.3%, dairy products by 8%, bread by 4%, and restaurants by 3.9%,” in the first five months of 2002.  “Other surveys have found that 80% of restaurants and bars have upped their prices by up to 30%.  In some cases, products and services such as television sets and car parking have doubled in price.”

Or take Estonia, Latvia’s neighbor to the north, which also happened to be the last country to join the eurozone, back on 1 January 2011.  The year before, in 2010, general food prices, per the government, increased three percent.  In 2011?  Five percent.  A large jump.  But food was even more drastic.  Food prices were also 3% in 2010 before euro accession.  But the year after they rose nearly 10%.

Apply the rule of 72 to that.

I can contend that Riga was always the most expensive city in the Baltics… until Estonia joined the euro.  Then its capital Tallinn became significantly more expensive than Riga for the casual tourist – from restaurants to bars to hotels.  It was incredible how it had inverted.  Having once enjoyed a travel break to Estonia for the goods it afforded, I have since 2011 been economically calmed to return to Riga after every business trip.

There is a town with a border running through it—called Valga on the Estonian side and Valka on the Latvian edge.  Colleagues have told me that even in these small towns, Latvians used to go to Estonia for their shopping; after the euro, that trend actually reversed and more Estonians came to Latvia.

The Estonian kroon was pegged to the euro at an official rate of 15.65 kroons to 1 euro before eurozone entry in 2010.  All retailers and wholesalers were supposed to use that rate when they made the switch to pricing goods in euros.  Many claim this wasn’t the case.  Even after 1 January, there was still a market for businesses changing kroons to euros, if at the supplier level.  Structurally, as time went on, the market simply rounded off to a more expensive rate.  “In less than a year or so, to the surprise of many, retailers and suppliers were changing kroons at a rate of 10 to 1 instead of 15 to 1.  If you measure it that way, that’s a de facto loss of purchasing power of 36% for the new euro versus the old kroon,” said chairman of Uus Maa Property Advisors Ardi Roosimaa, in an interview done specifically for this article.  “That was the tendency, even though the government tried to implement checks that businesses wouldn’t increase prices.”

This will happen in Latvia.  It’s already been happening.  For example, the government and central bank promoted an “honesty day” back on 1 October.  That day, all retailers were obliged to quote their prices in both lats and euros.  They must continue to do so until July of this year, less the public get confused from the mystical new currency.  Officials are also auditing against businesses’ rounding and raising prices, as all prices needed to convert at the official rate of 70 santims (Latvian cents) to 1 euro.

(And again, yes, the LVL was stronger than the EUR, USD and GBP).

But it’s so painfully clear, when government delivers such a mandate, and on such a date, what will happen.  On 30 September, 24 hours before “honesty day” took place, what do you think retailers did with their prices?

This may sound trivial, but let’s illustrate with pastries.  A banker friend of mine (that’s “banker” not “baker”) noticed during this time that his favorite bakery raised the price on his go-to cinnamon bun from 25 santims (approx. $0.50) to 28 santims.  Why?  Well, at the officially pegged rate, 25 santims would have converted to almost 36 euro cents.  The store obviously wouldn’t round down to a nice even 35 euro cents when pricing its pastry in the new currency.  So they did the completely rational thing on 30 September…they took the price to 28 santims, or 40 euro cents!

Trivial?  For some.

Representative of the bigger picture?  Very much so.

A price increase?  12 percent, in this example.  Whether we’re talking santims or hundreds of lats, out of malevolence or necessity, such rounding on the euro conversion has already occurred and will likely continue to occur, as it did in Estonia.

Board member Salvis Lapiņš of Latvia’s second-largest drug manufacturer, Olainfarm, went on the record last year, “Whatever the government says, there will be price rises…This will inevitably lead to salary pressures.”

So, no matter how the officials want to spin the transition, prices will rise under the euro.  And 8…, 10…, 12% price inflation looks a lot different using the rule of 72 than the 2% ECB target.

Many have pondered this smokescreen before when it comes to “inflation targeting.”  To me the central bankers are (badly) trying to convince us that they’re managing prices—especially in the eurozone.  The solution is quite simple, which would be 1) them getting out of the way, and 2) allowing the market/productivity to naturally create its own price tendency, which is deflation.

Eurozone Rule No. 2: Low government annual deficit to GDP

This table is less debatable as we’re talking real, unweighted numbers, at least on the deficit side.  Still, we tend to agree with successful people like Jim Rogers’s assessment on the merits of GDP.  Nonetheless, the eurozone countries set themselves a target for government deficits being no more than 3.0% of GDP.  Here’s the history of the boys and girls actually in the club:

Remember, this is the governments’ own report card.  This time, nearly half of the kids missed the mark.  Of all the possible scores that could be achieved by eurozone member countries in 14 years, 47% failed.  Portugal, Greece and Italy are the outstanding problem children in this scenario; however, even Germany and France have missed their own benchmark 50% of the time.

As an aside about the ongoing financial crisis, readers no doubt are familiar with the loathing, howling and downright disdain for “austerity” all over Europe.  Remember the shrieks about it in 2009, 2010, 2011, 2012, and 2013?  Notice how they will reluctantly continue the austerity madness into 2014… and even 2015 god forbid??

Does one really need to look any further than the red splashed across the right side of the above table—during those same years—to see how utterly false this nonsense is??  If austerity means drastically and painfully cutting spending, “enforced or extreme economy,” as has so often been argued by the mainstream in both Europe and US, how can anyone possibly argue that this has actually taken place?  Can one honestly portend that the screws were put on these governments to get their fiscal houses in order (as many, unlike Paul Krugman, would support)?  It seems clear to me and those of like mind that euro

zone governments continue to run nothing but larger Keynesian deficits.  Where was the pain in shrinking them?  Where were the hard spending cuts, unlike, as a matter of fact, what Latvia actually did?

I don’t see any.

Finland, Luxembourg and Estonia were the only eurozone countries to actually average a surplus during their time in the eurozone.  These countries are also the ones bailing out the reckless kids.  Hopefully, Latvia can stay close to the model students, and avoid too much trouble; or worse, falling into an abysmal, drug addicted spiral of stimulus and bailouts.

Eurozone Rule No. 3: Low total debt to GDP

The underbelly of this barren, bankrupt public school (with enough deferred maintenance the kindergartners’ grandchildren can’t pay for it!) seems to be emblematic of the real question: government debt.  Let’s understand what debt is in its literal sense: it is all of those deficits from prior years, stacked upon each other to form the government’s latest “stock” of liabilities—the total stuff it owes to its creditors at any point in time.  So if the deficits weren’t looking good, we shouldn’t expect the debt to look much better.

But as all econspeak goes, as long as it’s at “manageable” levels, surely we’ll be OK…  So, what is manageable?

Look no further than the benchmark the state set for itself.  60% debt to the member government’s annual GDP to be in good standing.  Here are all the euro classmates again, one by one, over the eurozone’s existence:

Hard to wonder how one could possibly misunderstand this table.  Kudos to Austria, Belgium, Greece and Italy.  They could not follow their own borrowing benchmarks—the same that new members like Latvia must meet—for their entire tenure in the eurozone club.

57 percent of the time for the whole lot.  Nearly 3 in 5 kids in school don’t pass…ever.  I will say it once more and put it in italics, this is for the entire history of the eurozone, not just the past few years.  Austria, Belgium, France and Germany… Greece, Italy and Portugal.  North and South.  Pre-crisis and post.  We’re literally all across the map.

We should be excited about this… why?

Let’s recap.

So far we have established that the political process to join the eurozone is not democratic, but set from somewhere on high.  In fact, the unilateral, state decision by technocrats to force a fictional currency on the very people with real jobs who pay those technocrats’ salaries has been contemplated for a long time.  Brussels and Frankfurt have made much headway in this effort over the past 15 years.  And of the 17 countries that are already in the eurozone (in the midst of something you may have heard about called the “eurozone crisis”), approximately half of the members don’t follow the first three rules that they themselves set for new entrants.  All in direct violation of the Stability and Growth Pact.  From 1999 through 2012, out of 564 possible results of the first three Maastricht criteria discussed above, 46% of the eurozone members violated their own rules.

And today Latvia joins the fold.

Happy New Year.