Welcome to the Eurozone, Lithuania!

With the beginning of 2015 Lithuania, as the last of the three Baltic states, will adopt the euro. A first attempt to join the single currency in 2007 failed because the inflation rate was above Maastricht requirements. Seven years later, Lithuania is considered to be ready to be a part of the eurozone. But what are the prospects of the small country of only 3 million inhabitants in a currency area which, according to theory, is far from being optimal?

Lithuanian flag on top of Gedimina’s tower

It’s now a good time to look at the data. Estonia already adopted the euro in 2011, Latvia in 2014. It’s very likely that Lithuania will make similar experiences with the euro as those two economies which are structurally very similar.

To have another benchmark, putting Lithuania’s economic development into perspective, I will look at data from Belarus, Lithuania’s south-eastern neighbor. The Baltic states as well as Belarus were both part of the Soviet Union until 1991*. Since then, however, Minsk took a quite different route and remained much more oriented towards Moscow, economically as well as politically.

The financial crisis hit the Baltic economies hard, with unemployment rates rising far over 16% in all three states (see Figure 1), proving how fragile the fast growth of the “Baltic Tigers” actually was. Since 2011, however, the region is slowly recovering and approaching pre-crisis levels of unemployment and growth. In 1991, the Baltic states and Belarus started from roughly the same level of GDP per capita (see Figure 2). Since then, output per capita has almost doubled in the Baltics compared to Belarus. Even the severe economic crisis could not stop this trend.

In the course of the changeover, Lithuanians are probably most afraid of inflation. This is not very surprising if your nominal salary gets divided by 3.45. Fortunately, official inflation rates do not provide much evidence to support this fear (see Figure 3). Estonia, after 2011, showed only moderate increases in consumer prices. The inflation rate was above the ECB target of 2%, but this was coupled with high growth rates.

Since many months, all major shops in Lithuania relabeled prices from litas to euro and launched an advertising campaign assuring that prices will remain stable. This might help to gain trust in the new currency. But people will remain very sensitive to price movements, especially in every-day goods. This is a phenomenon which we know from Germany, where perceived inflation in 2002, when Germany adopted the euro, was out of sync with official accounts. A currency change suddenly brings the topic of inflation on people’s agenda, which otherwise might go unnoticed to a large extent.

However, it is highly unlikely that Lithuania needs to be afraid of inflation rates such as we see in Belarus since some years. The problems of the Belarussian ruble are very particular and not comparable to the situation in the Baltics. In these times, a close connection to the Russian economy might not be the best strategy to stabilize a currency.

A recent IMF working paper (Ebeke and Everaert, 2014), published this year, analyzes the labor market in the Baltics and its recovery in times of the Great Recession. The paper attests a dynamic labor market but with a high component of structural unemployment. This might pose one of the major challenges for the Baltic societies as a non-negligible part of the population does not seem to possess the necessary skills to compete in an international market.

There is a well-educated, young population which is the main asset of the Baltic economies. But these young people are inclined to leave the countryside in favor of the urban centers as well as leaving the country to work or study abroad. As a result, this emigration worsens the situation in the rural areas of which Lithuania has plenty. This problem can also be observed in other European economies, but it is particularly severe in transition economies. Germany’s eastern parts, for example, experience pretty much the same problems.

As the IMF paper suggests, countries at the periphery of Europe, which face a problem of labor emigration, “may need to exceed educational outcomes in other countries in order to attract FDI and other investments”. This is related to overall expenditures on research and development (R&D, see Figure 4). The Baltics must be willing to invest a substantial part of their GDP to achieve a transition to a knowledge-based economy and to exploit the potential of their well-educated youth.

Innovative technologies and entrepreneurship will play a crucial role for the future development of the Baltic economies. Their cost of labor is already today too high to compete with other countries to be Europe’s “workbench”. Estonia seems to have recognized the signs of the times. It was able to boost the R&D expenditures as a fraction of GDP to over 2%. A ratio of 3% is the ambitious target of the Europe 2020 strategy, which most of the European economies still miss. Recent success stories such as the development of Skype in Estonia sets the example. Internet-based business is currently a promising sector in the Baltics. But other innovative technologies, such as biotech in Lithuania, are gaining ground.

Since the breakdown of the Soviet Union and the Singing Revolution, the Baltics have come a long way both economically but even more politically. In stark contrast to Belarus its societies were able to establish functioning democracies and a rule of law. Estonia, Latvia, and Lithuania place well in various dimensions of the Worldwide Governance Indicator (see Figure 5). This shift towards inclusive institutions is the necessary basis for success within the eurozone. Together with the general dynamism of the new EU member states in Northeastern and Central Europe, the adoption of the euro, despite its challenges, will prove to be a natural step towards the future development of Lithuania.

* Lithuania declared its independence already in 1990.

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