Latvia: let the lat go

July 29, 2009

Do as you would be done by. This excellent rule surely applies as much in monetary affairs as it does in other fields of human endeavour. Those who loudly urge Latvia not to devalue its currency should reflect upon it.

Since Latvia’s monetary crisis started in 2007, a host of non-Latvians — led by the European Commission — have urged the small Baltic state to cleave to its currency board system, which pegs the lat at the wildly uncompetitive rate of 0.702804 to the euro. Regardless of the cost in terms of spending cuts, higher taxes and lower wages, this is supposedly all for the Latvians’ own good.

This is simply wrong.

When a country loses competitiveness against its principal trading partners, there are only two ways to regain it; devaluation or “internal devaluation”. This newspeak-like formulation is a euphemism for severe wage cuts and prolonged recession. After all, it is only by cutting real wages (or through increasing productivity) that the country can “grow back into” its unaltered exchange rate.

Latvia has listened to the advice of Brussels and pursued the latter course with dogged determination. The central bank has been obliged to raise interest rates, extinguishing what few animal spirits remain in the country during a severe economic downturn. Meanwhile, the government has slashed expenditure and raised taxes.

The result is a frighteningly deep recession. Latvia’s GDP is expected to decline by a thumping 18 percent this year, and a further 4 percent in 2010.

Oh well, there’s no pain without gain, one might say. But if this is really the path of virtue, then surely the Western nations should be administering similar medicine to their own sick economies?

Not a chance. Across the Oder-Niesse line, it’s a wholly different world. Far from cutting spending and raising taxes, Western countries have done the opposite. Some have even committed the high crime of devaluation. Both the US and Britain have seen (and welcomed) falls in the external value of their currencies.

This isn’t just the West being decadent. History tells us that internal devaluations do not work — at least in the case of democracies. In the 1930s, the idea was tested to destruction as one country after another lost the battle to stay on the gold standard. As the economist Barry Eichengreen has observed, the big difference between the early and late abandoners was that the former remained relatively open to external trade while those which clung on became highly protectionist.

The real reason we are urging masochism on the poor Latvians is to do with low European politics.

Having signed up for the euro when they joined the Union in 2004, the Latvians, were “half in” when the crisis struck. Foreigners had lent in euros, thinking they were getting an above average yield on what would soon be a euro-denominated obligation. This assumption was exploded by the crisis. Credit, previously freely available, evaporated.

At the same time the Germans became alarmed by the volatility of peripheral euro zone members such as Ireland and Spain, which had gone from credit-fuelled booms to bust. As the de facto lender of last resort to the zone, they had no desire to admit any more members to the currency bloc. The result? Latvia and the other Central Europeans were left with huge foreign debts, no further access to credit, and vulnerable currencies that were suddenly “out” and not “in”.

Devaluation is not a pain-free option. Many Latvians who have borrowed in euros would be bankrupted (although as things stand all Latvians are paying for their foolishness). Inflation may rise (although experience of depressed economies devaluing suggest the effect would be modest) and its neighbours would find their own precarious financial positions made worse.

This might set off contagion, with competitive devaluations across Central Europe, but that is hardly Latvia’s problem. Those who framed the treaties that Central European states signed in the last EU accession wave should have thought more carefully before they drafted protocols that automatically committed all the joiners to euro membership. Brussels should be thinking hard about how to deal with the devaluations when they come.

So far, the Latvians are gritting their teeth, clinging to the peg and going for the internal devaluation burn. Or at least the government is, having backed itself into a corner by agreeing to the onerous terms of financial assistance from Brussels and the IMF. The Latvian people take a different view. A survey by DnB reports that 55 percent of them are very dissatisfied, with a further 32 percent more dissatisfied than satisfied. If the remaining 13 percent were too confused to have a view, that would be understandable. They know it’s hurting, but it isn’t working.

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