Latvia: Apocalypse (not quite) now . . .

June 21, 2009

Morten Hansen

-Morten Hansen is head of the economics department at the Stockholm School of Economics in Riga. The opinions expressed are his own.-

Latvia, with its 18 percent year-on-year economic decline, ruthless budget cuts to meet the demands stated by the IMF-EU bailout package and recurring rumours of devaluation, may be the most written about country in the world right now, at least on a per capita basis.

Yet life goes on here and journalists I speak to seem somewhat disappointed when I cannot confirm sighting starvation or death in the streets…. Admittedly, it is very hard to be optimistic but it was clearly a positive sign when the parliament approved yet another round of budget cuts including across-the-board 20 percent wage cuts in the public sector and a 10 percent cut in pensions, which should release another tranche of much-needed money from the IMF and the EU. These cuts are tough but necessary as Latvian public finances were unsustainable – even in the years of growth rates of 9, 10, 11 percent the country still ran budget deficits.

Whatever the value of the currency, the public sector needs serious reform, which is why I am somewhat annoyed by the incessant rumours of devaluation emanating from in particular Sweden and the UK. The currency and the public sector are not linked to each other and should be treated as separate issues.

The Latvian central bank has repeatedly made it very clear that devaluation is not an option – and let me be the first to admit that such announcements have been made by numerous central banks on numerous occasions in the past, only to see devaluation nevertheless.

What foreign observers miss is the length to which the Latvian authorities will go to maintain the peg – very considerable pain in the form of high unemployment and declining GDP is acceptable here, rightly or wrongly, as the currency is viewed as an anchor of stability and euro adoption as the main monetary goal.

The spectre of an uncontrolled devaluation/currency collapse and of the collateral damage in the form of contagion effects are the main arguments against devaluation.

Competitiveness in the private sector is to be raised by “internal devaluation” in the form of declining wages – an “undoing of the past”, so to speak, where wages in some years rose as much as 35 percent year-on-year. Textbook-wise this works well, practical examples are, however, few and far between. Casual evidence does suggest, however, that this mechanism is working here (at 17 percent unemployment choosing between a wage cut and being laid off is easy and there are barely any trade unions to resist wage compression).

Will it work and will it work fast enough? This is still uncharted territory but I think it should be given a chance – but of course it is an uphill struggle and the mythical figure of Sisyphus might have found his task quite a bit easier.

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