The economic consequences of Mr Rimsevics

June 22, 2009

alf vanags– Alf Vanags is director of the Baltic International Centre for Economic Policy Studies. The opinions expressed are his own. –

On April 28, 1925 the then Chancellor of the Exchequer, Winston Churchill, put Britain back on the gold standard at the pre-World War I parity, a move that was strongly criticized by Maynard Keynes in his pamphlet “The Economic Consequences of Mr. Churchill”.

The lack of competitiveness that faced Britain as a result of Churchill’s action pales into insignificance when compared with Latvia’s today, where the Churchill role is taken by Bank of Latvia President Ilmars Rimsevics. The scale of the problem is illustrated in the following chart, which tracks real exchange rate developments using unit labour cost indices since EU accession in 2004.


Source: Eurostat

As can be seen Latvian competitiveness has declined by more than 75 percent as against countries such as Sweden or Germany and rather less against the EU 27 as a whole. The so-called internal devaluation will be a very painful and prolonged process. A major adjustment of the exchange rate would provide an overnight adjustment to competitiveness, would remove the ongoing uncertainty about the exchange rate and would provide a boost to demand for Latvian produced goods – both from exports and import substitution.

Will the 500 million LVL budget cuts passed by the parliament help? They do nothing to promote competitiveness and actually reduce domestic demand. Moreover, the measures are rushed and ill-thought out. The only motivation behind them was to do “enough” to ensure that the second tranche of international lending would be released so as to avoid government bankruptcy. The Central Bank president has even been talking of the need to introduce “taloni” (vouchers) if the budget cuts were not delivered.

It seems that the lenders will release the funds in early July, but will the measures really be implemented. The whole history of policy since the IMF was called in has been one of the Latvian government promising to act but doing nothing. A similar fate may lie in wait for the present round of measures. The problem lies in the deep flaws that are present in the Latvian political system.

All governments are uneasy coalitions of different business interest groups. When the going was good in the boom years the problem was how to share the “growth dividend” – not always easy, but much easier than agreeing on how to share the burden of the massive cuts now called for. I fear, that once the second tranche of international funding is delivered the ill-disguised antipathy between coalition members will surface and the government in will fall.

Perhaps this time, the lenders will have the will to persuade whatever government that follows to adopt what many outside Latvia now feel is an inevitable adjustment of the peg.

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Other commentators, too, have pointed to the economic necessity for a devaluation. The problem is, of course, the euro and the fact that it is a political not an economic project. Brussels would rather have Latvia (and Estonia and Lithuania) tear itself apart than sacrifice the onward march of the Euro.

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