Wrong, wrong and wrong again – a response to “Latvia: let the lat go”

July 31, 2009

morten-hansen1– Morten Hansen is a guest columnist, the views expressed are his own. He is head of the economics department at the Stockholm School of Economics in Riga –

The debate for or against a Latvian fixed exchange rate rages on. There are good pieces of analyses on both sides of the debate, there are less good ones, there are mediocre ones – and then there is Jonathan Ford’s “Latvia: let the lat go” from 29 July.

The article does not argue why the lat should be devalued –- fair enough, the arguments have been heard before. Neither does it mention all the potential risks of devaluation such as a currency collapse but I can live with that, too. But an 804-word article that contains no less than 10 – 10! – inaccuracies or outright wrong statements is highly objectionable.

For those who have read Mr. Ford’s article allow me to make comments on these 10 points.

“The central bank has been obliged to raise interest rates” –- no it lowered its refinancing rate from six percent to five percent on 24 March 2009 and to four percent on 24 May. And lat rates are not that important anyway for Latvians as most loans are in euro.

“… a host of non-Latvians … have urged the small Baltic state to cleave to its currency board system”. Latvia operates a fixed exchange rate system that allows the lat to fluctuate at +/- one percent around a parity of 0.702804 LVL/EUR; it is not a currency board. More importantly a host of non-Latvians have recommended devaluation (Nouriel Roubini and Kenneth Rogoff among others), arguing that maintaining the peg is a foreign plot is just plain wrong –- it is actually the Latvian authorities that have demanded this.

“…which pegs the lat at the wildly uncompetitive rate of 0.702804 to the euro”. Proof? I believe myself that the lat is overvalued but I haven’t seen any analysis pointing at it being “wildly uncompetitive”.

“Far from cutting spending and raising taxes, Western countries have done the opposite”. True –- and Latvia would have preferred that but due to an unsustainably procyclical fiscal policy in the boom days it is not possible as the ensuing budget deficits could not be financed as it cannot borrow in international financial markets.

Latvia can only maintain a budget deficit via the loans from the International Monetary Fund (IMF) and the European Union (EU); without those it would have to run a balanced budget which would be even more contractionary for the economy.

Mr. Ford argues, based on analysis from the 1930s that “those which clung on [to their pegs] became highly protectionist”. In the days of the EU and World Trade Organisation that analysis is hardly an indicator worth anything.

“As the de facto lender of last resort [the Germans], they had no desire to admit any more members to the currency bloc”. The lender of last resort is of course the European Central Bank and while Germany may or may not want more eurozone members, it is the Maastricht criteria and their interpretation that determines entry –- witness Slovakia that entered just half a year ago.

“This might set off contagion, with competitive devaluations across Central Europe” -– yep, and if everybody (or at least many) devalues, the impact on competitiveness will be minimal in the end and thus hardly worthwhile in the first place.

“…drafted protocols that automatically committed all the joiners to euro membership” – but the Latvians are not unhappy about this; on the contrary they crave eurozone membership!

“They know [the internal devaluation] it’s hurting, but it isn’t working” –- well, come and see for yourself! Wage decreases are the norm here!

OK, one is allowed to be against the euro or to believe that the IMF/EU package for Latvia is a sinister Brussels-led cabal –- but for Mr. Ford’s article to obtain at least a small degree of credibility it would be nice if it at least got the facts right.

One comment

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I am very happy to be criticised, but Morten Hansen seems to have forgotten (or changed) his own critical view of Latvia’s currency peg. He is quite right to pull me up for using the term “currency board”. As he correctly states Latvia operates a peg system with fluctuation bands around a central rate.

His point about the interest rates is also valid although it is worth pointing out that refi rates had been kept high for several years precisely because, as he has himself observed many times in articles and academic papers, Latvian inflation had made the currency uncompetitive (we can argue about the degree, I guess).

However, I take exception to his suggestion that I am alleging that some sort of “foreign plot” is in operation. Many concerned foreigners have of course urged devaluation on the Latvian government, including Roubini and Rogoff. No, my point was that Latvia is caught in a sort of institutional trap – thanks to the Maastricht criteria, some foolish lending by foreign banks hooked on the idea of convergence, and the conditionality of the assistance Brussels has offered.

Of course the Latvians say they will hold the peg – how could they do other? Once you commit to these things, you are on the hook.

But one is left pondering whether the remedy is the right one. If the public sector is too big, or Latvians have taken out mortgages in foreign currencies, why should the whole of society be made to pay for this?

Hansen now seems to argue that Latvians should take the pain and hold to the peg. Yet this was not always his view. In his June 2007 paper, “Inflation in Latvia, causes, prospects and consequences” http://www.biceps.org/files/Inflation%20 report%20II%20BICEPS%20web%20page%20vers ion%206%20June.pdf he explained the trade-off between internal and external devaluation in the following terms:

“The [Latvian] government plan attempts to solve internal disequilibrium (inflation) and external disequilibrium (the current account deficit) with essentially one instrument, namely fiscal policy. As demonstrated this may restore competitiveness and thus external balance but is likely to require a long and costly process of deflation as has been done by e.g. Germany over a six year period, the price being substantial unemployment. Germany being in the eurozone no longer had the option of using the exchange rate instrument whereas Latvia still does.

Latvia may eventually find itself in a situation where the pain of a long and costly period of deflation may be weighed against the cost of altering the peg to strengthen competitiveness – and where the latter may be the rational and less painful choice.”

Curious – that sounds pretty close to the Rogoff/Roubini assessment. So what’s caused Hansen to change his view? Is it really because he thinks an internal devaluation has more chance of working in a global recession, or simply because he fears the consequences now if the country changes course?

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