Mark Weisbrot
The Guardian Unlimited, January 15, 2010

See article on original website

RIGA, LATVIA – The signs of recession are more noticeable to those who live here – restaurants and coffee shops have lost most of their customers, and construction has practically ground to a halt. Emigration has soared.

Latvia has set a world-historical record by losing more than 24 percent of its economy in just two years. The International Monetary Fund (IMF) projects that 2010 will be another bad year, with GDP shrinking by another 4 percent. The Fund forecasts a fall of 30 percent from peak to bottom, which would surpass the U.S. decline during the 1929-1933 downturn of the Great Depression.

Yet Uldis Rutkaste, an economist who is Deputy Head of the Monetary Policy Department and advisor to the Governor of the Latvia’s Central Bank, told a public audience of several hundred people here on Wednesday that the government would continue with its “pro-cyclical fiscal policy.” The word “pro-cyclical,” which he used, refers to a policy that would be expected to reinforce the downward trend of the economy. This would continue, he said, until wages had fallen further.

It is difficult to imagine a government official in the United States, Western Europe, or indeed most countries of the world making an argument like this in public. But these are “true believers,” and they will stay the course so long as their citizens are willing to accept the punishment.

What is the reasoning behind dong the opposite of what most governments in the world are doing – i.e. stimulating their economies with counter-cyclical policies in order to speed recovery from the global recession? And in a country that has suffered the steepest recession in the world?

The logic goes like this: Latvia has a fixed exchange rate, with the currency pegged to the Euro, and the government does not want this to change. If this nominal rate of exchange stays fixed (at one Euro for 0.7 Lats), then the only way to lower the value of the currency internationally is to do so in “real terms.” This means pushing wages and prices down. In other words, Latvian production can become more internationally competitive by lowering prices and wages internally, while keeping the currency’s international exchange rate fixed.

While this is theoretically possible, it is extremely difficult in practice – and even if it were to “succeed,” the disease is cured by killing the patient. Unemployment in Latvia has passed 22 percent, and despite the world record decline in GDP, the real exchange rate, as noted recently by the IMF, has barely moved.

An overvalued exchange rate hurts a country’s exports by making them more expensive and encourages imports by making them artificially cheap.

But in this case, the direct effect of the overvalued exchange rate on trade is the lesser part of the problem. The bigger problem is that the government’s commitment to the peg makes it extremely difficult or impossible to adopt the policies that would get the economy out of recession. This includes fiscal policy, as noted above: as part of its agreement for a loan from the IMF, the government has agreed to budget cuts and tax hikes amounting to 6.5 percent of GDP in 2010. As the Fund acknowledges, this will further weaken the economy in 2010.

Then there is monetary policy – in the United States the Fed has cut short-term interest rates to zero and expanded money creation in response to the recession. The Latvian central bank is restricted in using expansionary monetary policy because of fears that this could undermine confidence in the peg. This leaves the Latvian government in the unfortunate situation that the three major economic policy tools available to counteract a recession: fiscal, monetary, and exchange rate policy – are either heavily restricted or working against them (pro-cyclical).

Maintaining the fixed, overvalued exchange rate also creates enormous uncertainty that undermines investment and causes capital flight. The IMF projects that an additional 1.5 billion Euros will leave the country this year. Investors and depositors in this situation are worried that the currency will be devalued, no matter what the government’s stated commitment.

The government has argued that Latvia has no choice but to maintain the peg. The alternative would be worse, they say: a devaluation would send inflation through the roof (because import prices would rise). And since an estimated 85 percent of the country’s domestic borrowing is in Euros, an even bigger fear is that a devaluation would cause a wave of defaults and bankruptcies.

The fear of runaway inflation is exaggerated; inflation in Latvia is negative and falling right now. Thanks to the depression, imports have collapsed to 31 percent of GDP, from 52 percent in 2007 – this reduces the inflationary impact of a devaluation. But most importantly, the greater threat to economic recovery is actually deflation – which, as the IMF has also noted, increases the burden of the country’s spiraling public debt. A devaluation would help resolve those problems.

But the problem of loans denominated in foreign currency is a serious one, and would have to be addressed. This could be done by allowing homeowners, for example, to pay back their loans in lats at the current exchange rate – with the government picking up some of the losses. There are ways to make sure that the majority of people do not bear most of the burden of the adjustment, and the government would have to come up with a plan to do this.

It makes no sense to continue to shrink the Latvian economy, with no end in sight to the recession, simply to maintain the pegged exchange rate. Argentina tried this from 1998-2002, also suffering its worst recession ever and pushing 42 percent of its households into poverty. After the devaluation, the economy contracted for just one more quarter and then began a remarkable recovery, growing more than 60 percent in the ensuing six years.

By contrast, the IMF projections for Latvia – under assumptions that are looking increasingly over-optimistic – show the economy in 2014 still smaller than it was in 2006. And to make things even worse, these projections show a public debt of 90 percent of GDP in 2014 – far beyond the 60 percent limit required by the EU for the country to adopt the Euro. This has been one of the main goals, and justifications, for maintaining the peg and putting the country through hell – but this exit strategy looks increasingly unlikely.

The IMF has long had a double standard when it comes to macroeconomic policy: for the rich countries it is generally Keynesian, advocating the kinds of counter-cyclical fiscal and monetary policies that the United States has adopted during the current recession. Yet for the low-and-middle income countries it has often pushed the opposite policies.

But to be fair, the IMF does not appear to be the driving force behind these decisions – rather it is the European governments, who are putting up most of the loan money for Latvia. In this case the Fund is going along with the EU, even though it appears that its economists can see that these policies are wrong. Of course the Latvian government has also been a strong advocate of keeping the peg; but there is a limit to the punishment that Latvians will accept; and of course the EU will not loan money for policies that it finds objectionable. So EU governments are playing a pivotal role here.

These governments have an enormous conflict of interest in this case. Their banks, including those of Austria, Sweden, Belgium, the Netherlands, and France – have hundreds of billions of dollars of Euro-denominated loans to Central and Eastern Europe. A devaluation in Latvia could trigger the same result in Lithuania, Estonia, and Bulgaria, and increase defaults on the bad loans that these banks made during bubble years throughout the region. It is most likely for this reason that Europe increased its contribution to the IMF by $175 billion last year, with $108 billion also coming from the US congress and $100 billion from Japan. While they are squeezing Latvia dry right now, and the IMF is pressuring other countries to cut spending, they will have hundreds of billions of taxpayer dollars on hand to bail out European banks if the need arises.

This part of the story is familiar even to Americans who have watched as our largest financial institutions have received top priority from the government – and indeed are doing quite well right now – while millions lose their homes and their jobs. But Latvia is an extreme case, partly because the macro-economic policy is so far to the right, and 19th-century-brutal. The World Bank has complained about the pension cuts that disproportionately hurt the poor, and the long-term damage to the educational system from mandated budget cuts in that area.

There really is no excuse for this to continue.

Mark Weisbrot is co-director of the Center for Economic and Policy Research, in Washington, D.C. He received his Ph.D. in economics from the University of Michigan. He is co-author, with Dean Baker, of Social Security: The Phony Crisis (University of Chicago Press, 2000), and has written numerous research papers on economic policy. He is also president of Just Foreign Policy.

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