OCR F585 - Global Economy - Latvia’s Internal Devaluation

Much has been made of Latvia's internal devaluation, so much so that it has featured in OCR's Global Economy pre release. Most commentators have reacted negatively to the effect of Latvia's internal devaluation; here's why:

Many would say looking at figures and charts that Latvia's internal devaluation has been a marked success. Latvia, a country scarred by a desperate banking crisis and deep recession had no choice but to rely on net exports to escape from the pits of a 24% fall in GDP as a result of economic crisis.

By aiming to reduce nominal wages and prices through deflationary tightening of fiscal policy (austerity), thus also fulfilling stricter IMF government finance conditions, the Latvian government embarked in a policy aimed at increasing the competitiveness of its exports (domestic goods) and hopefully, simultaneously easing the pressure to purchase imports as consumers switched to more competitive domestic goods.

From the outside, it looks like Latvia was successful, the current account deficit moved to surplus roughly during the period of internal devaluation, recovery soon followed with production up.

But is this really the whole story? And can internal devaluation really be credited for this so called 'recovery'? Many, myself included, argue not and here's why;

Advocates of internal devaluation argue using the counter factual, stating that if Latvia hadn't adopted this policy, the end position of Latvia's economy would have been much worse.

Soaring government, private and personal debt was crippling the economy, investors were quickly losing confidence in the country with arguments that regular devaluation with expansionary monetary policies would have simply made the situation worse. Well it is hard to argue the situation in Latvia could have been worse after internal devaluation;

1. Real incomes losses have been staggering post internal devaluation, difficult to imagine how any other policies could have done any worse! Coupled with this, there have been huge social and economic costs of the policy. Unemployment sky rocketed to 20.5%, income inequality increased significantly and emigration took off; all considerable factors contributing to the the shrinking of the Latvian economy. It is important to note that this was the intention of the policy to lower the real exchange rate by lowering wages but crucial is to note that internal devaluation deepened the crisis but had no real role in pulling Latvia out
2. Deflationary pressures increased the real burden of debt (of which there was plenty in Latvia!) The IMF raised this as a major concern yet remained adamant that Latvia maintain austerity measures. This pushed up real interest rates (reaching a peak real figure of 12.2% at the beginning of 2010) trapping the economy in a downward cycle.

So what changed and how did Latvia escape, bottoming out at a loss of 24% GDP?

Simply, fiscal tightening was abandoned in 2010 and monetary policy became expansionary as external shocks increased inflation in Latvia. Suddenly competitiveness and net export growth was no longer even a potential driver of growth.

Though going against the intentions of internal devaluation, this inflation now was crucial for Latvia as it reduced the real value of debt, pushed down real interest rates and fundamentally, as it was accompanied by expansionary monetary policy, confidence flowed back into the economy from investors and consumers.

Advocates may argue that the recovery was caused by export growth as a result of Latvia's REER (real effective exchange rate) falling by 21% from its peak in 2009 but actually this was matched by an equal rise in import expenditure cancelling out any net trade gains.

Crucially any improvements in Latvia's trade position occurred before any depreciation in Latvia's REER (before internal devaluation) so even the transformation of current account deficit to surplus cannot be attributed to internal devaluation.

The costs of internal devaluation have outweighed any dubious benefits of the policy; massive social and economics costs, emigration and the worst economic crisis to hit Latvia in the last 20-25 years.

It was a neutralisation of fiscal austerity in 2010 that brought about recovery and although the country is now stable, any hope for sustained growth relies heavily on productivity improvements, investment increases and a reduction of poisonous indebtedness in both the public and private sectors.

To read more about this view of Latvia's internal devaluation, where these claims can be back up with figures, please visit this link