Is It Hot In Latvia In August?

Well the big news this morning is that the IMF mission to Latvia has finally reached agreement with the Latvian government on a new policy package that will give the country access to about $278 million in new financing. Details of the deal are scant at the moment, since the Letter of Intent will not be published until the IMF board approves the agreement, but it seems the terms of the IMF deal are (on the face of it) tough: additional budget cuts worth a reported 500 million lats ($1.02 billion) for 2010, a progressive income tax with the possibility of an increase in VAT if the cuts do not reduce the budget deficit to the stipulated level.

Really, this agreement changes very little in my opinion. As Capital Economics’ Neil Shearing points out, many people are assuming that with the rapid Current Account adjustment in many CEE countries, the threat to external financial stability has largely gone away. But as Neil argues, while theoretically, it should be enough for the countries just to move back to balance, practical experience from Argentina etc suggests that as recovery arrives the CA tends to move from large deficit to large surplus. And this of course means exports growing at a much faster rate than imports. This is the only practical way to pay down the debt.

And as Afoe’s own Claus Vistesen puts it:

This is all about the composition of the external balance and what kind of extensions foreign creditors give. Now, the benefit of the peg is of course that you can begin to accumulate foreign assets at reasonable valuation to your liabilities. HOWEVER, the only way to reasonably begin this process is of course to actually begin accumulating those assets and in order to so so, you need productive investment targeted at foreign operations and this is very difficult unless the “internal devaluation” has run its course. Essentially, domestic investment to serve foreign markets are not productive until deflation has taken its toll.

So basically the message is, whatever the final details of the new agreement, stay tuned and keep watching, since all of this is far from over.

Edward Will Not Be Going To Latvia In August

The little news of the day is that I will not be attending the conference on Latvia’s economic future which members of the Peoples Party are trying to organise for August, even though I was invited. As the Latvia Daily Diena (Latvian only I’m afraid) which reports on the preparations for the conference puts it “E. Hugh, who declared himself a defender of the lat devaluation, however, declined to participate, adding he’d like to maintain political neutrality.” Well, this is fair enough as a presentation of my opinion, but, just for the record, here’s what I actually did say.

First of all I would like to say thank you very much for thinking of me and inviting me to your conference….

….while I think a decision to accept the original IMF proposal of a 15% devaluation of the Lat, and pressure the EU Commission into euro entry was the best option last autumn, this is now no longer the situation. So while I was advocating devaluation back then, what I am saying now is that in my opinion devaluation is inevitable at some point, but that it will now be an unholy mess. Serious contagion problems will most likely ensue, and so in this sense I am no longer “advocating” Latvian devaluation. Ideally it needs to take place as part of a much more general solution to problems in the economies of the Eastern European countries who are members of the EU.

If Latvia is simply forced off the peg, then we should all watch out. I am in Spain, and I am expecting consequences here.

Thirdly, I am not in basic disagreement with the IMF, and would not wish to do anything which may make their work more difficult. Basically, from where I am sitting the issue is to put pressure on the EU institutional structure in an attempt to get them to recognise some of the basic ABCs of economics.

Lastly, I would emphasise that I am an economist, a mere technician of economic systems, and not a politician. I am explicitly non politicial, and am maintaining this stance both vigourously and adamantly.

Basically, as I said, I consider devaluation inevitable….. tomorrow, in August, after Christmas, in 2011, I don’t know when. I also know that the longer it is in coming, the more serious the consequences will be, due to the continuous degradation in the credibility of the associated institutions (IMF, ECB, EU Commission, EBRD etc). This is all now quite likely to eventually become (via the other Baltic states, Bulgaria, Hungary, Romania and even Ukraine and Serbia) a very serious problem, with potentially major global implications.

So there will be a before and after. After devaluation there will need to be a major rethink about where Latvia is going. Devaluation is not an end in itself, it is simply a means to an end, a begininning. We also need to think about how Latvia will earn its living, pay off its debts, and find its way in the world.

Long term structural, and strategic economic thinking are needed.

Here I think I do have a part to play. As you may well have noticed, my view is that the ongoing demographic deterioration of your country lies at the heart of your macro economic problems.

I think this deterioration needs to be addressed as soon as possible, and I see three large issue.

i) Productive capacity needs to be increased substantially. This means increasing the labour force, and this means (as outlined in the World Bank Report, From Red To Grey) facilitating large scale inward migration. Given the serious political implications of encouraging ethnic Russian migration into your country, I see only two viable source regions, the Central Asian Republics in the CIS, and Sub. Saharan Africa. Possibly this solution will not be widely popular with Latvian voters. Well, they do have the right to choose. Your country can take the measures needed to become sustainable, or you can watch it die, as the economy shrinks, and the young people leave. That, I think, is your choice.

The other two measures you need to take are contingent on the first being implemented, since without the first measure you will simply not dispose of the economic resources for the other two.

ii) A serious policy to support those Latvian women who do wish to have children. But with major financial advantages, not half measures, and propaganda stunts. You need policies that can work, and I know plenty of demographers with ideas.But this needs money. Important quantities of money. And gender empowerment, right across the economy, at every level. We have formal legal equality in the labour market, but evident biological and reproductive inequality, in that only one of the parties gets to bear the children. The institutional resources of the state need to redress this imbalance.

iii) Major reforms in the health system to address the underlying male life expectancy problem. You can only seriously hope to raise the labour force participation rates at 65 and over if people arrive at these ages in a fundamentally healthy condition. In economic terms, simple investment theory shows why this is the case. A given society spends a given quantity of resources on producing a given number of children, those who have citizens who live and work longer evidently get a better return on their investment. If you want to raise Latvian living standards, you have to raise the life expectancy. And this apart from the evident human issues.

OK, I am saying no for the moment, but I would like to stress that when conditions change, I would be more than willing to come to your country to try to help. But not for a day, for a month, and not to give a talk, but to work with some serious people who are willing to roll their sleeves up and do the serious spadework that will be needed to find those solutions you so badly need.

Basically, my feeling is that the issues you face are so complex that public debate is unlikely to produce a very fruitful outcome at this point. You need a long term education process, and for the time being more or less technocratic solutions, but not the technocratic solutions you are being offered by the EU now (which basically won’t work), technocratic solutions which get to the heart of the problem and set your country on a sustainable path.

This entry was posted in A Fistful Of Euros, Economics and demography, Economics: Country briefings, Economics: Currencies by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo' is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

15 thoughts on “Is It Hot In Latvia In August?

  1. I am latvian and I am on you side.

    Ps Future economist who will roll up his sleeves and do some work.

  2. Hi, Edward,

    Here is one thing I do not understand, and this is bugging me a lot. If you say that “devaluation is inevitable at some point,” but also that “the longer it is in coming, the more serious the consequences will be”, it kinda means that the sooner it is done, the better. Thus I would be led to believe that you are advocating devaluation now, as the least painful way to go.

    Edward, I really like many of your thoughts and I agree to many of your ideas. But at the end of the day I am Lithuanian, and you must understand that devaluation for the Baltic countries is a lot more than a macroeconomic decision. The peg is sort of like a symbol, saying that for the last 15 years we have been trying hard to put the past behind us and become a market economy, and we have succeeded, because foreign investors trust our currency. So, if we are given a choice of devaluation or, as you put it, deflation, we will go for the latter. No matter how hard it will be, or how long it will take. Unfortunately for us, we are quite used to bad times and suffering, so this will just be another crappy decade. On the bright side, our persistent approach might encourage other countries not to devalue, which at the end of the day might save us all from the God-awful economic mess that you envision.

  3. Edward, perhaps you are getting “it” finally. Devaluation is not imminent and in the long run it is also low prob event, if the deflationary way works. And when already started, better not to sow the seeds of doubt.

    Brgrds,
    Kristjan

  4. Hi Darius,

    “Thus I would be led to believe that you are advocating devaluation now, as the least painful way to go.”

    The topic here is the use of the word “advocating”. This is all a very delicate issue. Basically I think you need to respect due democratic process. My personal view is that it has been a serious mistake not to devalue, that devaluation is inevitable, and, as you say, the longer they leave it the worse the contagion problem will get, since more credibility will have been invested in maintaining it. So yes, the sooner the better.

    But…. this is a decision for the Latvian government, to be taken in consultation with the IMF and the EU Commission, it is not the topic for holding meetings, rallies or conferences. It is not a campaigning issue. The dividing line is a senstitive one, but I hope you can see it.

    Basically, the problem now is that Latvia has become “too small to fail”. Large institutions have been using a sledgehammer to crush a fly (the size of the lending is massive in comparison with Latvian GDP), and if they fail then the consequences will not be positive. On the other hand, it would have made more sense to lend the money to fund the fiscal deficit and loan defaults, but this is impossible, since understandably lots of other members of the EU10 would want the same.

    So they are all stuck, between a rock and a hard place, waiting for something to give. And the day it does give, well just try and stay under cover.

  5. Hi, Edward,

    I do like your phrase “too small too fail”, as it sort of gives me hope, that in the grander scheme of things the Baltic states will benefit from being the first to get financial aid – there might not be enough to go around if things turn sour. Don’t want to sound like a free-rider, but if we have a hard time and in the mean time the world is recovering from the recession with, maybe part of our IMF/EU debt will even be, how to put it mildly, forgiven… (written off).

  6. Hi, Edward.

    “Ideally it needs to take place as part of a much more general solution to problems in the economies of the Eastern European countries who are members of the EU.”

    Do you have any worked out ideas of what they should do?

    Could a coordinated measures limit the fallout of devaluation?

  7. There is no solution in the EC for all these problems. The only opportunity is if abnormal inflation will start in US and blow away the debt.

  8. With all the problems in the global economy, I am surprised that gold has still not regained the $1,000 level, as shown herehttp://www.bloomberg.com/apps/news?pid=20601116&sid=aA3eLD2EZ5CM

  9. >>> “Productive capacity needs to be increased substantially. This means increasing the labour force, and this means (as outlined in the World Bank Report, From Red To Grey) facilitating large scale inward migration.”
    ========
    All kinds of conclusions may be drawn from that report. Large scale immigration from the CIS/Subsaharan countries (which do not have very good education systems) would be helpful only if there is a massive growth of export industries. And even in this case the benefits would be short-term.

    Here is what Russel Shorto (No Babies?, NYTimes, June 29, 2008) writes about the immigration as a solution against aging of the European populations (I believe that this applies to Latvia as well) —- “By one analysis of U.N. figures, Britain would need more than 60 million new immigrants by 2050 — more than doubling the size of the country — to keep its current ratio of workers to pensioners, and Germany would need a staggering 188 million immigrants in the same time period. One reason for such huge numbers is that while immigration helps fill cities and schools and factories in the short term, the dynamic adjusts over time. Immigrants who come from cultures where large families are standard quickly adapt to the customs of their new homes. And eventually immigrants age, too, so that the benefit that incoming workers give to the pension system today becomes a drag on the system in the future. A European Commission working document published in November 2007 concludes that “truly massive and increasing flows of young migrants would be required” to offset current demographic changes. Few Europeans want that. Immigration already touches all sorts of raw nerves, forcing debates about cultural identity, citizenship tests, national canons, terrorism and tolerance, religious versus secular values”

  10. I am very surprised at the suggestion that Latvia urgently needs more immigrants – from CIS (Central Asia) countries or Subsaharan Africa. Immigration cannot solve problems related to aging workforce in any sustainable way. Here is reasoning by Russel Shorto (“No Babies?” NYTimes, 28 July, 2008):

    By one analysis of U.N. figures, Britain would need more than 60 million new immigrants by 2050 — more than doubling the size of the country — to keep its current ratio of workers to pensioners, and Germany would need a staggering 188 million immigrants in the same time period. One reason for such huge numbers is that while immigration helps fill cities and schools and factories in the short term, the dynamic adjusts over time. Immigrants who come from cultures where large families are standard quickly adapt to the customs of their new homes. And eventually immigrants age, too, so that the benefit that incoming workers give to the pension system today becomes a drag on the system in the future. A European Commission working document published in November 2007 concludes that “truly massive and increasing flows of young migrants would be required” to offset current demographic changes. Few Europeans want that. Immigration already touches all sorts of raw nerves, forcing debates about cultural identity, citizenship tests, national canons, terrorism and tolerance, religious versus secular values

  11. The proposal of devaluation rings a bell in my head. As far as I remember this was the instinctive reaction during the ’30es and led to a series of devaluation. (A war if You like.) It is a beggar-thy-neighbor style reaction that is last thing the global economy needs during the current crisis.
    On the other hand with the high share of FX loans devaluation can be more painful compared to deflation. Both of them lead to decreasing consumption. The big difference is the credibility of the local currency. A devaluation would push rational agents towards assets denominated in FX. I do not think this would be a desired outcome.

    Just for my 5 eurocents.

  12. Hi R/Hardt

    “The proposal of devaluation rings a bell in my head.”

    Well, of course it rings a bell in your head. The other word from the 1930s that doesn’t ring a bell in your head is deflation, which is the other alternative.

    Many economists take the view (myself included) that for simple technical reasons devaluation is much more straightforward and desireable, for economies which are seriously distorted and in need of correction like the Latvian one. Latvia may now need something like a 30% devaulation to get back to sustainable growth, doing this by internal deflation will be a nightmare. That’s actually the lesson of the 1930s.

    You are not seriously suggesting the war with Hitler was caused by devaluation, are you????

    In fact, Eichengreen, who has made the most extensive study of this issue, suggests that even competitive devaluations had a net positive benefit, since they produced a strange form of monetary loosening by generating inflation. He also was very clear that devaluation is much the lesser evil than trade restrictions (think of the US and China now, much better for the US to devalue the dollar than start active trade measures against China), and devaluation may help head off protectionist pressures.

    “On the other hand with the high share of FX loans devaluation can be more painful compared to deflation.”

    I’m afraid the consensus now is that there is absolutely no difference for the forex loan holders.

  13. Hi Edward,

    of course I was not referring to the Secound World War. I was depicting a series of devaluation as war. (Like Utopia devalues the Utopian currency versus the Bitopian currency. Then, as a response, Bitopia devalues the Bitopian currency versus the Utopian currency. To counter this action, Utopia devalues the Utopian currency versus the Bitopian currency. Remember German companies complaining at ECB for too strong euro?)

    I agree, for forex loan holders there is no difference. But there is a huge difference for the owners of local currency denominated assets. (Exempli gratia for the buyers of government bonds denominated in latvian lat.)

    I belive cutting wages and pensions (this is actually happening in Latvia) is favourable for the owners of financial assets denominated in latvian lat compared to a devaluation. As You just pointed out there is no difference for the forex loan holders. (And I belive there is no difference for the active workers, either. One way or the other the purchasing power of their salary will vanish.)

    I agree there is a huge need to increase competitiveness in Latvia. One way is devaluation of the local currency (with stable nominal wages), the other way is cutting nominal wages (with stable exchange rate). The point is: real wages have to decrease.

    A stable exchange rate (accompanied with a more than zero inflation abroad) grants prices will not start falling lowering the threat of deflation. (Especially in a small open economy like Latvia. Of course, deflationary pressures in EU is a problem.) I agree, in a big closed economy (like US) falling nominal wages would lead to falling prices. I belive the stable exchange rate can prevent Latvia to fall into deflation, since the majority of the consumed goods are imported at stable foreign currency prices – thus at stable local currency prices since the exchange rate is stable.

    In short:
    I do not belive cutting wages would lead to deflation in a small open economy when the exchange rate is stable and there is no deflation abroad.
    The menu for economic policy makers: either cutting nominal wages or devaluing the local currency.

    Devaluation is equal to eliminating the value of financial assets denominated in local currency. On the long term this action would lead to increased euroisation of the Latvian economy, and I belive this is not a desired outcome.

    Just for my 5 eurocents.

    PS Actually I do belive the economic crisis in the thirties with sky-rocketing unemployment rate across the globe did help a lot for extremists (amongs them Hitler) to gain power.

  14. A great blog, thank you.

    But before immigrantion takes place there is huge scope for redistribution of labour. There are far too many public servants still and the service industry is hugely inefficient with far too many shops for the numbers buying. Quite simply, shops are easy to create. The tax system also supports an army of bookkeepers that could be dispensed with if the system was modernised.

    This is also a country of meaningless NGOs agencies and organisations, all eating people who deliver nothing productive for the economy. But again, after the wall came down, jobs like this were easy to create.

    The key to regeneration of Latvia is the tax system. Until this is developed to support honesty and endeavour, we will continue to struggle.

    Yesterday I was asked to pay by cash in a shop and not to use my card. You can draw your own conclusions from this.

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