Latvia: No victory yet, no defeat either

Some comments or, perhaps better, some additions to Ed Hugh’s piece of February 26, To Soon To Cry “Victory” on Latvia?, by Morten Hansen, Stockholm School of Economics in Riga.

Thanks a lot to Ed for welcoming some comments/further arguments on the debate on whether Latvia can indeed cry “Victory” (as seemingly suggested by Edward Lucas in The Economist) in the internal devaluation battle that it is fighting.

I am too smart (or too timid…) to declare either side a winner at the moment but for those who might be interested I would like to present some more data as fuel for the debate. Furthermore, at the end, I allow myself just a couple of reflections on the Latvian strategy.

Ed argues that the “internal devaluation is only working at a hellishly slow pace” by referring to the development in CPI inflation. I don’t find CPI inflation a very useful measure in this context since it contains a lot of imported goods and non-traded services neither of which are important for competitiveness. Should I use it nevertheless it would be to say that the change from high inflation to deflation has been quite fast. Inflation topped at 17.9% in May 2008, now it is -3.1% (January 2010) i.e. a 21 percentage point decline over 20 months. This speaks of some, albeit chaotic, flexibility.

Ed is not too happy about the wage development (“… and what deep cuts in wages and salaries?”) either and here I somehow have to agree. Wage growth has indeed entered negative territory, see Figure 2.

As wage data here can at times be dodgy it is good to look at several series and more pronounced decreases are found if one uses the total wage bill from GDP data and compare it to employment. Both series are dramatically down but wages more so, leading to significant decreases in wage compensation per employee and thus speaking well of the internal devaluation, see Figure 3.

But when splitting the overall development in wages from Figure 2 into public and private sector developments the picture changes quite a bit back again, see Figure 4. In particular the very latest data (2 March 2010) show that the by far biggest wage decreases have taken place in the public sector – good for the public finances and the IMF-EU package but irrelevant for competitiveness and should be a matter of concern.

Swinging the pendulum once again one might look at export unit values. To the extent that one will accept it as an index for export prices recent data suggests that Latvia should have regained quite a bit of competitiveness via falling export unit values throughout 2009, see Figure 5.

Altogether still a mixed but more nuanced picture and one thing is still in the cards: Figures 1, 2, 3 and 4 seem to suggest gaining momentum. It will be interesting to see if that continues.

Summing up, I think it is premature to just dismiss the internal devaluation; on the other hand, declaring victory now would sound a bit too much like George Bush and his “mission accomplished” speech.

Some reflections on the ‘internal devaluation’ strategy

So why not just devalue? Many certainly put blame on the fixed exchange rate e.g. Paul Krugman in his recent ‘Riga Mortis’ blog* as well as here but perhaps he provides the answer himself by his statement ‘Latvia is the new Argentina’ (video link, opens after 10 seconds of commercials). What if a controlled and credible devaluation** is not possible but turns into an Argentinian-style collapse? In all three Baltic countries devaluation, rightly or wrongly, is seen as Pandora’s Box size XXXL and rapid euro introduction is seen, again rightly or wrongly, as an entry ticket to monetary Nirvana.

And the internal adjustment does reflect the economic policy instruments available when in the eurozone – it will all be fiscal. If Latvia cannot do it now then how will Greece or Spain ever accomplish internal devaluation? And if it is impossible/too lengthy then EMU was perhaps a wrong concoction in the first place?

Internal vs. external devaluation

Whatever strategy is chosen it should see ‘good implementation’. This has lacked in certain aspects with respect to the internal devaluation in Latvia:

1. Implementation was delayed for too long after signing the Stand-By agreement in December 2008.

2. There are examples of cheating – wage cuts being based on non-implemented wage increases.

3. Uneven distribution of cuts – a hacker calling himself Neo (who must have seen the movie Matrix a few times too many…) managed to hack more than seven million files from the State Revenue Service (the local IRS) showing that some in the public or semi-public sector have had just tiny if any pay cuts.

4. The Constitutional Court has complicated the process by rendering unconstitutionally pay cuts for itself (sic!) as well as cuts in pensions. Several civil servants groups may now put their cases to the Constitutional Court, hoping for similar rulings.

And it remains to be seen a) if the correction needed is too big to accomplish and b) if it is fast enough.

But external devaluations tend to be messy, too, don’t they? Overshooting, collapse, contagion.

Those favouring an external devaluation should present a way in which this is done credibly and how to address the very likely contagion effects in the Baltics, all of this to ensure an orderly devaluation process.

But I haven’t seen such a suggestion.

* Why did I not come up with that one….. ???

** A little example: Most people here have multi-currency accounts; my own very simple account allows me with my computer and mouse to shift between 17 different currencies. Perhaps a ‘click-run’ or virtual run on the currency might be possible?

26 thoughts on “Latvia: No victory yet, no defeat either

  1. As I wrote on another site, as long as your currency is linked to the euro (or you are part of the eurozone) and as long as there is inflation of the euro (2%/year) you are cutting wages as long as you hold them still, nominally. This may not be enough in Latvia obviously, but it’s not inherently cheating on the wage cutting to keep them still, nominally. It seems to me it’s this kind of adjustment – inflating less rather than deflating – that can be done in normal cases in the eurozone.

    You may even, occasionally, have to cut wages in some sector to maintain competitiveness. It can be done, if the workers agree. They do it, occasionally, in Germany. So that is how the eurozone could be maintained.

  2. “As I wrote on another site, as long as your currency is linked to the euro (or you are part of the eurozone) and as long as there is inflation of the euro (2%/year) you are cutting wages as long as you hold them still, nominally.”

    But that is a long term plan. If you need to “devaluate” now, you don’t have the time to wait until 2% inflation has eroded wages etc.
    Right now the inflation in the euro area is zero anyway, so just upholding your peg and waiting won’t help you.

  3. 1% isn’t much either and during 2009 some months had deflation. And right now is not a normal case.

    Could a country not in normal times make small changes in its peg? After all the peg not being under pressure then a controlled devaluation should be possible.
    Such planned devaluations did happen sometimes in the old pre euro european currency system.

    Of course what worked for France and Belgium back then probably won’t work for Latvia.

  4. It would be interesting to have a framework.
    So, could we say that there is a similarity between the early 80´s chilean crisis and this of Latvia (and baltic states)?
    Maybe this can be useful to analyze the case, of course, with the relevant qualifications.

  5. “They do it, occasionally, in Germany. So that is how the eurozone could be maintained.”

    Germany _is_ doing that right now. So if you want to compete with Germany, that won’t be enough.

  6. Based on conversations I have had with various persons close to the matter, I firmly believe that none of the Baltic states will be allowed into the EUR in the foreseeable future, no matter what. And I firmly believe the leaders and central bankers of the Baltic states know this full well. So assuming I am right about this, we will see Estonia, without a doubt the best of the bunch, getting rejected sometime in 2010. When that happens, what will be the reaction in the populations of the three countries ?

    Henrik

  7. But, why exactly the people think that if Latvia devalue it will be harder to join the euro?

  8. Normally I do not comment SSE Riga articles, because SSE Riga is a fraudulent vehicle to abuse Structural funds in CEE in favour of the SSE Stockholm.

    Carlos,

    this is very hard question, because Latvia could devalue 15% and even stay in ERM II. No idea.

    Henrik,

    this will be very strong signal to all CEE that EUR and ECB is not feasible for them for decades. But then we have to ask: what the sense for CEE to stay into full EU? ECB is not for them, Structural funds will extinct in 2013. Free trade area is harmfull for CEE, it is needed so much by the Germany to be able to implement turbo-production with high productivity.

    CEE will realize very fast that they will be much better off if they will reintroduce custom taxes. Because this will be an enormous source of additional tax income and will directly support national economy. But this will be enormous problem for Germany, because no more German cookies and German shoes will be competitive. And for cars Germany has many competitors.

  9. Why is free trade harmful for CEE? On the contrary, standard trade theory says that a free trade zone is beneficial for the most average countries in it, which in the high-income EU means the lower-income CEE. CEE needs Western European markets for the same reason Ireland, Spain, and Greece needed French and German markets in the 1980s: if its countries leave the EU, Germany has no reason to keep importing low-value-added goods from them instead of from lower-wage China and Southeast Asia.

  10. Alon,

    you do not understand the problems of EU. And the problem No 1 is that old comparative-advantage theories do not work in the EU. Because less advanced countries as CEE have nowhere advantages, and Germany has advantages everywhere and flood the demand for everything.

    The German advantage is absolutely not related to some mystical nature of Germans a la Loreley etc., but by the shear fact that Germany is having by far the biggest internal market, and that allows for firms to raise their productivity by enormous automatisation means, and after that harvest the profits from other EU markets. This method is not accessible for any CEE firm, because they just can not grow in an environment where everything is dumped by German products, popped with enormous German export subsidies and stimulation measures during crisis, and based also on relatively lower money costs for German firms due to German dominance in the ECB, which is questioning once more for what reason the Eurozone does exist?

    Exactly this leads to Germany exporting so much cookies, milk powder and other low technological grade goods to CEE. In the segment of high-tech Germany has by far not so good positions.

    So if CEE would like to instantiate some kind of national economies, they must protect for at least for 15-20 years their firms from the German dumping.

    Additional momentum to German dumping is given by now much discussed wage dumping in Germany, because over the decade real wages in Germany stagnated, in some segments decreased significantly. Despite the comparably high wages in the German upper class, do not forget that there are 3 million workers in Germany working for 400 EUR/month, without social taxes payable by the employer (competitiveness!!!). And during the crisis the number of workers which cost to their employer less than 800 EUR/month fulltime, has increased to additional 8 millions. So there are the grounds for German competitiveness.

  11. The only possibility by CEE to increase the competitiveness is by devaluation, which worked very well in case of Poland and CZ.

  12. Henrik: talk is cheap, how about a bet – you say Estonia will be refused eurozone membership in 2010 and I say it will be granted eurozone membership in 2010. And if your sources are as accurate as you seem to thnik then surelt odds of 3:1 or 5:1 should also be acceptable.

  13. There is talk of victory and defeat. The more important question is whether or not the battle is worth fighting in the first place.

    Monetary policy is a tool to be used in order to achieve real policy objectives, such as a higher standard of living for the population. Having euro membership as a policy goal, and sacrificing the real economy for that, is ludicrous.

    It has been clear all along that a country like Latvia is not on the same economic development level as the ‘core’ Eurozone (Germany & France). For the foreseeable future, Latvia would be better off conducting its own monetary policy and concentrating on achieving real economic progress rather than pursuing ‘a pie in the sky’, i.e. euro membership.

  14. German export subsidies? Nowhere advantage? What planet do you spend most of your time on?

    Of course, in the real world, Germany had low wage and productivity growth over the last 20 years, having to subsidize a second world country and what not. And meanwhile, the CEE economies grew so rapidly everyone was crowing about them as the new model for the world to follow. The ones further west didn’t even crash. Poland had positive economic growth in 2009; Slovenia, Slovakia, and the Czech Republic had a smaller negative growth than Germany. Somehow I’m supposed to believe that Germany has been destroying Lithuania, Latvia, Estonia, and Ireland, but not any of the other non-core countries in Europe. What gives?

  15. Of course, there are abundant schemes of direct and non-direct export subsidies in Germany, this is the 4th most protectionistic economy in the World. Combined with maximum wage dumping this makes a great export nation.

    A lot of German goods are reimported in Latvia from Russia.

  16. Germany has already destroyed Spain and Greece with its export surpluses. See Krugman

  17. ‘Somehow I’m supposed to believe that Germany has been destroying Lithuania, Latvia, Estonia, and Ireland, but not any of the other non-core countries in Europe. What gives?’

    Check the currency fluctuations and whether these economies have been pegged (or not) to the Deutsch Mark err… sorry Euro.

  18. Jüri,
    I understand your desire to make a wager. After all, my point of view is definitely in the minority as yet. I don’t think a bet would be practical + the odds you suggest are risible. After all, my point of view IS in the minority, and any odds given to me by a bookmaker (or the financial markets) would reflect this, whereas yours don’t. However, I would like to substanciate my point a little.
    Given the trouble EU is in at the moment, I think it is very likely, that Bruxelles and ECB don’t want to widen the circle further, unless they are 100% convinced, that any new members will not be a cause for concern in any way. And given the Greek problem, it is equally unlikely they will allow anybody to fiddle a little with the numbers to gain entry, even if that may seem unfair to the countries outside the single currency, given that virtually all the members of the EUR cheated in the first place (except Finland and Luxembourg). I also know for a fact, that this has been communicated on CB level to the Baltic states and indeed to the other candidate countries. This means that ECB, Eurostat, etc. will go over the numbers of Estonia very carefully. And I have been told by people in the know about these matters, that there are indeed flaws in the Estonian numbers; to be more specific there seems to be some double counting of dividend from government owned entities. Even if that should turn out not to be the case, it is my firm belief, that EU/ECB/Eurostat will use the sustainability clause to strike down any candidates at this point in time.
    I may well be wrong about this, though of course I don’t think I am, but at least we will learn about this soon enough.

    Henrik

  19. Henrik,

    sustainability clause will be not deadly against Estonia because Estonia does not have external debt.

    However, internal debt clause is worth of scrutiny, because 3% were attained by massive one-time measures. If ECB will not count them, Estonian debt is around 8% of GDP.

    Generally, Estonia is somewhere dangereous to the system, because not having to spend a single sou for banking bailouts (absolutely different from Latvia who has to kill 50% of government budget for that purpose) and not having any other obvious problems, Estonia has shown GDP fall -15% in 2009. There is no logical explanation for that.

  20. Henrik: “Based on conversations I have had with various persons close to the matter, I firmly believe that none of the Baltic states will be allowed into the EUR in the foreseeable future, no matter what.”

    I haven’t seen it mentioned yet, but if the Baltic States try to stay linked to the Euro rate by internal deflation, that must impact their tax revenues negatively. That in turn raises the prospect of default risk down the road. I would say that you are most likely correct, and the ECB will not want to assume new and not very predictable problems in addition to those it already has.

  21. NikosR: Spain had a smaller economic contraction in 2009 than Germany. But nice try.

    And Govs from Latvia: which Krugman are you referring to? Because I can’t find any article of his arguing that the EU has no benefit for CEE, or that Germany has “abundant” export subsidies (what the hell does “4th most protectionist” even mean?), or that trade surpluses are evil.

  22. govs from latvia wrote:
    Normally I do not comment SSE Riga articles, because SSE Riga is a fraudulent vehicle to abuse Structural funds in CEE in favour of the SSE Stockholm.”

    this is the dumbest thing you’ve written yet. please provide even a shred of evidence that this latest claim is true, if not then it goes into the dust bin of the latest distortions and otherwise effluvia you’ve written. to whit, that the `butterfly effect’ an effect that deals with time travel, explains the demise of parex banka, the second biggest bank in latvia. its just sad what you write. now, Germany is protectionist?!

    big hans

  23. Big Hans – I disagree. Govs tells the truth. The Swedes use this SSE Riga as trojan horse to occupy Latvia and steal all our mineral resources – cow dung & sprats – mark my words.

  24. Pingback: Latvia: Living in the Land of Extremes | afoe | A Fistful of Euros | European Opinion