Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday 9 June 2012

What is it about Latvia?

                that either makes visitors lose their critical faculties, or non-visitors like myself and Paul Krugman lose theirs. In my earlier post, I was not that surprised that a member of the ECB’s Executive Board would trumpet Latvia’s ‘success story’, because that fitted the party line. I was a little more surprised to find the head of the IMF saying similar things, because the IMF has been rather more realistic about the consequences of austerity and internal devaluation. (Although the contrast between the IMF’s recent UK assessment in writing, and what Lagarde said in public, was widely noted at the time). What really surprised me was this post from Dani Rodrik, who has also just visited Latvia.
                Dani Rodrick’s post goes into more detail about recent Latvian macroeconomics. In particular, he suggests that despite the massive decline in GDP and huge rise in unemployment, the economy may still have not completely regained the competitiveness they lost in the preceding boom. So, in terms of the evidence, he sees what I see if not worse. But then he says this.

“The main lesson I take from all this is the need to avoid easy generalizations that do not respect country peculiarities. Fiscal austerity missionaries are surely off base when they say Latvia’s experience decisively proves Keynesians and advocates of currency depreciation wrong.  It is too early to judge the Latvian experience a success.  But it is also too early to say Latvia has been a failure.  Growth may continue, in which case the country will look better and better.”

                When someone like Dani Rodrik looks at the same facts, but comes to rather different conclusions than me, I get worried that perhaps I’m wrong. It is also wise to heed Brian Ashcroft’s warning, that small countries do have different characteristics to larger countries. With this in mind, let me go through some of my own macroeconomic reasoning carefully.
                Was the depth of the recession inevitable given the preceding boom? Paul Krugman is perhaps a little too dismissive on this point. The economy clearly was overheating in 2007/8, which is why it became uncompetitive. At the very least, inflation had to come back to a reasonable level. In principle this need not require any subsequent deflation if we have a totally credible macroeconomic policy, a suitable devaluation and a completely forward looking Phillips curve, but that is an idealisation. So some recession was probably inevitable, as it has been for many Eurozone countries. But in 2008/9 Latvia suffered the worst loss of output in the world!
                The key issue is not that Latvia had to get inflation down, but that having done that it also needed to regain competitiveness. It is here that the macroeconomics of a short sharp recession with a fixed exchange rate looks so bad. To see why, think of the following little experiment.
                We have an economy, which through overheating has become uncompetitive. It needs to get its prices in Euro terms down by, say, 20%. The government has dealt with the overheating: the output gap is now zero and inflation is at its competitors’ level. But prices are still 20% too high.
                The least cost option is to devalue the currency by 20%. Now it would be foolish to believe that is all you need to do. Restoring competitiveness will boost demand, so to prevent the overheating starting up again you need to undertake deflationary policy of some kind. You may also need some negative output gap because higher import prices will raise price inflation. However you do not need a 20% decline in output.
                But suppose we take the fixed exchange rate as given. Even in this case, a short sharp recession makes no macroeconomic sense. Suppose that, for given inflation expectations, a 1% output gap will reduce inflation by 1%. A short sharp shock of output 20% below potential for a year will give you -20% inflation in that year, so you will have restored competitiveness quickly, but at great cost. Now think about spreading the correction over two years.
                To see how that works, we need to say a bit more about the Phillips curve. As we discovered in the 1970s, inflation today depends not just on the output gap, but also expected inflation. Suppose our Phillips curve is of the modern New Keynesian kind, so this year’s inflation rate depends on next year’s expected inflation, and let’s assume people are pretty rational in forming their expectations. What if we have an output gap next year of -10%. This will mean that inflation next year will also be -10%. But this year we do not need any output gap at all. Inflation will still be -10%, because expected inflation is -10%. So we get our competitiveness adjustment over two years, but at half the cost in terms of lost output.
                Is my assumption about rational expectations critical here? No. Imagine instead that the Phillips curve is of the old fashioned kind, where expectations are naive and backward looking, so current inflation effectively depends on past inflation. In this case we need an output gap of -10% this year, but then nothing next year, and we still get our correction over two years at half the cost. (We have to do something to get inflation back up after two years in this case, but that is not important to the point I’m making.)
                Now this is all very stylised and partial equilibrium, but there is one important message that will survive complications. The Phillips curve tells us that reducing the price level gradually over time is more efficient than doing it quickly. So even if you believe that you have to stick with a fixed exchange rate, a short sharp recession is much less efficient than a more modest but prolonged recession. Thinking about the convexity of the social welfare function reinforces this point.
                As a result, even if output growth this year and next year was over 5% p.a., and the country achieves a sustainable level of competitiveness, I would not call the Latvian experience a success story. The competitiveness correction will have cost the economy a huge amount in wasted resources and unemployment misery, when it could have achieved this correction at a much reduced cost.


  1. This is an unusually excellent post even for you.

    I very much like the willingness to check that the same argument works with a forward looking and a backward looking Phillips curve. I guess I have a concern about the implicit reliance on Calvo type price stickiness.

    On devaluation, it seems to me that the country might not need a negative output gap if the deliberately overshoot devaluing by say 25% and allowing 5% of inflation above that of their trading partners due to passing through the increased domestic currency price (the Lat if I recall correctly) of imported inputs.

  2. A lot to think about in this post... I just posted my latest on recovery (hopefully) in Japan following the Tsunami.

  3. Argentina (no bailout)
    real gdp equal after 2 years
    real above baseline 10% 3 years

    us FDR (no bailout)
    gdp 3 years equal

    Estonia (bailout from swede banks)
    real gdp 10% below 2 years
    10% below 3 years

    Latvia (bailout 44% of gdp+Swedish banks)
    real gdp 3 years 12% below

    Lithuania (bailout from swede banks)
    real gdp 3 years down 9%

    austerity failed

    1. Swedish banks (which dominate the Baltic banking sectors) didnt bailout the Baltic countries - rather the opposite! They suddenly stopped credit expansion in their Baltic subsidiaries in 2007 (a wise choice but nonetheless) and, thus, contributed to the near collapse of the Baltic economies from what was certainly an excessive credit boom (again caused by Swedish banks)...

  4. You know what would be easy way to correct competitiveness problems and current account imbalances? Close movements on capital and reserve accounts. There exist fundamental balance of payments accounting identity explained here: that the current, capital, and official transactions accounts must sum to zero, balance of payment balances.

    current accout + capital accout + change in reserves = 0.

    From this equation we see that if movements in capital and reserve accounts are prohibited, currenct account balances automatically!

    You know capital accounts used to be closed, before push for deregulation and free movement of capital. That is where the all problems began.

    Any economist who does not incorporate fundamental accounting identities into his analysis is poor economist at best, misleading charlatan at worst.

  5. "current accout + capital accout + change in reserves = 0.

    From this equation we see that if movements in capital and reserve accounts are prohibited, currenct account balances automatically!"

    What we cannot see is how that would be achieved in the real world, namely through a fall in GDP.

    This is the kind of thing that economists who do seem to be keen in incorporating fundamental accounting identities into their analysis have difficulty in understanding.

  6. Latvians don't have any safety nets. They were bound to have deep recession. Austerity policies too - history matters. Latvian history is somewhat austere.

    When finnish and swedish tourists hear that hotel prices have went down somwe 40% they flock to Riga. How to model that?

  7. where is the proof Latvia became uncompetitive during the bubble years?
    I think the discussion about being uncompetitive or not or if internal devaluation works or not is missing the point what happened to Latvia.
    As Krugman shows on his blog, during the euro bubble era, abundant easy money did flow into Latvia (as it did in Spain, Ireland, etc.). A lot of this money was simply consumed or did end up in real estate bubbles.
    When the bubble bursted, the party stopped, the economy contracted, trade balance is back at more normal levels, banks failed or have to be recapitalized, debts have to be written down or paid back, which results in some painful years.
    The bubble growth will not return, so Latvia has to continue from where it was before the bubble years.
    As far as I see it, that's all there is to the Latvian experience, and I think it's similar for Spain and Ireland.
    What I don't understand is the discussion about supposed uncompetitiveness: any proof for this? Exports in Spain and Latvia are growing, this is not a sign of uncompetitiveness. Similar for claim about lack of demand or output gap: unemployment in Latvia , but also Spain, is back at levels before the euro bubble began in 2000. If you just went through a bubble, and you're back at pre-bubble levels, you are not under performing as an economy (at least not in the extreme if you look at pre-bubble numbers), but back at your ''normal'' level. You will not make up for the contraction anytime soon, because it was all unsustainable.
    The only potential issue I see is the debt overhang. If people are left with too much debt, this might hurt the economy, and the government might need to compensate for the private market not spending.
    Japan is the example here. Although I don't think you can claim Japan to be a success until they finally start paying down their government debts.

    1. Japan's a success because despite having a asset bubble burst 3 times of the size of that of the USA in 1929, they never had high unemployment or fell below 1992 output (remember USA decline 46% to 1933).

      If Richard Koo is correct then the private was effectively trying to shrink itself by 10% per year 1992-2005. Add in compounding and the potential GDP losses become ridiculous.

      In retrospect Japan made two critical mistakes, first it attempt to rein fiscal stimulus too early in 1997 and 2001, these created year long recession that reduced tax revenues to cancel government restraint. Second was to allow deflation to set in (debt deflation added a lot to the debt burden) though QE and more fiscal stimulus were tried it was problem.

      Faced with that kind of crisis to my mind suggests the nuclear option was and possibly still is the best hope, money financed fiscal stimulus. In normal insane, but the Japanese haven't been normal for a while and neither is the Eurozone.

  8. I referenced you in our client piece....

  9. I'm from Lithuania.

    The GDP that was lost was actually a "bubble" GDP, which was mainly construction of unproductive and increasingly expensive real estate financed by easy money from Swedish banks. All this mini bubble made wages and input prices too high for our current level of productivity, which stopped investments into long term productive capacities. The only way to sustainably replace this "lost" GDP is to do a lot of microeconomic work (labor flexibility, training, elimination of red tape etc.) to attract long term export oriented investments into productive assets. That's what we are trying to do. And no amount of macro "stimulus" in the form of extra loans or Government expenditures will help. But to enact real reforms on a micro level is much more difficult that to just throw money that you do not have from the top. I think the reforms in the Baltics are going to be success. That said, I think it will be much more difficult to achieve the same feat in PI(taly)GS. Will they cut their wages by 20% across the board in a year (and the only way to do that is to liberalize the job market that you can actually fire the existing employee and replace him with a cheaper one) and increase productivity to become competitive with emerging markets (where most of their jobs emigrated in the past decade)? Will they pay taxes? Do people understand that this is what they have to do to revive the economy? If not, exit and devaluation will be the only way, since eventually reality will catch up with you :)


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