Hugh: Latvia Needs To Devalue Soon

Edward Hugh has posted his response to the post "Why the IMF Supports the Latvian Currency Peg" by Christoph Rosenberg at RGE Monitor. It is definitely worth reading the full missive.

But lazy reader can get the excerpt of conclusions here:

So where does all this leave us. Well basically that what we have on our hands is one hell of a mess, and that here there are no easy solutions. Did anyone tell you we lived in an imperfect world? Well what is going on in Latvia is surely as good an illustration that you are likely to find that this is the case. There are no easy, quick fix, policy solutions, and I fully understand Christoph's dilemma in this case.

So while nothing is guaranteed to work, some approaches may be better placed than others, and it is my considered opinion that the best way of addressing the Latvian problem is by trying to kick-start the economy via devaluation, and to then tackle the wage increase problem might by explicitly opening Latvia's frontiers to external migrant labour (as, for example, the Czech Republic have, to some extent, done). Such devaluation, backed by imaginative enough greenfield site support from the government, could attract the FDI, and the migrants to provide the manpower for unskilled positions, with better educated Latvians being able to get involved in some of the higher value work. If something is not done to break the population vicious circle, and the meltdown in internal demand and property prices as young Latvians seek work elsewhere then the outcome is all too clear, and not for that any less tragic, as Krugman suggests.

Of course, some may wish to object at this point that devaluation has the same effect on wages as wage cuts do, and they would be right, but the point is the overall level of economic activity is greater on the V shaped approach (this was Keynes, and is today Bernanke's basic insight). Latvian GDP is about to be thrown, from a period of trying to operate above capacity, to one where for an extended period of time it will operate below capacity. This can never be a good solution. On the V shaped recovery scenario time path of GDP is higher, and the possibility of finding remunerative employment for each and every individual Latvian is to that extent greater. More idle resources will be put to work at a time when there is huge slack in the system, and energy and material costs are at very low levels. Investment (building factories etc, buying machinery and equipment) simply couldn't be cheaper . Putting the resources to work to make this possible quite simply can't be a bad thing, or so I contend, and certainly not if the alternative may be sitting back and waiting till you have a sovereign default coming crashing in on top of you.

I see plenty of work for Latvian parliamentarians (passing much needed laws etc) in the current proposals. I see comparatively few to keep the idle hands of Latvia's valuable human resource base from freezing over.

Let us be clear, of course there is no single clear "cure all" remedy here, but I think we need to say strongly that the earlier attempt to stem the migrant out-flow by being lax on the wage inflation front was to invite disaster (and the disaster of course came), whereas now, excessively compressing wages as the solution will have the impact which was previously feared.

And the Latvian exit strategy is in doubt too:

Finally Christoph has one additional point which really serves as a conclusion and a monument to all this, and that is the idea that Latvia has a clear exit strategy from its currency predicament: euro adoption.

As Christoph says, the Latvian authorities are determined to work to meet the Maastricht criteria in 2012. Certainly entering the euro zone will not do away - at a click of the finger - with the hard lifting necessary to address the competitiveness and high external debt problems (as he suggests in his avoiding the Portuguese trap article, and I go through in my Portugal Sustains post here). But it would offer support to a struggling Latvia and help bring back investor confidence. The point is, at which exchange rate should Latvia enter ERM2? Indeed, it is now apparent - if you read the IMF staff report on the standby arrangement, on their website, that they favoured an expansion of the band to 15% (which basically means 15% devaluation) and it was the EU itself who objected and pushed to retain the peg (see appendix below).

Basically, the EU objected to the IMF proposal for emergency eurozone membership on the grounds that this would sat a precedent in other cases. But I really do feel that the Commission (and the ECB presumably) are being ridiculously pig-headed here. We have an emergency on our hands, and exceptional measures are called for.

Read the full article!