Friday, August 07, 2009

Aslund: Latvia Defies The American Conventional Wisdom

Anders Aslund has a story at RGE Monitor:Latvia Defies the American Conventional Wisdom.

Here is an excerpt with key message:
... conventional wisdom is not always a guide to the present. In the May issue of American Economic Review, Stanford economists Peter Blair Henry and Conrad Miller argue that Barbados has been economically more successful than Jamaica because Barbados pegged its exchange rate to the US dollar in 1975 and stuck to it. In 1991, Barbados experienced a serious current account crisis, and “the IMF recommended devaluation,” but “the Barbadians resisted the recommendation,” according to their paper. “Instead of devaluing, the government began a set of negotiations with employers, unions, and workers that culminated with a tripartite protocol on wages and prices in 1993,” they write, in which “workers and unions assented to a one-time cut in real wages of about 9 percent….The fall in real wages helped restore external competitiveness and profitability….The economy recovered quickly.” Unlike Barbados, Jamaica devalued repeatedly and ignored structural reforms.

There are many other examples. Slovakia has outperformed Hungary in the last decade, and their main difference is that Slovakia had a pegged exchange rate for long periods, while Hungary has had a floating rate. In 1982 Denmark pegged its krone to the Deutschmark. This peg that still holds helped Denmark start radical liberalizing reforms a decade before Sweden, which persistently devalued.

The conventional wisdom that devaluation is inevitable in a severe current account crisis is simply not correct. Barbados, Slovakia, and Denmark have shown that a peg can enforce economic discipline and facilitate structural reforms.

The goal of any country in this kind of economic distress is to reduce costs, which is best done directly by cutting salaries, prices, and public expenditures. Devaluation is a second-best solution if the government lacks the political strength to undertake direct cuts, because devaluation boosts the foreign debt burden of the country in crisis.

But run and read the full article!

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