Latvia is the new Argentina (slightly wonkish)

I’ve been saying this for a couple of weeks, but Edward Hugh has the goods.

Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We can’t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative — sharp wage cuts, and basically a major domestic deflation — will also make it hard to service those debts. In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)

This looks like events repeating themselves, the first time as tragedy, the second time as another tragedy.

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This doesn’t have anything to do with Latvia, but recently it has been reported that Larry Summers has been considering a plan from Glenn Hubbard and Chris Mayer to stabilize housing. A summary of the plan and an even more in depth look at the plan can be found here:
//www4.gsb.columbia.edu/realestate/research/housingcrisis/mortgagemarket

My question is: Do you think the plan could actually work to achieve housing price stability? Brad DeLong seems to have given it a thumbs up, and I was wondering what you thought.

It would be interesting to know WHO in Latvia has debt in euros. If it is the richer and more powerful, they might want to protect themselves a bit and sacrifice the others in the process.

Strange how few economists predicted the crisis while many non-economists have been actually talking about it for so long now.

“Latvia is the new Argentina”

I thought the European Central Bank provides virtually infinite credit to support troubled economies. So, how can you compare Latvia to Argentina?

Besides, devaluation would be a bad idea if they plan to adopt euro in 2012 (there are strict rules)

Ukraine isn’t EU member, you can tell, their currency has lost half of its value.

Latvia isn’t the new Argentina.

US is the new Argentina. We still haven’t found a solution to the crisis and to Argentina’s credit the IMF isn’t even advising the US on conditions that need to be met. I guess the American taxpayer doesn’t have a say in what happens nor how well the solution is implemented.

RS

If a firm has borrowings in euros then I would expect that it has either hedged its position or is expecting to have receipts in euros in sufficient amounts to pay back the debt. If not, tough luck.

Whenever there is polemic about a certain policy, my guess is that it is always because there is a looser and a winner.

Professor Krugman,

Increase of the debt burden in case of currency depreciation is probably the main problem facing the highly dolarized (euroized) Central and East European countries as capital inflows suddenly stop as the result of the current financial crisis.

Issuing credits in euros was championed by a group of West European banks present throughout the region that pursued very aggressive credit policies during the last few years. The possible losses the Western banks face should hopefully give additional weight to building the necessary political consensus in the EU to quickly widen the eurozone to the new and prospective EU member states, which was so far strongly resisted by the ECB. Although the severe recession can’t be avoided, this would prevent the outright financial implosion that threatens those countries.

It is a shame that Latvia was denied the eurozone entry when it applied for it a few years ago!

Maroje Lang
Croatia

Dear Dr. Krugman!
Thanx for your comments about situation in Latvia, one of the former-USSR country. Hope you’ll find time to estimate an economic situation in Russia. Several “anticrisis” measures undertaken by the Russian government, leads to an impression that government analysts read some of your articles :)

“a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service”

This is true only if a deflation affects all lat-denominated income streams equally, which it won’t. Consider a bank that has borrowed in euros to make consumer loans in lats. In the case of deflation, the nominal amount due to it in lats hasn’t changed. Even though the bank’s debtors will be taking in less in wages, the bank can still hope it will get repaid if consumers feel compelled to devote a higher share of their income to paying off their credit cards. So the bank will still have some chance of covering its euro-denominated debts, if the deflation doesn’t lead to too many defaults.

In the case of a (sufficiently large) devaluation, this bank is instantly under water, because even full payment by its debtors will leave it with too few lats to pay back its euro-denominated loans.

In general, the financial sector’s income stream will tend to be downward sticky in a deflation–that’s what makes deflation so hard on debtors. And this means that the financial sector ought to prefer deflation to devaluation (assuming it has net euro liabilities, as you point out).

and the tragedy is set to continue… see Romania and Hungary that have similar Euro (and also Swiss Franc) loans as in Latvia…

Yes Devaluation would seem the most logical considering that Tourism for Latvia is a high priority with millions being spent on upgrading the airport etc. The IMF placing the condition that the Lat can not be devalued has put a slow strangulation on Latvia. The Brit pound devaluaing will result in a top 3 source of tourists dropping down to an Argentina level.

Eventually the Latvian economy will collapse because the leadership in Latvia do not have the education to be able to make executive decisions that result in economic growth. The IMF has a history of throwing money and not making the people responsible be responsible. I fear that we will see a story within 12 months of how the Latvian leadership have taken Latvian money for their own pockets and used IMF money to fill the gap.

I worked for many years trying to influence the Latvian government towards Swedish models of success but there was no interest.

I have offered Australian and US support with Health and the Economy but the Latvian leadership don’t want it. They think they are proud and too good to do the right things for the people of Latvia.

//www.austcham.lv

Jacques René Giguère December 24, 2008 · 5:42 am

But there is a difference: the burden of devaluation is supported by everyone including the rentier class,the banking industry and other parasites. Wage reduction is borne only by the working class and other producers.
The choice is obvious,though according to your social class it is not the same one.

Jacques René Giguère
Professor of economics
Collège de Sept-Îles
Sept-Îles Québec Canada

There are 2 reasons that a devaluation and a redution in nominal wages are not equivalent.

1. I would conjecture that a significant part of the debt is in terms of domestic currency, in which case the devaluation will cause a smaller increase in the real value of the debt than a reduction in wages and the required accompaning reduction in prices.

2.But even if ALL the debt is in the form of Euros the two policies are NOT equivalent. The reason is that the devaluation can be imposed as a single step by government edict. Only if the economy had a Walrasian autioneer who lowered the wages and prices simultanously in one single step would a reduction in nominal wages and the required accompanying reduction in prices be equivalent to a devaluation. But since real world economies not have such an auctioneer, the process of wage and price reduction will take place gradually, and sequentially, which will cause an extended period of high unemployment until the process is completed. This is especially true in the case of the nominal wages. It will take a long, extended period of high unemployment to force them down. The resulting period of high unemployment and reduced output is a major ADDITIONAL economic cost in addition to the cost of the increase in the real value of the debt. Therefore such a gradual process will impose much more hardship on the economy than the devaluation. And if the wage reductions and high unemployment cause civil unrest, that will be still another additional cost.

Latvia should devalute.

Almost all the lending comes from Swedish banks, let them take the hit.

Swedbank, the largest bank in Latvia, is a Swedish Bank. The next biggest bank, SEB, is also a Swedish Bank.

Devalution should not hurt Latvia very much since most of the lending comes from a foregin country.

MARC (CATALONIA), economics student December 24, 2008 · 6:53 am

First, sorry for my english.
you believe that monetary union would be the solution for latvia and other countries in similar situation as iceland where the collapse of its currency can suppose a problem for these countries?

The second time it is not only the hero of the tragedy who dies, but everyone. That is to say, Latvia is on the way of becoming a “no country left” country. The only hope on the horizon is that the winter solstice is past and the sun is ascending. On the other hand, even the Sun can be cruel. Time will tell how it all ends.

Do you think that other CEE countries are on the same path? There was a massive growth in FCY loan for many other countries.
Do you think that a managed devaluation is possible in such situation? Just to avoid crisis and currency overshooting?

There is a slight but important difference between Latvia and Argentina.

Latvia is part of the EU and part of it’s population can just start to do (seasonal) work there and fix the foreign exchange balance with the Euro.

All temporary barriers created by western EU unions in some countries, have just passed their final date and have been removed.

As far as I know the inhabitants of Argentina did not have that option when their government pegged the peso to the dollar.

So Latvia isn’t and will not be Argentina. That is a false metaphor.

A serious question: why do the usual crowd not complain about moral hazard in countries with fixed or dirty pegs? Borrowers worldwide were borrowing in foreign currency (dollars, euros) because rates were lower than borrowing in local currency – even in countries where the exchange rates were nominally fixed.

Defending an indefensible peg through extraordinary means is just a way of bailing out a separate set of borrowers, those who tried to benefit from a (nominally) risk-free arbitrage based on a fixed exchange rate. In other words, they were getting cheaper funds while expecting “someone else” to pay the difference (government, in this case).

When can we purge the IMF of the Miltonites?

Poor tiny Latvia. Forced to replace a failed ideology with a failing one.

Plus, if a real depreciation through deflation damaged real output and employment, that would make it harder to service the debts.

given the rigidities in a nominal economy, it is almost certainly the case that a devaluation is a less painful way of achieving a realignment, than a forced deflation.

You can’t force contract holders (think policemen, or firemen) to take the necessary cuts in wages and prices (your landlord doesn’t usually cut the rent) rather, you have significant unemployment and then a downward spiral of fear of spending leading to more unemployment, etc.

If Latvian (or Icelandic) borrowers go bust, so be it. The recapitalisation of the banking systems of the lenders will cover for that. If someone was fool enough to lend a Hungarian a euro or Swiss Franc-mortgage, then that was a bad lending risk, for which they will be punished.

There isn’t a whole lot of ‘moral hazard’ in that (a much overstated force in economics) in the sense that the borrowers very clearly didn’t know what they were doing, nor anticipate the radical economic realignments that are taking place.

Boy, I’m sure glad most international trade was conducted in DOLLARS. Inflation or devaluation doesn’t affect our debt service the same way some other country has to service debts to us.

We devalue the dollar, and Chinese get fewer Yuan; Germans get fewer Marks; Japanese get fewer Yen; Britons get fewer Euros. We still pay in Dollars.

At least for the moment. Its gonna be a bummer when the currency standard becomes the EURO next year.

Well put Mr. Krugman … well put. Especially this …

“other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)”

Basically, my guess is that this whole idea of Latvia “accepting” the extraordinary dose of tough policies in order to stay within the realm of euro membership is bound to fail. It is pretty simple; the Baltics (and for that matter the rest of the CEE) will NOT join the Euro on the back of this crisis unless the ECB adopts a whole new approach towards the economy over which it presides.

It will be difficult for the IMF to wriggle itself out of this one but they need to since the amount of pain the Baltics need to undergo to make this happen with the current peg is simply impossible to implement in any serious policy context. I would hold this to be true especially if the Euro is now set to “enjoy” another dose of rebalancing (carry anyone?) flows if and when the USD crumbles under the Fed’s QE measures.

claus vistesen