Latvia’s Internal Devaluation: A Success Story?

by Guest Authors Mark Weisbrot, an economist and Co-Director of the Center for Economic and Policy Research (CEPR), in Washington, D.C. – Full bio here; and Rebecca Ray, Research Associate, CEPR – LinkedIn bio here.

Global Economic Intersection Article of the Week

Executive Summary

Advocates of an economic strategy of “internal devaluation” have recently pointed to Latvia as an example of successful macroeconomic policy. The Latvian economy is projected to grow by four percent in 2011. They argue that the Latvian government, along with the European authorities (including the International Monetary Fund – IMF), pursued the correct macroeconomic policies by maintaining Latvia’s fixed exchange rate and implementing pro-cyclical fiscal policies (that shrunk the economy further) and sometimes pro-cyclical monetary policies. They argue that these were the best policies –as opposed to counter-cyclical, expansionary fiscal and monetary policies, accompanied by devaluation– designed to promote a rapid economic recovery. 

In 2008 and 2009, as many countries fell into recession due to the global financial crisis and world recession, Latvia experienced the worst loss of output in the world. From late 2007 to late 2009, the country lost about 24 percent of its GDP. Official unemployment rose from 5.3 percent in late 2007 to 20.5 percent in early 2010.

Any argument that the “internal devaluation” strategy was an economic success would therefore have to be based on the counterfactual that a devaluation with expansionary macroeconomic policy would have been worse.

Table 1 below shows the loss of GDP following other large, crisis-driven devaluations, for a number of countries in the past two decades. Argentina, which defaulted on a record $95 billion of sovereign debt and suffered a financial collapse, lost 4.9 percent of GDP, after its devaluation, before it started growing again. The average loss for countries with devaluations in crisis situations was 4.5 percent of GDP. This compares to a loss of 24.1 percent of GDP for Latvia during its recession, while it kept its exchange rate fixed.

More importantly, we can also look at where each of these countries GDP was three years after these large, crisis-driven devaluations. Most of the countries are considerably above their pre-devaluation level of GDP three years later. The average economy is up by 6.5 percent over their pre-devaluation level of GDP. Latvia, by contrast, is down 21.3 percent of GDP, three years after the crisis began.

In addition to the loss of national income, there have been other social and economic costs of the Latvian government’s strategy of internal devaluation. The official unemployment rate rose from 5.3 percent at the end of 2007 to 20.1 percent at peak in early 2010. Even after more than a year of recovery, the unemployment rate remains devastatingly high at 14.4 percent. That is mainly because the recovery has been relatively weak, especially given the depth of the severe economic contraction.

But the official unemployment rate does not measure the full cost of this recession and weak recovery to Latvia’s labor force. If we take into account those who are involuntarily working part-time and those who have given up looking for work, we get peak unemployment/under-employment of 30.1 percent in 2010, declining to 21.1 percent in the third quarter of 2011.

It also does not include all the people who have left the country in search of employment since the crisis began. It is estimated that the net loss of population in 2009-2011 amounts to as many as 120,000 people, or 10 percent of the labor force. If not for this migration, the broader measure of unemployment could be as high as 29 percent in the third quarter of 2011, instead of 21.1 percent.

Introduction

In 2008 and 2009, as many countries fell into recession due to the global financial crisis and world recession, Latvia experienced the worst loss of output in the world. From late 2007 to late 2009, the country lost about 24 percent of its GDP. Official unemployment rose from 5.3 percent in late 2007 to 20.5 percent in early 2010. Figure 1 shows Latvia’s loss of GDP as compared with other recessions and depressions over the past century. Latvia’s loss of output is the worst over a two-year period or less.

In the fourth quarter of 2009, the economy began to recover, and while year-over-year growth for 2010 was still negative (falling 0.3 percent), it is projected to be positive 4.0 percent for 2011. On this basis, advocates of “internal devaluation” have now pronounced Latvia to be an example of successful macroeconomic policy. They argue that the Latvian government, along with the European authorities (including the International Monetary Fund – IMF), pursued the correct macroeconomic policies by maintaining Latvia’s fixed exchange rate and implementing pro-cyclical fiscal policies (that shrunk the economy further) and sometimes pro-cyclical monetary policies. They argue that these were the best policies –as opposed to counter-cyclical, expansionary fiscal and monetary policies, accompanied by devaluation– designed to promote a rapid economic recovery.

“Latvia stands out as an example of how such a financial crisis can be resolved,” write Anders Aslund and Valdis Dombrovskis in a 2011 book published by the Peterson Institute for International Economics. “When a country needs to address underlying structural inefficiencies in the economy, internal devaluation is preferable to exchange rate devaluation . . .” [1]

This argument could be relevant to a policy debate that is an important part of the current crisis in Europe. The weaker eurozone economies (Greece, Ireland, Portugal, Spain, and Italy) are currently carrying out a similar “internal devaluation” strategy. The idea is that they can regain competitiveness, and eventually resume normal growth and employment levels, by pushing down labor costs through high unemployment and downward pressure on wages. Fiscal consolidation – budget tightening – is also seen as necessary, even if it worsens the economy in the short run, for additional reasons: to reduce the public debt and public payroll. The weaker eurozone economies are under heavy pressure to “stay the course,” and continue with the painful process (although in the case of Greece there is finally recognition that some debt cancellation will be necessary). The Latvian “success story” is being used as evidence that there is light at the end of the tunnel. It is the best-developed argument for “internal devaluation,” based on a country study that has been put forward.

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