Latvia: Should You Care?

In the current field of grand economic strategy, against crisis and for recovery, Latvia looms small. This is a country with just two million residents, best known recently for a huge current account deficit – the excess of imports over exports peaked out around 25 percent of GDP.  Ordinarily, there is nothing here that should move the world economy.

Yet, there are some intriguing and somewhat disconcerting signs that point towards our common future – much like a close study of Iceland, back in October 2008, told us a great deal about what was to come.

First and foremost, we are looking at a creditor bailout-type situation.  Latvia is receiving large amounts of foreign financial assistance – from the IMF and the European Union – with the express purpose of making all payments due on its debts (mostly owed to West European banks; thank you, Sweden).  This is strikingly reminiscent of Latin America after 1982: above all else, protect the foreign banks.

Second, the bailout – at Latvia’s request – focuses on keeping the exchange rate peg.  The payments adjustment (exports up, imports down) must still come entirely from lower wages and prices.  This is an incredibly difficult task, which brings to mind Argentina’s struggles within its currency board in the 1990s.  If you make it very costly to change an exchange rate, you won’t devalue – until you absolutely have to, and then of course it is very costly.

Third, there is a fundamental contradiction in the approach favored by Latvia and the European Union.  They say they can’t consider devaluation, because so many households have borrowed so heavily through mortgages denominated in foreign currency.  But what happens to real debt payments as wages fall?  Is debt default being avoided or just deferred until the banks have got their money out – and the IMF has come in to the full extent possible?

My takeaway: we are still not ready for hard economic conversations anywhere in the world.  Wishful thinking prevails, in Europe as much as in the United States.  No one wants to start the difficult and messy task of restructuring – i.e., reducing – debt payments.  Everyone feels entitled to a bailout.  And the banks get one.

Or put it to your elected representative like this – we’re transferring Latvia’s debts from European banks onto the IMF, which is underwritten by our future tax dollars; then there will be default and devaluation for which no one is prepared.

Brussels, you’re doing a heck of a job.

By Simon Johnson

37 thoughts on “Latvia: Should You Care?

  1. Latvia could be the second ukraine, then again its so small that it relatively wont do much damage to the economy in the area. I think icelands problem was similar in scale? and they seem to be working it out?

  2. Iceland and Latvia are not comparable.
    Dominoes may start falling in Eastern Europe and Latvia is an EU member state even if not a eurozone member.
    Poles are watching nervously as are Swedish banks.

  3. This is looking more and more like a huge transfer of wealth from the taxpayer to the banker. And it is becoming a global phenomenon.

    State side what happens to the FDIC when the government loses its ability to raise capital. Will the few remaining savers take a larger than the bankers who so far have taken none? If so, will the public continue to accept this transfer of wealth?

  4. I would not presume to disagree, insofar as the perspective is limited to that of financial crisis and the management of emerging markets economies.

    However, I have always been troubled by lumping the successors to the constituent states of the former Soviet Empire with the rest of the globe’s ’emerging markets’. It seems to me that Eastern Europe, the near abroad and, emphatically, the greater Caucasus geography must all be viewed through a strategic lens focused on political, military and strategic concerns.

    I don’t know what should be done about Latvia. I would approach it with some diffidence because it was formerly a republic of the Soviet Union.

    Nice echo of New Orleans. Hope you European readers caught the allusion. I wonder where Brownie is now?

  5. This is depressing. I am musing about social contracts. Something about how society is held together by social contracts, citizens enjoy (even the pro-deregulation lobby), and too often take for granted.

  6. “They say they can’t consider devaluation, because so many households have borrowed so heavily through mortgages denominated in foreign currency.”

    Borrowing in a foreign currency should be ILLEGAL!!!

    Even if it is allowed, the banks should ALWAYS be the losers!!! That way they will stop loaning to people who can’t pay it back and won’t be able to take their collateral and not receive a bailout.

    If that means less debt in the world, fantastic!!!

  7. “Or put it to your elected representative like this – we’re transferring Latvia’s debts from European banks onto the IMF, which is underwritten by our future tax dollars”

    Sounds like socialism for the bankers and the bondholders. But, isn’t that the purpose of the fed and the IMF, to bailout the bondholders so they do NOT have to take any losses???

    Is it FAR BEYOND TIME for this “person’s” precious little IMF to be ABOLISHED, just like the fed???

  8. “In the current field of grand economic strategy, against crisis and for recovery, Latvia looms small.”

    If someone is against crisis and for recovery, the best thing to do is GET RID OF THE DEBT (future demand), even if and especially if it means lower stock prices, lower housing prices, and less wealth/income inequality!

  9. Many have characterized the modern crisis as Keynesianism/socialism etc. It really is not. It’s a return to oligopolistic mercantilism. That is the essence of economic warfare – the control of future spending power.

    The net result of this could be global de-integration as nations re-exert sovereignty (rather than allow themselves to become debt-slaves), which will result in lower global international capital flows.

    But maybe this is a good thing. Clearly, if the world can’t get its act together to create a robust regulatory system capable of handling international integration of finance and trade, then maybe we’re better off with a little less globalization.

  10. My only good question, to which, I believe there is no good answer: When will this cease? The unfortunate thing is that this appears to be, as one reads between the lines, simply more of the deleveraging balancing act that has turned into the ultimate high wire act. It makes me believe that the world’s recovery, if it actually happens in the near term, will be essentially flat — FOR YEARS!!!! But then, if we want to point fingers, I will guarantee anyone who wants a guarantee, that the key players (international oligarchs and the super rich and super powerful) will never accede to the blame. They wanted control, had control, and now contrive to keep control. If the pain becomes to pronounced for the rest of the world, there will be massive revolution. There is a real doomsday scenario brewing and nobody can stop it except those who refuse to. Makes me happy to be 63, and unhappy that my granddaughter is only 13, and is talented and smart enough to have a marvelous future, if it will only be possible. I am hopeful, but very pessimistic.

  11. It might be worth mentioning why they are so keen on keeping the currency pegged (prospective Euro membership etc.), and why at least borrowing in Euros was not completely crazy given the self-imposed 1%-currency fluctuation band (Yen and Swiss Francs, that’s another story of course). Judging from some of the comments, not all of your readers are aware of this part of the story.

  12. I don’t think the Latvian politicians are willing to make that decision, at least not yet. Public support of politicians is very low in Latvia and the decision can’t be made by anyone else than Latvians themselves.

    BUT Latvia needs the money. Please don’t confuse this with a bailout like the ones given to AIG, GM, C etc. It’s a loan. But to secure the loan, Latvia has to cut it’s budget deficit below 5% of GDP (right now, it’s at 12%). The Latvian govt has been trying to renegotiate the rules, but the IMF has not moved an inch, rightly so. So the only other option besides cutting govt expenditure is devaluation. I think the Latvian govt will ultimately devalue and conveniently blame the IMF to save face in front of the home crowd.

    Meanwhile, RIGIBOR is at 19.6%

    I live next to Latvia, just so you know. I’m not hoping for a devaluation, as the Estonian kroon is likely to be devalued in such a case, but frankly, I don’t see any other way out.

  13. As you describe it, Latvia reminds me of S. Korea in ’97-98. Peg the exchange rate and the private sector takes on huge fx exposure (for S. Korea, it was banks with the carry trade; borrow cheap in USD, lend dear in KRW.)

    While Latvia is small, East Asia isn’t. East Asia seems to be where we find the really big economies with pretty fixed exchange rates. They also seem to have targeted a USD exchange rate that few think is sustainable.

    I’m wondering what you thoughts are on the coming Asian adjustment problems. Is it much less likely to cause serious financial sector problems? (major Asian currencies will need to *appreciate*.) Do we know who bears the downside risk of this exchange rate movement?

  14. Kristjan,

    What do you mean when you say the RIGBOR is at 19.6%

    I’ve heard Estonia adopted Milton Friedman’s economic policy, including a flat tax, as a post-Soviet approach to economic development.

    What do Estonians think about Milton Friedman and his economic theory since the melt down of the global financial system?

  15. Simon said: “we are still not ready for hard economic conversations anywhere in the world…No one wants to start the difficult and messy task of restructuring – i.e., reducing – debt payments. Everyone feels entitled to a bailout. And the banks get one.”

    Could this conversation include pre-emptive bankruptcy?

    Just desserts for those who played casino in the world financial system. Refuse to repay and then plead charity in a bid for international aide !

    More honest perhaps?

  16. Tippy Golden,
    RIGIBOR (Riga Interbank Offered Rate) is the index of Latvian interbank credit interest rates. The current 19.6% is a sign of a lack of trust toward the Latvian national currency, the lat. You can have a look at the latest data here. During the recent weeks, there has been a lot of talk about a possible devaluation, at least on the international financial media (and a few blogs). So it is only logical that the interbank offered rate is so high.

    You are right about the Friedman economic policy. The flat tax started out at 26% and now it’s down to 21%. We have a liberal govt who thought it’d nice to cut the income tax and replace it with all sorts of new fees and a hike in other taxes. I don’t think this is a very good idea as the income of the state is too dependent on spending (I’ll give you specific stats if you want to see them, just let me know).

    Friedman’s ideas are holding ground, I’d have to say. The govt has cut spending to keep the budget deficit in check and I think the people are mostly fine with it. We don’t like the bad times, that’s for sure, but I think it’s a necessary step for us, Estonians, because ever since we got our country back, our economy has been growing without a serious setback. That means constant wage increases, a constant rise in living standards. You don’t know what a 10% rise in GDP does to people until you’ve lived it. I’ve lived it and I can assure you that there were way too many illusions and I’m sort of glad that the crisis is so severe – it’ll theach people the harsh reality of economic cycles…..

    Sorry…I got a little distracted. The people would of course like to lynch the politicians, but that’s not a local anomaly. In most parts, they have accepted the cuts in state spending. The voices of those chanting for Keynesian economics are fortunately very weak.

  17. Kristjan,

    I live in Canada. I know very little about Estonia. But it seems there was a breath of fresh air (political and economic) that has been good for Estonians.

    Yes, I would be interested in learning what your government spends its revenues on, so kindly post the link.

    In Canada, our overnight / interbank lending rate is 25 basis points. Our dollar is floating around US 90-cents. Mixed reviews, in Canada, on the value of our currency depending on whether you are an exporter or importer.

    As an Estonian, what do you think about the Obama government using, Keynesian economics, in its effort to stabilize the American economy? Though the banks got a great deal of bailout money, so there is the oxymoron of socialism for big banks.

  18. The European Union Euro members have huge problems, as do many of its major banks that have huge exposures to the EU periphery states, Latvia being only one of these. However, we must remember that the EU is a bulwark against totalitarian regimes and the ways of the past, hence both an economic and political solution will be found, it may take a few years though.
    That said, Friedmanite economics have failed, yet both the World Bank and IMF keep ramming them down everyones throats as panaceas to whatever ails an economy, such reforms as envisaged by both institutions usually only ever benefit a minority.
    A return to a more utilitarian view of economics is necessary if extreme political views are not to gain a foothold again in Europe. It shames me to say that fascism is evening showing its ugly head in the UK, surprisingly, we see little yearning for communism. Thus, it must be said that Keynes is about the best we have until some bright economists can offer a better path to lead us out of the current mess.
    Although, given the gutting of the manufacturing sector in many nations, coupled with the growth of a parasitic financial services sector utterly divorced from reality, we really should be asking ourselves what Mr. Keynes would have made of all this if he were alive today.
    Still, given the treatment doled out to him by the US in the aftermath of WWII a sense of irony is now apparent as the US itself goes begging to China to keep purchasing its debt.
    We do seem to be in a vicious downwards spiral, however, out of this detris I’m confident something will emerge, one just not is sure what exactly this will be at the moment.

  19. Tippy,
    I’m afraid I can’t give you a link because the Estonian Ministry of Finance doesn’t have the documents in English. I’ve no idea as to why that is. Anyway, the files that they’ve uploaded are quite messy and I tried translating one of them…which only got me so far as to make me mad. You see, the software they use just doesn’t run very good on my computer. Anyway, I will try to translate the data and I’ll get back at you. Here’s my e-mail (just in case): kvelbri[at]gmail[dot]com

  20. Thanks Kristjan,

    If the moderators did not mind, perhaps you could post the info. A way to learn how other economies are working around the world. (After all we are globalized and so too the financial crisis.)

    Since I joined this blog, my learning curve has definitely gone up, and I’ve come to appreciate my own country more. Many Canadians (myself included) take what we have for granted. Fish not knowing the water they swim in.

    For instance, Canada is ranked by the World Economic Forum as having the — soundest banking system — in the world. We had a great run for more than a decade with Paul Martin as our Finance Minister. I am very sorry he left politics. He is the right person to be our Prime Minister during these uncertain times. Indeed, good for the international scene.

    The pro-deregulation lobby — did not — manage to convince our government to allow high-risk mortgages (and derivatives?) til very late in the American game. Hah! Part of their argument was our financial system is falling behind, regulation is stifling competition! they said.

    So we took a hit. But the exposure has not sunk any Canadian banks. They are still posting profits. Just not the record-breaking profits of the past. Definitely not bank bailouts required.

  21. We can complain and moan about Latvia and IMF, but the fact remains that it all started in US and EU countries got “infected” with same financial shenanigans. Now most countries are in a “catch 22”. Real estate values went down about 50%, GDPs are going to hell. Before you know it, the dominos start tumbling.
    No, 2.3MM people going under will not create even larger crisis. Unfortunately, we are not talking about an isolated island nation in the middle of the ocean. EU countries are closely tied together. If one falls, the rest suffer as much. Capital markets are awfully intertwined, we all got into this mess and we all will have to figure it out. There will be lots of anger, spite, bad feelings, and heck knows what else. Again, we can moan and grumble, but that will not make these problems disappear.
    What do I suggest? We deal with this one day at a time. There is nothing else we can do.

  22. There is one key point that differs Latvia from Argentina. They are free to travel and work in the Eurozone. Many of them are doing it in this season earning money in farms and working in private construction for households.

    You have to calculate not only the current account deficit but also the money send back home / taken home from the hard coin countries were citizens have lend the money for their mortgages.

    This is the real difference between the eastern Eurozone countries and South-America.

  23. Tippy,
    I’m sorry it took such a long time for me to post these charts. Anyway, here they are. If you want additional information, please let me know.

    As far as Canadian banks are concerned, you’ve done a great job handling them. The US is way out of line with its backstopping, guarantees and bailouts. They’re gonna finally kill the dollar.

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