In a measure of how desperate Brussels has become for success stories in the ongoing European debt crisis, the European Commission holds up tiny Latvia as the poster child for how countries should cope with their external and public finance imbalances. For in 2008, rather than take the easier route of devaluing its currency to deal with a balance of payments crisis, Latvia rigidly stuck with its exchange rate peg. And instead of devaluation, Latvia chose to go down a path of severe IMF-EU imposed austerity, including very large cuts in public wages, aimed at securing an “internal devaluation”.
According to the European Commission’s narrative, this approach has paid off handsomely. Over the past two years, the Latvian economy has staged an economic recovery, regained international competitiveness, and is now meeting the conditions for Euro membership. This prompts the Commission to ask why other troubled European countries do not follow the Latvian model of budget austerity with the same determination as did Latvia.
A basic problem with the Commission’s narrative is that it glosses over the extraordinarily high economic and social price that Latvia has paid for eschewing exchange rate devaluation as a means to restore external imbalance. From its peak in 2008, the Latvian economy contracted by 25% while its unemployment surged to over 21% of the labor force in 2010, making its recession by far the worst suffered in Europe during the 2008-2009 Lehman-crisis. And even now, after the economic recovery has got under way, Latvia’s economic output remains more than 15% below its peak level, while its unemployment rate remains at 13.5% even after a very large amount of emigration.
A counterfactual as to what might have happened in Latvia had it chosen to abandon its exchange rate peg is provided by the recent Icelandic economic experience. In 2008, Iceland suffered a financial and economic crisis similar in severity to that of Latvia. However, unlike Latvia, it chose to abandon its currency peg as part of a heterodox policy approach to restoring external and internal balance. And it did so with considerable success. By 2011, the Icelandic economy was also recovering with relatively low inflation while at no point did Iceland experience a cumulative output loss of more than 10% or unemployment in excess of 8 ½%.
An ironic twist in the Latvian saga is that its prime minister is now acknowledging that the majority of Latvians have lost their appetite for Euro membership. It seems that in pursuit of the holy grail of Euro membership the Latvian population has now got cold feet. This has to raise the basic question as to what purpose was the extreme suffering through which the Latvian economy went in order to preserve its exchange rate peg. It also has to raise the question whether the Latvian experience is indeed something that Cyprus, Ireland, Portugal, and Spain might want to repeat.