Anti-Keynesian Insanity in Latvia

Has the Latvian government gone mad? Sacrificing the whole economy of the country to maintain a currency peg is insane. It will most probably result in a devaluation later anyway, with much less results than an earlier devaluation.

It is a question of fairness. The only party that gains an advantage from the currency peg are those with Lat-denominated paper assets. It doesn't make much sense either, because the kind of deflation that is required for keeping up the peg will result in the paper assets being defaulted upon anyway, except for the government paper.

Devaluation will not prevent the problems that were created by excess credit, but it is an important tool in preventing a deflationary spiral.

Robert Anderson and Stefan Wagstyl wrote in the Financial Times about Latvia's conundrum:

With the backing of the International Monetary Fund and the European Union, Riga is hoping that if it can impose enough pain on the domestic economy, it will be able to maintain its exchange rate peg to the euro. That would allow it entry into the single currency zone within the next four years.

After months of dithering, the government last week put together a package of measures that will mean Ms Blumberga – who earns just 280 lats ($552, £337, €398) a month – along with hundreds of thousands of other public sector workers will suffer a 20 per cent pay cut. Even pensioners will see reductions of 10 per cent.

This is just insane. A crash in domestic demand is the only thing that is sure to follow from such moves. There is a very high risk of starting a deflationary spiral.

Landmark property developments such as the twin Panorama Plaza towers on the road between Riga and the airport stand all but empty and shopping malls look forlorn. House prices fell by one-third last year, insolvencies are up and banks are repossessing more mortgaged properties and leased cars. “Business is in hibernation,” says Gunnar Ljungdahl, who chairs the Swedish chamber of commerce in Riga.

How exactly is intentional deflation going to help in this situation? When wages are drastically cut, we can safely wait for even more insolvencies and repossessions. Shopping malls are a dead investment when the purchasing power of the population rapidly shrinks.

In these circumstances, many governments devalue to spread some of the costs to foreign creditors and to boost the economy by making exports – which include wood products – more competitive. IMF officials have indicated that the organisation was divided over the wisdom of defending the lat’s peg but was finally persuaded by pressure from Riga’s EU partners as well as the Latvian government’s own refusal to contemplate devaluation.

So it's actually other EU countries that Latvians can thank for this disastrous policy. I thought the EU was supposed to be a project of peace. Killing a member country to "protect" irresponsible creditors at other member countries is a recipe for serious conflict.

Latvia sees the currency peg as the linchpin of its economic policies. It helped drive down inflation and is the route to euro entry. Latvia’s governments have often been weak but have always defended the peg and supported the powerful central bank, where both the prime minister and finance minister used to serve. “For Latvia the peg is the last pillar of trust,” says Henrik Hololei, an Estonian cabinet head at the European Commission.

All hail The Peg!

Also, Latvian officials argue that in a small economy, where 60 per cent of export value is in imported content, devaluation will not do much except encourage inflation. With some 90 per cent of all loans in euros, they add, it could bankrupt tens of thousands of companies and individuals. But the price of avoiding devaluation will be huge economic, social and political strains. Valdis Dombrovskis, prime minister, admits his main challenge now is “to preserve the social peace”.

"Encouraging inflation" (or discouraging deflation) is exactly what is needed at the threat of a deflationary spiral. Instead, Latvian officials are ready to give the economy a good kick to the backside. The foreign loans that turn out to be unaffordable will be defaulted upon one way or the other. If the income of debtors shrinks the effect is exactly the same. And a defaulted loan in euros is no bigger loss to the creditors, whatever the exchange rate.

So, as there is a wave of defaults anyway, why should there be a wave of deflation as an insult added to the injury. Deflation is an unjust reward of those who hold paper assets, and a punishment for those who hold actual assets.

IMF's Anti-Stimulus Rules

Mark Weisbrot writes in the Guardian of how the IMF is hurting poor countries by imposing tough rules on government deficits and interest rates at the face of a severe economic downturn. He refers to the anti-stimulative and deflationary conditions that are associated with IMF loans as "punishment". This seems to be quite justified at the face of the fact that even a 40 % budget cut in Latvia is not enough for the IMF.

Mr. Weisbrot points to the severe additional tension that IMF's diktats might potentially cause in already volatile Pakistan: "Slowing Pakistan's economy at a time when the global economic crisis is already doing that may not be the best policy from the point of view of political stability."

Getting away from government deficits is without doubt necessary in the long run, but the severity of the measures are and should be up for debate. Application of such measures should be postponed until the end of the economic downturn. They should also be associated with at least some concessions from creditors.

It also seems that American and European economists are not quite so ready to apply their "scientific" doctrines at home. This creates the inevitable appearance of high hypocrisy. Forcing some nations to tighter their belts 'till they pass out, while others freely splurge on trillion-dollar government deficits is very ugly to look at.

Western economists are quite easily throwing about the notion that these measures are for the good of the target nations, and that they must "swallow the bitter pill". What is easily forgotten is that some people's lives will be permanently ruined by such measures. When your children are about to die for the lack of medical services, the "long run" can be surprisingly short.

How the IMF works can only be described with the term "predatory lending". The whole point seems to be the creation of a permanent debt relationship, with all of the resources of a nation directed at paying the interest on the debt.

IMF strongly opposes progressive taxation as a way of escaping government debt. The regressive cuts to the most productive parts of the target governments' budgets, like education and health care, keep the debtor nations at the status of quasi-colonized sources of free labour and raw materials.

New Targets for IMF "Bail-outs"

The UK Telegraph writes under a headline: "Pakistan to receive $9bn from IMF in fight against bankruptcy".

Pakistan is to receive a $9bn (£5.5bn) bail-out loan from the International Monetary Fund as the country has three weeks to stave off bankruptcy.

Sound more like a bail-out of Pakistan's creditors. Pakistan will have just as much trouble paying to IMF as it has to its current creditors, and even more so after its public infrastructure, especially education, has been demolished by IMF demand. The same goes for Iceland and the others. Many earlier IMF clients would probably have done better by going bankrupt.

Now that the IMF is "aiding" both developed and developing countries at the same time, it will be most interesting to see it the same standards and conditions are applied for all, or if its demands for "tough medicine" are for developing countries only.

The demand for 18% interest rates for Iceland does seem to be quite insane tough. Expect a very hard landing indeed for the Icelandic economy. I guess the people in IMF will never learn from their experiences. What these countries need is debt relief and negotiations with creditors. Bailing out the creditors will just make sure that the same thing happens again and again and again...