Grinding on

An often raised question recently has been what Greece can learn from Latvia's path of internal devaluation i.e. the compression of wages and prices that should lead to increased competitiveness. I don't think Greece has anything much to learn because I don't think they are able or willing to go Latvia's way. In Latvia internal devaluation has been going on for more than a year, in Greece it hasn't really started yet and already three are dead, riots and strikes are commonplace etc.

But does internal devaluation work in Latvia? Seemingly so. The following graph is one way of displaying Latvia's competitiveness. It shows the development of Latvian consumer prices compared to consumer prices in trading partner countries. An increase is a loss of competitiveness (Latvian prices rising faster than foreign prices) and a decrease is a gain in competitiveness.

Latvian competitiveness (REER, Real Effective Exchange Rate, 2000 = 100)

Due to deflation, competitiveness is returning but slowly as is the case with internal devaluations. REER vis-à-vis main trading partners is now back to its level of March 2008 but is that enough? An answer to this question would require knowledge of whether the lat is overvalued (which basically means that Latvian prices on average are higher than a weighted average of foreign prices) or not. Whereas it is relatively easy to tell whether competitiveness is improving or not, it is very hard to measure over- or undervaluation which is why such a debate continues.

A very simplistic way of looking at this is in the following graph. When the spending binge, fuelled by the credit boom, ended in 2008, imports collapsed. So did exports and for the same reasons (collapsing demand in our trading partner countries) but to a much lesser extent.

Exports and imports, 1000 LVL, monthly data

Right now exports are actually on the increase but as the graph shows Latvia is not exactly a red-hot German-type export machine, indicating that still more activity in the export sector is needed and that further deflation is thus needed, too. In other words, the internal deflation grinds on….

The main arguments against internal devaluation are that it comes at the cost of very high unemployment for a very long time (true in Latvia) and that it may be politically impossible (perhaps true in Latvia, see this excellent blog by my colleague, young Dombrovskis).

I have yet another argument and that is: When can one declare that internal devaluation is over and the battle has been won? There is no clear indicator to be met which means that in some camps a nagging expectation of external devaluation may continue, perhaps all the way to Latvian euro adoption. Such a lingering uncertainty is harmful.