The Devil and the Bible: Belated follow-up

Any manipulation with the existing currency regime could create significant uncertainty

There were some comments on my last piece that deserve some reply/added arguments so let this be all about the exchange rate (again, again…).

The question is, in the light of the IMF working paper discussed there, whether a more active monetary policy – devaluation, revaluation, widening of the fluctuation band or a floating exchange rate – should have been adopted by Bank of Latvia as a means to counter the credit boom.

Let me try a new argument of why I think fiddling with the exchange rate here is problematic: a) Because the average Latvian knows too much about the exchange and b) because he/she is paranoid on the issue of devaluation.

Re a): Whereas far from everybody knows the 0.702804 LVL/EUR parity, most are perfectly aware of ‘some 70 santims per euro’. People save in foreign currency, they hold foreign currency and they borrow in foreign currency. I mean, try to ask an American how many dollars it takes to buy a euro (OK, unfair, there is not a fixed exchange rate between USD and EUR but then ask a Dane and you would still find much more variation than here. Danes earn DKK, they spend DKK, they save in DKK and they borrow in DKK – only).

Re b): Perhaps due to lack of debate (at least prior to 2007), perhaps due to Russia’s 1998 experience, perhaps due to indoctrination, perhaps knowing or feeling this great saying by someone whose name I don’t recall: “In developing countries there are no small devaluations” or perhaps just due to some ‘Latvionomic’ attitude towards the currency, Latvians have displayed paranoia vis-à-vis a possible devaluation – just recall the rumours in March 2007, allegedly sent via SMS, that a devaluation was imminent and the reactions it caused.

Thus any manipulation with the existing currency regime could create significant uncertainty and a massive sell-off of LVL by currency-paranoid persons. My main argument against devaluation here has always been the risk of a currency collapse. 20% would sting, 40% would hurt but 60-80% would bankrupt all individuals and companies and lead to a collapse of the banking system.

And it is not so obvious when what should have been done to the exchange rate. Some examples:

2005-07, the time of overheating: A devaluation would have acted as a slap on the wrist of borrowers of foreign currency (fine) but would have stimulated activity in the export sector (not needed at a time of overheating). A revaluation would have dampened activity (fine) but would have been crazy given the size of the current account deficit. And perhaps a revaluation would have induced even more borrowing as people realize that they could pay back a euro loan with fewer lats?

December 2008, time of the Stand-by arrangement with the IMF: This was at the height of the international financial crisis and any change of the exchange rate would have resulted in panic, possibly a currency collapse (and Paul Krugman would have been right that “Latvia is the new Argentina”) and contagion effects in Estonia, Lithuania and elsewhere.

2009: If at any time devaluation should have been pursued then in 2009 but only after the 2010 budget had been approved. And the drawbacks would still be how to do a credible devaluation plus a need to change the IMF-EU agreement plus a changed strategy vis-à-vis euro adoption.

2010: No – like kicking a man who is already lying down. First you cut his wages in the internal devaluation, then you raise the prices of his imported goods via an external devaluation. The only benefit from a petty nationalistic point of view is that it could act as spitting the Estonians in their face but we’re too civilized for that, of course 

And why not a floating rate? Since they tend to overshoot (which I am certain it would have done at the time of changing from fixed to floating) plus one should not forget that the arguments for a fixed exchange rate are strongest for small open economies like Latvia’s.

And widening the band? The currency really didn’t need appreciation in 2005-07 which would then have been a possibility and perhaps likely due to the massive capital inflows and if the the new band was seen as credible.

So I am still in favour of the internal devaluation although it is costly and prolonged and I certainly remain convinced that lack of proper fiscal policy (should have been much tighter and should have taxed real estate to avert some of the capital inflows) is mainly to blame for the credit boom.

Incidentally, Latvia also pursued an internal devaluation strategy in the 1930s, check e.g. this quite fascinating article by historian Viesturs Karnups. It failed and ended in a big devaluation in 1936 – ouch! – but although similarities exist (e.g. bank failures), differences prevail, too: Lots of countries devalued then, there was no IMF and there was no euro as exit strategy. But the article is a good reminder of that the current situation is not unique and it is simply a fascinating read.

Morten Hansen is the Head of Economics Department, Stockholm School of Economics in Riga