The harder they come, the harder they fall
Paul Krugman, Nobel Prize winner in economics 2008, when in need of the antithesis of a role model for economic policy often chooses Latvia. He has been very critical of the insistence of the authorities to maintain the fixed exchange rate when the country faces recession and double-digit unemployment and of course he has a point. Prof. Krugman has similar posts comparing Iceland with Ireland , the latter via its participation in the eurozone being unable to undertake an external devaluation.
For me it is still not clear that the strategy of internal devaluation is better than an external one although I (still, especially if the authorities support it with proper 2011 and 2012 budgets) support the former. His Riga Mortis piece was fun but the post from 17th December 2010 lacks balance, I think, and certainly deserves some comment. Not to defend Latvia – the reckless boom-time ultra-procyclical fiscal policy in particular is very much the culprit of the current woes as I have argued previously and its effects rightly produces comments and interest from Prof. Krugman and many others.
Similar with different starting point
Prof. Krugman’s 17th December piece compares Latvia with Iceland. Facing banking crisis and recession Iceland let its currency, the krona/kronur, depreciate in order to increase export competitiveness to stimulate economic activity. The kronur was trading at around 92 ISK/EUR in 2006-07, increasing (depreciating) slightly in 2008 to some 120 ISK/EUR, to 160-180 ISK/EUR in 2009 while it has appreciated somewhat in 2010 and currently stands at 153 ISK/EUR. Check for details .
All in all a pretty substantial depreciation of about 40% of the Icelandic currency between 2007 and 2010. To the extent this has helped export competitiveness (which I am certain it has – but how your average Icelander repays his Swiss franc loan (55 ISK/CHF in 2007, 122 ISK/CHF today) I don’t know…) it should have softened the blow to the economy from the banking crisis and resulted in a lower GDP fall – which is exactly what Prof. Krugman’s graph shows. Conclusion: Soon the internal devaluation will have reduced the Latvian economy to nothing, a desert.
Allow me a similar graph below, only with a different starting point.
GDP, quarterly figures, constant prices, seasonally adjusted, Iceland and Latvia, 2000 = 100
Source: www.statice.is , www.csb.gov.lv
It is old news that Latvia’s economy grew rapidly in the early parts of this decade and it was not due to particularly smart policy; rather it was a consequence of catching up (and some OK policy…). Iceland is rich, Latvia is poor and thus has potential for catching up.
And the fall of the Latvian economy is indeed spectacular and seems to be the reason for receiving so much attention from abroad: From peak to trough, Q4 2007 to Q4 2009, GDP fell an accumulated 25,1%, the highest, well…, anywhere. Similarly, Iceland’s economy lost 13,5% of GDP between Q3 2008 (the recession started later) and Q2 2010, thus just over half the loss of Latvia. But I think two more points should be noted.
Firstly, the time from peak to trough in Latvia was eight quarters while in Iceland seven quarters, thus roughly the same amount of time and it would be stretching it quite a bit if someone were to say that currency depreciation speeded up recovery. Secondly, at the low point, Q4 2009, Latvia’s GDP had reached the level of Q4 2004 – one could say that the economy had been “bombed back” five years. This is actually also exactly what happened in Iceland: At the bottom, Q2 2010, the economy had the same size as Q1/Q2 2005.
Different currency regimes, similar performance: Both countries saw GDP decline for about two years, both countries saw GDP bombed back five years. Latvia’s cumulative fall was bigger than Iceland’s because its previous growth had been similarly bigger as is of course easily visible from the graph above.
The real reason
But was Iceland’s much smaller GDP decline really driven by exports due to a more competitive currency? Everything is in the eye of the beholder but the graph below does not exactly portray a lean, mean, Icelandic export machine. True, 2009 saw diverging export performances, possibly due to currency depreciation in Iceland – but then one can just as well argue that by 2010 the internal devaluation has started to work in Latvia where exports are up 15,5% y-o-y (Q3 2010 over Q3 2009) while in Iceland they are down 2,1%.
Exports, constant prices, Iceland and Latvia, Q1 2007 = 100
Source: www.statice.is, www.csb.gov.lv
Note: Seasonally adjusted data for Iceland but not for Latvia but the picture should be clear nevertheless.
Perhaps capacity constraints are at play in Iceland (see The Economist, 18th December 2010, p. 127-8, European edition) but similar problems exist in Latvia
a) due to underinvestment during the crisis and
b) perversely, in the face of 18% unemployment, lack of qualified labour and this leads me to my last point here.
As Prof. Krugman points out in yet another post on 21st December 2010 , Latvia has seen a much bigger decline in employment than e.g. Iceland. Very true and very sad but – even more sadly – not that strange either. Low unemployment is an anomaly in Latvia, not high unemployment as I have pointed out . In 2007, at the height of the boom, this ECFIN Economic Brief estimated Latvian GDP at no less than 16% above the level consistent with full employment, a degree of overheating best described as sizzling. Unemployment reached 5,4% at its lowest point, a point way, way below the uncomfortably high equilibrium level. Or to put it simply: any return to normality would have implied a huge drop in employment, no matter what.
The rich and the poor
It is easy to ridicule Latvia for its massive GDP decline and huge fall in employment but a more balanced analysis would see this partly as the result of the preceding rapid increases in GDP and employment – from boom through bust the numbers have always been more extreme and this little entry just tries to argue that the magnitude of the current decline is very much a function of the size of the preceding boom.
Without defending Latvia I actually see quite a few similarities between Iceland and Latvia:
That credit booms do not create long term growth.
That credit booms create long term pain instead: I do not envy Latvians who have to repay a car loan on a much reduced wage just as I don’t envy the Icelander who has to repay a CHF loan with devalued ISK.
GDP was kicked back five years in both countries – down, yes, but 2005 was not catastrophic in GDP terms in either country.
Currency depreciation or not, GDP declined in both countries for about two years.
And during the boom the private sector in both countries felt they could walk on water while the authorities were way too slow to react. The “nothing special” and “pedal to the metal” comments still live on here; for Iceland this paper by Willem Buiter and Anne Siebert is a good one.
Will the Icelandic currency depreciation ultimately be more successful than the Latvian internal devaluation? Perhaps, but I don’t see conclusive evidence yet.
But at the end of the day Iceland is still a rich country while Latvia is a poor one (in a European context) and that is what should receive much, much more attention here.
Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga.