(This post by Marshall Auerback and Robert Parenteau was published on Newdeal20.org.)
Want to see the real consequence of smash mouth economics? Forget about Greece and take a look at Latvia. Its 25.5 per cent plunge in GDP over just the past two years (almost 20 per cent in this past year alone) is already the worst two-year drop on record. The country recently reported a 12% decline in annual wages in Q4 2009 versus Q4 2008. The IMF projects another 4 per cent drop this year, and predicts that the total loss of output from peak to bottom will reach 30 per cent. The magnitude of this loss of output in Latvia is more than that of the U.S. Great Depression downturn of 1929-1933.
Policies and systems built for failure
Mainstream economics insists that one path to full employment is via lower wages. If you want to sell more labour services, lower the price of them, namely wages. This is a classic fallacy of composition argument. What might work for one firm is unlikely to work for all firms. Wage cuts in the aggregate simply destroy aggregate spending power, unless the lost demand is made up for in other ways.
But even though Latvia’s external balance is improving (largely through a collapse of imports as a result of the collapse of domestic demand), the country is unable to deploy fiscal policy effectively due to the external constraints of its monetary system, which is predicated on the existence of a currency board system. True, the current account is now turning positive, but to suggest that every single country can “internally deflate” its economy via wage destruction of this magnitude to achieve this state of affairs is another fallacy of composition argument. The whole world cannot run trade surpluses, especially not if policy is designed to destroy demand via massive wage destruction.
More importantly, the very structure of a currency board is wrong. It requires a nation to have sufficient foreign reserves to facilitate 100 per cent convertibility of the monetary base (reserves and cash outstanding). Under this system, the central bank stands by to guarantee this convertibility at a fixed exchange rate against the so-called anchor currency. The government is then fiscally constrained and all spending must be backed by taxation revenue or debt-issuance. Pegging one’s currency, then, means that the central bank has to manage interest rates to ensure the parity is maintained and fiscal policy is hamstrung by the currency requirements (which is why organisations like the IMF love them so much; it ties governments’ hands). Latvia pegs its currency at 0.71 lat per Euro and joined the ERM in 2005 with the intent of qualifying for the euro zone. It operates a system similar to Argentina in the 1990s which ultimately collapsed and led to its default in 2001 (Argentina pegged against the US dollar).
The country’s debt is projected to be 74 per cent of GDP for this year, supposedly stabilizing at 89 per cent in 2014 in the best-case IMF scenario. A devaluation, however, would substantially raise the debt service ratios, given the high prevalence of foreign debt (about 89% of Latvia’s debt is euro denominated). The currency peg, then, not only restricted the Latvia government’s freedom of fiscal manoeuvre, but also created huge financial fragility because Latvians operated under the mistaken assumption that the peg was inviolable, encouraging borrowers to act with no sense of exchange rate risk. As in Argentina nearly a decade ago, a devaluation would, in all likelihood, lead to a default on external debt. Argentina did eventually manage a 25% recovery in output in the two years following Q1 2002, but only after a 190% devaluation (which was 300% at its maximum)
As Michael Hudson and Jeff Sommers have noted, “these debt levels place Latvia far outside the debt Maastricht debt limits for adopting the euro. Yet achieving entry into the euro zone has been the chief pretext of the Latvia’s Central Bank for the painful austerity measures necessary to keep its currency peg.” They also point out that maintaining that peg has burned through mountains of currency reserves that otherwise could have been invested in its domestic economy. It has also precluded the use of fiscal policy, since (by virtue of Latvia’s peg to the euro), the country operates under the same constraints as if it were already working within the Stability and Growth Pact rules.
‘Internal devaluation’ is a toxic remedy
With no room to adjust the exchange rate, the only other way to make the currency lose value is to engineer a real depreciation — that is, reduce labour costs and prices in order to make its tradable products more attractive. This is euphemistically being described as an “internal devaluation” — a one-off coordinated reduction of wages and prices across the board. It is, in reality, more like an “infernal devaluation”. It amounts to a domestic income deflation as wages are crushed in order to get the prices of tradable goods down enough so the current account balance increases sufficiently enough to carry the next wave of growth. The hidden assumption is that a debt deflation spiral does not do the host country in as domestic private incomes are deflated. The argument to justify this toxic remedy is that a reduction in nominal wages and salaries can help Latvia accomplish a boom in net exports, thereby enhancing an economic recovery which would quickly attenuate or short circuit any accompanying debt deflation dynamics that might have been set off at the inception of the internal devaluation .
Here, in a nutshell, is a country which shows us all of the misery that is enacted through the creation of self-imposed political constraints on policy. The Latvian government has voluntarily abandoned the policy tools that could make the lives of its citizens better. Policy makers have tied both their hands and their feet behind their backs so that markets could work.