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Latvia’s Internal Deflation: A Model for Greece?

By Mary Stokes


A number of commentators (see below) are holding up Latvia as a model for Greece, citing it as a successful example of internal deflation, similar to the ‘Plan A’ approach discussed in Greek Endgame: Time for 'Plan B'. However, RGE believes it is still too early to declare Latvia’s adjustment a success. Competitiveness has only modestly improved as the economy heads toward a third straight year of annual contraction. (See insightful posts from bloggers Edward Hugh and Morten Hansen on this topic.)

“The international investor is now confident about Latvia and, in fact, is using the Latvian case as an example for countries who need to deliver on the fiscal front.” (Yarkin Cebeci, JP Morgan; Bloomberg; Mar 5, 2010)

“Greece’s problems are temporary…Greece needs the same reforms as Latvia.” (Andris Liepins, deputy minister of economy in Latvia; NYT; Feb 12, 2010)

“Latvia seems to have achieved something many thought impossible: an internal devaluation.” (Economist; Feb 25, 2010)

Internal Deflation and Austerity Measures

After unsustainable, booming growth earlier this decade, Latvia’s economy is now in the painful process of restoring competitiveness via internal deflation (wage and price cuts), rather than nominal depreciation of the currency (which in Latvia’s case would mean devaluation given the currency peg to the euro). The idea is that export growth will eventually power the economy to a recovery. (See related Critical Issue: Latvia Macro View: Another Year of Contraction Expected in 2010.)

While Latvians’ endurance of the harsh austerity measures has been remarkable thus far, more economic pain and political pitfalls lie down the road before Latvia’s internal deflation can be declared a success story. While indicators suggest competitiveness has somewhat improved (see below), there are signs that the political will to continue with austerity measures may not endure.

Further budget cuts are required this year to keep the EU/IMF loan program on track and the government’s continued ability/willingness to meet the loan terms faces several key political challenges: 1) October parliamentary elections could lead to a breakdown of the consensus surrounding austerity measures; 2) the need to pass a 2011 budget with additional spending cuts could break down the political will to meet the IMF/EU loan terms. (See related RGE Analysis: Latvia: Crisis Again Rears Its Ugly Head)

Progress Report: Regaining Competitiveness

Below we examine a couple of indicators to see where Latvia is in terms of regaining competitiveness.

Figure 1

Source: Bank of Latvia

As can be seen in Figure 1, Latvia’s real effective exchange rate has depreciated since the peak in early 2009, showing a modest gain in competitiveness. However, the graph also shows that there is further ground to recover.

 Figure 2


Source: ECB

Figure 2, which shows how much output an economy receives relative to wages, indicates a reduction in unit labor costs as of Q4 2009 to below 2007 levels (the peak of the country’s boom). Nevertheless, unit labor cost trends demonstrate that further improvement is needed. 

In a recent report, Swedbank provides an in-depth look at Latvia’s progress in regaining competitiveness. See: Competitiveness adjustment in Latvia – no pain, no gain?

Erosion in Potential Growth

In addition to looking at competitiveness indicators to examine the success of Latvia’s internal deflation adjustment, it is also important to take note of the damage being done to long-term potential growth. More specifically, the internal deflation adjustment process runs the risk of eroding Latvia’s existing labor pool and capital stock. The concern is that the dismal labor market will lead to a brain drain, whereby Latvia’s best and brightest leave the country in search of jobs. Meanwhile, the capital stock is in decline amid limited capital inflows and high real interest rates that disincentivize investment in the country.

Michal Dybula of BNP notes: “The decline in the capital stock, combined with weak labor supply growth, as the demographic outlook for Baltic countries is poor, points to a substantial reduction in potential rates of growth to some 2-3% per annum over the coming decade.”

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