Academic journal article Brookings Papers on Economic Activity

Boom, Bust, Recovery: Forensics of the Latvia Crisis

Academic journal article Brookings Papers on Economic Activity

Boom, Bust, Recovery: Forensics of the Latvia Crisis

Article excerpt

ABSTRACT

Latvia's boom, bust, and recovery provide a rare case study for macroeconomists: an economy that responded to a balance-of-payments crisis by maintaining its currency peg and adjusting through internal devaluation and front-loaded consolidation. This paper lays down the facts about Latvia's boom and bust and analyzes the policy response and the mechanics of the adjustment through internal devaluation. While Latvia's adjustment was very costly, with a large drop in output, a big increase in unemployment, and substantial emigration, it was eventually successful. The internal devaluation worked faster, though quite differently, than what had been expected. Productivity increases, rather than nominal wage cuts, drove much of the unit labor cost reduction. These then led to an increase in profit margins, rather than a decrease in prices, and to a surprisingly fast supply response. The strong front-loaded adjustment did not prevent the recovery. The lessons of the Latvian experience for other countries may however be limited, since many of the elements of the eventual success appear to have been due to factors largely specific to Latvia, factors that are not present in southern euro countries, in particular.

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Latvia is a small country, with a population of only two million, yet it has been an object of intense attention during the financial crisis. In response to their country's own twin crises--in balance of payments and banking--and against the recommendations of many economists, the Latvian authorities decided to maintain their currency peg and adjust through internal devaluation and front-loaded fiscal austerity rather than devalue.

Five years later, the proponents of this approach see it as a clear success. Its opponents see it, if not as a clear failure, at least as an excessively painful adjustment. Witness the recent back-and-forth between Latvia's prime minister, Valdis Dombrovskis, and Paul Krugman:

Krugman famously said back in December 2008 that Latvia is the new Argentina, it will inevitably go bankrupt, and now he has difficulty apparently admitting he was wrong and so he tries to seek some problems in how Latvia is recovering from the economic crisis [...] But I think that the mere fact that for the last two years we are enjoying rapid growth shows that it was probably the right strategy.

--Prime Minister Valdis Dombrovskis, March 15, 2013 (1)

The adulation over Latvia really tells us more about what the European policy elite wants to believe than it does either about the realities of Latvian experience or the fundamentals of macroeconomics. [...] We're looking at a Depression-level slump, and five years later only a partial bounce back; unemployment is down but still very high, and the decline has a lot to do with emigration. It's not what you'd call a triumphant success story.

--Paul Krugman, January 2, 2013 (2)

The main goal of this paper is to lay down the (often misstated) facts about Latvia's adjustment. On its own, this would be a fascinating story of boom, bust, and (at least partial) recovery. But the story has wider relevance. Adjustment under a fixed exchange rate and the speed of fiscal consolidation have been and remain central issues in the euro debate, and Latvia is often used by one side or the other as an example of what to do or not to do. We hope our paper contributes toward moving this debate forward.

The basic and striking facts to be explained are illustrated in figure 1. GDP increased by almost 90 percent from 2000Q1 to 2007Q4, followed by a decrease of 25 percent from 2007Q4 to 2009Q3 and then a recovery, as of 2013Q2, of 18 percent. Meanwhile, the unemployment rate sketched a mirror image, decreasing from 14 percent in 2000Q1 to 6 percent in 2007Q4, then increasing to more than 21 percent by 2010Q1 and then decreasing since then to 11.4 percent as of 2013Q2.

We focus in this paper on six aspects of the story. …

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