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

VI.B. Unemployment

As of June 2013, the unemployment rate was still high at 11.4 percent. The question is how far this rate was from the natural unemployment rate, and thus how much remained to be done. To think through this question, we have two--admittedly imperfect--tools: the Beveridge curve and the Phillips curve.

Figure 16 plots the Beveridge curve, which shows the relation between the unemployment rate and the vacancy rate, from 2005Q1, the first quarter for which data on vacancies (from an official survey) are available. After an early inward shift of the curve toward the end of the boom, the relation appears quite stable. Indeed, as unemployment starts declining from its peak, it appears to be retracing its movement in the slump. In short, there is no evidence of an adverse shift in the Beveridge curve due to the crisis. (38)

However, this does not settle the issue of what the natural rate might be. For this, we must look at the relation between inflation and unemployment, the Phillips curve. Figure 17 plots core inflation minus expected inflation against the unemployment rate, as well as the corresponding regression line. (Details of the estimation are given in the appendix to this paper and in the online appendix as well.)

The point estimate for the unemployment rate at which core inflation is equal to expected inflation is a surprisingly high 13.3 percent (a 95 percent confidence interval ranges from 11.7 percent to 14.8 percent). The figure also makes clear that an unemployment rate below 8 percent has been typically associated with large increases in inflation. This is indeed what we found earlier when looking at inflation in the boom. Thus, using this metric, the actual unemployment rate is rapidly approaching the natural rate.

This raises a final question, which, while not central to the issues of this paper, is nevertheless intriguing: How can a country with a low minimum wage, weak unions, and limited unemployment insurance and employment protection have such a high natural rate? We do not have a good answer. (39) High unemployment appears to reflect high duration rather than high reallocation and high flows through the labor market. The "Lilien index," defined as the standard deviation of sectoral employment growth rates for 10 sectors for the decade 2001-10, is substantially higher in Latvia than in Germany or France. But job turnover, defined as the sum of job creation and job destruction, appears to be similar in Latvia to that in Germany and France (Boeri and Garibaldi 2006). Unemployment duration appears similar to that for the European Union, with a large upper tail. This might be caused by high reservation wages due to a still extensive informal economy (including home production and barter networks, especially in rural areas) or to skill mismatches.

To summarize: The actual unemployment rate is probably close to the natural rate of unemployment. Latvia may well want to take measures

to reduce its natural rate, but the recovery from the slump is largely complete.

VII. Conclusion and Tentative Lessons

The Latvian boom-bust recovery story is a striking one. While we have tried throughout this paper to stick with the facts and avoid normative statements, here we will venture to draw some lessons, beginning with six that are more narrowly focused and then addressing larger matters.

The first lesson is an old one: Healthy booms often turn unhealthy, and policymakers often react to them too late. The boom in Latvia was healthy until 2005, unhealthy thereafter. Clearly Latvia could not have avoided the adverse effects of the global crisis, but had monetary policy been tighter from 2006 on, the adjustment would have been easier.

The second lesson is that if a country's financial sector is largely composed of foreign subsidiaries, it is a good idea for its government to be friendly toward the parent banks. …

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