Latvia Shows the Damage That Far Right Economic Policy Can Do – With Support from the European Union and IMF

Mark Weisbrot:

 The signs of recession are more noticeable to those who live here – restaurants and coffee shops have lost most of their customers, and construction has practically ground to a halt. Emigration has soared.

Latvia has set a world-historical record by losing more than 24 percent of its economy in just two years. The International Monetary Fund (IMF) projects that 2010 will be another bad year, with GDP shrinking by another 4 percent. The Fund forecasts a fall of 30 percent from peak to bottom, which would surpass the U.S. decline during the 1929-1933 downturn of the Great Depression.

Yet Uldis Rutkaste, an economist who is Deputy Head of the Monetary Policy Department and advisor to the Governor of the Latvia’s Central Bank, told a public audience of several hundred people here on Wednesday that the government would continue with its “pro-cyclical fiscal policy.” The word “pro-cyclical,” which he used, refers to a policy that would be expected to reinforce the downward trend of the economy. This would continue, he said, until wages had fallen further.

It is difficult to imagine a government official in the United States, Western Europe, or indeed most countries of the world making an argument like this in public. But these are “true believers,” and they will stay the course so long as their citizens are willing to accept the punishment.

What is the reasoning behind dong the opposite of what most governments in the world are doing – i.e. stimulating their economies with counter-cyclical policies in order to speed recovery from the global recession? And in a country that has suffered the steepest recession in the world?

The logic goes like this: Latvia has a fixed exchange rate, with the currency pegged to the Euro, and the government does not want this to change. If this nominal rate of exchange stays fixed (at 0.7 Euros for 1 Lats), then the only way to lower the value of the currency internationally is to do so in “real terms.” This means pushing wages and prices down. In other words, Latvian production can become more internationally competitive by lowering prices and wages internally, while keeping the currency’s international exchange rate fixed.

While this is theoretically possible, it is extremely difficult in practice – and even if it were to “succeed,” the disease is cured by killing the patient. Unemployment in Latvia has passed 22 percent, and despite the world record decline in GDP, the real exchange rate, as noted recently by the IMF, has barely moved.

Posted via email from Jim Nichols