Floating and pegged exchange rates – or Polish succes against Baltic failure.

from Jesse Frederik and Merijn Knibbe

´ The International Monetary Fund had privately suggested a devaluation in Latvia to help cushion the blow, but this was overruled by the European Union on grounds that most of the country’s corporate and mortgage debt is in foreign currencies.’
Ambrose Evans-Pritchard, The Telegraph, August 10, 2009.

Small as they are, the tiny Baltic economies Lithuania, Estonia and Latvia are important – as ‘internal devaluation’ in these countries seems to be the ‘role model’ for comparable policies in Greece and Spain and whatever. What is to be learned from their experience?  Their total number of inhabitants is not even 7 million (1,4% of the total number of inhabitants of the EU) but they were among the transition countries which, after the implosion of the Soviet empire in 1990, were most eager to embrace market oriented reforms and which introduced the ‘Washington consensus model’ most thoroughly – even when after 2007 they were hit by a severe crisis. Instead of devaluating, as even the IMF suggested, these countries pursued (pushed by the EU) a ruthless policy of ‘internal devaluation’ and are, as such, role models for countries like Greece and Spain.

Should Greece and Spain follow their example? Did Extreme Austerity lead to growth, a surplus on the current account, 3% unemployment (well, unemployment which within one or two years might be below 10%), rising incomes and, above all, countries which were able to pay down their debts? No, it didn’t. It all went horribly wrong. And their 20% unemployment rates in combination with GDP declines which are among the largest ever recorded for market economies warrant the word ‘horrible’. This is not supposed to happen to market economies, not even in the ‘return on capital’ oriented Washington-consensus model. Still, it did happen – and no ‘prosperity is just around the corner’ talk of Baltic  presidents, IMF pundits or even cheerleader Anders Aslund (the ideologue of internal devaluation) does change this fact. Ironically, even though they did pay down part of their foreign debts, debts as a % of GDP are larger than ever, as GDP declined with 20 to 25% (official figures). See the graphs below.

Also, neighboring Poland, another non-euro, EU member transition economy, which introduced market oriented reforms (though of a less flexibility and ‘return on capital’ oriented kind), which is situated in the same region, which faces the same external environment and, like the Baltics, is blessed with an eager and well-educated work force and knows a more or less comparable level of productivity, did not experience a horrible downturn. What’s the difference? Below, we’ll provide some data.

The answer is disharteningly simple: the Baltics experienced an ‘Asian style’ debt fuelled boom which led to an increase in debts, asset inflation (an absolute mind boggling increase in house prices, for one thing) and unsustainable increases in wages (+30% a year) and which went bust when capital started to search safety instead of yield. This part of the story is well-known, but it’s good to tell it again. Less well-known are the consequences of the decision to maintain the europeg at all costs. The already dramatic bust was severely aggravated by the economic policy of the Baltics. Poland allowed the Zloty to depreciate almost as soon as the crisis started (see graphs below). As a consequence, the Zloty fell about 25% while Polish short-term interbank interest rates declined from about 7 to about 4 and later 3%. Latvia maintained its europeg and interbank rates went up to almost 30%. As a consequence, the Baltic economies fell of the cliff – while the Polish economy was able to crawl back and in fact weathered the crisis quite well. Could these countries have done better? The comparison with Poland suggest: yes, though we do have to keep in mind that the boom preceding the bust went very fast and was exceptionally large (look, below, at house prices – a threefold increase in two years in Latvia…).

 

Source: BIS/IMF/World Bank Joint External Debt Hub

Addendum: debt deflation in action. The increase post 2007 was despite a net reduction in nominal debt, as these economies shrank with twenty to twenty-five percent.

 

Source: Hypostat

Addendum: 90% of mortgage debt was denominated in foreign currencies… Note the correlation between total external debt and mortgages

 

Source: Central Statistics Bureau of Latvia, Statistics Estonia en Ober Haus

Addendum a: the house price increase in the USA was 60%, in countries like the Netherlands it took twenty-five years before house prices had tripled.
Addendum b: Estonia and Latvia: apartments only (price per square meter). Considering the sheer magnitude of the increase they however do warrant the conclusion that a housing bubble was taking place

 

Source: OESO, ECB, Central bank of Latvia

Historical epilogue: before World War I, external debt of Sweden increased fast. Not problem: after this war, they were able to pay down these debts with inflated money, which enabled Sweden to grow and prosper. One hundred years later, the EU Swedish banks pressed the Baltics to deflate….

P.S. – there is a kind of model behind this, ‘the impossible trinity’, which states that a country can’t have it all: an independent monetary policy, a pegged exchange rate and free flows of capital.