Latvia and the output gaps

Nobody who knew about it ever doubted it. Before 2008 countries like Spain and Latvia had ‘positive output gaps’- aggregate demand was larger than the capacity of the domestic economy. This led among other things to large and unsustainable current account deficits. According to the (vintage…) textbooks you solve this problem by restricting domestic demand as this will lead to a decline of imports. As foreign demand will keep increasing exports will however increase which means that the deficit will dwindle in no time. See also this blogpost for some empirical data which vindicate this wisdom.

However. Not all positive output gaps are created alike. And the textbook wisdom only applies to what I call ‘endogenous positive output gaps (ENPOG’s)’. And not to ‘exogenous positive output gaps’ (EXPOG’s). And Spain and Latvia had EXPOG’s, not ENPOG’s (Paul Krugman and Olivier Blanchard seem to be rather confused about this…).

ENPOG’s are created by domestic events inherent in the domestic economy, like a housing boom fuelled by domestic credit. They generally lead to limited deficits on the current account which can be cured by a limited restriction of demand. EXPOG’s are however created by external circumstances, like large inflows of capital or a war. In such a case current account deficits tend to be much larger than in the case of ENPOG’s. To restrict these large deficits domestic demand has to be decreased much more (or will be reduced much more, for instance by a ‘sudden stop’ of the inflow of capital) than in the case of exogenous gaps, with disastrous unemployment as a consequence. While the same crisis which is often causes the ‘sudden stop’ will also prevent an increase of foreign demand and an increase of exports.

Which is of course exactly what happened in the Baltic states, Bulgaria and Ireland and what is happening in Spain, Greece and Italy. Restraining domestic demand works (‘A) in the graph) – but once this phase is over exports (as a % of GDP) only increase haphazard – as foreign demand is restricted (B in the graph). And the country is left with debts and über-unemployment which is only solved by massive emigration.

By the way – the mother of all EXPOG’s  was of course the USA economy during World War II. Which also shows dat EXPOG’s can have quite different natures. During WW II, USA labour shortages were ‘solved’ by unsustainable increases in participation rates and hours. And the slump in aggregate demand after the war did not lead to massive unemployment – but to (voluntary) lower participation rates and a large decline in the average number of hours worked. In Latvia and Spain somewhat comparable shortages however led to either very high wage increases (Latvia) or absolutely massive immigration in combination with in fact quite moderate wage increases (Spain) and the decline in demand led to unemployment rates of 20% or more (while an increase of 1 or 2% might have been enough to cool the economy).

Aside: in the blogpost linked above Krugman is a bit wrong about Latvia and the Great Depression. The fact that Latvia is characterized by a fast increase of productivity does not set it apart from countries during the Great Depression – on of the key facts of this area is in fact that productivity did increase quite fast, despite the decline in production. There is however a demographic difference: during the thirties most countries had growing populations while the Latvian population decreases.