On Latvia and Ireland as austerity models
Editor’s note: this is a daily commentary for Credit Writedowns Pro members that is now freely accessible in order to highlight some of the themes James Mackintosh makes in the FT video in this link.
Earlier in the week, ECB German board member Jörg Asmussen delivered a speech on the challenges of the economic crisis for countries in Central and Eastern Europe. The part which caught most people’s eyes was his commentary on Latvia and its use of austerity as an economic model for the euro zone. Latvia really is not the model though. I have covered this ground before. However, I would like to re-visit it due to some numbers coming out of Ireland, the country I believe is most similar to Latvia within the euro zone.
Just to give a brief overview of the Latvian case here, the small Baltic country was the beneficiary of a tremendous amount of capital inflow from Scandinavia during the bubble years. Swedish banks in particular loaded up on Latvian assets as a huge property bubble formed. I first started mentioned Latvia in 2008 comparing the situation to Argentina. And as the bubble popped and things turned down there, I focussed on the currency overvaluation as a key issue for the Baltics. The similarity to Argentina was the fixed exchange rate that produced significant overvaluation, hot money inflows, current account deficits, and a bubble economy. When the bubble burst, the inflows turned to outflows but the peg still remained, leaving the country in a difficult situation regarding reflating the economy amidst widespread debt deflation. Violence and civil unrest erupted by January 2009.
The question then was what to do. And I think this is the same question being asked throughout the periphery since the euro is in effect a permanently fixed exchange rate. The answer in the Baltics was internal devaluation aka austerity. This is the deflationary route out of crisis, using wage and budget cuts as means of making labour less expensive and turning an external current account deficit into an external surplus, eventually reflating the economy via exports. Latvia’s situation was made harder because, as in Ireland, the country opted to socialize bank losses onto the state, transferring Swedish bank risk onto Latvian taxpayers.
The situation was touch and go and Latvia was forced into an IMF bailout program as a result. Despite the bailout and the loss socialization, Swedish banks were still petrified about the level of writedowns they had to take and stories in the Swedish press told of preparations for a complete collapse in Latvia. The key consideration during this process was the peg. Should Latvia drop its peg to the euro? People like Paul Krugman, Ed Hugh and Marshall Auerback argued yes. This would reflate the economy but it would also scupper Latvia’s desire to join the euro zone in a timely fashion. However, the Latvians put all their eggs in the internal devaluation basket and went on a hard core austerity drive. Early in the experiment in 2010, it was too early to cry victory. Eventually, however, this austerity brought results and Latvia is now on the verge of joining the euro zone and permanently leaving the orbit of the Russians. There was a tremendous cost though. And it’s here where the debate is.
Asmussen wrote the following first on 29 April:
“Latvia is the leading example of how to adjust through internal devaluation, and it is a model for others in the euro area. Its “V-shaped” economic recovery illustrates what can be done with a strong consensus to undo the excesses of the past. After an initial fall in GDP of almost 18% in 2009, GDP increased by more than 11% from 2010 to 2012, and unemployment has fallen by almost 7 percentage points from its peak.”
Martin Wolf of the Financial Times took issue with this and wrote as follows the next day:
“These huge recessions do matter. For Latvia, the cumulative loss from 2008 to 2012 adds up to 77 per cent of the country’s pre-crisis annual output. On the same basis, the loss was 44 per cent for Lithuania and 43 per cent for Estonia. In the fourth quarter of 2012, Latvian GDP was 41 per cent below where it would have been if the 2000-7 trend had continued. Estonian and Lithuanian GDPs were 34 per cent below trend. Unemployment has been falling, but it was still 14 per cent of the Latvian labour force in December 2012, as it was in Ireland.
In brief, Latvia, worst-hit of the Baltic countries, suffered one of the biggest depressions in history. It is recovering. But it has not yet fully recovered. Are its policies a model for others? In a word, no.”
So, that’s the debate in a nutshell. Is Latvia an austerity success or failure? It’s hard to say actually. There are a lot of differing opinions.
Where I have come out on the Latvia-as-austerity-model before is that Latvia is not a good model for large economies like Spain or Italy. It is still inadequate for Portugal and Greece but may be most applicable for Ireland. Here’s what I wrote in January:
“I want to posit a thesis about the European crisis countries. On the one hand, there are smaller, export oriented countries like Ireland and Latvia, which are highly dependent on external trade and money flows. Then, there are larger economies like Spain’s which have a more sizeable domestic economy relative to their external trade and money flows. Because all of these economies have fixed exchange rate policies as part of the euro system or desire to join the euro system, external devaluation vis-a-vis trade partners is a route to growth that is not available. Instead, all of these countries have had to implement internal devaluation strategies via harsh wage and spending cuts in order to regain external competitiveness.
“Ireland and Latvia, because of their small size and dependence on external flows are much more able to pull this off. Internal devaluation is a bigger boost due to the importance of the external sector and their small size makes the changes and the emigration abroad easily absorbed by their much larger trade partners. Spain, on the other hand, cannot benefit as readily from these factors. And so internal devaluation is even more destructive economically in Spain than it has been in Ireland and Latvia. That’s my thesis. And what it means for Spain is that it was never going to become the next Ireland. Instead, it has always been at risk of becoming the next Greece.
“And so I think its misleading for people like Jörg Asmussen to suggest that the Latvian model can be used in places like Portugal or Greece, let alone Italy or Spain. The debt deflation in those large economies is catastrophic for the integrity of their banking systems. NPLs in Italy are weakening right now in an alarming way that could have grave implications if this is not arrested. If you add in France and the Netherlands to this same chain you can see why the austerity yoke has been partly thrown off. Targets are being relaxed, but the fiscal drag remains. Even in Ireland, the government is saying austerity will continue, for example.”
And this is where I have a problem. In February I wrote of the weakening Ireland success story in a post optimistically titled, “On Ireland’s superior economic performance“. Here is the key takeaway:
“the Irish Independent article [on Ireland’s January manufacturing data] reinforces my contention that it was really only Germany that showed good numbers in the euro zone PMIs for January. The other important countries were below the 50 mark. And the one country that has consistently done well in manufacturing over the last year, Ireland, saw its numbers decline to near contraction levels. Also notice that Ireland’s new orders numbers were actually below 50 i.e. foretelling of a potential contraction.
“My conclusion about Ireland is similar to what I wrote about Latvia, that its small size and dependence on external flows make Ireland more able to pull off an internal devaluation. Internal devaluation is a bigger boost due to the importance of trade and money flows. And Ireland’s small size makes the changes and the emigration abroad easer to absorb by its trade partners. But note that Ireland has suffered mightily nonetheless. Unemployment is about 15%, deficits are large and government debt to GDP has ballooned from 25% to well over 100% because of the effect on the financial sector and its bailout by the state. Any setback in Ireland’s growth trajectory would be catastrophic.
“So it’s important that Europe doesn’t get complacent. I believe European policy makers want to use Ireland as an example of success.”
Sure enough, the numbers have got worse. The Wall Street Journal writes today:
“the second straight month of declining manufacturing activity, coupled with declining export orders, suggests it may prove difficult for Ireland to continue to recover from its economic crisis while much of the euro zone is in contraction.
At 48.0, the Irish manufacturing purchasing managers’ index is below the threshold of 50 separating contraction from expansion, and marks the sharpest decline in activity since September 2011, Markit Economics and NCB Stockbrokers said. It has slipped from 48.6 posted in March and 51.5 in February.
Ireland’s manufacturing sector had already broken a long winning streak, posting its first contraction for 13 months in March.”
My conclusion here: Latvia is of limited applicability. Where it is most applicable is to Ireland. And we can see now that the numbers in Ireland are deteriorating as the internal devaluation policy is being carried out right across Europe. Austerity and internal devaluation can work for a small open economy in isolation. But these policies are poison when applied across a broad swathe of economies at the same time. As I wrote predicting the sovereign debt crisis three years ago, this is exactly where the origins of the next crisis lay. “Unfortunately, a collective debt reduction across a wide swathe of countries cannot occur indefinitely under smooth glide-path scenarios. This is an outcome which lowers incomes, which lowers GDP, which lowers the ability to repay. We will have a sovereign debt crisis. The weakest debtors will default and haircuts will be taken.”
And that’s what has happened. The further austerity continues across the breadth of Europe, the more haircuts we will get in both the sovereign and banking sectors. Latvia is not the model.