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Wednesday, December 24, 2008

Travelling Through Latvia In Good Company

Well, it seems I'm not the only one who thinks that the IMF have made a bad decision here, this year's economics Nobel Prize winner Paul Krugman seems to agree. From his New York Times blog:

I’ve been saying this for a couple of weeks, but Edward Hugh has the goods.

Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We can’t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative — sharp wage cuts, and basically a major domestic deflation — will also make it hard to service those debts. In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)

This looks like events repeating themselves, the first time as tragedy, the second time as another tragedy.

And while I am talking about travelling in good company, here's Claus Vistesen's Xmas piece on the Latvian peg issue for you all to enjoy.

IMF and the Baltics

by Claus Vistesen

The ink on the post below suggesting that I would wind down for Christmas (and exam preparation) has hardly dried before I am forced back into action (more or less that is).
And the occasion?

Well, I am not going into too much background here, but one event important to remember (out of so many this year) was the announcement of the € 1.7 billion IMF stand-by-agreement for the Baltics. The bail-out plan itself is not so interesting in the sense that it has been on the drawing board for a some months, but the juicy part was the firm IMF position that the euro pegs should remain (and presumably that this means a future for Euro membership).
This surprised me since I have been relentlessly arguing that whatever kind of route the Baltics would take out of the current mess it would be one in which the pegs would need to be tweaked (or abandoned all together).

Now, the surprise did not, obviously, spring from the fact that the IMF [1] chose to take a route other than the one I expected, but more so from the fact that I have always thought that the alternative in the form of a very painful deflationary correction wouldn't be plausible in a policy context. As such, my analysis of the Baltics have always been grounded in two related policy objectives. Given the size of the imbalances inherent in the economy as well the situation surrounding the foreign banks and their balance sheet exposure a deal would ultimately have to be struck which allowed the Baltics to regain competitiveness through the loosening of the pegs as well as measures to shore up the black hole which would be left in the balance sheets of foreign banks' subsidiaries operating in the Baltics.

By some strenuously confirming the pegs it seems to be me that the cure might just end up killing the patient which is another way to say that I wholeheartedly believe that the IMF's decision to solidify the pegs is a mistake.

My colleague Edward Hugh thinks the same and in a recent whopper of a post (follow-up here) he argues why. I recommend you to read the whole thing but pay especially attention to following which sets the stage nicely both in the context of political and economic issues.

So there seems to have been a trade-off here, between the IMF agreeing (reluctantly I think, but this is pure conjecture since there is little real evidence either way) to accept the peg, and the Latvian government agreeing to exceptionally strong adjustment policies. But the question is: was this agreement a good one, and will the bailout work as planned? I think not, and below I will present my argumentation. But before I do, I think it important to point out that the kind of internal deflation process the Latvian government has just accepted is normally very difficult to implement, which is why economists tend to favour the devaluation approach.

I think it is important to stress that a lot is riding on this one not least in the context of that small, but ever so important issue, of getting it right in the context of the CEE economies. Because, we really do need to get it right less we want to be confronted with half a continent worth of testaments to why the standard neo-classical assumption of convergence and catch-up growth be reconsidered (which may of course ultimately be the end case anyway).

And don't for a minute think that this is just me and Edward's attempt to personify Don Quixote in his fight against those dreaded wind mills. That is, unless you believe that Paul Krugman too is pulling a Don Quixote.

In the context of the wonkery of exchange rate economics, Krugman hits the proverbial nail on the head since as I have shown on several occasions; the crossover currency exposure in these economies is substantial. The vast majority of business and household liabilities are in Euros (driven to a large extent by lower interest rates and the simple fact that more than half of these economies' financial sector is maintained by the subsidiaries of foreign banks). This is clearly a problem in the context of a devaluation but it is a well known problem and one which quite simply needs to be managed sooner or later since continuing to maintain the imbalances won't work. This brings me to Krugman's and essentially also one of Edward's main points (taken from Krugman);

(...) other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)

Finally, I would pay special attention to the last sentence in Krugman's small plug since this is really a question of making a right decision and not a wrong one in the context of the evidence presented before you. I still think that the Baltics need to come off the pegs (especially if the Euro is now set to take on another round of re-balancing as the USD caves in to the Fed's QE measures); the alternative in the form of wage and price deflation may be a very dangerous road to take.
---
[1] whose mission in the Baltics is headed by Christoph Rosenberg whose writings we get to enjoy from time to time in the context of RGE's economics blogs (the European vintage most often).
[2] For some of my latest excursions into this subject I recommend you to go here and here.

17 comments:

Anonymous said...

Hi there from the Democratic Republic of Latvia
Here comes a candid question : if all of you people agree on this devaluation - deflation issue, how can our enlightened leaders choose else and drive us harder into the wall ?
Latvians this year don't even dare wishing each other "prosperity" as is customary before new year. They wish for a year "rich ... in good surprises" and, less officially "may you be able to live through the year without too big losses".
From the "crisis ? What crisis ?" of last year (and even last summer), the new motto is "2009 will be the mother of depression"
From uninformed optimism to blind pessimism, the only constant is the lack of information and knowledge. The Latvian people in its majority thinks there's no choice, no alternative. Nobody contradicts the government in order not to face Drosibas Policija or one of these "blackening" campaigns our independant press is so good at. No class of intellectuals, no engaged artists, and we sometimes think that Europe forgot us, giving a free hand to our government to contradict or curb all EU or civil rights rules.
That's enough to make any aware person a tenant of federalism: let's outsource or government for the better.
Besides, I wish you a year full of nice surprises :0)

Edward Hugh said...

Hello There:

"if all of you people agree on this devaluation - deflation issue, how can our enlightened leaders choose else and drive us harder into the wall ?"

Well, I think there is politics and there is economics here. And there are the macro economists, and there are the rest. And among macro economists there are those who know about how to handle financial crises, and those that don't, but I think if you get down to this very reduced group you will find there is a virtual consensus about devaluation being a better (not perfect, there is no perfect easy way at this point) bet. Including I'll wager most of the staff economists at the IMF who were involved in the negotations.

Indeed you have a couple of quite good macro economists over at BICEPS, but I think the only attention that has been paid to them recently has been by the state security police interviewing one of them.

Basically I think this is a pretty complex situation, and I think a lot of factors all came together in the decision. I think pressure from the other countries who are on pegs - via the EU perhaps - must have played a part, as would pressure from the governments of the countries with the Nordic banks, since they would have to include the lossses in their own national bank bailouts - an outcome which I think would be fair, since these banks obviously aided and abetted the boom bust by facilitating the lending, which they did not simply to be nice but to create business. They evidently didn't really know what they were doing, and they - and not the Latvian people - should pay for this to some extent.

Then there are the people who invested the social and political capital in the peg, and who now don't want to lose face. And finally there is the "euro-membership cure all" view.

Krugman quoted yesterday a nice extract from FT journalist Martin Wolf.


"Keynes’s genius – a very English one – was to insist we should approach an economic system not as a morality play but as a technical challenge."

I absolutely agree here. People shouldn't play politics so much, and should listen a bit more to those with technical arguments. But this is hard, since going by my random survey fo the world over the years, most non economists think economics is all about politics. Nothing could be farther from the truth, an economic system is a technical system, just like your power generation one is. Of course, both can very easily break down as a result of very simple "human error".

Happy Xmas,

Edward

Resident said...

this is a copy from previous topic

Hi Edward,
(this is also wonkish and in no particular logical order, by the way - i am not a "professional" economist... :))

well, there is no question that it has been a fundamental mistake to de facto fix the FX rate in such a narrow range and the all Krugman's working in full extent (destroyed local economy after the exit from USSR, and small, and quite open), adding up the easy access to foreign money (mainly via Scandi banks that made the same mistake in the early 1990-ties?), and promises of joining the euro-zone very soon ... made the illusion of fast catch-up to West so sweet!

Well, Scandinavia solved its crisis in 90ties (partly) by devaluing, but then there was no global consumption bust in works ....

I do not say either that Latvia should focus on "fixing" internal market only, it should go for exports too ... However, it is unfortunately very unclear what to focus on, assuming the current conditions (collapse of consumption, production, exports in double digits almost everywhere on global scale). You may simply make a costly (you would be running a competition among even desperate exporters... with much larger resources to promote themselves) mistake, by achieving too little ... just because there may be too many desperate exporters. Yea, and just imagine that Japan and Eurozone finally realize that they are "exploited" by US, UK, Russia etc. to go for global competitive devaluation ... In this context Latvia is in much more disadvantageous position vs e.g. US or UK that have no or very little foreign currency debt. Interestingly, but it seems that the consensus of CNY (Chinese yuan) appreciation vs USD is broken, too..?

As Krugman wrote: "In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)". Well, this is probably an accounting issue, but by deflating local cost factors you would save the equity capital on the balance sheets of Latvian corporate sector (not only banks)(unless they are not the same as a result of deflation), as devaluation (this would happen very fast) would increase the value of debt in foreign currency and reduce by that amount the equity ... Well, equity capital appears to be very expensive at moment? And may add up enough to compensate for the 15% local currency debt...

As to Krugman, he seems to be quite unsure that the Obama's "kiss" (ie. fiscal stimulus in 2009) is a guarantee for a sustained recovery in US thereafter, see here: http://economistsview.typepad.com/economistsview/2008/12/paul-krugman-li.html , but he is an advocate for fiscal stimulus ... so, he appears to prefer the "managed" (Keynes) approach to break the vicious cycle. At what cost?

I do not believe Latvia can make a managed devaluation on stand-alone basis - that would be rather a repeat of Ukraine (down 50% and not sure where the bottom/equilibrium is?).

Well, it is not clear to me - why the Latvian government has decided to borrow from IMF consortia, devalue the workforce instead of currency? But I would list following items:
1. Government suddenly realized that the revenue in government budget are falling rapidly due to local and global economy, so they needed to fill the gap, but that was not the most critical ..
2. if not the collapse of Parex bank, that will need ca 1.5-2.5 bln EUR from government to keep alive, and this came as a "slam dunk" to enter the emergency ...
3. i would say that rather fortunately, government was forced to ask IMF for funding, as government reforms were desperately needed ... (the politically unpopular reforms got new enemy, and abroad)
4. I still do not get - why the donors accepted the no devaluation scenario ... i do not know either, what the government has promised, but:

a) it may be due to current global conditions, as i list here ..
b)Sweden (other Scandi too) was actively promoting orderly solution, as this may be disorderly for Sweden/Scandi ... but Krugman may call his pal at Riksbank, he should have the answer. Let' s speculate - this is a rather temporary bailout of Scandi banks, and they will take the hit as global conditions stabilizes? Well, why Latvian taxpayer should pay that?
c) Labor deflation is certainly unfair to poor, but government, if i understand correctly, has promised, within the IMF consortia framework agreement, to keep the living standards of "very poor". But current solution favors the rich ...

Still, if the ERM2 agreement with ECB is in force, the ECB should support the +/-15% band ... and this should be used for "managed" floating vs EUR later on, as situation stabilizes ... just to make imports more risky, and promote local economy.

If you have smart people and good management, you would more likely achieve much more on your domestic soil currently - well, if you have them - smart people and management? So far the Latvian government rather appears on the opposite side of this wishful thinking. But if you assume you can manage that, it would be more effective in terms of available resources invested...

Actually, I wonder why the Latvian government has not contracted Krugman for good advise in exports and trade ...

... but Krugman's statement contains "unavoidable destiny" and ignores the "inability of humans to forecast" (although his track record is rather good :)). And the US has the right to use "managed" approach vs Latvia that does not deserve it ... The US approach may end in tears too http://www.nakedcapitalism.com/2008/12/martin-wolf-says-big-stimulus-programs.html, and depends on Sandy Feet, Chinese Communists and Japanese Desperate Housewives Investors accepting the US dollar AS IS, otherwise the global competitive devaluation will end in US peso, or US shekel, or US yuan? Assuming such background the new Argentina' s "another tragedy" will be not noticed and the damage for civilization will be less than Mad-Off Ponzi. Well, this is no fun, if comes true ...

What yea think?

Merry Christmas!

Anonymous said...

Well, currently there is almost no chance of staying within the +/`-15% bands anyway without major intervention, so if Latvia went from a 1% band to 15% band, it wold just be a dead-cat bounce from one baseline to a new lower baseline. It might help a bit, but not for all those poor mortgage holders.

By the way, a recent petition to merge with Sweden gained a few thousand signatures....

Edward Hugh said...

Hi again Resident.

My, my you are persistent. Which is all to the good I suppose, since your country is in trouble, and there is no better way to spend xmas than trying to think of ways to dig yourselves out. Now if everyone was only like you.

"However, it is unfortunately very unclear what to focus on"

Well, this is just the point, isn't it. And let me tell you one thing - I don't have it all that much clearer than you. This is a difficult situation and there are no easy answers.

"Interestingly, but it seems that the consensus of CNY (Chinese yuan) appreciation vs USD is broken, too..?"

Yep. I would agree. My guess is that the next serious move of the yuan is down, and this is likely to give Obama his first big test.

"i would say that rather fortunately, government was forced to ask IMF for funding, as government reforms were desperately needed ... (the politically unpopular reforms got new enemy, and abroad)"

Yep. I think this is definitely part of the picture.

"Still, if the ERM2 agreement with ECB is in force, the ECB should support the +/-15% band ... and this should be used for "managed" floating vs EUR later on, as situation stabilizes ... just to make imports more risky, and promote local economy."

But will the situation "stabilise", most of your argument seems to suggest it might not. eg:

"As to Krugman, he seems to be quite unsure that the Obama's "kiss" (ie. fiscal stimulus in 2009) is a guarantee for a sustained recovery in US thereafter,"

Basically, I would agree. I think we are in for a number of quite difficult years, and then we will see what the new "stabilisation" looks like.

"If you have smart people and good management, you would more likely achieve much more on your domestic soil currently - well, if you have them - smart people and management?"

People always say this in any country that gets into trouble, and it is surely true. But where were these people over the last five years, as Latvia got into this mess. Why should they only suddenly appear now? I don't find this too convincing.

"Actually, I wonder why the Latvian government has not contracted Krugman for good advise in exports and trade ..."

This raises quite an important point. Neither Krugman or I have any real idea about what to actually do on the ground about exports, only Latvian entrepreneurs know about that. Macro economists look at ssytem dynamics at a rather abstract level, and try to think about what kind of conditions you need so these Latvian entrepreneurs (assuming you have some) can go to work effectively.

"martin-wolf-says-big-stimulus-programs.html, and depends on Sandy Feet, Chinese Communists and Japanese Desperate Housewives Investors accepting the US dollar AS IS, otherwise the global competitive devaluation will end in US peso, or US shekel, or US yuan? Assuming such background the new Argentina' s "another tragedy" will be not noticed and the damage for civilization will be less than Mad-Off Ponzi. Well, this is no fun, if comes true ...

What yea think?"

I think you are throwing everything in bar the proverbial kitchen sink here, and that Martin Wolf, despite his protests to the contrary, is running a morality play in all this. There are actually quite complex mechhanisms at work here that I don't think he understands. I would stick with Krugman if I were you.

Also, I would work on things step by step: The issue at the moment is to stop meltdown in the Latvian banking system, and to stop the rapid and dramatic contraction in national output. I would leave China and the Japanese housewives for later :).

Clearly I think there are major international issues to thrash out, but Latvia is a small country, and I am sure that there are small scale local things that can be done while the rest of the world finds its own level.

First of all the CA deficit needs to come to zero. If the Latvians are hell bent on doing this simply by reducing imports, then so be it. As long as you continue to run a CA deficit the banks will continue to gasp for air, and there will be little finance available for either consumer or corporate loans. So on you go. Cut out coffee if you like, since that comes from Brazil, doesn't it?

Oh, and go easy on the petrol too, since you don't have much of that.

Actually, new biological, wood fired trains might work, if you could sort out the smoke pollution problem.

Resident said...

Hi Edward again,
Well, well ... then let' s start from scratch again:
1. All the mistakes in the past are valid.
2. I do not see any problem so far (as October 2008 data) with Latvian exports on stand -alone basis. The data series are probably "too good" to believe they are real, but they will suffer in coming months, for sure (I cannot imagine they can withstand the global melt-down, if Japanese exports are making almost 30% y/y haircut)… So, I would not attribute all CA deficit to the currency. Are you still worried by 2005 analysis? Is my explanation not sufficient to remove those worries? Well, Latvian exports are mystery anyway, frankly speaking …
3. Latvia had a boom (domestic consumption) driven by easily available credit, accompanied by hefty inflation (so Latvia had not enough internal capacity to cope with rapidly rising demand that was fueled by easy credit). Am I correct?
4. If we remove easy credit, so the demand (at least part of that excess) will be removed too… and as Latvia had no extra internal capacity to fill the excess demand, Latvia will not suffer that much from deflationary forces? Am I correct?
5. Removal of easy credit will remove pressure from imports to satisfy demand, so correction in CA sounds organic? So, we can remove the hot red emergency alert from CA? well, It is probably not hot red, but orange…?
6. Well, there are structural problems with exports and foreign trade in general, anyway … I fully agree, and they need urgent solution.
You wrote: “People always say this in any country that gets into trouble, and it is surely true. But where were these people over the last five years, as Latvia got into this mess. Why should they only suddenly appear now? I don't find this too convincing.” Well, I do not pretend to be the one, but I assume (like me) that majority of people were focusing on their own buz at micro level and assumed that government was in charge at macro level … At least I assumed, and wrongly …
I cannot stick with Krugman (he’s smart though), as dude seems to be smoking something ? See his post here: http://krugman.blogs.nytimes.com/2008/12/27/hangover-theorists/ . It is quite obvious to me why employment (it looks like spelling error? But that’s not the point …) “why recessions reduce unemployment across the board, not just in industries that were bloated by a bubble.” Or he has got it wrong that the core of problem was easy credit, and housing was only one of the areas where the credit was used (oh, probably also used a lot to extract additional credit too …). Well, and you know that many laureates are challenged even for their prizes, e.g., Merton and Scholes (do you remember LTCM?), Markowitz, Miller and Sharpe (they are hunted by Nassim “ The Black Swan” Taleb now), and even Friedman now (Krugman did it too? http://krugman.blogs.nytimes.com/2008/11/28/was-the-great-depression-a-monetary-phenomenon/ ) … I hope Krugman will escape that destiny. Take it as joke …
Well, all in all, Latvia has fundamentally structural problem with CA, no doubt … but I am wary to jump into global competitive devaluation race (Latvia has too many disadvantages to win) in current conditions, assuming that on stand-alone basis we would have the copy-paste of disorderly solution in Ukraine … I assume that more efficient would be selected export areas where you have better visibility, and there’ s enough to do in domestic markets, until the wave subsides …
Or it is though better to jump into the devaluation race?

Philippe said...

Happy new year to everyone.
As was already mentionned, Latvia's is a small and -still- open economy. Therefore even limited in scale decisions can quickly show a huge impact on the country. This makes for an interesting life when you are a local SME... but this could also be an ace in the decision makers' sleeve, would they not use it -as they've been doing for 17 years- to line their pockets and their friends and sponsors.
As shown by recent history, Latvia has a great ability for change -whatever the direction, good or bad ; ideas and business life cycles are short and the Latvian people are very inventive and hard working when they are not shown the "easy way" (as in easy money, easy credit, etc).
Though, of course, the current priority is to deal with the emergency situation, steps could already be taken to help for recovery and sustainability. Latvia has no heavy weight natural or industrial resource -but for the forest which is quite poorly managed compared to EU neighbours. Nevertheless, Latvia has young brains and arms, who are not all willing to emigrate. But this reservoir is not used: most of Latvian university system is expensive, hyperconventionnal, business-fantasy driven. If business incentives -as in tax relief for example- are needed, medium and long term needs call for a suppler, R&D and PPP oriented higher education, aiming at reasonable and sustainable possibilities : agriculture and forestry can be a part of the answer, but thinking out of the box : biomass, biodiesel (and not the energy consuming heavy environmental footprint bioethanol), safe biotechnologies (Monsanto ? No, thanks!), energy saving building components, alternate uses of cellulose, forest farming. This would at the same time reduce the country energetic and import dependance and provide for new, high added value, export products.
The means are less costly than other options that ignore Latvian resources and are willing to play in already very frequented courtyards, where other players have more means and experience. They mostly rely on incentives: promoting and rewarding technical and innovation culture, fund targetting not only supposed-to-be high ROI project but also high sustainability ones, proposing tax relief and Govt aided micro-credit for SME, enhancing PPP with education and research structures, ...
But this asks for bright, foreseeing, and honest leadership. And this is what Latvia lacks the most.
I know this post goes a bit away from macro-economy topics and the pure analyst's ways, but we are here talking about a real country, with real people, and real strengths. We are talking about a country small and young enough to change direction when it took the wrong way and the current crisis is certainly the best moment to do it: there's nothing to loose when most is surely lost or soon to be.
Lacitis

Edward Hugh said...

Hello Philippe,

Thanks for a very interesting comment.

"I know this post goes a bit away from macro-economy topics and the pure analyst's ways, but we are here talking about a real country, with real people, and real strengths. We are talking about a country small and young enough to change direction when it took the wrong way and the current crisis is certainly the best moment to do it:"

I totally agree. I don't think people like me and Krugman have the answers to your problems, I think you do (all of you Latvians). Macro economics is a very abstract body of thought at the end of the day, all we can hope to do is nudge you in the right direction so that you can get on with it, and all I can do is wish you good luck, with or without devaluation.

"there's nothing to loose when most is surely lost or soon to be."

Well quite. I think it is fear of losing something which you effectively no longer have which is driving things at the moment, which is a pity.

Edward Hugh said...

Hello Again Resident,

Excuse me for being slow in replying, but I need time to digest what you say, and also my birthday, and New Year and other little details like that intervened - like being snowed in the mountains with no internet and no phone cover for 5 days, not that I'm complaining about that part :)

Now I want to thank you for drawing my attention to something very interesting.

The Krugman link. Somehow I had missed this one - well you know, can't read all the blogs, and the statistics offices and keep answering comments all at once all the time. Now this link turns out to be very interesting, since he asks the question - "Has anyone else noticed that the current crisis sheds light on one of the great controversies of economic history?"

And the answer is that at least one person had been thinking about this - little old me. And there is a story which lies behind this, since the most recent links I got from Krugman weren't exactly my first. Way back then - in 2003 - at the time when Uncle Milt decided to rethink the past and bare his chest, Krugman published a piece on his Princeton Site (subsequently gone down, but you can find it here, or on the externally unlinkable Unofficial Paul Krugman site) where he drew attention to the fact that Freidman himself appeared to have changed his mind, and the citation he used ( But guess who now concedes the point?) was a link to a post on Brad Delong's Blog, which contained a link to me, since I was basically the person who first read the FT interview, and put it up online (this is basically what you could call a small world of macro economics phenomenon). Now the point that occured to me at the time about that interview was the following, which I am now rescuing, since I do seem to be answering's Paul's point, about whether anyone else had been thinking about the significance of what was happening, and the answer is a robust YES, I have, and that since August 9 2007, the day PNB Paribas discovered they were $2 billion short to close their books, pinching a phrase from Robert Lucas, barely a day has gone by when I have not been thinking about this point.




The matter in question is Friedman and Schwartz's Monetary History (1963). Chapter 7 of this book is entitled 'The Great Contraction', but in fact it is not clear to which 'contraction' we are referring at times, to the monetary or to the output contraction. The impression is that the two are inextrically intertwined, but the innocent mind might draw the conclusion that this impression is in fact never justified with anything amounting to precision. The point being, there could well be plenty of debate as to whether the monetary contraction was the cause or the effect of the real contraction.


What seems preoccupying in the F&S view is that they never seem to actively consider the possibility that banks may have been held back by factors other than their reserve position. This appears to be because they take virtually no account of the assett side of the bank's balance sheets. Indeed it seems to be the case that their conceptual framework leaves little place for a consideration of the role of the banks as financial intermediaries between two types of client: depositors and borrowers. Nor do they seem to put great store by the fact that the banks as intermediaries operate in a world of uncertainty, that banks assessment of their clients' creditworthiness varies, and that in the short trem their lending determines the size of the money stock. (And how do I know all this: because my brother used to be a banker, and he has spent years perforating my eardrums with this and other relevant information as to the realities of money stock fluctuations).


Now why is any of this of any real importance today, and why is the problem more than merely a semantic one: because right now, in Japan, there is a problem, and many economists once more failing to listen to what the bankers are telling them, imagine that there is a simple monetarist solution to the problem: dramatically expand the money stock. And why may the problem assume even more importance: because right now in Germany and the United States deflationary pressures may well be raising their ugly head, and because, once more the simple monetarist solutions are going the rounds without giving sufficient consideration to the question as to in which direction the causal chain may in fact be operating.

In fact the argument I use owes a lot to the work of a now dead UK economist, Christopher Dow, who more or less, it could be argued, saw the possibility that all that is now happening would happen.

Edward Hugh said...

And now for some more substantial comments on your post, resident:

"Or it is though better to jump into the devaluation race?"

Well you are stubborn. I admire you for that. But I too am stubborn, and I think it would, and to get in quickly, among the leaders, and not to hang back at the rear, participating that other race to see whose industrial output can contract most quickly. Japan seem to be winning that at the moment (have you seen where the yen is - but then they may soon "intevene" to try and change things), and Spain are coming a close second (but then they don't have much choice), whilst Lavia now can surely not be far behind (funny how all that industry that people say doesn't exist keeps contracting).

"Or he has got it wrong that the core of problem was easy credit,"

Well, Krugman can surely speak for himself, but on my view the *core* of this problem is not "easy credit" (which doesn't mean that inadequate monetary policy in some cases hasn't been a problem, and that a range of credit products have been faulty, but unfortunately the problem goes rather deeper than this.

On my view the *core* of the problem are the global imbalances, and these are to some large degree the by-product of the fact that different societies are passing through the ongoing demographic transition at different rates. But this is all to long and tiresome to explain here.

Nonetheless the fact that far too many people and products were given investment grade rating when they shouldn't have been has created quite a mess, and the fact that these ratings were then used to lull people into complacency about unhedged forex borrowing has only added to this.

"Latvia had a boom (domestic consumption) driven by easily available credit,"

True, this is the investment grade issue.

" accompanied by hefty inflation (so Latvia had not enough internal capacity to cope with rapidly rising demand that was fueled by easy credit). Am I correct?"

This is my view, yes. And this was additionally fuelled by out migration and remittances, which often went to finance mortgages.

"If we remove easy credit, so the demand (at least part of that excess) will be removed too…"

Well this isn't quite so easy, becuase we go from one extreme to another - which is why it is called boom/bust - there is not some convenient mechanism whereby things can just be stopped in the middle. This is the flaw I think in what you seem to be assuming. Latvia will now suffer from an acute lack of demand, since the credit was brought forward from future demand, and now this has to be paid for, plus people need to save.

"Latvia will not suffer that much from deflationary forces? Am I correct?"

No, no. This is not my view, You are actually voting for massive internal deflation (to restore price competitiveness) as the alternative to devaluation. With the additional impact that those who were prudent enough to take out their loans in Lati will suffer too. This was Krugman's point.

Basically, Latvia (if it stays on the peg) is about to have some of the strongest deflation on the planet.The question is really how long people will be prepared to put up with this for before they demand devaluation.

Basically all of this is just a re-run of the old "hard landing- soft landing" debate, with those who said then "no worry, you'll get a soft landing, the Nordic banks will guarantee that" now arguing that devaltuation would be disastrous since you will only put off the Nordic banks. The point is, one day or another the local population, who understand little economics but do trust their leaders, will get sick and tired of all of this, and then things will snap.

Resident said...

The government publishes its "Letter of intent", see for English version to download the Microsoft Word Document here, Click on "Lejupielādēt" besides the "Letter of intent" http://www.mk.gov.lv/lv/aktuali/zinas/2008gads/12/06012009-01/ ...

Had no time to read it ...

Resident said...

I went over the headlines quickly, and the first impression is a bitter disappointment ... Oh Lord!

Resident said...

Sorry, the right hope should be this, probably http://www.mk.gov.lv/lv/aktuali/zinas/2009gads/janvaris/06012009-14/ ?But no details and English version available yet ...

Anonymous said...

Hello Edward!

Have you seen this?
http://www.rgemonitor.com/euro-monitor/254975/why_the_imf_supports_the_latvian_currency_peg

Edward Hugh said...

"Hello Edward!

Have you seen this?"

I hadn't. I will have to think about trying to find the time to make a reasoned response.

Meanwhile also thanks to Resident for the letter of intent link. Busy days. Happy New Year to you all, by the way.

Resident said...

Hi Edward,
it looks like, indeed, both published at Roubini's RGE Monitor - Christoph Rosenberg http://www.rgemonitor.com/euro-monitor/254975/why_the_imf_supports_the_latvian_currency_peg and Mary Stokes http://www.rgemonitor.com/economonitor-monitor/254905/devaluation_in_latvia_why_not are lining up similar rationale and reasoning as I was trying to do in the comments here ...

Well, I would still probably use the +/-15% band ERM2 agreement with ECB in a measured way, if really in force, just to ignite the still then lazy spirits ... but after the calm has returned to global markets. Otherwise there is a real risk of repeating the Ukraine, and your pal may be wondering about the Depression Economics even more, as here: http://krugman.blogs.nytimes.com/2008/12/25/the-second-great-depression-has-arrived/.

As I have noted before, Krugman is smart indeed, but the most striking with him is the "inconsistency of approaches" (i will revert to this in more depth later) and the general problem of macro-economists to link "macro" to "micro", including the "behavioural" into that ...

Inconsistency of approaches - well there are many examples, but just few to name: 1) Krugman is promoting the Keynesian stimulus and opposing the Austrian-style purgery for the US economy, but suggests the outright devaluation to Latvia, and then wonders about "Great Depression Part II" in Ukraine; 2) he was opposing Willem Buiter on Monday http://krugman.blogs.nytimes.com/2009/01/05/faith-based-macroeconomics/, with data that are correct on macro level, but do not reveal the details of a) who owns the foreign assets and who has the liabilities, b)what is the nature of those foreign assets (mainly equities that suffered a bit last year?) ... so the micro level may destroy the macro assumptions.

As to your latest reply to my comments ... Well, you are right about the global imbalances, these made the "easy credit bubble" possible ...

I have not seen anything promising re "Latvian restructuring and stimulus plan" yet, but will revert, if any.

Happy New Year!

Philippe said...

Hi there.
Another naive question : does not deflation mean that consumer prices go down ?
Let's what's happening in real Latvia now. All "good" managers -the ones who believed in easy credit, easy money and easy business- including the State are simultaneously
-reducing wages by, on average, 20% (so goes for teachers, civil servants, and, in the private businesses, the service sector) ;
-killing projects, without so much as an impact study ;
-raising prices -Govt side : excise, VAT, service fees. / private sector : many companies capped the VAT increase with something of their own. For example : transportation went up by 15% for buses and 25% for train.

Unless I'm very much mistaken -or official figures are very much tweaked- the 1st quarter will show some more inflation.

On a funnier note : Morten Hansen, who recently had to deal with the security police for talking about devaluation, praised the Parex bank management in a recent interview with a local english language newspaper. This is quite an atonement from his previous position. Obviously, security police is efficient in controlling local economists.
Lacitis