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Can Eastern Europe go bust: a story of Latvia

M*_Edgars — Sat, 18 Jul 2009 03:44:00 GMT

This question has been puzzling me for the past arguably 6 months or even longer. After joining the European Union (EU) in 2004, the former Soviet block countries in Eastern and Central Europe seemed to be doing just fine. There was the sentiment that they will somehow magically catch up with the “rich” Western Europe. Nobody, of course, could outline the specifics but the politicians vehemently argued that it “just will happen”, but, of course, we know better than this: economics does not operate like Harry Potter’s magic stick. We know (unlike politicians) that theology and economics are two different concepts. Needless to say, right now the sentiment is quite different. But one remark is in order here: we should be careful not to lump Eastern Europe (or Central Europe for that matter) in one block, since there are differences among the countries, yet we should not disregard the interaction effects either. It is quite clear that negative economic indicators, coming out of one country, will have a significant negative impact on the region as investors will likely revisit country’s risk profiles and reconsider their investment sin the region.

The story here is about a particularly badly hit country located on the Baltic Sea – Latvia. It is about the size of West Virginia (in fact, 2000 square kilometers bigger, if that makes a difference for anyone). Hence, there is nothing special about it. However, it may as well prove to be the hardest challenge for the European Union. Like other new EU members, it was doing “just fine” until recently. Now, it is the hardest hit country in the EU.

In December 2008, it become clear that internal resources will not be sufficient to overcome the crisis and Latvia “secured” EUR 7.5 billion in loans mainly from IMF and the EU, some other countries (most notably Sweden because it has substantial banking operations in Latvia) chipped in a few cents as well. The loan was scheduled to be disbursed in parts according to a schedule over the course of the next year or so, depending upon the reform achieved in government. The main requirement was to cut the salaries in public sector which had been growing at an astonishing annual rate of 30% (yes, there is “0”, it’s not a typo) for the past 3 years – that means more than doubling salaries over the period of 3 years. Of course, this is not universally true, but on average it is so. Also, cutting jobs was another requirement (very sensible, considering the overinflated government). Hence, the government of Latvia chose the route of “internal devaluation” as opposed to “external devaluation”, a.k.a. simply currency devaluation. Here I have to mention that Latvia maintains a de facto fixed exchange rate regime, the lat (national currency) is pegged to EUR and it can fluctuate +/- 1%. Thus, the exchange rate is de facto fixed. Right now, the government is faced by drastic cuts in public services, some government employees have seen their salaries cut by over 50% and it looks like more is to come.

Right now the loan funds have not been disbursed according to the schedule, since the IMF claims that not enough reforms have been achieved. The budget deficit for 2009 looks to be around 7% right now, despite the IMF requirement of 5% or so (this has changed several times over the past 2 months), for 2010 is it to early to call but, considering declining tax revenues, it is likely to exceed 10%, otherwise I fear that government will not be able to function and provide even basic services as police and emergency health care to its citizens. Also, the GDP is projected to shrink in 2009 by 18% – 20%, with some estimates being as high as 25% and possibly higher, if tax hikes are to be implemented and business activity contracts further.

The country’s debt right now is rated BB+ by S&P with a negative outlook. This is equivalent to junk bond rating (oops, sorry, I meant “high yield”) and hence Latvia right now finds it impossible to borrow in the global market. It already attempted to issue government bonds a month back and it failed miserably.

So the question becomes: can an EU country fail and become de facto a “failed state”? Latvia’s oligarchy, corrupt and incompetent government along with impotent central bank seems to be pre-conditions for a status of a failed state. What if the IMF funds do not arrive? Then the government will be out of cash….and what then? There is no precedent for such an event since always, despite how bad it is, some international organization, be it IMF, EU or UN comes to the rescue. Can this time be different and does the EU realize how much is at stake? If Latvia falls, the fixed exchange rate regime collapses as well and it may trigger “competitive devaluations” in Eastern Europe and possibly beyond. Yet, a grand failure may just be what the country needs, since the government does not seem to be able to manage the current crisis and way too many vested interests get in the way of sensible public policy.

Macroeconomics: how insightful has been the research output?

M*_Edgars — Fri, 17 Jul 2009 22:21:00 GMT

This is not a joke. Many prominent economists with the arrival of this economic crisis have been questioning the validity and usefullness of the macroeconomic theory developed over the past 30 or so years. Most notably, as "The Economist" reported on June 11th 2009, the Nobel Prize winning economist Paul Krugman gave the annual Lionel Robbins memorial lecture at the London School of Economics. One of his most famous statements from the lecture was this: "Most work in macroeconomics in the past 30 years has been useless at best and harmful at worst". This is very refreshing, coming from a prominent economist since most economists are so absorbed in the dismal science that questioning the assumed doctrines in the academia seems like a task no one is ready to undertake.

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