Latvia & The Issue Of Devaluation

Given the deep problems experienced by Latvia (and only to a slightly lower extent also Estonia), should it perhaps change course, drop the peg to the euro and/or reset the peg at a much lower exchange rate (which is to say, devalue)?

The short answer is that devaluation would probably reduce the short-term severity of the slump-but not by much and it would prolong the adjustment process.

To understand why that is so, we should first analyze the usual trade off between adjustment through devaluation and deflation for a country facing an economic downturn, and then also add the particular elements relevant for Latvia.

During an economic slump caused by a previous period of malinvestments, a need exists to adjust to more sound and sustainable patterns of spending. That can be achieved by a higher real interest rate (higher interest rates lowers demand for investment goods by increasing the cost of funding) and a lower real exchange rate (which makes investment goods more expensive).

A country which is part of a monetary union (or has a fixed exchange rate) will see its relative price inflation rate fall, something which given the equality of nominal interest rates and the unchanged nominal exchange rate will cause its real interest rates to increase and its real exchange rate to decline. Both of these effects makes it more profitable to reduce domestic investment spending and to instead invest money abroad.

By contrast, if a country has a floating exchange rate and the domestic central bank responds to the recession by cutting interest rates, this will lower the nominal exchange rate. The lower nominal exchange rate will in turn likely raise price inflation, but the real exchange rate will still likely fall significantly. Indeed, it will likely lower the real exchange rate a lot faster than through the deflationary way that the real exchange rate is reduced in a monetary union or under a fixed exchange rate policy. But while that price mechanism will adjust faster under a floating exchange rate policy, the interest rate adjustment will be prevented and counteract the adjustment. Instead of encouraging a shift from investment goods industries through higher real interest rates, the reduced real interest rates caused by both lower nominal interest rates and higher price inflation will discourage that adjustment.

With the exchange rate adjustment going faster with floating exchange rate but with the interest rate adjustment being prevented, does that mean that the overall result will be theoretically ambiguous? Yes, in terms of the effect on the symptom of the current account balance. But not in terms of the underlying adjustment to more sound structure of production.

The lower real interest rates and lower real exchange rate under a floating exchange rate system will mean that inefficient lines of production will be preserved to a greater extent, something which will mean a milder short term contraction (however, the reduced domestic purchasing power caused by the lower exchange rate will reduce the size of that relief). But this also means that the desired adjustment from sectors that depend on various forms of indirect subsidies (artificially lowered interest rates and exchange rates) to sectors that reflect people's preferences is counteracted, something which in the long term will lower real output.

Because the undervalued exchange rate will hit some foreign producers, it should be noted that some of the negative effects of the floating exchange rate system will hit foreigners, instead of the country with the undervalued exchange rate. That may mean that even if the undervalued exchange rate hasn't increased domestic growth, it may appear to do so because of the damage done to others, which in relative terms makes domestic growth look better. For example, even if the weak pound weakens the U.K. economy in absolute terms, it might still appear as if it is strengthening it if the weak pound inflicts even greater damage to Ireland and other euro area countries.

Generally speaking though, the choice is between the lower short term under floating exchange rates and the better long term outcome under fixed exchange rates.

For Latvia however, even the short term boost is not as clear as it is for Sweden, because of the high burden of euro denominated debt. If Latvia devalues, or "floats" (which is to say enabling it to sink)its currency, this will mean that the domestic currency value of that debt will soar, creating big problems for those Latvian households and companies that took those loans.