The Lessons From The Depressions Of Ukraine & Latvia

The two European countries that have suffered most from the economic crisis are arguably Ukraine and Latvia.

The two have a lot in common as they both used to be part of the Soviet Union, and as a result both have a large ethnic Russian minority. Both are seeing its population shrink due to a low birth rate. Both saw big output declines in the 1990s, followed by very rapid growth throughout most of the 2000s. In both cases, the booms were in part the result of tax cuts, in part the result of inflationary credit. Because of the latter factor, both had huge current account deficits at the peak of their booms.

There are significant differences however, not least in terms of currency policy. Latvia's currency, the lat, has a fixed exchange rate against the euro, while the Ukrainian currency, the hryvnia, has a floating exchange rate, or perhaps more accurately a sinking exchange rate, with the hryvnia losing more than a third of its value against the euro and the lat (which in inverted terms means that the the euro and the lat is up more than 50% against the hryvnia).

Both have had really dramatic declines in output. The question of which of these two countries had the biggest drop depends on what measure of GDP change you use.

Using the standard volume measure, it is Latvia. Latvia's volume GDP dropped by 19% in the year to the third quarter, while Ukraine saw its volume GDP drop by 15.9% during the same period.

Using the more accurate terms of trade adjusted measure however, Ukraine has had the biggest drop in output. Adjusted for terms of trade, Latvia's drop in GDP was 20%, while Ukraine's adjusted GDP dropped by 22.5%. The reason for this is that import prices in Ukraine rose as much as 74.5% while export prices rose by "only" 49.8%. In Latvia the difference was much smaller with import prices falling 7.4% while export prices fell 10.3%.

Still, regardless of what gauge you use the difference isn't that dramatic. Both Latvia and Ukraine have clearly been in an economic depression.

The main difference is that Latvia is in a deflationary depression, while Ukraine is in an inflationary depression. The domestic demand deflator fell 2.5% in the third quarter in Latvia, while it rose 13.9% in Ukraine. This difference can be directly attributed to the difference in currency policy, something which is illustrated by the fact that export and import prices fell even more than domestic prices in Latvia, while export and import prices rose far more than domestic prices in Ukraine.

How has this difference in currency policy affected the depth of their depressions? As I noted in my discussion of the pros and cons of a devaluation in Latvia, it can be expected that devaluation in an ideal situation (with no foreign currency debt) would make the slump milder in the short term, while also producing a lower adjustment.

However, given the reality of large foreign currency debts, the above will not necessarily hold true, and the big slump in Ukraine (which like Latvia has large foreign currency debts) confirms that devaluation does little to ease the slump in output.

The main benefit produced by the devaluation/inflation path of Ukraine is that the increase in unemployment has been limited, rising from 6.5% to 9.4% in the latest year. By contrast, unemployment has increased far more in Latvia, from 10.2% to 22.3%.

The reason why the increase in unemployment has been much smaller in Ukraine is that the high level of inflation there has reduced real wages dramatically, by more than 10%. By contrast, real wages have dropped only about 4% in Latvia given the 2.5% deflation rate (and only 1% in the private sector), and the small drop we've seen can mostly be attributed to the consumption tax increase.

This illustrates again how the key to reducing unemployment is wage flexibility-which in this context means that real wages must be reduced.