From Latvia to Greece
The IMF's Road to Ruin
By MARK WEISBROT
Latvia has experienced the worst two-year economic downturn on record, losing more than 25 percent of GDP. It is projected to shrink further during the first half of this year, before beginning a slow recovery, in which the International Monetary Fund (IMF) projects that it will not reach even its 2006 level of output by 2015 – nine years later.
With 22 percent unemployment, a sharp increase in emigration and cuts to education funding that will cause long-term damage, the social costs of this trajectory are also high.
By keeping its currency pegged to the euro, the government gives up the opportunity to allow a depreciation that would stimulate growth by improving the trade balance. But even more importantly, maintaining the peg means that Latvia cannot use expansionary monetary policy, or expansionary fiscal policy, to get out of recession. (The United States has used both: in addition to its fiscal stimulus and cutting interest rates to near zero, it has created more than 1.5 trillion dollars since the recession began).
Some who believe that doing the opposite of what rich countries do – i.e. pro-cyclical policies -- can work point to neighboring Estonia as a success story. Estonia has kept its currency pegged to the Euro, and like Latvia is trying to accomplish an “internal devaluation.” In other words, with a deep enough recession and sufficient unemployment, wages and prices can be pushed down. In theory this would allow the economy to become competitive again, even while keeping the (nominal) exchange rate fixed.
But the cost to Estonia has been almost as high as in Latvia. The economy has shrunk by nearly 20 percent. Unemployment has shot up from about 2 percent to 15.5 percent. And recovery is expected to be painfully slow: the IMF projects that the economy will grow by just 0.8 percent this year. Amazingly, by 2015 Estonia is projected to still be less welloff than it was in 2007. This is an enormous cost in terms of lost actual and potential output, as well as the social costs associated with high long-term unemployment that will accompany this slow recovery. And despite the economic collapse and a sharp drop in wages, Estonia’s real effective exchange rate was the same at the end of last year as it was at the beginning of 2008 – in other words, no “internal devaluation” had occurred.
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