From Riga to Wall Street

If you can remember the British Exchange Rate Mechanism (ERM) experiment and Black Wednesday you’ll have an insight into a bit of the Latvian economy’s current plight. Latvia, like Britain, pegged the exchange rate of its currency to another, stronger currency. In Latvia’s case it’s the Euro, which has increased in value. The standard response here for maintaining a peg is to raise interest rates, drawing in foreign capital to prop up the exchange rate. Latvian central bank rates are accordingly a good chunk higher than the ECB’s right now.

The downside to this is straightforward; higher interest rates typically dampen down economic activity. In addition, propping up an over-valued currency misses out on the benefits of a cheap one i.e. if its cheaper to buy Latvian then exports are more competitive, domestic goods have an advantage over imports and more drunken Brits will go on stag weekends to Riga.

The particular problem Latvia has is the currency peg led to Latvians borrowing en masse in foreign currency to the extent that over 80 per cent of Latvian households now have debt denominated in Euros (for debt read mortgages). So if the currency is devalued by say 10% allova sudden everyone in the country owes 10% more. Now that’s an awfy good way to muck things up. It also means monetary policy is stuffed big time leaving fiscal measures the order of the day. Except for Latvia this means cutting public spending hard at a time when the economy is forecast to shrink by 20% this year alone.

By contrast the IMF had this to say yesterday about Euro Area fiscal policies “Given the large automatic stabilizers in the euro area, the discretionary measures currently adopted seem broadly appropriate, with further stimulus to be set aside for contingencies.” – the automatic stabilizers being benefit payments and what not which increase along with unemployment at the same time as tax revenues fall.

So the apparent consensus is Euro-area government shouldn’t cut public spending and should allow government borrowing to increase whereas Latvia needs to cut public spending regardless of Latvians no exactly being well off to begin with.

The bigger picture here is if Latvia devalues its currency or the economy collapses, then the question becomes which Baltic state will be next. Plus there’s the Swedish banks that were doing a big chunk of the lending who might find themselves well stuffed by all these Latvian borrowers defaulting.

All this leaves me wondering if the Latvian economy is being sacrificed to avoid a domino effect that could undermine the well-being of the broader Baltic region. Such an event could in turn undermine global confidence in the financial system just as its getting itself back together again.

if this is the case though shouldn’t more be getting done to help them? I mean in April Latvian unemployment reached 17.4% and is going to keep on rising meaning we’re looking at at least one in five people is going to be on the dole in a country where mass emmigration has been making the unemployment statistics look better than they actually are for years!

So there you are then, Latvia is totally stuffed and the degree of economic distress and all that brings is well beyond anything we’re going to experience. At the same time it’s just been announced 10 US banks are now allowed to repay the funds they’d previously received from the US TARP fund. The motive here is relatively straightforward – if they no longer have obligations to government, government is in a much weaker position when it comes to imposing restrictions on executive pay. Shame that the economy would benefit more from these banks using these funds to actually finance more lending, but what the hey, we can’t have the financiers who caused all this in the first place missing out on their bonuses for 2 years on the trot.

To get a sense of how much taxpayer help this involved just one US bank (JP Morgan) received $25bn in support. By contrast the Latvian government is going to cut public spending so as to get the next tranche of just $10.4bn in aid from the IMF.

So sure Latvia is looking to membership of the Euro in 2012 I think it is when presumably/hopefully/fingers-crossededly all this will be less of an issue. But, between now and then the economy is going to be absolutely humped and with it hundreds of thousands of peoples lives. And it gets worse because the reality, judging by the British experience throughout the twentieth century, is that over-valued currencies tend not to stay over-valued for ever and eventually get devalued, which implies much of the current Latvian pain is being endured for no good reason. But, hey ho, an eventual devaluation would at least allow Western investors to run in and buy up everything worth buying in the country.

In the meantime it appears that in much the same way that the Latvian government hacking back on public spending on the basics of life is necessary to maintain confidence in the global financial system, so is paying US bankers mega bonuses. Regardless of the fact I’ve only read about all this, it’s still difficult to avoid the bad taste it all leaves. Plus, if I was a Latvian I would be thinking what the fuck? And what the fuck has all this post-Soviet Union look West, not East actually got me i.e. theres potential political consequences here.