IMF and the Baltics

The ink on the post below suggesting that I would wind down for Christmas (and exam preparation) has hardly dried before I am forced back into action (more or less that is).

And the occasion? 

Well, I am not going into too much background here, but one event important to remember (out of so many this year) was the announcement of the € 1.7 billion IMF stand-by-agreement for the Baltics. The bail-out plan itself is not so interesting in the sense that it has been on the drawing board for a some months, but the juicy part was the firm IMF position that the euro pegs should remain (and presumably that this means a future for Euro membership).

This surprised me since I have been relentlessly arguing that whatever kind of route the Baltics would take out of the current mess it would be one in which the pegs would need to be tweaked (or abandoned all together). Now, the surprise did not, obviously, spring from the fact that the IMF [1] chose to take a route other than the one I expected, but more so from the fact that I have always thought that the alternative in the form of a very painful deflationary correction wouldn't be plausible in a policy context. As such, my analysis of the Baltics have always been grounded in two related policy objectives. Given the size of the imbalances inherent in the economy as well the situation surrounding the foreign banks and their balance sheet exposure a deal would ultimately have to be struck which allowed the Baltics to regain competitiveness through the loosening of the pegs as well as measures to shore up the black hole which would be left in the balance sheets of foreign banks' subsidiaries operating in the Baltics.  By some strenuously confirming the pegs it seems to be me that the cure might just end up killing the patient which is another way to say that I wholeheartedly believe that the IMF's decision to solidify the pegs is a mistake. 

My colleague Edward Hugh thinks the same and in a recent whopper of a post (follow-up here) he argues why. I recommend you to read the whole thing but pay especially attention to following which sets the stage nicely both in the context of political and economic issues.

So there seems to have been a trade-off here, between the IMF agreeing (reluctantly I think, but this is pure conjecture since there is little real evidence either way) to accept the peg, and the Latvian government agreeing to exceptionally strong adjustment policies. But the question is: was this agreement a good one, and will the bailout work as planned? I think not, and below I will present my argumentation. But before I do, I think it important to point out that the kind of internal deflation process the Latvian government has just accepted is normally very difficult to implement, which is why economists tend to favour the devaluation approach.

I think it is important to stress that a lot is riding on this one not least in the context of that small, but ever so important issue, of getting it right in the context of the CEE economies. Because, we really do need to get it right less we want to be confronted with half a continent worth of testaments to why the standard neo-classical assumption of convergence and catch-up growth be reconsidered (which may of course ultimately be the end case anyway).

And don't for a minute think that this is just me and Edward's attempt to personify Don Quixote in his fight against those dreaded wind mills. That is, unless you believe that Paul Krugman too is pulling a Don Quixote. Here is consequently what the recent Nobel laureate has to say about Edward's nudge towards the IMF ...

I’ve been saying this for a couple of weeks, but Edward Hugh has the goods.

Hugh puts his finger, in particular, on one gaping hole in the logic of the opponents of devaluation. We can’t devalue, they say, because the Latvian private sector has a lot of debts in euros, and a devaluation would make it very hard for borrowers to service those debts. As Hugh points out, the proposed alternative — sharp wage cuts, and basically a major domestic deflation — will also make it hard to service those debts. In fact, I’d be a bit more specific than Hugh: other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)

This looks like events repeating themselves, the first time as tragedy, the second time as another tragedy.

In the context of the wonkery of exchange rate economics, Krugman hits the proverbial nail on the head since as I have shown on several occasions; the crossover currency exposure in these economies is substantial.  The vast majority of business and household liabilities are in Euros (driven to a large extent by lower interest rates and the simple fact that more than half of these economies' financial sector is maintained by the subsidiaries of foreign banks). This is clearly a problem in the context of a devaluation but it is a well known problem and one which quite simply needs to be managed sooner or later since continuing to maintain the imbalances won't work. This brings me to Krugman's and essentially also one of Edward's main points (taken from Krugman);

(...) other things equal, a nominal devaluation and a real depreciation achieved through deflation should have exactly the same effect on debt service (unless some of the debt is in lats rather than euros, in which case devaluation would do less damage.)

Finally, I would pay special attention to the last sentence in Krugman's small plug since this is really a question of making a right decision and not a wrong one in the context of the evidence presented before you. I still think that the Baltics need to come off the pegs (especially if the Euro is now set to take on another round of re-balancing as the USD caves in to the Fed's QE measures); the alternative in the form of wage and price deflation may be a very dangerous road to take.


[1] whose mission in the Baltics is headed by Christoph Rosenberg whose writings we get to enjoy from time to time in the context of RGE's economics blogs (the European vintage most often).

[2] For some of my latest excursions into this subject I recommend you to go here and here.