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A 'Success Story'

There is a truly amazing article in Saturday's Diena, titled "Less painful, and slower". It is basically saying that there is less reason now to devalue because the deflation, or what the article calls an "internal devaluation", seems to be working just fine. The pinnacle of the article is SEB's (in Latvia) chief economist, Andris Vilks, saying that "if Latvia will get out of the crisis in such a way [deflation], it will be a unique success story…".

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I have to admit my first reaction was disbelief, and then (quite) a bit of an outrage. first reaction disbelief. A "success story"??! Well, it certainly does not seem that way to the 168 thousands of Latvians who were unemployed in the first quarter of this year, according to the Labor Force Survey. And my guess is that many more thousands, who will lose their jobs in the near future, will not think of this all as a "success story". What does it have to do with "internal devaluation"? Well, that's precisely how it works. Deflation works by creating unemployment, and thereby forcing people to accept lower wages. Deflation works through inflicting massive economic misery on the ordinary people for a relatively long time. And that's the major difference with nominal devaluation. Alf Vanags made this point very clearly (same article) when he said that "900 thousand households will have to suffer [as a result of internal devaluation], whereas [nominal] devaluation would force adjustment on the 150,000 household that have the loans". In the end, what matters is not whether the crisis will 'end' - both nominal devaluation and 'internal devaluation' would accomplish this, but at what cost to the society it will happen.

So why did Mr. Vilks say such an outrageous thing? Is it because he does not understand what the effects of devaluation are? I think there might be another explanation. It IS a “success story” – but for the banks. To understand this, stop being naïve and recognize that experts can be self-interested, too. Lets take an example with buying used cars. Not being professional mechanics, most people do not know whether a used car is a "lemon". So they often turn for help to the experts - professional mechanics. There is a large market for such professional advice. However, suppose a mechanic is also a seller of used cars. Would you take his 'advice' at face value? Or, would you search for a mechanic whose well-being does not depend on whether he sells you a used car?

When it comes to 'devaluation vs deflation', bank economists are like used cars salesmen. The welfare of the banks, and their employees (including the economists), depends on whether there is a devaluation. To be more precise, both nominal and internal devaluation will generate the same number of defaults on the loans issued by the banks. To be even more precise, the latter will generate more defaults because not all borrowing is in foreign currency. The crucial difference, though, is in timing. Defaults now (devaluation), vs defaults later (deflation). Just like 100 LVL today are worth more than 100 LVL tomorrow, a financial loss tomorrow is preferable to financial loss today. Simply put, banks have perfectly sound reasons for wanting a deflation, rather than devaluation. I really wonder whether a bank economist can say he favors devaluation and keep his job the next day. Moreover, any observer of the economics profession would realize that economists, in fact, often disagree among each other. Isn't it striking how unanimous bank economists (in Latvia) are in their loathing of devaluation? On the other hand, nearly all independent economists that I know think devaluation is a better option. Period.

Finally, even more amazing is how people, and the media, do not understand the implications that arise when 'experts' have stakes in what they advice on. Remember the newspapers in 2005-2007? Lots of people were (rightfully) worried whether real estate prices were too high, and lending too exorbitant. The journalists nearly always asked two kinds of 'experts': directors of real estate companies and bank economists. And both groups of people told us that there was nothing to seriously worry about, that real estate prices would keep rising, that the future was wide open. "Keep buying (and taking loans)"! Naturally, real estate companies made fortunes from rising real estate prices, and banks made good profits from the lending that fueled it the real estate boom. Well, the real estate 'experts' are largely gone now, but the newspapers are full of bank economists, who tell us that devaluation is evil.

I wonder if people in Latvia are ever going to learn...

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