I think the People's Party (TP) is a key to what will happen next. And it's not just because it's the largest party in the Latvian Parliament. First, it's much more than just a largest party and, second, it is facing some very interesting incentives now. Let me explain.
All eyes on Tautas Partija! 9
First, some trivia on Latvian politics. What many outsiders don't understand is that ruling coalitions in Latvia are not built from a simple majority in the Saeima (Parliament). Latvia is an ethnically divided country where ethnic Latvians voted for 'Latvian' parties, and a sizable Russian minority votes for 'Russian' parties. The product of these ethnic tension is that in politics, Latvian and Russian parties cannot co-exist. A Russian party has never been to the ruling coalition. For example, in the last election, SC and PCTVL, the 'Russian' parties, got 23 seats in the Parliament. Since each 'Latvian' party thinks allying with a 'Russian' party is political suicide, a ruling coalition really operates with (51/(100-23))*100=66% of the relevant vote. This also explains why Latvian political system is so ineffective. Ethnic divisions severely restrict options for forming coalitions and increase bargaining power of each coalition member vis-a-vis other members. In the current Saeima, for instance, effective exclusion of 'Russian' parties means there are only four possible majority coalitions of minimum necessary size. These are:
Note that there is only one possible coalition (#4) without People's Party (TP). This, however, requires New Era Party (JL) to go in with the First Party/Latvian Way (LPP/LC), which they [JL] detest more than anybody else. Besides, LPP/LC was brave enough to share power with the Harmony Center, a Russian(!) party in the Riga City Council, which complicates matters even further. Naturally, both People's Party and the New Era understand this very well. It is probably only a slight exaggeration to say that New Era party cannot govern without the People's Party.
Second, People's Party is cornered. According to the polls, if elections were tomorrow, it would only get 2% of the vote (5% is the minimum threshold to get elected). The main reason is that People's Party presided over the 'fat years' and is universally blamed (somewhat deservedly) for the economic crisis. The election is in October of 2010. If the economy would not recover by then, voters would blame People's Party (and New Era). If the economy would show signs of recovery, voters would attribute any success to New Era party, but would still blame TP. Either way, it's extremely unlikely that People's Party would be re-elected.
The leaders of People's Party must be aware of this, and they are making moves. So far most of these resemble helpless convulsions, like making fuss about budget reductions in the ministries controlled by the TP. But the logic of deflation is inescapable. People's Party must either implement unpopular budget cuts and tax increases, or open itself to accusations (from eager New Era) of trying to sabotage a stabilization program that it itself signed into life. Clearly, the only way for the TP to distance itself from the unpopular measures is a radical change of approach. And the only alternative to deflation is devaluation. If TP pushed for devaluation and it helped the economy, People's Party could come on top by claiming that they saved the country from the fallacies of the present government. That could be a ticket to re-election. I see no other alternatives. If TP sticks to the deflation plan, it is not re-elected, no matter how much noise it makes. If TP initiates devaluation and it fails, it is not re-elected. If devaluation works (as I think it would), TP comes on top. The solution is clear.
The two important questions are whether (i) TP understands it; and (ii) it can initiate devaluation. I think the answers to both questions are "yes". First, TP politicians increasingly talk of devaluation. TP invited Torbjorn Becker (a known advocate of devaluation) to speak at its congress, after an unsuccessful attempt to invite Edward Hugh (another ardent advocate of devaluation). Mr Skele, often described as the Godfather of TP, made a speech (at the congress) effectively saying there should be 15% devaluation. What could hold TP back are (substantial) political risks of such a move. Large majority of Latvians, subjected to extraordinary amount of propaganda from the government, the Central Bank, and the commercial banks, do not favor devaluation. This could change, of course, if devaluation were to work. After all, there was a time when majority firmly believed that Earth was flat.
Second, TP has ( exactly one) option. The only (minimum) coalition without JL is #3: TP+ZZS+LPP/LC, with 51 votes. TB or LPP/LC new friend, SC, might throw in their support as well. Of course, New Era can prevent this. It has has (exactly one) option: JL+ZZS+LPP/LC+TB with 54 votes. The question is, can it be friends with its enemy: LPP/LC? LPP/LC will probably support any move (devaluation or deflation) if it were sufficiently rewarded. This leaves us with one more question of what would be the position of ZZS, i.e. the farmers' party. The farmers have plenty of FX denominated loans, but they would also gain a lot from devaluation. CAP payments are denominated in euros and then there are exports and demand substitution effects. I think ZZS could easily side with TP on this. No matter how you look at this, TP is the key player.
So, all eyes on TP!
Some readers (Reinis and Q) kindly pointed out that I ignored some relatively recent development in the Saeima, such as the breaking up of both the New Era Party and the People's Party. The Saeima now is indeed substantially more fragmented. To simplify the analysis, I will lump the New Era Party (14 MPs), Pilsoniska Savieniba (7 MPs), and SCP (2 MPs) into one 'party': JL&Co (23 MPs). The reason is that these parties declared they will go into the next election as one block. This modifies above analysis as follows. Excluding 'Russian' parties, there are still four coalitions:
There is still only one coalition without the People's Party. If People's Party wishes to go without the New Era Party, it also needs to get TB. I have no priors as to how likely that is. Thus, the task of People's Party is harder, but not impossible.