The AmCham lecture

17. February, 2009

Some impressions from last Friday's lecture, organized by the American Chamber of Commerce, which featured Governor of the Bank of Latvia Rimsevics and Andris Strazds, my colleague at the school.

In short, nothing exciting has happened. The Governor repeated his old points on why nominal devaluation would be bad for Latvia, in contrast to what he referred to as wage devaluation. Discussion by Andris Strazds was nicely summarized by him saying there should be no discussion (of devaluation). The government adopted a plan and that’s it, we should just all work on this plan. Needless to say, Andris was in complete accord with Governor Rimsevics on all the major points.

Well, maybe the Prime Minister Godmanis (or is it the President?) is a commander-in-chief, but I thought you’re only supposed to blindly follow the orders if you’re in the military, or if there is a state of war. I might be committing an act of treason here (by interpretation of some gentlemen), but I am not convinced by the ‘official’ arguments. I think government decisions should be discussed, and I believe that’s what the taxpayers pay me for. So here comes some discussion of the major points.

1. Devaluation is a bad idea because most private sector loans are denominated in euros. Thus, devaluation will result in large-scale defaults as many people will not be able to pay back their loans.

Well, what difference does it make whether you’re not able to pay your loan because the value of payment in lats has increased (devaluation), or because your wage is cut via ‘wage devaluation’? And there will be a world of difference to those who lost their jobs. In the end, it’s going to be the same effect, nominal devaluation or ‘wage devaluation’. Moreover, because ‘wage devaluation’ usually results in a more protracted recession, it is likely that more people will be affected.

2. Devaluation will result in inflation because many intermediate goods and production inputs (e.g. energy) are imported.

Actually, more like a one-time increase in prices. But you shouldn’t forget that in this case wages need not fall by the amount they will without the devaluation. Whether the purchasing power of your income will decrease as a result of higher prices (devaluation), or as a result of lower wages (wage devaluation) is a matter of taste, not of substance.

3. Devaluation will not increase exports because of (i) global recession, and (ii) Latvia’s major trade partners (Estonia and Lithuania) would devalue as well.

I’ll agree to that it may not increase exports, giving decreasing global demand. However, it will make exports decrease by less, especially in the environment where many other trade partners have devalued (Sweden, Poland, Ukraine, Belorussia, Russia, etc.) Exporters will be better off from devaluation and the effect will be immediate, even if it would be somewhat ameliorated by the likely devaluations of Estonia and Lithuania. Thus, the notion that devaluation will not help exporters is just wrong.

4. Devaluation will not help the local producers because prices for their products will increase

Well this is just bad economics. Of course the prices in lats would increase and overall demand will fall. However, wage devaluation means exactly the same thing. In case of devaluation, however, locally produced goods would still become cheaper relative to imports. Thus, there would be a substitution effect and an increase in demand for locally produced goods.

5. Devaluation will result in the halt in lending

Maybe. However, hasn’t lending halted anyway? Some time ago Governor Rimsevics himself said that with regard to lending Latvia is in the state of clinical death.

6. Devaluation will undermine confidence in Latvia’s economy

I think that would depend on the extent of devaluation. I used to think that the purpose of devaluing an overvalued currency is precisely to restore the confidence. In any case, the 7.5 billion euros loan may have bought some confidence, for now. However, the government is trying very hard not to see that one prominent economist after another says that this is a mistake. I mean Paul Krugman, Nouriel Roubini, etc. The list keeps growing. I wonder what effect it has on investors’ confidence.

In the end, the only serious argument against devaluation is that it might result in disorderly adjustment, that is, that banks, courts, etc. will be overwhelmed by the wave of defaults. The opponents of devaluation say that Latvia’s institutions are not ready for the amount of private debt restructuring (i.e. lots of people not being able to pay their loans). Well, I guess it better get ready real soon.

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