Extract 4 internal v external devaluation

1. Extract
4:
Latvia
and
Iceland
–
Internal
Devaluation
v
Exchange
Rate
Devaluation
Extract
Some
economists
are
sceptical
about
the
success
of
Latvia’s
internal
devaluation
in
delivering
a
sustained
economic
recovery
and
correcting
external
imbalances.
Although
Latvia’s
GDP
has
grown
since
2010,
it
is
not
clear
that
such
growth
can
be
sustained.
This
is
because
of
the
sharp
change
in
the
composition
of
GDP
growth
which
has
resulted
from
internal
devaluation.
High
levels
of
private
sector
indebtedness
remain
in
Latvia
and,
as
a
result,
growth
in
both
investment
and
consumer
expenditure
remain
weak
(see
Fig.
4.1).
Fiscal
tightening
has
limited
the
contribution
of
government
expenditure
to
GDP
growth.
Latvia’s
economic
growth
is,
therefore,
very
heavily
dependent
on
growth
in
net
trade.
Whether
Latvia
can
sustain
economic
growth
solely
from
exports
depends
not
only
on
the
growth
in
world
trade
but
also
on
Latvia’s
international
competitiveness.
What
is
meant
by
an
internal
devaluation?
An
internal
devaluation
happens
where
the
government
of
a
country
attempts
to
improve
competitiveness
(and
ultimately
the
trade
balance)
through
lowering
unit
wage
costs
and
increasing
labour
productivity
rather
than
relying
on
a
depreciation
or
devaluation
of
their
exchange
rate.
How
did
Latvia
achieve
an
internal
devaluation?
This
was
attempted
using
a
mix
of
macroeconomic
policies:
1. Maintaining
Latvia’s
fixed
exchange
rate
against
the
Euro
–
i.e.
avoiding
a
depreciation
which
is
usually
regarded
as
a
counter-­‐cyclical,
expansionary
policy
–
one
reason
for
this
was
that
the
vast
bulk
of
her
debts
are
in
euros
–
this
is
a
big
risk
if
the
exchange
rate
collapses
2. Implementing
pro-­‐cyclical
fiscal
policies
such
as
higher
taxes
and
cuts
in
government
spending
–
that
made
the
downturn
worse
in
the
short
run
with
the
aim
of
cutting
their
budget
deficit.
In
Latvia,
VAT
was
raised
by
3%
and
wages
&
salaries
in
the
public
sector
were
cut
by
more
than
20%.
3. Rising
real
interest
rates
–
official
monetary
policy
interest
rates
in
Latvia
remained
at
7.5%
throughout
the
recession
and
with
inflation
falling
and
briefly
entering
deflation
in
2009-­‐2010,
the
real
cost
of
borrowed
money
was
positive.
At
the
start
of
2010,
with
nominal
interest
rates
at
7.5%
and
CPI
inflation
at
-­‐4%,
the
real
interest
rate
was
approximately
+11.5%
-­‐
strongly
deflationary
for
the
Latvian
economy.

2. Key
point:
Latvia
chose
a
strategy
of
internal
devaluation
in
the
wake
of
the
start
of
the
global
financial
crisis
–
the
bulk
of
their
macro
policies
were
pro-­‐cyclical
rather
than
the
Keynesian
approach
of
introducing
counter-­‐cyclical
policies
to
address
falling
output
and
employment.
Crucial
issues
to
address
in
the
case
study
include
whether
Latvia’s
strategy
has
worked
and
whether
the
economic
and
social
(human)
costs
have
been
worth
it.
Has
Iceland’s
devaluation
been
a
better
option?
Per cent
Latvia: CPI Inflation and Policy Interest Rates
CPI Inflation for Latvia (%) Policy Interest Rates for Latvia (%)
Source: Euro Stat
Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep Jan May Sep
07 08 09 10 11 12 13
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
20.0
-6.0
-4.0
-2.0
0.0
2.0
4.0
6.0
8.0
10.0
12.0
14.0
16.0
18.0
20.0

3. Fig.
4.1
–
Latvian
investment
and
consumer
expenditure
(billion
lats,
constant
2000
prices)
Analysis
of
the
data
chart
in
Figure
4.1
Note
the
way
in
which
the
data
is
presented:
• The
data
is
quarterly
i.e.
four
data
points
each
year
• It
is
measured
in
lats
–
the
Latvian
currency
until
they
joined
the
Euro
in
January
2014
• It
is
measured
at
constant
2000
prices,
i.e.
2000
is
the
base
year
and
the
figures
are
therefore
inflation-­‐adjusted,
i.e.
real
consumption
and
investment
The
peak
data
for
both
consumption
(C)
and
investment
(I)
was
in
the
final
quarter
of
2007
Thereafter,
both
C
and
I
dropped
sharply
through
2008
and
2009
In
the
1st
quarter
of
2010:
• Real
consumer
spending
was
1.1
billion
lats
compared
to
1.62
billion
lats
in
Q4
2007
–
a
fall
of
32%
• Real
investment
spending
was
0.21
billion
lats
compared
to
0.89
billion
lats
in
Q4
2007
–
down
76%
• The
percentage
fall
in
real
capital
investment
spending
was
more
than
twice
the
decline
in
real
consumer
demand
–
but
both
fell
sharply
and
by
more
than
Latvian
real
GDP

4. Since
the
start
of
2010,
there
has
been
a
slow
recovery
in
both
consumer
demand
and
investment,
but
both
remain
well
below
the
peak
levels
of
the
4th
quarter
of
2007.
• Consumption
in
the
2nd
quarter
of
2012
was
1.28
billion
lats
–
20%
below
the
2007
peak
• Investment
in
the
2nd
quarter
of
2012
was
0.44
billion
lats
–
less
than
50%
of
the
2007
peak
Some
key
points
to
consider:
1. To
what
extent
was
the
dramatic
fall
in
consumer
spending
the
direct
result
of
the
policy
of
internal
devaluation?
2. Analyse
why
the
drop
in
consumer
demand
will
have
affected
the
real
level
of
capital
investment
3. Why
has
investment
spending
failed
to
recover
despite
a
strong
rebound
in
Latvian
economic
growth?
Extract
Internal
devaluation
puts
downward
pressure
on
nominal
wages
and
prices
and
has
been
responsible
for
restoring
some
of
Latvia’s
international
competitiveness
which
was
lost
prior
to
2007.
However,
most
of
the
reduction
in
nominal
wages
occurred
in
the
public
sector
and
not
in
the
private
sector.
In
addition,
for
reductions
in
unit
labour
costs
to
be
sustained,
there
needs
to
be
improvements
in
productivity
as
well
as
a
reduction
in
nominal
wages.
The
improvement
in
Latvia’s
current
account
balance
has
been
short
lived.
The
surplus
recorded
in
2010
disappeared
and
by
2012
a
deficit
on
the
current
account
re-­‐emerged.
What
are
nominal
wages
and
prices?
Nominal
wages
and
prices
are
the
value
of
wages
expressed
at
current
prices
i.e.
not
inflation
adjusted
To
what
extent
has
Latvia’s
international
competitiveness
improved?
We
covered
competitiveness
in
an
earlier
section
of
the
case
study
toolkit.
The
main
annual
ranking
of
global
competitiveness
comes
from
the
annual
publication
of
the
World
Economic
Forum.
In
the
2014
Global
Competitiveness
Report,
Latvia
is
ranked
52nd
out
of
148
countries,
compared
with
55th
place
in
2012-­‐2013.
A
selection
of
results
from
the
last
two
surveys
is
shown
below:
Latvia
is
well
ahead
of
Greece
(the
lowest
ranking
EU
member
country)
but
behind
fellow
Baltic
States
Estonia
and
Lithuania
and
also
Iceland.

5. Switzerland 1 1
Singapore 2 2
Finland 3 3
Germany 4 6
United States 5 7
Sweden 6 4
United Kingdom 10 8
Norway 11 15
Korea, Rep. 25 19
Ireland 28 27
China 29 29
Iceland 31 30
Estonia 32 34
Spain 35 36
Poland 42 41
Lithuania 48 45
Portugal 51 49
Latvia 52 55
South Africa 53 52
Brazil 56 48
India 60 59
Russian Federation 64 67
Greece 91 96
Latvia
is
surrounded
by
countries
such
as
Norway,
Russia
and
Poland
–
all
of
whom
have
retained
their
own
currencies
and
seemed
to
weather
the
global
financial
crisis
relatively
well
–
Poland’s
currency
the
zloty
depreciated
by
more
than
20%
for
example.
It
was
the
only
EU
country
to
avoid
recession
after
the
2007-­‐08
financial
crises.

6. Comparing
Latvia
and
Iceland
Extract
Economists
who
are
sceptical
about
the
success
of
Latvia’s
internal
devaluation
in
delivering
a
sustained
economic
recovery
and
correcting
external
imbalances
draw
a
comparison
with
the
experience
of
Iceland.
Unlike
Latvia,
Iceland
has
a
floating
exchange
rate.
Iceland’s
nominal
effective
exchange
rate
(NEER)
index
depreciated
by
almost
50%
after
the
end
of
2007.
In
comparison,
Latvia’s
NEER
was
broadly
unchanged
(see
Fig.
4.2).
Latvia
was
more
dependent
on
a
change
in
its
real
effective
exchange
rate
(REER),
which
depreciated
by
around
20%
measured
in
terms
of
unit
labour
costs.
This
compares
to
45%
depreciation
in
Iceland’s
REER
based
on
changes
in
unit
labour
costs.
In
addition,
Iceland’s
fiscal
tightening
was
not
as
aggressive
as
Latvia’s.
Fig.
4.3
shows
the
different
outcomes
from
2007
until
2012
in
the
two
economies
of
the
different
approaches
to
the
problem
of
external
imbalances.
This
section
makes
reference
to
“Economists
who
are
sceptical
about
the
success
of
Latvia’s
internal
devaluation”
Most
prominent
amongst
them
has
been
the
Nobel-­‐prize
winning
economist
Paul
Krugman.
In
March
2012
Krugman
wrote
a
piece
in
the
Financial
Times
entitled
“Iceland:
Recovery
and
Reconciliation.”
Krugman
argued
that:
• Iceland
“offers
a
test
of
the
advantages
of
indebted
nations
simply
letting
their
banks
collapse
and
default
on
their
loans”
• The
country
provides
a
useful
example
of
how
a
country
can
recover
from
allowing
their
currency
to
depreciate
Krugman
has
been
an
especially
vocal
critic
of
the
Latvian
model
of
internal
devaluation.
As
a
Keynesian
economist
you
would
expect
Krugman
to
believe
that
macro-­‐economic
adjustments
after
a
big
external
demand
shock
/
recession
are
easier
to
make
when
you
have
a
floating
currency
and
avoid
sticking
to
deep
fiscal
austerity
measures.
Some
Krugman
articles
to
read
on
Iceland
and
Latvia
• Latvian
adventures
(2013)
-­‐
http://krugman.blogs.nytimes.com/2013/09/19/latvian-­‐adventures/
• Baltic
Brouhaha
(2013)
-­‐
http://krugman.blogs.nytimes.com/2013/05/01/baltic-­‐brouhaha/
In
March
2013,
the
Latvian
prime
Minister
hit
back
at
Krugman:
Krugman
Can't
Admit
He
Was
Wrong
on
Austerity:
Latvia
PM:
We
also
recommend
that
you
read
this
article
from
the
Economist
(July
2012):
The
Iceland
Question:
http://www.economist.com/blogs/freeexchange/2012/07/crisis-­‐and-­‐recovery

8. Fig.
4.2
–
Nominal
Effective
Exchange
Rate
Indices
for
Iceland
and
Latvia,
2007–11
Note
the
way
in
which
the
data
is
presented:
• The
data
shows
the
monthly
value
of
the
nominal
effective
exchange
rate
index
(NEER)
• The
base
value
for
the
index
is
December
2007,
the
base
value
is
always
100
For
Latvia,
the
nominal
exchange
rate
index
moved
within
a
narrow
band
throughout
the
period
shown
–
it
stayed
within
5%
of
the
base
year
value.
This
is
of
course
due
to
the
fixed
currency
peg
with
the
Euro.
The
nominal
exchange
rate
rose
by
around
5%
during
2009
–
which
was
a
year
of
deep
recession
for
the
Latvian
economy
For
Iceland
-­‐
operating
a
floating
exchange
rate
-­‐
depreciation
started
in
the
second
half
of
2007
but
continued
throughout
2008.
By
the
end
of
2008,
Iceland’s
nominal
exchange
rate
was
almost
50%
lower
than
a
year
earlier.
It
appreciated
in
the
early
months
of
2009
(signs
perhaps
of
some
speculative
buying
for
foreign
currency
traders)
before
falling
back
again.
Crucially
Iceland’s
nominal
exchange
rate
has
traded
at
a
discount
of
more
than
40%
to
the
December
2007
level
throughout
2009-­‐2011.
Our
updated
chart
below
carries
this
data
through
to
the
end
of
2013.
Key
question
to
consider
When
a
new
country
joins
the
EU,
it
is
expected
to
treat
its
exchange
rate
as
a
matter
of
common
interest
to
all
members
of
the
EU.
This
means
that
it
should
not
pursue
competitive
devaluations
for
fear
of
undermining
the
EU’s
single

9. Has
a
floating
exchange
rate
and
the
significant
depreciation
of
her
currency
helped
the
Icelandic
economy
to
achieve
a
stronger,
more
sustainable
recovery
than
in
Latvia?
This
is
a
crucial
debate
in
the
June
2014
pre-­‐release
case
study
materials!
Fig.
4.3
–
A
comparison
of
key
economic
indicators
in
Iceland
and
Latvia,
2007–12
Monthly effective exchange rate index, December 2007 = 100
Iceland - Exchange Rate Index
Source: International Monetary Fund
06 07 08 09 10 11 12 13
40
50
60
70
80
90
100
110
Index
40
50
60
70
80
90
100
110
A
key
reason
behind
the
dramatic
collapse
of
the
Icelandic
exchange
rate
was
that
as
the
global
financial
crisis
engulfed
the
country
they
allowed
their
three
largest
banks
–
Kaupthing,
Landsbanki
and
Glitnir,
which
together
had
assets
10
times
the
size
of
the
country’s
economy
–
to
fail.
Iceland
forced
losses
on
to
the
bank’s
creditors
leading
to
big
losses
for
foreign
investors
many
of
whom
pulled
money
out
of
the
country

10. Note
the
way
in
which
the
data
is
presented:
• The
chart
shows
the
annual
level
of
real
national
output
(GDP)
for
Iceland
and
Latvia
• The
base
index
is
real
GDP
in
2007
• Real
GDP
for
Iceland
was
higher
in
2008
than
2007
(by
around
1%)
but
for
Latvia
there
was
a
fall
of
over
3%
during
2008
• The
deepest
year
of
recession
came
in
2009:
o Real
GDP
in
Iceland
fell
by
6.6%
o Real
GDP
in
Latvia
fell
by
18%
in
2009
(the
deepest
recession
of
any
country
in
the
world)
• In
2010
o Iceland
continued
to
experience
recession
with
another
4.1%
decline
in
real
GDP
o Latvia’s
negative
growth
rate
was
only
0.5%
• In
2011-­‐12
both
economies
started
to
recover
o
Iceland
grew
by
2.7%
in
2011
and
1.4%
in
2012
o Latvia
grew
at
a
faster
rate
but
by
the
end
of
2012,
the
economy
was
still
12%
below
the
2007
level
whereas
Iceland’s
real
GDP
was
only
4%
below
their
2007
level
Key
Questions
to
consider:
To
what
extent
was
the
shallower
recession
in
Iceland
compared
to
Latvia
in
part
the
result
of
50%
depreciation
in
her
nominal
exchange
rate
index?
To
what
extent
was
the
stronger
rate
of
growth
of
Latvian
real
GDP
a
consequence
of
her
policy
of
internal
devaluation?
What
are
some
of
the
possible
short
term
and
longer
term
consequences
for
Latvia
of
the
collapse
in
real
national
output?
Comparing
export
volumes

11.
Note
the
way
in
which
the
data
is
presented:
• The
data
is
presented
in
index
number
format
with
a
base
year
of
2007
• The
data
shows
the
annual
level
of
export
volumes
• This
shows
the
real
quantity
of
exports
of
goods
and
services
sold
overseas
Exports
from
Latvia
fell
sharply
during
the
deep
recession
year
of
2009
–
from
an
index
of
102
to
87,
a
fall
of
just
under
15%.
Since
then
exports
have
recovered
strongly
in
each
year,
the
index
climbed
from
87
in
2009
to
110
in
2011
(an
increase
of
26%
over
two
years).
The
rate
of
increase
slowed
down
in
2012
–
this
links
to
mention
in
an
earlier
part
of
extract
4
about
whether
the
improvement
in
Latvia’s
current
account
position
can
be
maintained
given
her
dependence
on
trade.
Exports
from
Iceland
rose
in
2008
and
2009
–
despite
2009
being
a
year
when
world
output
fell
by
over
2%
and
global
trade
contracted
by
more
than
10%.
Exports
of
goods
and
services
rose
14%
between
the
years
2007
and
2009,
surely
some
connection
here
with
the
50%
depreciation
of
the
nominal
exchange
rate?
Price
Elasticity
of
Demand
for
Exports
You
might
consider
using
some
of
the
data
in
Figure
4.2
and
Figure
4.3
to
estimate
a
price
elasticity
of
demand
for
Icelandic
and/or
Latvian
exports.
For
example,
between
2007
and
2009,
the
Icelandic
exchange
rate
depreciated
by
49%.
Assuming
that
this
fed
through
to
lower
prices
for
Icelandic
products
in
global
markets,
demand
for
exports
(reflected
in
export
volumes)
increased
by
14%
over
the
same
period.
This
implies
a
fairly
low
price
elasticity
of
demand
(14%/49%
x
100
=
0.28).
But
keep
in
mind
that:
• Exporters
do
not
necessarily
have
to
lower
their
export
prices
in
response
to
a
weaker
exchange
rate;
instead
they
may
choose
to
hold
prices
fairly
constant
and
take
a
higher
profit
margin
from
each
overseas
sale

12. • Many
other
factors
affect
export
demand
other
than
price,
for
example
changes
in
real
disposable
incomes
in
the
economies
of
a
nation’s
main
trading
partners.
2009
was
a
year
of
severe
recession
throughout
most
of
Europe
On
the
surface,
both
Iceland
and
Latvia
have
seen
a
relatively
strong
increase
in
export
volumes
since
2007
but
they
have
got
there
in
different
ways.
Icelandic
exports
were
22%
higher
in
2012
than
they
were
in
2007.
Latvian
exports
were
16%
higher.
Comparing
import
volumes
The
third
chart
in
Figure
4.3
tracks
the
volume
of
imported
goods
and
services
into
Iceland
and
Latvia.
As
before
the
data
is
annual,
in
index
number
format
and
in
real
terms
with
a
base
year
of
2007.
The
volume
of
imports
into
Iceland
and
Latvia
was
falling
during
2008
and
collapsed
during
2009
–
in
both
cases
imports
were
over
a
third
lower
in
2009
than
two
years
earlier.
In
the
years
since,
Latvia
has
seen
her
imports
recover
more
strongly
–
reaching
86%
of
the
2007
level,
whereas
in
Iceland
in
2012,
imports
remain
23%
lower
than
in
2007.
Consider
the
causes
of
the
steep
fall
in
import
demand
in
2009
especially
–
in
both
countries
there
was
a
deep
recession
causing
real
incomes
and
employment
to
contract.
Think
here
about
the
income
elasticity
of
• Iceland:
Between
2007
and
2009:
o Real
GDP
or
real
national
income
fell
by
9%,
import
volumes
dropped
by
37%
-­‐
suggesting
an
income
elasticity
of
demand
of
+4.1
(strongly
income
elastic)
• Latvia:
Between
2007
and
2009:

13. o Real
GDP
or
real
national
income
fell
by
21%
and
import
volumes
fell
by
41%
-­‐
suggesting
an
income
elasticity
of
demand
of
+1.95
(again
income
elastic
but
less
so
than
Iceland)
Putting
the
three
charts
that
form
Figure
4.3
together
here
are
some
summary
thoughts:
1. Latvia’s
recession
was
significantly
worse
than
Iceland’s
–
it
was
a
more
clearly
defined
V
shape
with
a
dramatic
loss
of
real
national
output
but
a
stronger
rebound
in
2011
and
2012
2. In
both
cases,
real
GDP
was
well
below
the
2007
peak
by
the
year
2012
–
a
similar
position
experienced
by
the
UK
economy
and
discussed
in
earlier
extracts
3. Iceland
managed
to
avoid
an
export-­‐led
recession
–
helped
by
her
depreciation
–
did
Iceland
take
most
of
her
pain
through
the
exchange
rate
rather
than
the
unemployment
rate?
4. In
all
three
chosen
charts,
Latvia
has
seen
a
faster
rebound
in
real
GDP,
exports
and
import
volumes
but
that
is
unlikely
to
be
the
sole
result
of
an
internal
devaluation.
Deep
recessions
often
provide
opportunities
for
an
economy
to
bounce
back
because
of
the
large
amount
of
spare
capacity
that
becomes
available.
Much
useful
data
is
missing
from
Extract
4
–
for
example,
we
are
provided
with
data
on
export
and
import
volumes
but
no
actual
data
the
current
account
balance
for
Latvia
or
Iceland.
This
would
allow
us
to
consider
for
example,
whether
a
depreciation
of
the
exchange
rate
(for
Iceland)
has
helped
bring
about
a
sustained
improvement
in
her
trade
balance
(net
trade)
or
whether
there
have
been
J
curve
effects
on
the
trade
balance
in
the
immediate
aftermath
of
the
declining
currency?
No
data
is
provided
on
relative
unit
labour
costs
for
the
two
countries,
or
their
rankings
in
terms
of
international
competitiveness.
We
are
not
told
the
scale
of
the
decline
in
nominal
or
real
wages
(an
important
aspect
of
the
internal
devaluation
debate)
or
what
has
happened
to
consumer
price
inflation
in
the
two
countries.
As
support
for
your
study
of
this
case
study,
we
have
produced
a
broad
overview
of
the
macroeconomic
performance
of
Iceland
–
this
comes
next
and
might
be
useful
in
understanding
the
context
for
Extract
4.
AD-­‐AS
Analysis
of
Exchange
Rate
Depreciation

14. Our
analysis
diagram
shows
that
• A
significant
depreciation
of
a
currency
ought
to
provide
a
boost
to
aggregate
demand
arising
from
an
improvement
in
net
exports
(X-­‐M)
• The
effect
of
a
currency
depreciation
depends
in
part
on
the
price
elasticities
of
demand
for
exports
and
imports
and
also
the
elasticity
of
supply
of
producers
in
the
domestic
economy
• A
lower
exchange
rate
also
causes
the
prices
of
imported
products
to
rise,
causing
an
inward
shift
of
short
run
aggregate
supply
• The
standard
impact
is
that
real
GDP
growth
is
higher
(at
least
in
the
short
run)
but
that
cost-­‐push
inflationary
pressures
also
rise,
leading
to
an
increase
in
the
general
price
level.
Price
Level
Real
Nati
Outpu
LRAS
Y1
SRAS1
AD
=
C+I+G+X-­‐M
Ye
AD2
from
lower
currency
(Increased
X
and
fall
in
M)
Y2
SRAS2
(higher
import
prices)
Y3
P1
P2