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Latvia and the Neoliberals

On June 2009, the newly appointed Latvian Prime Minister, Valdis Dombrovskis made a national public radio address and said that his country had to accept major cuts in the budget because they would allow the country to receive the next installment of its IMF/European Union bail-out loans.  He said the country was faced with looming “national bankruptcy” and then proceeded to ensure the validity of that claim, by implementing the economic equivalent of carpet bombing, in effect turning the Baltic republic into an industrial wasteland via the most virulent form of neo-liberal economics.

Having broken free from the former Soviet Empire, Latvia promptly surrendered its currency sovereignty by pegging its currency against the Euro. What this means is that it has to use monetary policy to manage the peg, and the domestic economy has to shrink if there is are downward pressures on the local currency emerging in the foreign exchange rates. So instead of allowing the currency to make the adjustments necessary, the Latvian government handled the “implied depreciation” by devastating the domestic economy (the public sector pay has been cut by 40 per cent over the last year, whilst the economy has contracted by almost a third).

But now, cries the government, there is light at the end of the tunnel! In the first quarter, GDP declined by a mere 6 per cent!  Well, when a country experiences a cumulative decline greater than anything sustained by the US during the Great Depression, I suppose a mere 6 per cent contraction seems like positive boom times again.  And sure enough, Prime Minister Dombrovski has proclaimed this as “confirmation of the economy’s flexibility” – what is left of it – and “yield from reforms and the fiscal consolidation program, the so-called internal devaluation”, according to The Baltic Course.  “Infernal devaluation” is a more appropriate description.

The currency peg is nonsensical even though devaluation would be severely disruptive given the current nominal contracts held by the Latvian private sector. Around 80 per cent of all private borrowing in Latvia is in Euro with the Swedish banks being the most exposed in Latvia. And, of course, the Latvia government has bought into a devaluation undermining Latvia’s ambitions to join the EMU (hardly an exclusive club worth joining these days, as any Greek, Spaniard or Italian would likely tell the Latvians). The debate in Latvia about the EMU is that it will provide financial stability for the country. The fact that membership destroys their fiscal sovereignty is never raised in the public debate over the narrow  range of policy options that the political classes are prepared to discuss, thereby legitimizing nonsensical ideas that a contraction of a “mere” 6 per cent is something worth celebrating.

All of this pain for an exclusive club which looks on the verge of imploding.  Getting lower interest rates as a potential benefit is a fools’ errand by comparison, as the Italians are now learning after years of sluggish growth and high unemployment.  Euro zone countries have faced two types of problems by entering the Euro regime. First, they have given up their monetary sovereignty by giving up their national currencies, and adopting a supranational one. By divorcing fiscal and monetary authorities, they have relinquished their public sector’s capacity to provide high levels of employment and output. This is the design flaw at the heart of the European Monetary Union, which might well cause its implosion before Latvia is scheduled to join.   Non-sovereign countries are limited in their ability to spend by taxation and bond revenues and this applies perfectly well to Greece, Portugal and even countries like Germany and France. Note that no US state has a budget deficit relative to its GDP that comes close to those of Greece or Italy—even with the current devastating recession in the US that is killing state budgets. Yet they are already meeting market resistance to any new borrowing precisely because they are recognized as non-sovereign.

Second, by entering the euro zone, these countries have also agreed to abide by the Maastricht treaty which restricts their budget deficit to only 3 per cent  and debt to 60 per cent  of GDP. Therefore, even if they are able to borrow and finance their deficit spending, like Germany and France, they are not supposed to use fiscal policy above those limits. So countries have resorted to different means to keep their national economies afloat, from trying to foster the export sector, as Germany does, to deploying Enron-style accounting tricks, as Italy and Greece did. These constraints have proven to be flexible but that does not mean that they do not matter. When a nation exceeds mandated limits, it can face sanctions imposed by the European Council of Finance Ministers (ECOFIN).  There is competition among the Euronations for ratings—with Germany usually winning (for example it usually enjoys lower credit default swap pricing), which allows it to issue euro debt at a lower interest rate. That in turn keeps its interest spending lower and its deficits lower in a nice virtuous cycle. Nations that exceed the limits by the greatest amounts are punished with high interest rates that drives them into a vicious death spiral because deficits rise and lead to further credit downgrades. That is what happened to Greece. Vultures are now looking for the next-weakest member. That’s another treat in store for Latvia.

In spite of the obvious design flaws now made manifest daily in the euro zone, it is clear that fiscal sovereignty has become a taboo subject in Europe.  The disease of deficit terrorism has metastasized globally, rendering it virtually impossible for governments with free floating non-convertible fiat currencies to construct adequate demand responses to the mounting crisis of unemployment. Certainly we don’t want any more government spending because, as my critics persistently remind me, that way leads to hyperinflation and Zimbabwe.

Channeling my inner Jonathan Swift, I therefore conclude that Latvia’s only hope is to devise a sensible supply-side response, so that today’s currently insufficient spending power is more closely aligned to the 80 per cent or so who are gainfully employed.

Perhaps we can take a page straight of the United Kingdom’s historic playbook. In the old days of the British Empire, many of the country’s criminals were either forcibly press-ganged or deported to Australia. Seeing that Australia today is a vastly more prosperous nation than almost any nation within the European Union, it’s highly unlikely that they would readily accept any more convicts.

But perhaps we can find some nice island in the South Pacific for the purposes of reducing Latvia’s national unemployment problems. After all, Latvians are a civilized people, so we certainly don’t want to resort to the drastic (though cost-effective!) expedient of mass extermination.

In any case, our proposal seems both “modest” and in keeping with the current fiscal aspirations of the Latvia government. We can start by shipping off the long-term unemployed. Then the orphans.  Encourage some Russian expatriates to go back to the motherland. And maybe empty the prisons, if need be, to create huge savings in Latvia’s criminal justice system. If the government has truly run out of money, best if it starts pursuing a supply side final solution of reducing their citizenry until the ratio of money to citizens is much more appropriate.

And in the meantime, we can “reward” those who are deported by allowing them to construct a sensible policy: they get to create their own new currency. They will soon learn that their new government, as a sovereign issuer of its own currency, will have all the capacity it needs to create jobs and prosperity. Freed from the shackles of their deficit terrorist leaders, hopefully they will soon learn that their government can provide all of the fiscal resources required to create full employment and prosperity.

It’s a “win-win” for both the deporters and deportees. The truly worrying thing about this idea is that the Latvian government might well take me up on this modern version of Jonathan Swift’s famous satire, given the relish with which it seems to inflict daily misery on its citizens.

MARSHALL AUERBACK is a market analyst and commentator. He is a brainstruster for the Franklin and Eleanor Roosevelt Intitute. He can be reached at MAuer1959@aol.com

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Marshall Auerback is a market analyst and a research associate at the Levy Institute for Economics at Bard College (www.levy.org).  His Twitter hashtag is @Mauerback

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