There are two schools of thought on whether Latvia should devalue the lat, or fight tooth and nail to keep its currency peg to the euro. One, espoused by the Latvian government, the International Monetary Fund and the European Commission, is that devaluation would destabilise the Latvian banking system, wouldn’t really address the long-term challenges facing the Latvian economy, and would risk spreading shock waves beyond Latvia across the Baltic and into other parts of central and eastern Europe.
The other view, espoused by some of the world’s leading economists, such as Paul Krugman and Nouriel Roubini, can be summed up as: “Get Real”. Without devaluation, the only path that Latvia can go down to extract itself from crisis is massive deflation, through spending cuts and sharp falls in wages that will inflict terrible damage on society and will unnecessarily prolong Latvia’s recession.
There is a lot to be said on both sides of the argument. Devaluation would clearly be a very serious matter for a country where loans in foreign currencies account for 85 per cent of total lending. Mass defaults would follow. And it is by no means clear that devaluation would give a boost to exports. Wood in its various forms – sawn wood, plywood and fuel wood – represented 20 per cent of Latvia’s total exports in 2007, but right now the world’s construction and housing sectors are in very poor shape and aren’t exactly thirsting for Latvian wood.
My own view is that, like most difficult economic choices in democracies, this is in the end a political matter. If the Latvian population is prepared to tough it out, and if the Latvian political classes have the stomach to preside over years of horrendous deflation, then they should be free to go for it.
But I have a caveat. It is pretty clear that the only reason why the Latvians think it’s worth accepting all this pain is because they have a burning ambition to join the eurozone. Latvia, which was annexed by the Soviet Union in the 1940s and only managed to break free in 1991, is already in Nato and the European Union. Eurozone membership would underpin Latvia’s independence by anchoring the country more deeply than ever in Euro-Atlantic structures.
What EU policymakers should really be looking at is a way to accelerate Latvia’s entry into the eurozone, so that the economic pain and social strains associated with sticking to the currency peg last for as short a time as possible.
The trouble is, this option isn’t under serious consideration in Brussels or at the European Central Bank. And that is why devaluation, though it is by no means the answer to Latvia’s troubles, remains a distinct possibility.
Across the globe: Gideon Rachman and his FT colleagues debate international affairs on