Fixed Exchange Rate Has Produced World's Worst Recession In Latvia, Says New CEPR Report

The Latvian economy
has suffered the worst two-year decline in output on record and will
have trouble recovering with its currency tied to the euro, according
to a new report from the Center for Economic and Policy Research.

The report, "Latvia's
Recession: The Cost of Adjustment With An 'Internal Devaluation'",
argues that maintaining the fixed exchange rate has prevented the
government from adopting the necessary macroeconomic policies to exit
from the world's worst recession.

"The European Union and the IMF are going to have to reconsider their
economic strategy for Latvia," said economist Mark Weisbrot,
CEPR Co-Director and lead author of the report. "The social and
economic cost has been staggering, and this can't go on indefinitely."

Weisbrot added that the Western European banks that made bad loans in
Latvia during the bubble years preceding the crash are going to have to
accept some of the losses that would come with a devaluation. Western
European banks, led by Austria and Sweden, and including Belgium, the
Netherlands, and France, have hundreds of billions of dollars in loans
in Central and Eastern Europe.

A devaluation in Latvia, if followed by other countries, could have
implications for their loans throughout the region.

Latvia's economy has already shrunk more than 25 percent in two years.
The IMF projects another 4 percent drop this year, and predicts that
the total loss of output from peak to bottom will reach 30 percent.
This would make Latvia's loss more than that of the U.S. Great
Depression downturn of 1929-1933.

The current IMF program, which the government has signed on to, calls
for a fiscal tightening of 6.5 percent of GDP for 2010. This would be
accomplished through a combination of spending cuts and tax increases.
The IMF acknowledges that this fiscal tightening "will likely cause
continued demand weakness through early 2010."

Expansionary monetary policy also runs counter to the need to maintain
the fixed exchange rate. The end result, the authors argue, is that the
economy is trapped in a deep recession in which all of the major
macroeconomic policy variables - the exchange rate, fiscal policy, and
monetary policy - are either pro-cyclical or cannot be utilized to help
stimulate the economy. This makes it very difficult for Latvia to get
out of its recession.

For the executive summary and the full report (PDF), click here.