Latvia's Economic Failure Has Important Lessons for Eurozone, New CEPR Paper Concludes

A new paper from the Center for Economic and Policy Research finds that Latvia's deep recession and slow recovery holds important lessons for other eurozone countries that may rely on an "internal devaluation" in an attempt to boost their economies through exports.

"The case of Latvia has important implications for the current debate on the eurozone crisis, since similar pro-cyclical policies are being implemented in a number of countries," CEPR Co-Director, and lead author of the paper, Mark Weisbrot said. "It provides further evidence that 'internal devaluation' - keeping unemployment high, and lowering wages to make the economy more internationally competitive - can be a very costly strategy, and one that does not work.

"The risks in the eurozone are even greater because of the enormous size of the European banking system, and the financial crisis that has resulted from these pro-cyclical policies.

"The risks from the continuation of failed macroeconomic policies in the eurozone are very high for the global economy, which has already slowed as a result of this policy failure," Weisbrot added.

The paper, "Latvia's Internal Devaluation: A Success Story?" finds that Latvia lags well behind other countries that have experienced large, crisis-driven devaluations in recent decades. Most of these were considerably above their pre-devaluation level of GDP three years later, by an average of 6.5 percent. Argentina - which notably pursued policies counter to the kinds of pro-cyclical measures adopted by Latvia - had passed its pre-devaluation GDP by 25.8% three years after the devaluation. Latvia, by contrast, is down 21.3 percent of GDP three years after its crisis started.

The paper also describes the significant, negative impact that Latvia's internal devaluation has had on the country's workforce. The official unemployment rate rose from 5.3 percent at the end of 2007 to 20.1 percent at peak in early 2010. Even after more than a year of recovery, unemployment remains devastatingly high at 14.4 percent.

However, taking into account those who are involuntarily working part-time, and those who have given up looking for work, peak unemployment/under-employment was 30.1 percent in 2010, declining to 21.1 percent in the third quarter of 2011. And this does not include all the people who have left the country in search of work since the crisis began - an estimated 120,000 people in 2009-2011, or 10 percent of the labor force. Had these people not left the country, unemployment/underemployment could have been as high as 29 percent in the third quarter of 2011, instead of 21.1 percent.

"The economic and social costs of Latvia's economic strategy since the global financial crisis and world recession of 2008-2009, of 'internal devaluation,' have been enormous for the people of Latvia," said Weisbrot.

The paper also finds that Latvia's net exports contributed little or nothing to the economic recovery over the past year and a half. This means that "internal devaluation" cannot have succeeded in bringing about the recovery. Rather, it appears that the recovery resulted from the government not adopting the fiscal tightening for 2010 that was prescribed by the IMF, and also from an expansionary monetary policy caused by rising inflation. The data contradict the notion that Latvia's experience provides an example of successful internal devaluation.