By Olivier Blanchard
In 2008, Latvia was widely seen as an economic “basket case,” a textbook example of a boom turned to bust.
From 2005 to 2007, average annual growth had exceeded 10%, the current account deficit had increased to more than 20% of GDP. By early 2008 however, the boom had come to an end, and, by the end of 2008, output was down by 10% from its peak, the fiscal deficit was shooting up, capital was leaving the country, and reserves were rapidly decreasing.
The treatment seemed straightforward: a sharp nominal depreciation, together with a steady fiscal consolidation. The Latvian government however, wanted to keep its currency peg, partly because of a commitment to eventually enter the euro, partly because of the fear of immediate balance sheet effects of devaluation on domestic loans, 90% of them denominated in euros. And it believed that credibility required strong frontloading of the fiscal adjustment.
Painful adjustment
Many, including me, believed that keeping the peg was likely to be a recipe for disaster, for a long and painful adjustment at best, or more likely, the eventual abandonment of the peg when failure became obvious.
Nevertheless, given the strong commitment of both Latvia and its European Union partners, the IMF went ahead with a program which kept the peg and included a strongly front-loaded fiscal adjustment.
Four years later, Latvia has one of the highest growth rates in Europe, the peg has held, and the fiscal and current accounts are close to balance.
(more…)
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