Regaining Competitiveness While Maintaining a Currency Peg – the Case of Latvia

What would you say if a sportsman whose records had been rescinded because of proven steroid use returned after a period of disqualification and started competing again? Would you take pride in pointing out that his results are below those attained while being on steroids? Or would you rather find his pre-steroid period to be a more relevant basis for comparison? We assume it’s probably the latter.

Some economists apparently think the records set while being on steroids should still be the benchmark. Take the case of Latvia. The economic development of Latvia has been nothing short of a roller coaster ride and has attracted considerable attention during both the boom in 2007, the bust in 2009 and the recovery in 2011. Balanced analyses, such as a recent one by the IMF’s Olivier Blanchard (“Lessons from Latvia”, iMFdirect, June 11, 2012 ), are the exception. Several economists, Paul Krugman perhaps being the most visible of them all, have repeatedly argued that “the catastrophe” in 2009 and Latvia still failing to reach the pre-crisis level of output in 2012 can be explained by the fact that the Bank of Latvia during the crisis stubbornly refused to devalue the lat, which since the end of 2004 has been pegged to the euro at a rate of 0.7028 lats per one euro. Krugman interprets the Latvian experience as a policy failure, and others, including  Charles Wyplosz (“The Eurozone’s May 2010 Strategy is a Disaster”, Economonitor, June 20, 2012 ), are skeptical about whether the Latvian policy is exportable to other countries.

2005 – 2009: An economy on steroids and an inevitable bust

To draw conclusions about the economic bust, one first needs to understand the preceding boom. To continue the sports analogy, the economy of Latvia was on steroids during the years 2005 to 2007. The increase in foreign borrowing by Latvians during those years brought more than EUR 13 billion of fresh money into the economy. This inflow was more than a fourth of the nominal GDP, which totaled EUR 50 billion during the same period. Other inflows included foreign direct investment, funds from the European Union, and remittances of Latvian residents working abroad. The huge inflows of money led to skyrocketing imports, double digit consumer price inflation in 2007 and double digit real GDP growth rates in 2005-2007. In 2007 the real GDP of Latvia was 34% higher than in 2004. Total employment increased by more than 100 thousand or 10%, but the boom was not sustainable.

To understand why, it is sufficient just to look at the structure of the above growth. A closer look reveals that wholesale and retail trade (largely of imported goods) accounted for about 9 percentage points of the total, construction 5% and operations with real estate and financial services 3%. Job creation was also mainly limited to the above sectors – 34,000 new jobs were added in wholesale and retail trade, but the most spectacular job growth was experienced by the construction industry which added 39,000 people or 45% in three years’ time. On the contrary, employment in the largely export oriented processing industry in 2007 was at about its level in 2004.

In 2009 the tissue that had been grown while taking the steroids melted away. To Paul Krugman, the 18% decline in 2009 was “the catastrophe” (See “Riga Mortis”, ). However, it primarily reflected the inevitable collapse of those parts of the economy of Latvia that were not sustainable going forward after the huge financial inflows dried out. If we dissect the GDP decline of about 20% in 2008 – 2009, we see that 6 percentage points of it are related to wholesale and retail trade and 3% to construction– altogether almost a half of the decline is attributable to sectors that showed annual growth rates far above the average during the period from 2005 to 2007 and where the demand spike was largely driven by net financial inflows. Needless to say, Latvia was also hit hard by the decline in global trade in 2009, but that was the lesser problem compared to the collapse of the domestic “bubblenomics”.

2010 – now: Recovery and improvement in external competitiveness

What has happened since 2010? A gradual recovery has been taking place. The seasonally adjusted quarterly GDP in Q1 2012 was already 12% above the crisis trough reached in Q3 2009. Industries relying on domestic demand such as trade and construction are still much below the pre-crisis output peaks as at the beginning of 2012. However, the industries directed at exports, such as the processing industry and transport and logistics, have shown consistent growth and have already surpassed the earlier pre-crisis peaks in volume terms. The tradable goods sector has become more competitive. More importantly, Latvia is one of a few countries in the EU where industrial output has reached its pre-crisis level. There are only two countries that clearly performed better – Poland and Slovakia as can be seen below:

When looking at the above chart one has to keep in mind that Poland never entered a recession even in 2009 and domestic demand has played a much more important role in its industrial output growth than in Latvia.

Latvian exporters have also lately been gaining market shares in the Scandinavian countries and Poland, as the chart below shows:

The above evidence is clearly at odds with the opinion voiced by several economists that Latvia’s internal devaluation did not work. A frequently mentioned argument is that the wage declines were too small and did not achieve a remarkable improvement in competitiveness. For example, Krugman in “Latvian Competitiveness” ( ) presented the following data from Eurostat:

However, the above data ignore the important increase in productivity. Unit labor cost, a more relevant competitiveness measure, shows a remarkable improvement since 2008:

Nominal unit labor cost, Index, 2008=100










Euro area

























Source: Eurostat


A negative side effect of the productivity boost, at least in the short term, was employment recovering more slowly than output. A comparison of today’s employment situation with that of 2007 would not be valid, but there are still about 50,000 jobs less in Latvia than there were in 2004. Social programs have been put in place by the World Bank and the national government to help mitigate the consequences. Thousands of people have left the country in search of employment elsewhere in the EU.

Another important factor behind the relatively favorable performance of exports is that most of Latvia’s main trading partners have had a strong recovery from the crisis as shown in the table below. About two thirds of Latvia’s merchandise exports go to the other Baltic Rim countries.


Real annual GDP growth, per cent




































Sources: Statistical offices of the respective countries


However, had the Latvian exporters been uncompetitive, they would not have been able to fully benefit from economic growth in the greater region, and even less grow their market shares in some of their main export markets.


Some output in sectors that were dependent on the huge inflow of credit for growth in Latvia is apparently lost forever. The loss was inevitable, though, as lending growth came to a stop. Sectoral output loss in non-tradeable sectors cannot be a sign of lack of competitiveness. On the contrary, the exporting sectors have done very well despite the fixed exchange rate. Domestic demand also started growing again in 2011. No doubt, without the steroids growth now is more modest than the double digit rates experienced in 2005 – 2007. However, it is also more healthy and the economic tissue built and jobs created as a result of it are much more likely to be sustainable in the longer term.

Productivity growth has played a substantial role in regaining competitiveness. It is clear that the considerable increase in productivity was possible because Latvian producers and exporters were still far from the technology frontier when the crisis hit (and they still are). However, it can also be hypothesized that as a result of not taking the devaluation route there was more pressure to increase productivity fast.

Latvia continues to face major economic issues such as a relatively high debt burden in the private sector and it will probably take several more years of moderate growth before employment reaches its 2004 level, but the Latvian economy has recovered from the massive shock of 2009 faster than many of its neighbors while some other EU countries have been going in and out of recession since 2008 with no end in sight.

Because of economic differences, policies that are best for Latvia need not be best for all EU countries and would obviously not be appropriate for economies that are structurally sound and experience a cyclical weakness of demand. However, postponing an inevitable structural adjustment does not appear to be a sensible policy alternative either. There are other small, open economies with flexible labor markets that could learn from Latvia’s experience.  There are also economies, such as Italy and Spain, with structural problems and labor market rigidities, which could in the longer term benefit from labor market reform as suggested by Mario Monti and others.

14 Responses to "Regaining Competitiveness While Maintaining a Currency Peg – the Case of Latvia"

  1. Ed Dolan
    EdDolan   June 25, 2012 at 6:54 am

    An excellent analysis. I would emphasize that not only was the precrisis boom unsustainable, but that Latvians recognized that fact, at least most of them that I have talked to. No doubt that contributed to the relatively muted political protest against austerity, compared to some countries of Southern Europe.

    We are still in the early quarters of recovery, so it is a little early to write a definitive account of the success or failure of the Latvian internal devaluations (and the similar experience of its Baltic neighbors). However, one thing is becoming clear, as this post notes. Going into the internal devaluation, nearly everyone saw decreases in nominal wages as the main mechanism that would determine the outcome. It is now apparent that instead, productivity has been the main driver of recovery. Nominal wages did fall for a while, but not by as much as was once thought necessary. We will have to wait to see whether the productivity trends hold up.

    Finally, I would like to add that the fact that the Latvian approach seems to be working does not necessarily mean it was the best of all possible policies. It has always seemed to me that if Latvia had, from the outset, allowed more flexibility within its fixed-rate policy, the boom would not have gone so far out of control, nor would the bust have been as dramatic. In contrast to neighboring Estonia, Latvia never committed itself to a full-fledged currency board. That means it would have been technically possible to introduce the needed flexibility at the moment the peg for the lats was switched from the earlier currency basket to the euro. If at that moment, the trading band had been reset to a wider limit, perhaps even to the maximum + or – 15 percent allowed by the ERM, Latvia's boomtime inflation would have been less severe and its crash less dramatic–more like the smoother ride through the crisis of floating-rate countries like Poland and the Czech Republic. Of course, it would also have been helpful if the Latvian government had not been content merely to balance its current budget during the boom, but had balanced is structural budget, which would have meant running a current surplus.

    • ThomasGrennes   June 27, 2012 at 1:46 pm

      Agree. Productivity growth was important and it probably reflects the flexible labor market
      in Latvia. There are no laws comparable to the Italian law that prevents employers from
      laying off workers for economic reasons.

      Whether limited flexibility of the exchange rate might have produced more favorable results is a difficult counterfactual question. My impression is that retaining the fixed rate is related to the central bank seeking credibility for its policy.

  2. Kostis   June 25, 2012 at 9:38 am

    I am fairly surprised that the above analysis has no mention on the fact that 200.000 Latvians., close to 10% of the population, has chosen to leave the country due to the crisis. That doesn't sound a sound result of the internal devaluation to me.

    • Janis   June 25, 2012 at 1:20 pm

      People left NOT because of the crise. They emigrated even when there was no unemployment and salaries were rising 30% a year. They emigrated and still emigrate because Latvia with Estonia and Lithuania was and still is one of the poorest countries of Europe. And they will stop to leave and will come back when and if we reach the levels of development closer to EU average. The "steroids " of unsustainable spending did not help. Reforms though seem to be working. So I still guess the latter is better than former.

    • ThomasGrennes   June 27, 2012 at 1:53 pm

      Kostis and Janis: I agree with Janis that large differences in wages and income per capita
      are the main stimulus to migration. New 2011 data from Eurostat show that Latvia's GDP per capita (PPP measure) was third lowest in the EU27. It was $14,600 Euros, 58% of the
      EU mean of 25,100 Euros. Migration can be expected to be one factor that will narrow the cross-country income gap.

  3. guest   June 25, 2012 at 10:19 am

  4. Tom   June 25, 2012 at 6:16 pm

    Excellent piece. It's sad that economics has become such a hysterically partisan field that people like Krugman find it necessary to mock the Balts and try to paint them as slow cavemen. Thank you very much for bucking the trend.

    @ Ed – I think the Balts simply decided that their political reasons for joining the euro early outweighed the economic grounds for keeping flexible exchange rates. Since they seem to be accepting the consequences with few regrets and little blaming of their creditors, I don't think you can call it a mistake.

    • ThomasGrennes   June 27, 2012 at 2:07 pm

      Tom: For some people who think that fiscal expansion is the answer to most economic problems, a successful austerity program in Latvia would be an embarrassment. Also,
      Latvia, Estonia, and Lithuania are small countries, and many people, especially Americans,
      know little about them. Perhaps an exchange of ideas about the Baltics will be an educational experience. Toomas Ilves of Estonia is an active participant in the exchange.

  5. kiP   June 26, 2012 at 3:27 am

    @Tom You call Krugman a partisan, and then you tell Ed that joining the euro early is a political and not an economic desicion. This is at least a contradiction on your part.

    @Tom, Janis and the authors. It is now obvious to me that the Balts are in the same state of denial as the euro periphery (South Europe including the no so-South Ireland) has been for a long time. Euro zone membership is perceived as an honour not a tool and so the elites and the people were "accepting the consequences with few regrets." This forbid a true public discussion on the issue and a dissent negotiation with the creditors (terms were unilaterally imposed). Now the narrative is gradually moving to the extremes (look at the rise of the far right in Greece).

    • ThomasGrennes   June 27, 2012 at 2:17 pm

      kiP and Tom: Whether to join or remain in the Eurozone has both economic and political dimensions. What membership means has changed and continues to change, and candidate countries must re-evaluate the costs and benefits of membership. Initially members were not obliged to bail-out other members. Now substantial bailing-out has already occurred and more may be forthcoming. There is strong evidence that joining the EMU has been more popular with government leaders than with the general population.

  6. bill G   June 28, 2012 at 6:23 pm

    Except for Kostis, no one mentioned the 10% of Letts who left the country. Check articles byu Michael Hudson, a top flight economist who teaches in the US midwest.

  7. bill g.   June 28, 2012 at 6:29 pm

    Here is the web cite on the Michael Hudson article about Latvia not being a success

  8. Rolands   June 29, 2012 at 4:26 am

    The article is very good.
    Janis is totally right when saying that Latvians have not left their country because of the crisis. 200.000 inhabitants of Latvia left between 2000-2010.
    EdDolan: the Lats was pegged to the Euro when we believed that we would join the Euro in 2008. You miss one argument about more flexibility with the currency. About 80% of the bank credits were given in Euro. To devaluate the Lats would have meant an unbearable burden for a lot of small creditors earning wages in Lats – to my opinion a disaster (reminder: the debt burden in Latvia in 2008 was mostly private).
    kiP You must know some things that I don't know because your conclusions about the lack of true debates and the imposed conditions in negotiations with the creditors are simply wrong.

  9. Andrea   July 26, 2012 at 2:28 am

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    Don't believe the Latvian government propaganda that gets rehashed by
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