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New Report casts doubt on IMF program

Sep 24, 2009
By TBT Staff

In a recently-published report by the Washington, D.C.-based Center for Economic and Policy Research's Center, senior economist Jose Antonio Cordero argues that Latvia's "responses to the [global economic] downturn, along with IMF conditions for assistance, are… seen to have caused harm with pro-cyclical policies." Latvia's economy is expected to contract by up to 18 percent this year, much worse than the IMF's January 2009 prediction of 5 percent shrinkage.

The report points out that the government, in maintaining the currency peg, has made recovery much more difficult. With the fixed currency, the only way to reduce the current account imbalance is through "shrinking the economy, which reduces imports faster than exports…" It compares this response to the IMF policies in Argentine's 1998-2002 recession, where "a fixed, over-valued currency worsened and prolonged the downturn until the Argentine currency collapsed, in 2002."

The report says that there are "more sensible responses to the crisis that would have reduced the loss of employment and output, cuts in social services, and political instability that have resulted from the downturn. The IMF, with its vastly expanded resources, is capable of providing the necessary foreign exchange to allow for counter-cyclical policies 's yet it has opted instead for pro-cyclical policies…"

Pro-cyclical policies are defined as those that exacerbate an economic downturn. The OECD recommends that "governments aim at balancing budgets over the complete business cycle, and that to maintain fiscal credibility, discretionary fiscal measures should be reserved mainly for longer-term issues, used only in exceptional circumstances, such as… severe recessions. To facilitate sustainability and efficiency of public spending, the deficit target could be accompanied by an expenditure rule, with a medium-term budgetary framework, and there should be a debt-to-GDP target ratio, similar to the Swiss debt rule."

Cordero credits export growth, capital inflows and access to cheap loans from foreign lenders for Latvia's strong economic performance. Foreign lenders saw "opportunities to profit from growing credit demand, and the perceived credit risk was alleviated in part due to growing macroeconomic stability and EU membership."

The local population saw a way to catch up rapidly to Western European standards of living, with credit in the Baltics, from 2002 's 2006, expanding by an average annual rate of 44 percent.

The 'conditions' agreed by Latvia for receiving assistance loans "allow for 'flexibilities' on the fiscal front, but counteract those flexibilities with tight monetary policy. Given the sharp falloff in growth, it is not clear why [Latvia] would want to pursue a restrictive monetary policy. These measures may be aimed at protecting their foreign sectors from further imbalances, but it is also true that the policy could be pushing [Latvia's] economy off a cliff."

The self- reinforcing cycle of the recession is "a decline in disposable income, and falling income contributes to the accumulation of non-performing loans; these, in turn, weaken the financial system and scare investors away from the country."

In order to prevent further growth of the public deficit, the stand-by arrangements have the following usual recipe: reducing government spending (even if that ends up hurting areas like health and education) to meet the lower levels of tax revenue. "These arrangements fail to take into account the temporary nature of the global recession, and that once recovery is under way, revenues will start to rise and the deficits may be reduced."

Insistence on maintaining the currency peg is based on concerns about adverse balance sheet effects on households and firms, as they have a high percentage of loans denominated in foreign currencies, and on the need to adhere to Europe's fixed exchange-rate orthodoxy, especially with regard to the goal of joining the euro-zone.

Policy options are limited, as the currency peg rules out the possibility of using expansionary monetary policy; instead, the money supply tends to decline as a result of the continuing deterioration of the balance of payments. Maintaining the peg prevents the government from allowing the currency to depreciate, which would not only stimulate growth but also adjust the current account, as exports become cheaper and imports more expensive.

Poland, for example, remains relatively unscathed through the crisis, and reported second quarter growth of 1.1 percent. It has seen its floating currency depreciate, which has helped companies survive the downturn as they have remained competitive and maintained exports to Western Europe, reports The Financial Times.

In Latvia's case, argues Cordero, the only option to bring the current account deficit under control, is to shrink the economy, to reduce imports more quickly than exports fall.

The report argues that devaluation could provide support for export growth, and reducing wages, as measured in foreign currency, would favor prospects for direct investment from abroad. This would hurt Latvian households' balance sheets and the Nordic banks, and would probably shake other countries in Eastern Europe, but it may very well be the fastest and best route to economic recovery.

Devaluation could also help stabilize government revenues, which could eventually be applied to find ways to restore the equity lost by households as a result of devaluation. The EU and IMF could then concentrate on helping the government mitigate the adverse effects that the crisis is having on the vulnerable sectors of the population.

Pro-cyclical policies make it difficult for government to stimulate economy, where the cycle is still heading down. The main constraint in pursuing expansionary fiscal and monetary policies, particularly in a time of falling inflation, is to have sufficient foreign exchange to avoid balance of payment problems.
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