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Devaluation or deflation - are these genuine alternatives?

15 Jun 2009 - Bruno Prior

The choice for countries like Latvia, whose currency-peg to the Euro is crippling their economy and which have borrowed heavily in Euros, is routinely presented as devaluation or deflation. Either they must allow their currency to float (down), making their exports more competitive and imports less competitive but at the cost of making their Euro debts more expensive, or wages and prices must be driven down if they wish to retain their currency peg. Are these genuine alternatives, and is either of them a solution?

What I am wondering, which no one who posits these alternatives seems to address, is: how will they pay their debts when wages and profits have been decimated? Or conversely, if they honour their debts (whose cost of finance will be a major component of overall costs, as will be taxation to pay for increasing welfare requirements from a shrinking tax-base), will cuts to wages and prices make much of a difference to their competitive position? And won't their government deficit get even worse in these circumstances, maintaining pressure on their currency? Already, no one wants to buy their government bonds.

Isn't the reality that we long ago passed the point at which Latvian default on external debts was inevitable, and all the efforts to prop them up is simply delaying the inevitable? Massive deficits, government borrowing and (when they arrive) defaults already put them in breach of the terms required to enter the Euro. And if they maintain the fiction of exchange-rate stability, they will have to join the Euro at a level that will cripple their economy for decades. Isn't it time to bow to the inevitable, allow their currency to revalue, and start the process again at a more realistic exchange rate, if they are so foolishly determined to join the Euro?

Topics: Economics
Organisations:
Locations: Latvia

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