Defense of Latvia's Currency Is Doomed
Letter to the Editor

Your editorial calling on Europe to help save the Latvian currency peg ("Europe must not let Latvia fail", June, 5) is all too reminiscent of similar calls in 2000 to save the Argentine Convertibility Plan long after that plan had become unsalvageable. It glosses over a number of key facts that would suggest how costly and ultimately futile a defense of the Latvian currency would now be.

As the International Monetary Fund itself has noted, in the years following Latvia's acceptance into the European Union, Latvia experienced an excessive housing and financial sector-led boom that gave rise to big economic imbalances. The external current account deficit widened to a peak of 25 per cent of gross domestic product, private external debt ballooned to 130 per cent of GDP, and the country experienced a major loss in international competitiveness that has only been exacerbated by the recent large depreciations of many east European currencies.

Over the past year, in the wake of the bursting of the Latvian bubble and despite an IMF support programme, Latvia's GDP has already contracted by 18 per cent, while the public sector deficit has ballooned to over 10 per cent of GDP, or to more than double the IMF target. Subjecting Latvia to a further round of budget tightening while maintaining the exchange rate peg, as part of an IMF and EU rescue plan, would almost certainly plunge the economy further into recession and substantially raise unemployment from its present 14 per cent level. It would also give rise to a disorderly process of private sector debt defaults without offering any hope of an economic recovery for a long period of time.

It would seem that if a devaluation of the Latvian currency is indeed inevitable, it would be best that it were done quickly and in an orderly manner rather than subject the Latvian economy to a further extended and painful period of deflation with little hope of success.

Desmond Lachman is a resident fellow at AEI.

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