Latvia’s currency peg: Politics 1, Economics 0

I see that Anders Aslund from the Peterson Institute née IIE is defending Latvia’s currency peg again, this time in the Moscow Times. Given the dearth of such defenders among the conventional economics wisdom crowd, and considering Russia’s kabuki-like rhetoric over its own currency policy, I thought this something worth drawing attention to. Not only that, but I dare say currency peg cheerleaders are a dying breed. This is not to say that pegs are uncommon, but simply that nowadays no country is ultimately considered to be fully developed until it can float its own currency in the international foreign exchange market, somewhat like sitting for an exam without a crib sheet to consult (Hong Kong is an obvious exception, but also not technically a country).

Now, I could get all petty-nitpicky-snipey with Aslund’s defense and quibble that rejecting a comparison to Russia c. 1998 and ignoring a comparison to Argentina c. 2001 while choosing to compare Latvia with Denmark and Barbados – all while contending that Latvia is a special case – is a non-sequitur, self-serving, disingenuous and lazy all wrapped up in one. Or, I could get all econo-geeky and point out that substituting the triple-whammy of wage cuts, tighter government spending and deflation for a currency devaluation is tantamount to trading six for half a dozen when faced with an asset-liability mismatch as deeply embedded as Latvia’s.

But that’s not what I want to do here, in part because plenty of others have already taken enough of a swat at it from an economic standpoint (and indeed, those predicting a devaluation are many: Business Monitor International, Paul Krugman, Edward Hugh, Ambrose Evans-Pritchard, Marxist theoretician Boris Kagarlitsky, and, with an Op-Ed that frankly reads as though it was penned by one of his underpaid student assistants, Nouriel Roubini). No, what I would rather do is propose the Latvia currency situation as an example of politics trumping economics.

Two weeks ago in Washington, in a speech on political reform at the Centre for Strategic and International Studies, Nasir El-Rufai said something that wasn’t quoted in full but that made me sit up straight:

“Politics is far more important than economics. You get the politics right and everything else falls into place. Get the politics wrong, and everything else falls apart.”

Granted, he said this in the context of backsliding political reform in Nigeria, but it stuck in my head principally because although politics and economics have a lot of overlap, I have always ultimately believed the opposite to be true. Indeed, as I have previously expressed on this blog, a lot of what turns me off in the currency policy discussion coming out of Russia is precisely that it is more grounded in political grandstanding than economic practicalities.

But the sorts of politics embedded in the way Latvia has crafted its currency policy are just…different. Let’s consider them, borrowing from Aslund’s most recent defense as well as that of IMF Mission Chief Christoph Rosenberg – who seems to be the only other non-Latvian actively promoting the peg – writing for Roubini Global Economics in January:

  • Planned Euro adoption in 2012
  • “By standing firm, the government can finally force necessary structural reforms of its post-Soviet public sector.”
  • “The political support for the government’s austerity policy is amazingly strong. The recent budget and salary cuts were adopted by a majority of 63 percent of the parliament. Only two big businessmen favor devaluation.”

Let’s also include this one from Peg-basher Edward Hugh, in observing the comments he receives on his blog:

  • “Many Latvians (and citizens of other Baltic states) have accepted the peg as some indication of “post-independence” indication of national “seriousness”, and that any stepping-back from it would be seen as some kind of defeat.”

And just for good measure, I’ll add a few of my own points in the Latvia debate, mostly having to do with the broader public relations dynamics behind policy discourse as it concerns foreign exchange pegs:

  • The IMF has got to be thrilled to have Aslund, who specializes in the region, actively defending the peg when so many of his colleagues are predicting devaluation. Not only does he provide a much-needed third party confirmation for the Fund, but on top of that he’s a) Swedish and b) from the Peterson Institute.
  • To the extent that Aslund cares to raise his public profile, this isn’t a bad issue to do it with. In a town where preening, microphone-hogging econo-geeks are not only a dime a dozen, but are often elbowed aside by preening, microphone-hogging politicians, defending Latvia’s peg from Washington is certainly not a stance that should draw a lot of competition.
  • And just why wouldn’t such a stance draw a lot of competition? There is a certain visceral tone in the way peg bashers present their arguments, particularly when a peg is adhered to or implemented in times of crisis. The jaded cynic in me envisions a bunch of economists nobody has been paying any attention to all of a sudden raising their hands, shouting, “Oh! Oh! I know something about that topic! Interview me!” But the unadorned fact is that, well, let’s face it, fixing a foreign exchange rate is one of the bluntest anti-free market maneuvers around today. For this reason alone I think a lot of the conventional economic wisdom would relish in seeing Latvia’s peg break as it would be yet another piece of evidence that free market ideology reigns supreme, even though Latvia is far from being Public Enemy #1 in any major global debate today.
  • Finally, and this one has no logic backing it up whatsoever beyond simple observation: currency devaluations make for good headlines. Anyone making a big show of peg-bashing right now is sure to be offered a microphone if the peg breaks. And if it doesn’t break, those who predicted devaluation will surely find some unprecedented aspect driving the situation that no reasonable person could have foreseen, effectively letting themselves off the hook.

Different from the politically- and p.r.-driven motives Russia has for trying to change its currency policy, right? Instinctively, I have to believe that the political and public relations drivers of Latvia’s currency peg will eventually hit a wall, at which point the economic merits of the situation will take over. If I were to place a bet one way or the other right now, it would be that the peg is going to break some time at the end of this year or soon into 2010, but much of that bet would be made on a leap of faith. The fact is that attempting to reason this out according to conventional economic theories and/or drawing from lessons of Argentina in 2001, Russia in 1998 or any other remotely comparable scenario from recent history yields nothing near a rock solid forecast – good or bad – for Latvia.

What else is there to consider without getting knee deep in economics arcana? Well, just looking at some of the extreme cases of broken or dysfunctional currency pegs over the past 20 years or so – Thailand, Mexico, Venezuela, Vietnam, Argentina, Russia, Brazil, Uruguay, Ecuador, to name a few – one obvious difference in Latvia is that its adherence to relatively transparent governance is far superior to any of those other countries. Uncoincidentally, the shorter list of economies over the same period whose pegs have actually worked – Malaysia and Hong Kong come to mind as the most obvious examples – have a level of transparent governance generally better than their counterparts (I consider the jury to be still very much out on the currency pegs China and the GCC nations have in place).

Is that it? Political will and governance with a dash of p.r.? It could very well be. Let’s say that the Latvian public sticks with the plan. Surely there will continue to be defaults on debt payments throughout the country. If those defaults rise to a critical enough level, the IMF, the EU or both will have to step in again to help out. And they will do it so long as the Latvians remain cooperative, which I have no doubt they will.

Okay, one more thing, and now I’m going to get econo-geeky. And what’s more is that NOBODY has even brought this up yet (to my knowledge) so PERK UP: from what I can tell, Latvia’s Central Bank is right now somewhere between flirting with and outright violating what is known as the “Impossible Trinity”. That is, it is holding a fixed exchange rate, maintaining free capital movement and an independent monetary policy. Theory has it that it is impossible for any monetary authority to maintain these three policies simultaneously, and that attempts to do so will spell certain doom.

Granted, that theory came out of the 1960s and ’70s under some rather different circumstances. But even the most prominent peg-fixers in recent years today don’t even violate that rule – Malaysia post-1998, Hong Kong, China, the GCC states…is Latvia really in such a special situation today that it won’t get burned?

Could it be, just maybe, that a currency peg is the right policy for Latvia?

And if so, how long before it implements capital controls?