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Quietly clicking my way through Bloomberg last Sunday afternoon, I came across this:

Facebook Members Register Names at 550 a Second

Facebook Inc., the world’s largest social-networking site, said members registered new user names at a rate of more than 550 a second after the company offered people the chance to claim a personalized Web address.

Facebook started accepted registrations at midnight New York time on a first-come, first-served basis. Within the first seven minutes, 345,000 people had claimed user names, said Larry Yu, a spokesman for Palo Alto, California-based Facebook. Within 15 minutes, 500,000 users had grabbed a name.

Mein Gott, I thought to myself, if 550 people a second are doing something, they can't all be wrong. So I immediately signed up. Actually, this isn't my first experience with social networking since I did try Orkut out some years back, but somehow I didn't quite get the point. Either I was missing something, or Orkut was. Now I think I've finally got it. Perhaps the technology has improved, or perhaps I have. As I said in one of my first postings:

Ok. This is just what I've always wanted really. A quick'n dirty personal blog. Here we go. Boy am I going to enjoy this.

Daniel Dresner once broke bloggers down into two groups, the "thinkers" and the "linkers". I probably would be immodest enough to suggest that most of my material falls into the first category (my postings are lo-o-o-ng, horribly long), but since I don't really fit any mould, and I am hard to typecast, I also have that hidden "linker" part, struggling within and desperate to come out. Which is why Facebook is just great.

In addition, on blogs like this I can probably only manage to post something worthwhile perhaps once or twice a month, and there is news everyday.

So, if you want some of that up to the minute "breaking" stuff, and are willing to submit yourself to a good dose of link spam, why not come on in and subscribe to my new state-of-the-art blog? You can either send me a friend request via FB, or mail me direct (you can find the mail on my Roubini Global page). Let's all go and take a long hard look at the future, you never know, it might just work.

David Takes On Goliath and Loses: The Ferguson - Krugman Exchange

"As long as excessive debt is not digested, both monetary and fiscal policies are inefficient. There is not much of an alternative. Either to let the economy collapse, in order to reduce debts, and then use fiscal policy to revive it, or inundate the insolvent economy with public credit, to avoid the collapse, and loose the ability of fiscal policy to pull it out of a prolonged lethargy. Either a horrible end or an endless horror."
After the Crisis: Macro Imbalance, Credibility and Reserve-Currency: André Lara Resende

Well, I think the title to this post makes my view on the high-profile shenanigans we are currently witnessing on the part of two widely respected contemporary intellectuals clear enough, even if Paul would probably respond that he is perfectly well able to take care of himself, thank you very much. Nonetheless, looking at the way the tone of his most recent and most public debate with Niall Ferguson has deteriorated (yes, it is Niall I'm talking about here, and not Sir Bobby, although sometimes even I have my doubts), let me confess, I am not entirely convinced on this point (Niall Ferguson's argument can be found summarised in his Financial Times Op-Ed here, and in his rejoinder letter to Martin Wolf reproduced by the FT Alphaville's ever interesting Izabella Kaminska here, while Paul Krugman's "input" to the debate can be found here, here, and here).

So, since the thunder and lightening that such high profile exchanges generate tends to obscure more than it reveals, let me be so bold as to add my own 2 centimes worth - even if, apologies in advance, the whole affair ends up being most terribly "wonkish". If you want to save yourself a good deal of trouble, and heart searching, the central point is a simple one: are long term US interest rates rising because investors are worrying about having to buy so much public debt (as K would point out, what else were they thinking of doing with the money - which isn't really "money" at all, but, oh, never mind), or are they rising because investors expect the time path of US short term interest rates to move steadily upwards? It's as easy, or as hard, as that. So now, you decide!

Someone To Watch Over You

Amidst so much disagreement one point is, at least, agreed common ground: Paul Krugman is a macro economist, while Niall Ferguson is a historian, one who believes, if we are to take him at his word, that cats may sometimes look at kings, and live to tell the tale. Let's see if he's right.

The other point we are all agreed on, I think, is that yields on 10 year US treasuries have been rising of late, and this phenomenon lies at the heart of the debate. Indeed, if I read him aright, this is Niall's main point of current concern.

On Wednesday last week, yields on 10-year US Treasuries – generally seen as the benchmark for long-term interest rates – rose above 3.73 per cent. Once upon a time that would have been considered rather low. But the financial crisis has changed all that: at the end of last year, the yield on the 10-year fell to 2.06 per cent. In other words, long-term rates have risen by 167 basis points in the space of five months. In relative terms, that represents an 81 per cent jump.

Where we are not agreed - the economists and the historians among us that is - is over the significance to be placed on this evident fact. Although, having said this, Niall does rather seem to suggest that the development is some sort of litmus test for his view, since he argues it "settled a rather public argument between me and the Princeton economist Paul Krugman". Now what was it they used to say about rushing in where angels fear to tread!

Of course, Niall is no fool, he is an excellent historian, and I greatly enjoy reading his books, but he really, really should know better than to get himself involved in the kind of technical argument which his experience and background ill equips him for. Citing the Chinese central bank as authority for your monetary views (see below) may go down well with the after dinner port-and-stilton set, but it is hardly rigorous argument, and Niall must surely well know that.

It's The Expectation On Long Term Yield, Silly!

The Fed probably won’t make any adjustments to the size of the Treasury purchase program before its next policy meeting on June 23-24, in part to avoid reinforcing perceptions policy is reacting to swings in yields, according to Jim Bianco, president of Chicago-based Bianco Research LLC.

“The Fed wants to operate in predictable ways,” Bianco said. “They are also trying to not just look arbitrary, which makes people think ‘I can’t ever go to the bathroom because there could be a press release that the Fed changed the buybacks.’ That’s been a real concern: ‘Wow, I just went to the bathroom and lost $2 million dollars.’”

The thing you should always bear in mind when you enter the fray in areas where others have the benefit of the expertise is that there may be more than one available interpretation for the phenomena, and, as is so often the case in science, the counter intuitive explanation may have more going for it than the layman may grant at first sight (wasn't that the sun I just saw hurtling past across the sky). In this sense, the recent rise in long term US treasury interest rates has just provided some of us with a fascinating example of a phenomenon that those economists who have busied themselves studying the use of quantitative easing in Japan have been flagging for some time, and that is, that long term interest rates may indeed be unduly influenced by longer term inflation expectations, but not necessarily in the way laymen Niall and others may imagine they are.

Longer term inflation expectations - or so it is argued by a broad spectrum of monetary economists - may work against the fluid operating of a quantitative easing regime in or on the boundary of a liquidity trap, not because investors fear that a country like the United States is about to become the new Zimbabwe, but precisely because they know it won't. Indeed, as I frequently find myself saying of late, the United States is not Argentina, gee, it isn't even Italy, by which I mean that investors know perfectly well how Ben Bernanke and his colleagues over at the Federal Reserve will react to a situation where inflation is perceived as rising above their target range - they will start to raise short term interest rates, and it is this expectation of future increases in short term rates which ironically cause longer term interest rates to rise, in just the way they are doing right now, in what is almost a text book case study in the United States. As Krugman's former PhD student Gauti Eggertsson put it in one highly relevant paper (Eggertsson and Ostry: 2005, see references below).

A central bank following a Taylor rule raises interest rates in response to inflation above target and output above trend. Conversely, unless the zero bound is binding, the central bank reduces the interest rate if inflation is below target or output is below trend (an output gap). If the public expects the central bank to follow the Taylor rule, it anticipates an interest rate hike as soon as there are inflationary pressures in excess of the implicit inflation target. If the target is perceived to be price stability, this would imply that quantitative easing has no effect, because commitment to the Taylor rule would imply that any increase in the monetary base would be reversed as soon as deflationary pressures had subsided.

Indeed talking of the Taylor rule, none other than John Taylor himself recently came out and argued that -applying his rule - the Federal Reserve would need to start once more to raise interest rates in the near future, “My calculation implies we may not have much time before the Fed has to remove excess reserves and raise the rate,” he said recently at an Atlanta Fed conference. And if John can do the calculations so too can other investors.

Of course the United States Federal Reserve is not at this point following a Taylor-type rule (although Bernanke is a known supporter of some sort of inflation targeting) but let us not get bogged down in that minor, rather technical detail, the key issue is that long term interest rates are influenced more by the expected time path of short term rates than by any other single factor, and if, instead of beating about the bush, we go right to the heart of the matter, what do we find, well Lo & Behold, only last Friday:

The dollar advanced the most against the yen in more than three months and rose versus the euro as economic data showed evidence the U.S. recession is easing, boosting demand for the nation’s assets. The greenback climbed this week as a government report indicated slower deterioration of the labor market, supporting bets dollar-denominated assets will gain as the U.S. leads the global economy out of its slump.....

The dollar also gained against the yen on speculation the Federal Reserve will raise interest rates later this year, reducing the advantage of borrowing in the U.S. to fund purchases elsewhere. Traders added to bets the central bank will increase its target rate for overnight loans between banks by its November policy meeting, according to futures traded on the Chicago Board of Trade. The contracts show a 66 percent chance of a rate increase by then,compared with 24 percent odds a week ago.

Well, there you are, investors (I have no idea whether they are being rational or not) simply act as theory predicts, and chaffe at the bit (sometimes called "getting ahead of themselves") to take positions in anticipation of expected future hikes in US interest rates, something which sends rates rippling upwards all along the yield horizon. Incidentally, can someone kindly tell me where I have to write to become a formal member of the "Thank God For Bloomberg" brigade, since where would we really be without those dedicated scribes, who will, incidentally, obviously provide so much material for future generations of historians? (Incidentally, you can find a very good summary of just what a headache the volatility in US government bonds is proving to be for Bernanke in this Bloomberg article, from which the Bianco quote above was taken).

So, far from the position being as Niall imagines it is, with investors demanding enhanced premiums for holding US assets due to their fear of impending inflation, what we have here is a kind of see-saw process, whereby bad economic data, which leads investors to anticipate interest rates being held low in the US for some considerable time, raises risk sentiment (see this post: Don't Get Carried Away Now) and sends them off into riskier emerging market assets (with Big Ben playing sheet anchor) in the process sending the grenback to ever lower levels, while positive economic news makes playing carry with the USD as one of your currency pairs increasingly riskier, and thus leads the punters themselves to retreat, sending the dollar cruising back up again. All of which is very counterproductive, since given the knife edge character of the current US "recovery" all it does is slow things down (since the cheaper USD is good for exports) and ramp up the deflationary pressure.

But this story about investors being nervous about holding US Treasuries due to the high inflation risk, well, as far as I am concerned, go tell it to the marines, or at least to the those people over at the Chinese central bank (you know, the ones who have been running up all those dollar reserves) who Niall seems to regard as his economic authority in these matters.

"Monetary expansion in the US, where M2 is growing at an annual rate of 9 per cent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next. In the words of the Chinese central bank’s latest quarterly report: “A policy mistake ... may bring inflation risks to the whole world.”"

What we have here, is what the late Niklas Luhman would have termed a "narrative discourse". Repeating the same arguments ad infinitum may produce a pleasing to sensation among those who have convinced themselves they are right, but that does not make them "true", nor is it a substitute for rigourous economic analysis, or a basic understanding of what is actually going on. As I say, it does go down well with the port and stilton set though, and would undoubtedly make one VI Ulyanov (aka Lenin) turn merrily over in his mausoleum, since evidently he was right: "every cook can and does govern".

But back to the basic thread, putting all this pressure on public officials at this point is a completely counterproductive exercise, since the surge in long term interest rates - produced by the rise in expectations that the central bank will move to reign-in inflationary pressures sooner rather than later, simply leads to further signs of weakness in the US economy, which means the expectation once more grows that rates will stay lower longer, and on and on we go. But of course, as Niall Ferguson points out, it is none other than Bernanke himself who has most recently and most evidently been expressing concern about the future size of the Federal deficit, and again this would seem to me to be a reflection of the political pressure that this mistaken narrative is exerting. Accodring to the Wall Street Journal:

The Fed must decide, perhaps as soon as its June 23-24 policy meeting, whether to increase its purchases of Treasury bonds. It is on course to buy $300 billion worth of bonds by September. If investors perceive the Fed's actions as an effort by the central bank to facilitate bigger deficits, they could conclude inflation is coming and flee Treasurys, pushing interest rates up. Mr. Bernanke's comments were aimed at thwarting that perception.

Counter intuitively, the only real way to break this spiral is for Bernanke to commit to holding rates near the zero bound for an extended period of time - or to "commit to being irresponsible" in the immortal words of Eggerston and Woodford. At this point I find myself asking if it isn't the whole suite of Princeton monetary economists - including Lars Svennson - that Niall doesn't like (but remember, Bernanke also came from Princeton, and is certainly no Keynesian, so the simple version of the discourse doesn't work) rather than his simply holding Krugman in bad rather odour, which I could have understood more as a dislike of his fairly well known political views than as a rejection of a far more technical corpus of economic analyses, which I am sure Niall would have to admit he has not enetered into sufficiently to be able to pass judgement on. Arguing against what has to be the strongest group of academic monetary economists on the planet (and leaning on the "savants" of the Bank of China for support) may appeal to basic anti-intellectual gut instincts, but there's the rub: Niall is himself an intellectual.

Personally, I have no idea whatsover as to the properties semi-conductors may exhibit at temperatures below absolute zero, but then I would not join issue with a theoretical physicist who mentioned preposterous sounding processes by starting off saying "well when I heat milk in a saucepan, eventually it boils" Still, if you are foolish enough to stick your neck in the noose, in the noose it will go!.

As Eggertsson points out in the Japan context long-term interest rates depend on expectations about future short-term interest rates and the risk premium, and neither of these depends on the quantity of long-term bonds in circulation or on the monetary base at zero interest rates (my emphasis thoughout), and this is a technical finding - which may ultimately be right or wrong, but I doubt that the opinion over at the Chinese central bank counts as evidence one way or another, nor does it seem reasonable to strongly assert as evidence of inflation risk that a growth in M2 of 9 per cent a year "seems likely to lead to inflation if not this year, then next", since this is just the theoretical issue economists are struggling with at the moment (to what extent an increase in base money feeds through to an increase in economic activity such that the "output gap" would start to shrink). Without a much more rigourous technical analysis, and some examination of recent history, you just can't make this sort of claim, but in any event if Niall has good reason for being so sure about this, then the people over at the Bank of Japan would almost certainly like to hear from him.

And then, getting horribly wonkish, we have the whole debate about the so called "portfolio channel", and how expectations for increases in short term interest rates can even undermine the efficacy of one of Bernanke's most beloved tools -government purchases of long term bonds to lower rates at the longer end of the yield curve in the short term (see Bernanke and Reinhart: 2002), since according to the findings of Eggertsson and Woodford (2003), and basing themselves on assumptions implicit to any general equilibrium model, purchases of long-term government bonds have no effect on long-term yields if expectations about future interest rates remain constant. While discussing the experience of quantiative easing as used by the Bank of Japan (BoJ), Eggertsson already foresaw the liklihood of the kind of evolution in long term bond rates which Niall feels provides such strong evidence in support of his case.

It has been suggested that the irrelevance results outlined above can fail due
to a portfolio channel (see, e.g., Meltzer, 1999; McCallum, 2000; and Coenen and
Wieland, 2003). If the monetary base is expanded by purchasing assets other than
short-term governments bonds, the BoJ may be able to change the prices of those
assets. One example is purchases of long-term government bonds, a policy the BoJ
has in fact adopted. Eggertsson and Woodford (2003), however, cast doubt on the
effectiveness of such a portfolio channel, arguing that in a general equilibrium
model, purchases of long-term government bonds have no effect on long-term
yields if expectations about future interest rates remain constant.

The reason is that the long-term interest rate depends on expectations of future
short-term interest rates and a risk premium. Neither of these, however, depends on the quantity of long-term bonds in circulation or on the monetary base at zero interest rates. Open market operations involving purchases of long-term bonds, but which provide no credible indication about the duration of the quantitative easing policy, are thus unlikely to be effective.

Of course, all of this is highly obscure and technical. Fortunately the debate does have its lighter moments, as for example when Niall cites Krugman as the point of reference for the savings glut idea:

"Did I not grasp that the key to the crisis was “a vast excess of desired savings over willing investment”? “We have a global savings glut,” explained Mr Krugman, “which is why there is, in fact, no upward pressure on interest rates."

In fact, as those of us who have been following the liquidity debate over the last years well know, the global savings glut thesis is famously an idea which was first initially advanced not by Krugman but by none other than Ben Bernanke, and even more to the point the whole issue goes back well before the onset of the present crisis. Indeed the "savings glut" issue lies at the heart of the whole "imbalances" debate, that is, it is one of the possible explanations for how we got here in the first place, and not some rabbit conveniently drawn out of a hat Paul Krugman to gain the advantage in the current debate about bonds. But if you do understand the role the savings glut thesis plays in explaining how we generated the imbalances which are now correcting, then you may see why there may not be any special problem in "placing" the large quantity of government bonds which will hit the marekt next year. But then, maybe I just hit on the core of the problem: perhaps Niall doesn't see that the US economy is correcting, and that the large current account deficit we have gotten so used to is about to become, what else, history!

The we have this:

"It is hardly surprising, then, that the bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every US undergraduate) could such a tidal wave of debt issuance exert “no upward pressure on interest rates”."

Well I'm sorry Niall, but there is another place where a tidal wave of debt issuance has exerted “no upward pressure on interest rates”, and that place is planet Japan.

Even A Stopped Clock Is Right Twice a Day

Which takes me over to the rather historical issue of stopped clocks, and what has now been happening to Japan over the last decade and a half. At times even Daily Telegraph economics correspondent Ambrose Evans Pritchard has something interesting to say, since, of course, even stopped clocks are not wrong all the time. The point he makes here is very, very relevant:

"It is striking how many of those most alert to the deflation danger are either veterans of Japan's Lost Decade or close students of it: Albert Edwards at Société Générale, Russell Jones at RBC Capital, Nobel laureate Paul Krugman, the Fed's Ben Bernanke, and Athanasios Orphanides, who helped draft the Fed's study on the Japan trap. "People always thought Japan's bond yields had to rise, but they kept falling and Japan is still not really out of deflation," said Mr Edwards. Indeed, 20 years after the Nikkei peaked at over 39,000 it stands today at 9,280. Interest rates are 0.01pc. The yield on two-year state bonds is 0.34pc. Still there is not a whiff of inflation."

And guess what, Japan gross debt to GDP is about to push its way skywards through the 200% mark in the next year or two, which makes this retort to the FT's Martin Wolf (who had the temerity to question Niall's arguments):

Mr Wolf blithely writes: “Historically well-run economies are certainly able to support higher levels of public debt very comfortably.”His favourite macroeconomics textbook may make this claim. But the annals of history provide very few cases of economies with public debts in excess of 100 per cent of gross domestic product that were either well-run or very comfortable.

look frankly quite ridiculous, since while it may well be the case that Japan is neither well run nor a comfortable place to be (no comment, I have no opinion), it is still the world's second largest economy, so hardly an irrelevant comparison, and the Japanese government has been shoveling JGBs onto the market for years without the much predicted surge in interest rates (which doesn't mean that the US has to be the same as Japan, but it does mean that there is more to discuss here, and you can't have it so easy as Niall would like).

Well, the bottom line in all this surely is, what exactly are we being offered here, an empirically testable prediction, or just another load of old waffle?

At the end of the day what I think is, if I were a historian and not an economist, then I might like to be just a bit more modest in what I had to say (and even more modest in how I said it), be a bit more prepared to listen to those who have spent a lifetime studying these sort of problems, and then if, having done this, at the end of the day if I still found I wanted to differ from the experts I would at least try to make sure I understood what exactly it was they were trying to say first. Otherwise, I might find myself worrying that I was being more of a Xenophon than a Thucidydes, since while both were reputedly excellent generals, the latter stuck to what he was good at (namely writing history) while the former offered us (in his life of Socrates) the kind of philosophy which frankly reduced the both the author and his subject to the realm of port and stilton bufoonery. And, frankly, it would personally worry me to think that over two thousand years after the event people might still be remembering me more for what I was bad at than for any more positive contribution I might have made to the world.


Appendix

Extract From - Monetary policy with a zero interest rate, Lars E O Svensson, speech at SNS, Stockholm, February 17, 2009

Why not just increase the money supply in order to create expectations of a higher future price level? As long as the interest rate is zero then households and firms, as we have already seen, are indifferent about the choice between money and securities such as Treasury bills or bonds. An increased supply of money will then have no effect other than households and firms holding more money and fewer bills and bonds. However, at some time in the future the economy will return to normal, the interest rate will be positive and households and firms will no longer be indifferent when choosing between money and these securities. Somewhat simplified, we can say that the money supply will once again become approximately proportional to the price level. A larger money supply in the future will lead, all else being equal, to a higher price level in the future. If the central bank could thus credibly commit to a permanent and lasting increase in the money supply, the expected future price level would rise. The problem here is, however, that there is no way for the central bank to make a credible commitment to a larger money supply in the future. There is nothing to prevent the central bank from reneging on such a commitment and reducing the money supply in the future in order to reduce future inflation and keep it in line with the inflation target.

Experience from Japan's period of "quantitative easing" also shows that the extreme expansion of approximately 70 per cent of the monetary base between March 2001 and March 2006 did not noticeably affect expectations of inflation and the future price level.17 For example, the yen did not depreciate as it should otherwise have done. Firms and households clearly believed that the expansion of the monetary base was temporary and not permanent, which subsequently proved to be true. The monetary base fell back to normal levels when the interest rate was later raised to above zero.

Even if short-term interest rates are zero or close to zero, bond rates at longer maturities may still be positive. If the central bank therefore buys long-term bonds it may perhaps be able to squeeze down the long-term interest rates somewhat, which should stimulate the real economy. The central bank can also promise to keep the policy rate at zero for a prolonged period in
order to create expectations of lower future interest rates and a more expansionary monetary policy in the future.

Bibliography

Paul Krugman: It's Baaack! Japan's Slump And The Return Of The Liquidity Trap

Ben S. Bernanke and Vincent R. Reinhart, Director, Division of Monetary Affairs, Federal Reserve. Conducting Monetary Policy at Very Low Short-Term Interest Rates. Paper Presented in the form of a Lecture at the International Center for Monetary and Banking Studies , Geneva, Switzerland, 2002.


Ben S. Bernanke, Japanese Monetary Policy: A Case of Self-Induced Paralysis?, University of Princeton, Working Paper, 1999

Athanasios Orphanides, Board of Governors of the Federal Reserve System, Monetary Policy in Deflation: The Liquidity Trap in History and Practice, December 2003.

Kobayashi, Takeshi, Mark M. Spiegel, and Nobuyoshi Yamori. "Quantitative Easing and Japanese Bank Equity Values.", Journal of the Japanese and International Economies, 2006

Oda, Nobuyuki, and Kazuo Ueda. 2005. "The Effects of the Bank of Japan's Zero Interest Rate Commitment and Quantitative Monetary Easing on the Yield Curve: A Macro-Finance Approach." Bank of Japan Working Paper Series, No. 05-E-6.

Baba, Naohiko, Motoharu Nakashima, Yosuke Shigemi, Kazuo Ueda, and Hiroshi Ugai. 2005. "Japan's Deflation, Problems in the Financial System, and Monetary Policy." Monetary and Economic Studies 23(1), pp. 47-111.


Gauti Eggertsson and Jonathan D. Ostry, Does Excess Liquidity Pose a Threat in Japan?, IMF Working Paper, April 2005.

Gauti B. Eggertsson, How to Fight Deflation in a Liquidity Trap: Committing to Being Irresponsible, IMF Working Paper, March 2003


Gauti B. Eggertsson, and Michael Woodford, 2003, “The Zero Bound on Short-Term Interest Rates and Optimal Monetary Policy,” Brookings Papers on Economic Activity, No. 1, pp. 139–
211.

Paul Krugman: It's Baaack! Japan's Slump And The Return Of The Liquidity Trap

Lars E.O. Svensson, "The Zero Bound in an Open Economy: A Foolproof Way of Escaping from a Liquidity Trap,", Monetary and Economic Studies 19(S-1), February 2001.

Latvia - Devalue Now or Devalue Later?

The Latvian economy is certaily stuck in a hard and not especially pleasent place at the moment, and really one chart tells it all, since as we see above the local interbank overnight interest rates have been storming upwards and through the roof over the last two weeks. As a result of this unfortunate state of affairs the country has attained a higher profile in the international news media than most Latvians would ever have dreamt possible, or even, probably, considered desirable. Ever since Claus Vistesen's last post, my inbox hasn't stopped filling up with reports, analyses, forecasts etc. (apart from Claus, FT Alphaville's Izabella Kaminska has had a steady stream of posts - here, here, here and here - while RGE analyst Mary Stokes is a regular follower of the issues - and see again here for some thoughts on the contagion question).

The first issue that hits you is, can such a small country really be that important? The answer is, yes it can, and for a variety of reasons, although among these one is paramount, the so called "contagion" risk. As Danske Bank put it in their latest Emerging Markets Europe analysis:

Increasing concerns regarding a possible devaluation in Latvia yesterday spilled over into other countries in CEE. Although the direct link between the Baltic markets and others such as Poland, Hungary and Romania is very limited it is only natural that concerns over the situation in Baltic States triggers renewed concerns regarding the position in Central and Eastern Europe where many countries to a greater or lesser extent face problems similar to those in the Baltics. Those most at risk from negative spill-over effects are Latvia’s neighbours Estonia and Lithuania although we would expect contagion to affect countries in the region most like Latvia in terms of macroeconomic imbalancessuch as Romania and Bulgaria.

Personally, I think it possible that the immediate contagion risk may be being a little overdone at the present time. Certainly there will be immediate implications from any eventual Latvian devaluation for Baltic neighbours (and co-peggers) Estonia and Lithuania, and well as for more distant Bulgaria. A Latvian decion to break loose will, effectively, be the end of the road for the pegs, even if the unwinding may not necessarily be immediate. And beyond the Baltics and Bulgaria pressure will inevitably mount on other countries facing longer term economic and financial difficulties like Hungary and Romania (which may leave you asking just who exactly there is left inside the EU but outside the Euro - Poland and the Czech Republic to be precise), but my personal feeling is that while we may see everyone placed under stress we are unlikely to see dramatic short term "negative events". If I were looking for these it would rather be towards Russia I would be looking, and to the future path of oil prices, since if things were to go the wrong way on that front then the shock waves from Russia could easily destabilise all the rest of Central and Eastern Europe at one foul swoop.

But then, my relative lack of alarm on the contagion front stems from my perception of the present crisis in the East as less one of short term liquidity and balance of payments pressures, and more one of a longer term sustainability issues, given the relative poverty of the region when compared with West European neighbours, and the rapid population ageing and decline issues it is facing.

Ideological Lock-in?

Latvia is certainly hemmed in on all fronts at the moment, what with the 18% year on year GDP contraction registered in the first quarter, the projected 9.2% of GDP fiscal deficit for 2009 (if more cuts are not made), the rise of overnight interbank interest rates into the high teens, soaring credit default swap rates - Latvia's five-year credit default swap rose to a high of 721.1 basis points on Thursday - and almost vanishing Lati liquidity inside the country.

But over and beyond the immediate concerns, and contagion risk Latvia is currently a test-bed for a number of issues with implications which extend well beyond the borders of this small Baltic country. In particular three questions stand out.

a) The rather counter intuitive idea - which I call the new orthodoxy in this post - that even during strong recessions a fiscal contraction could turn out to be expansionary, if it signals a long term determination towards fiscal rectitude. The IMF put the idea thus:

In emerging market countries with debt overhangs, the “Keynesian” effect of fiscal adjustment is likely to be outweighed by “non-Keynesian” effects related to expectations and credibility. Non- Keynesian effects have to do with the offsetting response of private saving to policy-related changes in public saving. In particular, if fiscal adjustment credibly signals improved public sector solvency, a fiscal contraction could turn out to be expansionary, as private consumption rises based on the view that future tax hikes will be smaller than previously envisaged.
IMF - Hungary, Request for Stand-By Arrangement, November 4, 2008

b) The idea of "internal devaluation" as a viable strategy for carrying out a substantial correction in relative wages and prices for a country with a currency peg and large balance sheet exposure to foreign exchange loans. Now it may well be that currency peggars are likely soon to become an extinct species, given the difficulties they tend to produce when such pegs unwind, but the Baltic countries may still be considered as test cases for others who don't (for whatever reason) have an independent currency and thus a serviceable monetary policy. Countries like Ireland and Spain, for example, who are facing a sharp correction, but being inside the eurozone currency area have no local currency of their own to devalue and are hence now destined to follow a similar path to the one being pioneered in the Baltics.

c) The idea that structural reforms can - in the context of a country with long term low fertility, declining working age populations and rising elderly dependency ratios - free up sufficient growth potential to offset the underlying population dynamic and, as the IMF put it in the above citation, credibly signal the possibility of future public sector solvency.

So Latvia is at the heart of a massive experiment, of the kind which lead me to lament on my about page that "Economists hitherto have tried hard enough and often enough to change the world, the real difficulty however is to understand it." Since the question I cannot help asking myself in the Latvian context is: to what extent do we really understand what we are doing here?

The thing is, all of the above mentioned theories - "internal devaluation", "stimulatory fiscal tightening" and structural reforms to offset declining working age population - sound splendid enough, but are the the theories themselves actually valid? How do we test them? And do the measures adopted on the basis of "believing" in them actually work? And are there sufficient grounds for accepting both the validity of the thoeries and the efficacy of measures based on them to ask for sacrifice on the scale that is currently being demanded from the Latvian people? And do we have any consensually agreed benchmarks which would enable us to decide whether the measures are working? Do we indeed - and by "we" here I mean the EU Commission and the IMF - have any inspectable performance indicators against which to measure progress?

Certainly, for every inch of success that is painfully clawed forward (the positive CA balance, for example), we seem to be constantly thrown back a yard by a host of additional problems (the growing fiscal deficit issue, etc), and not for the first time, we - the economists - find ourselves playing with fire, when we, of course, aren't the ones who risk getting burnt in the process!

Plethora Of Statements.

Both the European Commission and InternationalMonetary Fund (IMF) have been busying themselves over the last week making extensive statements on Latvia's 2009 budget amendment process - which is, after all - what lies at the heart of the issue. What has been notably absent however in all these public declarations, is any indication about when exactly the much needed money will arrive. And this is not a request for information simply at the convenience of Latvian lawmakers, it is the sort of information market participants badly need to receive in order to take the kind of decisions which would bring the situation more back under control for the Latvian authorities, and meantime the ambiguity continues.

European Economic andMonetary Affairs Commissioner Joaquín Almunia said in his prepared statement he believes the new budgetary proposals to be a step in the right direction. But how much of a step are they, since he also stressed that more was still needed to contain the rapid increase in the budget deficit. So again, just how much more is needed, and are Latvia's politicians capable of delivering? Or is the pain simply too much to stand?

"Sadly, the economic recession is proving more severe than expected inLatvia
bringing hardship for many and increasing the deficit to higherlevels than
expected. Latvia needs to reduce the deficit in asustainable way with
significant budgetary and structural measures,although I acknowledge that the
original fiscal targets in thegovernment's economic program are no longer within
reach. I alsounderstand there are limits on how much the deficit can be reduced
toallow some breathing space for the economy and for the people ofLatvia,
especially the sections of population most in need. I takenote that the
authorities want to control government debt and maintaintheir exchange rate peg.
The supplementary budget presented this weekis a first step. The Commission
wants to support government's efforts.I am looking forward to seeing additional
steps adopted during the second reading of the budget, as announced by the
government,"

On the other hand, Caroline Atkinson, the IMF's director of external relations, restricted herself to saying the fund agrees with the comments made by Joaquin Almunia to the effect that the supplementary budget presented by the government this week represents an initial move in the right direction. "The government's budget is a first step, and there is more work to be done," she said. Again, how much more work?

When directly asked the key question as to whether the IMF would support a depegging of the lat from the euro, she simply stated that the fund hasn't changed its stance. "We have commented before that the situation is challenging and that there is a need for action, and I think the authorities have stressed the importance of controlling the government debt and deficits and maintaining the peg," she said. That is to say, the Fund's position is that on this topic the government decides. On the other hand, with Latvia's financial and currency markets coming under increasingly evident stress, and Prime Minister Valdis Dombrovskis saying the country needs the second portion of the loan by early next week, the Fund remains meticulously silent on when exactly the next tranche will be paid, and on what it would take for them to release the money. Of course, negotiating in public is not the most desireable of things, but then having hoardes of market participants speculating on what you might be saying isn't exactly a comfortable situation either.

Marek Belka, head of the European Department at the International Monetary Fund, also limited himself on Friday to saying Latvia may need to make further spending cuts as well as increase taxes if it is to stabilize the economy.

The Latvian central bank, for its part, noting all the emphasis on "the government decides" side, and obviously not wanting to be forgotten, issued, for its part, a statement openly defending the currency peg, and warning of "dire losses" for Latvian citizens should the currency be devalued. The bank effectively ticked off public officials and advised them to be more careful what they say when speaking and the national currency and its stability in future. It also took the unusual step of underlining that the central bank was an independent institution, and is the only body empowered to take decisions about changing the currency rate. This was notable, as it could be seen as suggesting that someone else thought they had the ability to take such decisions, and it could also be read as a warning to anyone tempted to think they had such powers.

Meantime the recession goes on, and on.........

Industrial Output Stabilises

Latvian industrial output was in fact up in April over March - by 4.8% on a seasonally adjusted basis. Mining and quarrying were up by 1.8%, manufacturing by 5%, and electricity and gas by 4.6%. Some sectors were up sharply, clothing output, for example, rose 14.6%, pharmaceuticals by 11.6%, and chemicals by 9.7%. On the other hand electrical equipment was down on March by 19.5%, while other transport equipment (defined as ships and boats, railway locomotives and rolling stock) was down 13.2%. Such stabilisation was consistent with what we have been seeing in other countries, and at this point does not enable us to draw and longer term conclusions.

As a result of the improvement in April the year on year output drop fell to 16.9% (after adjustment for calendar effects). The fall was thus weaker than the 23.4% year on year drop in
March and a 24.2% one in February.

The core of the problem is exports, since with domestic demand now sunk into a deep hole, and fiscal austerity the "ordre du jour", exports are the only hope for growth. I mean, this is evident from a simple formula:

Changes in GDP = Changes in private domestic demand + changes in government spending + changes in the net trade impact (exports minus imports)

Clearly Latvia's economy is not condemned simply to shrink forever, but it can come to rest at quite a low level, and for it to rebound something needs to drive growth. What I am arguing is, other things being equal, and relative prices being right, that a combination of new investment for greenfield sites directed to axports (which is a plus for private domestic demand) plus the exports themselves could provide the stimulus which starst to turn the motor over. Devaluation is half of the answer here, with the other half coming from having a responsible government, a serious reform programme which encourages confidence in the country and economic and political stability. End all the speculation which surrounds the continuation of the currency peg would be one way to move forward on the second half of the agenda.

The Latvia statistics office have yet to give us detailed data for Q1 GDP, but they initially reported that the 18% annual decline was broad-based, with manufacturing down 22%, retail trade down 25% and hotel and restaurant services output 34% lower (all from a year earlier). "The economic situation is of course very serious," Latvian Prime Minister Valdis Dombrovskis reportedly told a press conference in Stockholm recently, and who could disagree.

Latvian exports are also well down, falling 23% year on year in March, an improvement on the 29% drop in February, but still substantial. Going by the April industrial output numbers we could expect a further improvement in April too, nonetheless far, far more will be needed to start to turn this situation around.

In fact, Latvia still ran a goods trade deficit of just under 400 million Lati in the first three months of the year, down significantly from the 650 million Lati in the last three months of 2008, but still large, especially since GDP is shrinking fast.

Lavia's current account has however improved spectacularly, and was back in surplus (although only marginally) as of January this year according to central bank data. This transformation is entirely logical and anticipated (even if the speed of the correction was not), since Latvia is now about to become a net saver, with a current account surplus, and with an economy which is driven by exports, which at the end of the day is what the whole devaluation debate is all about.


In fact, the headline current account surplus number is a bit illusory, since it has been produced by a combination of two factors, neither of which are totally desireable in and of themselves. This is why we could say that the surplus is a forced one, and that Latvia is being forced to become a net saver. In the first place there is the improvement in the goods trade deficit, which as I say, is more produced by a the fall in imports (which follows the decline in domestic spending power and living standards) than it is by any improvement in exports (which have of course been falling):


And secondly we have movement in the income balance, from deficit to surplus, and this, ironically, is produced by the fact that the internal collapse in economic activity means that the income return on Latvian investments (equities, profitability of enterprises etc) has dropped much more than the return on investments made by Latvians outside the country (where things may also be bad, but not as bad as they are in Latvia). Thus ironically, Latvian's who have had the foresight to borrow funds from the Latvian branches of Swedish banks to invest in economic activities in Sweden may well be faring rather better than those very banks themselves who lent money to be used in Latvia.



Retail Sales

Apart from the drop in imports, perhaps the best short term indicator of the contraction which is taking place in internal demand is to be found in the retail sales numbers. These were actually up slightly in March compared to March - by 0.3%, on a constant price seasonally adjusted basis. The improvement was largely in the sale of food products, which increased by 2.7% on the month, while sales of non-food product fell by 1.1%.

Compared to April 2008 however sales were down by 29.6% (working day adjusted, constant price data), following a 27.3% fall in March. Since April last year seems to have been the peak month, we can expect the annual drops to reduce, although the actual level of sales may well keep falling (see chart below).


Apart from the credit crunch and the consequent difficulty in borrowing money, the other factor which is producing the slump in retail sales is the dramatic rise in unemployment, which according to Eurostat data has surged from a low of 6.1% in April 2008 to the present 17.4%. And it continues to rise.

The Eurostat numbers are rather different from the Latvian Labour Board ones, since the latter is based on a different methodology (and is thus not part of any "sinister conspiracy" to hide the facts - for a full discussion of the issues involved see my recent post on the same issue in Spain), but if you compare the charts, the undelying trend is evidently similar, a sharp upward climb.



Restoring Competitiveness

The principal conclusion we can draw from all this then is that it would be foolish to expect any recovery in economic activity to come from Latvian domestic demand, and this problem will only be added to by the impact of debt deflation on houseowners who, according to Global Property Guide, have just seen their properties fall at the fastest rate anywhere on the planet - it wasn't that long ago that Latvia and Estonia were leading everyone up - with prices down by 50% year on year in the first quarter, and the drop over the last quarter of 2008 being an incredible 30%.

So we need to look to exports. But this is where we hit a problem, since all the inflation which took place during the boom side of the boom-bust have made Latvian prices and industries totally uncompetitive when it comes to its main trading partners. If we look at the latest Real Effective Exchange Rate Data (curiously enough released by Eurostat last Friday), it should not surprise us to learn that the worst loss in competitiveness occured in 2008.

The above chart compares Finland and Latvia, and gives us an idea of just how much competitiveness the Latvian economy has lost since the index was set in 1999. In fact the graphs are even more interesting, since we can see that there was a period - between 2002 and 2005 - when, despite the fact that living standards were rising, productivity was rising faster, and Latvia actually improved its competitiveness vis-a-vis Finland. It is that earlier dynamic which now need to be recovered.

But as we can see from the sharp upward rise the the Latvian REER post 2006, the structural damage has been substantial, and this large scale of the correction needed makes the "internal devaluation" path - even if it were working, and even if markets were accepting it, which in neither case is true - particularly onerous. Prime Minister Dombrovskis himself estimated only last week that any devaluation would need to be of the order of 30% (and looking at the chart it is hard to disagree), and this is already much larger than the 15% "adjustment" in the trading band the IMF were considering during the original loan negotiations.

Ideally improvements in competitiveness can be achieved in two ways, through productivity enhancements which can be attained via structural reforms, and through changes in the wage and price level. Unfortunately the former needs time to work, and time is now absolutely something Latvia hasn't got, with the recession biting deeper by the day, and the markets hot on the heels of the government. So we need the wage and price correction. Well, people have supposedly been working on this for some six months or so now, so just how far have we got? Let's take a look.

Well, if we look at average gross wages and salaries, they fell 1st quarter of 2009 by 6.2% over the last quarter, but when compared with the first quarter of 2008 they are still up - by 3.5%. Of course, given the rise in unemployment the actual volume of wages and salaries paid is down even more - by 10.9% on the year, and by 17.2% over the last quarter. But this is a dop in living standards produced by the recession, and not a fall in unit labour costs.



In fact, according to data from the Latvian Statistics Office, the level of gross wages and salaries has so far only fallen back to the level of August 2008. This contrasts with a lot of anecdotal evidence I have been receiving in comments which speak of far larger reductions, but there you are, that is what the data says.



But restoring competiveness via internal devaluation is about reducing wages and prices in like measure, it is not simply about reducing wage costs, since slashing wages without reducing prices is only to cut living standards, and this in and of itself serves no evident purpose, and indeed causes untold hardship.So how are things going with prices?

Well, not much better. According to the statistics office, as compared to March, the average consumer price level in April was down by 0.4%. The average prices of goods decreased by 0.3%, but compared to April 2008, consumer prices still increased, and were up by 6.2%. In fact both the general and the core idexes (by core I mean ex energy, food, alchohol and tobacco) were still above the January level, so on the consumer prices front we have yet to take even the first step into attacking the loss of competitiveness reflected in the 2008 REER.



What about producer (or factory gate) prices then? Well, here the situation is a bit better, since as compared to March, April producer prices were down by 0.9%, while as compared to April producer prices fell by 2.6% (the first month of year on year drop). In the case of export prices, the situation was even better, since these were down by 9% year on year in April. In fact in both cases (domestic and export) prices have been falling since last July, which is hardly surprising since energy costs (which were a major component in the recent producer price spike) have fallen sharply. And remember, what interests us here is competitiveness, and energy prices have been falling everywhere. What Latvia needs is to improve its relative prices vis a vis its main reference markets.




Money Supply Problems

One indicator of the degree of stress which the Latvian economy is currently experiencing is the way in which bank lending (which fuelled the earlier boom) is now falling across the board. Year on year the numbers are still in positive territory, but the annual lending growth rate is steadily heading for zero - it decelerated to 4.3% in April (of which lending to non-financial corporations fell to a 9.2% growth rate while lending to households was down to 1.3% year on year). But month on month lending is contracting, and has been so doing since October. Loans to resident financial institutions, non-financial corporations and households contracted by 115.9 million lats or 0.8% in April alone.

Commercial credit and mortgage lending are both falling (by 3.4% and 0.8% respectively) and the negative momentum continues.

Money supply data show a similar tendency, even if in April M3 increased by 67.4 million lats and M2 by 63.6 million lats over March. Nevertheless the annual rate of decline in both measures of money supply continued to accelerate (to 8.2% and 8.1% respectively).

M1 - which consists of currency in circulation + checkable deposits (checking deposits, officially called demand deposits, and other deposits that work like checking deposits) + traveler's checks (ie assets that can be used to pay for a good or service or to repay debt) - has been falling now since December 2007.

Net foreign assets held by the Bank of Latvia fell by 218.7 million lats in April. According to the central bank the decrease in foreign reserves was a result of Bank of Latvia interventions (selling euro) and a reduction in foreign currency deposit held by the government as it drew down what remained of the last tranche of the international loan. Latvia has now spent about 503 million euros buying lats so far this year to support the currency. The bank had previously spent about 1 billion euros in 11 weeks last year defending the currency prior to the 7.5 billion-euro IMF-lead bailout.

Reserves had to some extent been boosted by currency swaps made available by the Swedish and Danish central banks. Indeed only in May Sweden’s central bank raised the amount of euros available for its Latvian counterpart to swap for lats to 500 million euros and extended the term of the agreement. The swap agreement dates back to last December, and allowed the Latvian central bank to borrow up to 500 million euros for lats. Under the original agreement the Riksbank was to provide 375 million euros and the Danish cb 125 million euros. However, according to the most recent statement from Swedish Finance Minister Anders Borg the Swedish government have now decided: so far and no further (see below).

Deteriorating Liquidity Conditions

As noted at the start of this post, Latvia is now suffering from a major Lat liquidity squeeze. And the shortage of lati on the internal market lifted has steadily been lifting interbank rates. One indication of the shortage was the inability of Latvia’s Treasury during the week to sell bills at a first auction at which 50 million lati (35 million euros) were offered. The Treasury did finally manage to sell a much smaller quantity (2.75 million lats - 4 million euros) . The problem is not one of price (yield) but of liquidity - there is simply a shortage of lati in the system overall as those who have the local currency sell and buy euros to protect against possible devaluation.

The lack of liquidity pushed Latvian interbank lending rates to their highest levels on record on Friday as the central bank removed lati from the market in an attempt to stem speculation. The six-month Rigibor rate rose to 16.00 percent. The three-month rate rose to 17.92 percent while the overnight rate rose to 19.6 percent. Obviously with levels like this devaluation becomes inevitable, but as Dombrovskis stresses: “This was a momentary situation and the moment when we have an agreement with the international lenders the market will calm down,” - for the time being at least. The critical question at this point is not whether a new agreement with the EU and the IMF is possible (it surely is), but rather whether it is worth the effort, since the government may well be in a situation were it is forced to agree to a series of extremely painful cuts only to find itself in the very same position three or six months from now.

Deficit Connundrum

As we can see, the Latvian people are being asked to make a bet in support of an economic idea, the idea (as presented above) that a fiscal contraction under present circumstances could turn out to be expansionary. Personally I am absolutely not convinced of the validity of this argument. What will convince lenders and investors to return to Latvia is:

a) a convincing commitment to structural reform and fiscal rigour in the longer term
b) a serious adjustment in relative wages and prices which converts Latvia once more into an attractive destination for export oriented investments.

At the present time we have the worst of both worlds here, since all the government's time, energy and attention is being focused on short term fiscal objectives, while the rate of price adjustment is far too slow. That is, the existing programme is NOT working, and I find myself wondering, do the IMF representatives have performance criteria, and if so what are they? And are these (assuming they exist) being in any way fulfilled, since the only visible positive outcome at this point is the recovery of a current account surplus, but if this is being achieved at the price of generating a massive fiscal deficit, then it is hard, really, to cry victory.

The general government consolidated budget showed a deficit of 190.8 million lats in April, with an accumulated deficit since the start of the year of 332.8 million lats). According to the central bank, the deterioration in the general government consolidated budget was largely the result is two processes: a) a revenue fall of 24.7%; and b) an increase in expenditure of 15.9%. Tax revenues were sharply down in all tax groups, with corporate income tax, VAT and personal income tax revenues dropping most (by 84.9%, 26.9% and 15.5% respectively).

The expenditure surge was primarily fuelled by payments of subsidies and grants which expanded by 70.3%. Rising expenditure for social benefits (by 26.2%) and the growth in interest expense (84.7%) were other significant contributors. General government gross debt increased by 143.2 million lats in April (to 3 119.0 million lats).

The consensus is that the current budget as agreed in a first reading before Latvia’s parliament last week implies a deficit of 9.2% of gross domestic product. It is anticipated that spending will be cut further via ammendments in the second reading scheduled for June 17 and that these should be sufficient to obtain additional disbursements from the European Commission and the International Monetary Fund. The question is not really (at this point) whether the Latvian parliament will pass the ammendments, but whether Latvia can hang out that long in the absence of stronger verbal and substantive support, and whether the measures if implemented will have the anticipated results.

On the latter point, as I have already indicated, I am extremely sceptical, and on the former, as we have seen statements from both the EU and the IMF have been much softer than might have been hoped for, while one leading ally (the Swedish banks and government) have now taken a much more ambiguous stance.

Swedish Finance Minister Anders Borg described the situation in Latvia as “markedly worrisome” in a statement on the Swedish government website at the end of last week. However, when it came to practical measures Borg was a lot less forthcoming, limiting himself to stating that Sweden would not offer Latvia any additional bilateral loan over and above the current contribution to the international bailout, adding the in his opinion the most important step forward was a show of determination by the government to rein in the budget gap. “They have to show that they have control over their public finances”. It is of the “utmost importance” that Latvia take “concrete and well-defined” additional measures to limit its public deficit to ensure that the IMF and the European Commission resume loan payment, he told reporters last week.

Swedbank, the largest bank in the Baltic states, has also stressed that they are fully prepared for a possible currency devaluation in Latvia. “We feel comfortable about our action preparedness regardless of which way the Latvian government chooses to go,” Chief Executive Officer Michael Wolf wrote in a statement published on the bank’s Website last week. As he also indicates, he gets the main point about the debt default problem:

“It’s not given that an external devaluation, over a longer period of time, will lead to larger credit losses for the banks,” Swedbank said. “But an external devaluation would give bigger credit losses during a shorter period of time as it directly hits the payment capacity for the many customers who have loans in euros.”

So What Happens Next?

Well , this is very hard to say, but certainly the omens - and especially Friday's Rigibor overnight reading - do not look good.

There is now evidently a growing consensus among observers that some sort of devaluation is well nigh inevitable, with the only real question being when. Certainly the trading community seem to be anticipating such a move, and forward contracts now price the lat some 53 percent below its current spot rate of 0.7073. Bloomberg quote fund manager Paul McNamara , from Augustus Asset Managers, as stating that “There seems to be a reasonable market consensus that Latvia will devalue", and I think this is a fair view.

Caroline Atkinson, director of external relations for the IMF, limited herself to describing the economic situation as “challenging", adding that there was clearly "a need for action.” She also pointed out the need for flexibility, which could refer to the IMF and the budget limit, or could refer to felixility on the part of the government, given the fact "the authorities have stressed the importance of controlling the government debt and deficits in maintaining the peg."

The problem is not that the IMF and the ECB would cease to support the Latvian government if they choose to continue down their chosen path, the question is really will they be able to continue down their chosen path, and indeed does it any longer make sense for them to do so?

No Exit Strategy

During this whole process one thing has become abundantly clear from the IMF statements, for the Latvian government's chosen path to be viable, there needs to be an exit strategy. Really it is very well worthwhile everyone reading the recent interview with IMF Survey Magazine (end of May) given by the IMF’s new mission chief for Latvia, Mark Griffiths, and Christoph Rosenberg, advisor in the IMF’s European Department and coordinator of the IMF’s work in the three Baltic Republics, since it makes a number of things very clear.

Particularly of note are Rosenberg's insistence (which has been a constant on his part throughout the process) that ownership of the adjustment program rests with the Latvian government:

"Let me first stress that this is the authorities’ program—they have very strong ownership of the policies that underpin it."

and secondly, having a viable exit strategy is central to success.

"The alternative strategy—abandoning the peg—would also be associated with large economic short-term costs. That is clearly one reason why there is such a strong preference in Latvia for maintaining the peg. Latvia also has a clear exit strategy in place: meeting the Maastricht criteria and adopting the euro by 2012."

But really, we now need to ask, is this exit strategy still viable? Certainly on the current path it may be possible (on the back of very considerable sacrifices on the part of the Latvian people) to bring the deficit down below the 3% limit in 2011 (although whether the EU Commission and the ECB would regard this as a sustainable process is another issue), but what about the 60% gross debt to GDP ratio? In their April forecast the EU commission pencilled in debt to GDP at 50.1% in 2010 (up from 9.0 in 2007 and 19.5 in 2008). That is debt to GDP is rising very fast (indeed some might say exploding). At the same time this 2010 estimate, which already makes being within the 60% limit in 2011 a reasonably close call (too close for my comfort anyway) is based on GDP contractions in 2009 and 2010 of 13.1% and 3.2% respectively, and we already know that the contraction in 2009 will be significantly greater than the EU forecast.

But it is worse than this, since not only is GDP contracting, prices are also falling (in fact, under the "internal devaluation" scenario this is what we want). But what this means is that nominal (or current price) GDP will fall faster than real GDP, with consequent negative consequences for the debt to GDP ratio (since as GDP falls, the money value of the debt remains constant). In fact the more successful the price correction the higher short term debt to GDP will rise. At the present time the EU forecast GDP deflators of only minus 2.2% in 2009 and minus 3.6% in 2010. But as we have seen above, for growth to return to the Latvian economy prices need to correct by far more than this, and hence debt to GDP will inevitably rise more than forecast - either because prices don't correct fast enough, and hence GDP contracts more (worst case) or that they correct rapidly (but with negative consequences for debt to GDP. This looks suspiciously like a Maastricht lose-lose to me.

That is, the simple fact of the matter is that there is no exit strategy. The programme simply doesn't work. It is "overdetermined", since whichever way you look at it, there is always one more problem than there is solution. Gentlemen. I think its time to give up. Honourably, but to give up. Come on out of the bunker, white flags and hands in the air will not be called for. There's a world out here waiting for you, it's on your side, and there will be a tomorrow.

Seeing is Believing, But Stabilising is NOT Recovering

This is one of the key points I have been hammering here on this blog for some weeks now. There is clear evidence of most economies globally "stabilising" at this point, you could even stretch it to say that the "worst is over" - since I doubt we will go back to the dreadful days of December and January (see German manufacturing PMI chart below) - when it was like someone had given a very sharp knock to the whole industrial sector with a large sledgehammer, and of course ultimately the vibrations settle down even if the damage remains.



But to go from this evident fact to drawing the conclusion that a full recovery is now in the works would be a very fast and loose use of both logic and economic theory. Production is falling less slowly (on an annual basis) and even increasing slightly (on a monthly basis) in some countries as orders can no longer simply be met from what are now very depleted inventories.

But as I suggest in this post, upping output to meet current orders is not a recovery, for the win-win dynamic to move us back into a new cycle investment activity has to increase. And on this front there is precious little actual evidence to back the more positive discourse, and indeed the data we are seeing indicate rather the contrary.

When I last wrote we did not have detailed data for Q1 GDP for the eurozone economies , so I took a look at the evidence from Japan, where investment activity slumped massively between January and March (pointing out that there was no good reason why we should expect the situation to be very different in Europe). Japanese business investment was down a record 10.4 percent year on year in the first three months, and a massive 35.5% over the last quarter.

But now we have detailed German Q1 GDP results from the Federal Statistics Office, and we find a very similar picture. Total investment was strongly down (– 7.9% quarter on quarter), while capital formation in machinery and equipment, was 16.2% lower than in the last quarter of 2008, and 19.6% lower than in the first three months of last year.



But all of that is to some extent history. Much more preoccupying - certainly for the "onward-annd-upward-we-go" thesis - is that German plant and machinery orders declined the most on record in April from a year earlier. Orders dropped an annual 58 percent, the most since data collection started in 1950, after falling an annual 35 percent in March, according to the Frankfurt-based VDMA machine makers association in a statement today. Export orders slumped 60 percent while domestic demand dropped 52 percent. So things actually seem to have deteriorated in April with respect to March. No good news this.

Especially when you read the same day an interview with Hans-Joachim Dübel - CEO of Berlin based FinPolConsult, one of the leading and few relatively independent voices in the German housing finance community - where he says: "My guess is that the Landesbanken alone will cause ultimate losses of 8-10% of German GDP, which is real money. Compare that sum with the 5% of GDP costs for the US S&L crisis".