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Saturday, March 27, 2010

Northern Exposure

Last updated: March 27, 2010

March 12, 2010

The graph below pretty much illustrates the essence of the internal devaluation in the Baltic region and why it does not look as a devaluation at all.

The Bank of Latvia says:

The real hourly wage grew faster than productivity up until the end of 2007, and after that the difference between these indicators increased mainly as a result of dropping productivity.

Within six months, i.e. in the second and third quarters of 2009, one third of the difference between wages and productivity has been eliminated. Moreover, if we assume that, as in all likelihood was the case, the actual wage level prior to the leap in the second half of 2006 was lower than the level commensurate with productivity – among other factors, the income of employees in total value added, at the time among the lowest in the EU, points to that – by the end of the third quarter of 2009, the greatest part of the gap accumulated between wages and productivity was canceled.

Source: Bank of Latvia

The self inflicted mini Great Depression has wiped out almost one quarter of the Latvian economy sending unemployment surging in double digits and scattering Latvian migrant workers all across the region and beyond. The wages collapsed by 12% over year but labor costs per hour shrank by only 3.9%. As to the CPI, the consumer prices have barely bulged.

Yet the economy seems to have largely eliminated the competitiveness gap between the former Baltic tiger and its trade partners variously estimated at between 15% to 20%. The staggering loss of output and rampant unemployment suggest structural readjustment as the driving force behind Latvia's internal devaluation with productivity gains instead of price and wage deflation closing much of the competitiveness gap.

There may be several reasons as to why the internal devaluation in Latvia and elsewhere has degenerated into such a massive loss of GDP. On one hand it might be natural for massively misstructured economies whose vulnerabilities have turned unsustainable under the pressure of the global crisis. Another thing is that migration flows may have significantly undermined the flexibility of the Baltic labor markets. The anecdotal evidence indeed suggests a massive exodus of workforce. The Baltic labor markets are less distorted than others as a result of market friendly labor legislation and the absence of strong trade unions. Yet, this advantage may have been eroded by the ease of global and intra European migration flows. Migration outflows may have blunted the impact of unemployment and the downward pressure on wages it was supposed to produce.

Finally, the common market may have made local prices incredibly sticky and resilient in the face of any decline in wages and local demand. In fact, price deflation now appears as the least likely outcome of internal devaluation, even though it's this aspect that was usually watched and monitored for signs of the policy working. Undue expectations from the CPI seem to be the main reason why so many analysts came to think that the policy was not working after it has already accomplished the bulk of its task.

The great Latvian internal devaluation epic will be sure studied across the world for years to come, if only because it smashed all known records in terms of what a single nation can withstand without descending into chaos and anarchy. However, some lessons can be drawn already and the implications for the troubled EU periphery are dire.

Over the last years price and wage inflation rendered countries surrounding the EU core uncompetitive. As the global crisis went detonating trade imbalances and financial bubbles around the world, country after country along the European periphery have succumbed. Yet, even wider than the competitiveness gap between the European center and periphery is a morale abyss separating northern Europe and the EU southern flank.

From Estonia to Ireland, the EU northern periphery responded to the crisis by tightening belts and taking a headlong plunge into internal devaluation. In all Baltic nations GDP losses are running in double digits. Ireland's living standards have sustained a massive setback that the OECD defined as permanent. Those preaching about decadence and moral decline of the West (me for example) may want to rethink their thesis in the face of impressive resilience and stoicism on display along the EU northern flank.

In contrast, the EU southern periphery was thrown into disarray. In Greece an austerity program, largely born out of pressure from Germany and other EU partners, has triggered an immediate wave of strikes and riots. A big part of Spain's housing bubble is still there, while the country is paralyzed by political infighting and denial of the true scale of the crisis.

What becomes increasingly clear now is that strong trade unions and public opposition to any attempt to make a dent in wages and social benefits almost guarantee that internal devaluation in countries like Greece and Spain will be even more structural than in Latvia and elsewhere in the North. The inflexibility of labor markets leaves these countries with no other option for restoring their competitiveness rather than to destroy parts of the economy overly dependent on internal demand or unable to compete on external markets.

This process is likely to be accompanied by an even greater exodus of workforce than in the Baltic region, eventually conspiring with the pensions crisis to make the future of these countries one big doom and gloom. As a matter of fact, the population seems to be rather unprepared to submit itself to so much pain. In fact, it seems to be unwilling to sustain any significant amount of pain whatsoever.

Of course, if the going gets really tough, Spain and Greece can simply exit the EMU. It's unthinkable right now, but as the mess keeps deepening and the pain growing, persistent noises about togetherness and solidarity may eventually give way to more immediate concerns. After all, idealism is worth nothing unless it's backed up by equally ruthless pragmatism and readiness to sacrifice. The free lunch idealism, that took hold of large chunks of the West lately, has never had any feet to stand on and was only waiting for a crisis like this one to come and send it packing.

Marco Polo - A Prayer To The Music (Northern Exposure Mix)

March 27, 2010
The Baltic Spirit

This is the spirit of internal devaluation: Bye bye snow

:D :D

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