Will Dr. Gloom and Dr. Doom’s Latvian Domino Fall?

This article appeared in the August 2009 issue of Globe Asia.
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The New York Times columnist and Nobel LaureatePaul Krugman ("Dr. Gloom") and New York Universityprofessor Nouriel Roubini ("Dr. Doom"), who gainedfame as one of the first to detect the U.S. housing bubble,have fingered tiny Latvia as the next domino to fall. They argue thatLatvia is in the same situation as Argentina was in late 2001. Andas a result, Latvia will be forced to devalue its currency and defaulton its debt, as did Argentina in early 2002. Then, the argumentgoes, neighboring Estonia and Lithuania will be forced to followsuit and a damaging wave of devaluations and defaults will sweepthrough Central and Eastern Europe. This will be followed by yetmore international gloom and doom.

Just what, if anything, does Latvia today have in commonwith Argentina in 2001? On the surface, it appears that Latvia isemploying the same type of exchange-rate system as did Argentina.Latvia's currency trades in a narrow band of plus or minus 1% around a peg of 0.7028 lats per euro. In 2001, the Argentine pesowas linked to the U.S. dollar at one to one. But the similaritiesstop there.

Latvia and its Baltic neighbors have been models of fiscalprudence (see Tables 1 and 2). Before last year, when the recessionbegan, all had low budget deficits or even budget surpluses. Theyhave shown willingness to make tough cuts in governmentspending. They also have ratios of debt to GDP that remain quite low by international standards. Argentina, in contrast, hadpersistent problems with cutting spending and had a much higherdebt to GDP ratio.

General government deficit and surplus

General government consolidated gross debt

In the monetary sphere, there is a straightforward way todetermine whether a monetary authority that links its currencyto another is in danger of breaking the link: compare it to an"automatic" system. The most automatic system is a currencyboard, which issues money convertible on demand into a foreignanchor currency at a fixed rate of exchange. As reserves, a currencyboard holds foreign assets equal to 100% or slightly more of themonetary base (its note, coin, and deposit liabilities).

These characteristics ensure that the quantity of domesticcurrency in circulation is determined solely by market demandfor domestic currency. They imply that for a currency board, netforeign reserves (foreign assets minus foreign liabilities) shouldbe close to 100% of the monetary base. Moreover, "reserve pass-through"(the change in the monetary base divided by the changein net foreign reserves over the period in question) should also beclose to 100%.

During the three years before Argentina's currency crisis ofDecember 2001-January 2002, Argentina's monetary system,often mistakenly termed a currency board, was not operatingin "automatic" fashion. Its reserve pass-through was not evenclose to 100%, and after mid 2001, its net foreign reserves as a percentage of its monetary base fell well below 100% (see Chart1). By comparison, Latvia's monetary system — even though notlegally a currency board system — is operating largely as though itwere one. In consequence, Latvia could convert its entire monetarybase into euros at the current exchange rate. The same can be saidof Estonia and Lithuania — two countries that officially adoptedmodified currency board systems in 1992 and 1994, respectively.

The data speak clearly. Latvia and its Baltic neighbors arenot repeats of Argentina. Their economies have suffered greatlyfrom a sudden stop of foreign investment and from recession inWestern Europe, but they retain ample foreign reserves.

They would do better to officially adopt the euro, even withoutthe blessing of the European Central Bank, than to devalue theirnational currencies.

Net Foreign Reserves and Reserve Pass-through

Steve H. Hanke

Steve H. Hanke is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute in Washington, D.C.