IR

Based on this Working Paper from the IMF , which tries to disentangle whether the credit booms and their fallout in the eastern new member states of the EU were unavoidable or due to bad policy, Bens Latkovskis, writing in Neatkarīgā on 21 July 2010 , comes to the conclusion that Bank of Latvia is to blame in the case of Latvia. It seems that this was picked up by much else of the media but here I must quite frankly ask: Did anyone else read the IMF paper or did they just report Mr. Latkovskis’ “findings”? I bet the latter.

But interesting – when I read the very same IMF report I found general evidence of blame to be put on the banks, on (lack of) supervision and, of course, on the main culprit here, fiscal policy. But not on the central bank – but let me in all fairness apportion some blame on them, too, as I move along.

But it surprises me how one can read this rather simple document and get to two such different conclusions!

Since this is about economics one should obviously start with Macro 101: In a fixed exchange rate system monetary policy is rendered powerless and policy adjustment falls entirely on the fiscal side. Already here one should be more than sceptical concerning Mr. Latkovskis’ findings. How can the central bank be guilty if it is largely powerless? True, it can change the fixed exchange rate policy to a floating rate policy but let us first have a look at the report.

To quote from the IMF paper (p.34):

The capital inflows period posed hitherto unseen challenges, but it remains unclear to what extent other policies—in particular fiscal and prudential—could not have more effectively compensated for the absence of monetary/exchange rate policy responses. Arguably, in the context of the crisis, a change in the exchange rate regime would have been too late to avoid the excesses, and possibly also associated with significant costs.

Enough to blame the central bank? No way, and even less in the light of the last sentence – a floating rate here could have created unrest in the market plus it would have been contrary to the goal of euro adoption (unless done with ERM II by widening the fluctuation margins).

So keen to find a possible culprit, why does Mr. Latkovskis not look elsewhere?

E.g. p. 29 in the report which blames banks for poor risk assessment.

Or p. 42 that asks for adequate supervision.

Or most damning in the Latvian case, e.g. p. 42:

… the role of fiscal policy in fixed exchange rate countries will need to be even more pronounced to reduce demand pressures in the economy.
- but it wasn’t…..

Or, the best, graphs 2 and 3 in Fig. 23 on p.41. I cannot reproduce them here but they scream procyclical fiscal policy in Latvia, thus exacerbating the overheating period as well as the downturn.

I am sorry, but I cannot help but think that Mr. Latkovskis had apportioned blame even before he read the IMF paper.


PS
If Bank of Latvia deserves blame it should be for an overoptimistic initial timeline towards euro adoption. Early on, that date was 1 January 2008 which possibly convinced too many too early that euro and lats were irrevocably fixed and that loans in euro thus posed no problem.

Morten Hansen is the Head of Economics Department, Stockholm School of Economics in Riga.