The winners of the internal devaluation contest

The winners of the internal devaluation contest 56

The benefits Latvia has from internal devaluation

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Foto: Anete Skuja, F64

Morten Hansen 20.jūnijs 2011 21:14

Izdrukāt Nosūtīt

One of the major differences between an external devaluation and an internal devaluation is the impact on incomes. An external devaluation of, say, 20% keeps incomes constant measured in LVL but reduce them by 20% measured in EUR. Equal treatment, so to say, which does not prevail in an internal devaluation where different LVL incomes are reduced differently based on where one is employed. In Latvia, public sector wages were reduced substantially (25-30%) while hearsay speaks of some private sector wages reduced by 50% or more while others by much, much less.

One group that benefited from the internal devaluation in this respect, though it does not seem to receive that much attention, was pensioners, partly, as we know, due to the Constitutional Court calling it unconstitutional to cut pensions (or something like that; I am not a lawyer...) and because of the agreement with international lenders (IMF, EU, World Bank etc) that, among so many other things mostly spoken of, also aims at safeguarding vulnerable groups - and, yes it does, it is not just a question of cut, cut, cut to make Latvian government expenditure (finally) start matching revenue.

This is a fine aim; most pensioners are indeed vulnerable and have had and continue to have a hard time but it should nevertheless raise some fiscal concern. Payments for old-age pensions in Latvia rose quite dramatically as a share of GDP from 2008 to 2009 because of this lack of internal devaluation, namely from 5.6% to 8.3%, see Eurostat* as other parts of the economy contracted heavily. 8.3% is still not a huge share by EU standards; several countries see the share in double-digits, such as Ireland, France, Italy, Austria and Sweden but with the upcoming demographic crunch on the horizon this spells trouble as the share, all other things held constant, will relentlessly increase.

Currently, the share of 65+ year olds in the Latvian population is 17.4% and by 2060 this is projected to grow to 35.7%, i.e. more than doubling, to the highest share in all of EU27. Much, much fewer tax payers to serve many, many more pensioners.

Fiscal policy may seem precarious today but is plain sailing compared to future fiscal policy...

Just three final comments on this:

a) Pensions and their (lack of) sustainability are of course already discussed and that's just brilliant.

b) One rosy argument of why this is not such a severe problem is Latvia's catch-up potential i.e. the idea that as a relatively poor country it has a long way to go in terms of GDP catch-up, making this affordable. Two caveats: Firstly, this relies on the incomes of the rest of the economy growing faster than pensions, which might be difficult to achieve with pensioners becoming such a significant share of the electorate. Secondly, and more ominously, GDP catch-up potential is exactly that, potential. It is like those who argue that Greece has ‘reform potential', right??? It is still naïve to believe that Latvia will ‘just' catch up!

c) And a bit far-fetched idea (I hope): What if existing and potential tax payers realize that they are part of a giant pension pyramid scheme they will never benefit from, only pay for, and start voting with their feet even more than they have already done?!?

Morten Hansen
Head of Economics Department
Stockholm School of Economics in Riga

* And then choose sub-group COFOG GF 1002

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Art Thanks for good article.

I try to be optimistic, at least until the results of next elections, but on this topic I have to add some rather less-rosy aspects.

1) Pensioners in Latvia, current and future ones, at the moment they retire will most likely have fewer assets than their retirees in other countries with similar ageing related problems. This will make it much harder to decrease transfers to them.

2) Pensioners will become larger part of electorate. This problem is currently discussed in context of USA where it is expected that share of retired in the next two decades will reach 26% of VOTING AGE population (versus 35,7% of TOTAL population expected in 2060 in Latvia). See article in Economist: www.economist.com/nod...
Smallest associated problem is that pensioners may vote for populists (example from Latvia – Mr. Lembergs and his loyal grannies with flowers). Then, pensioners are much more active voters – both in USA and Latvia, thus their effective share of electorate is even larger. Furthermore, according to abovementioned article, pensioners in USA are becoming much more distinctive voting block. I am afraid similar tendencies are also becoming visible here in Latvia, currently they are used in populist manner by Green and Farmers Union (ZZS) who are basing their strategy for next elections on slogans like “We won’t cut pensions” and similar. If pensioners manage to vote* in coalition, which is unable to cut transfers to them, it might stall most reforms and lead to short-term benefits for pensioners and longer-term misery for others, as this will accelerate the pace in which people in their 20s and 30s leave to other countries.
* This is not to accuse those of retired, who are willing to agree to necessary reforms despite their hardships, I am talking about majority here.

3) Retired people in Latvia are unhealthy compared to other countries with rapidly ageing population (maybe except Russia). Current and expected Healthy Life Expectancy (HALE) and Healthy Working Life Expectancy (HWLE) are both low compared to current and expected life expectancy. This brings with it two problems – (i) older people won’t be able to resume working for much longer after their current retirement age even if necessary measures to entice employers to hire them are implemented, and (ii) health care expenditure will increase rapidly, and it seems unlikely that government will manage to raise funds by attempts to depart from universal health care, as younger parts of population will smell another “pyramid scheme they will never benefit from” and stay off it.

4) Young generation will have mediocre education (on average) – and even if education reforms are implemented soon, I do not believe improvements will become visible before its too late, as fixing higher education is not enough, solid primary and secondary education are prerequisites. On the other hand, they will have mediocre or better English. Unless EU changes its stance on migration between Member States (or (i) Latvia leaves EU, much less likely, or (ii) EMU and EU breaks up, slightly more likely), I expect this will lead to massive emigration of working age population, especially after also taking into account other factors.

I could go on, but it probably is enough negativism (realism?) for one evening and one comment. People in Latvia still have (and are expected to have) higher disposable income and more opportunities than many others in various places all around the world. There is no war, we are mostly safe from natural disasters, and we aren’t yet in the situation of Arab Spring countries, where people are willing to sacrifice their lives just to regain back some power over their countries. We can still manage to face reality and deal with it - I hope - next elections will be litmus paper for me on this one.

IMHO,
Art

ATBILDĒT 20.jūnijs 2011 23:33

Kaspars Bērziņš Morten, to evaluate the budget sustainability you should take into account not only the share of pensions against he GDP (5.6% or 8.3%) but the ratio of public sector v/s GDP as well. Latvia has very low public sector revenues against the GDP, therefore our 8.3% could take the same share of public spending as in the 'double digit' countries.
The similar thing here - US has moderate spending on social security. However, it is unsustainable with the current tax rates.

1 ATBILDE ATBILDĒT 20.jūnijs 2011 23:02

Art One more point.

When we think about saving for retirement, we imagine that some more or less random events will happen in markets, but at the moment of retiring our savings will maintain at least the same purchasing power. This is correct enough when there are different ageing patterns around the globe. However, when most of the world is ageing*, this no longer holds.
* See this article about expected ageing in China, mostly result of one-child policy: www.economist.com/nod...

Imagine small lonely island with no money. Population ageing structure is stable. Younger people are working hard and giving some of the output to older people. When they age, they know that next generation will also work hard and give them similar amount of output.

Now introduce rapid ageing.

No matter how you look at it, next generation of old people will gain less output, as there are limits how much younger generation are willing to sacrifice knowing that they will get much less back. Best way for island population to ensure good living standards for the future is to produce really durable things like real estate, or devote resources to research and development, in order to make future production less labor intensive. Other means of output will become bad or obsolete until current generation retire. And, introduction of money cannot affect this.

Now, apply this to real world right now. There is no way next generations are getting same output when they retire. Less people of working age cannot maintain same production unless technology improves a lot, and you cannot transport your sandwich 40-50 years ahead in time without it rotting. Thus there is no real hope for positive real interest rates (approx. nominal interest rate minus inflation) in foreseeable future as I see it, and this is problem globally. Look at it from different angle, there are and will be lots of people from current generation, who will be willing to sacrifice lots of today's output for less of futures (when they retire) output. Price of today's output versus future output is real interest rate, and in this situation when people value future output more than today's, real interest rate must be negative.

Sorry, if this seems too obvious, just wanted to add this point in case someone has not yet thought about this from this angle.

IMHO,
Art

ATBILDĒT 21.jūnijs 2011 12:19

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