Friday, June 12, 2009

The crippled tigers

It's a funny old world in Wall Street Journal land. Why has the Irish economy gone pear-shaped? --

Government expenditures rose by 138% in nominal terms over the past decade, a time when the economy itself grew "only" 72%, according to Constantin Gurdgiev of Dublin's Trinity College. Much of that spending went to social programs and civil servant salaries. Combine those commitments with a tax base reliant on the bubble-prone property sector, and Ireland faced a 12.75% deficit this year before a new budget trimmed that to a still whopping 10.75%.

Which brings us to the other lesson, on the dangers of overly hasty government intervention even amid a financial crisis.

OK, government was too large. And yet --

Irish policy makers know how to spur an economy. Witness the country's low corporate tax rates, which fueled foreign investment and economic growth and transformed Ireland into the Celtic Tiger.

But it still has the low corporate tax rate. So it must be to do with other behaviour of government? But then there's Latvia --

Annual GDP growth of between 8% and 12% from 2004 to 2007 was fueled by a credit mania, especially in euro-denominated real-estate borrowing. Total residential mortgage debt hit 33.7% of GDP. Households now have to deleverage, while the government needs to restrain spending.

Yet instead of allowing nature to take its course, a growing chorus is calling for a devaluation of the lats, which currently trades in a band of plus or minus 1% around the peg of 0.70 lats to the euro. Some devaluationists argue that an inflation rate higher than in the euro zone has pushed the real lats exchange rate out of whack, thereby making Latvia's exports less competitive.

Now we're confused. Those naughty Latvians also allowed government spending to grow by a lot, but apparently their problem was excessive credit growth and falling competitiveness due to relatively high inflation.

Which is pretty much the story for any economist who actually looks at the Irish situation.

So what does the Journal recommend for Latvia? One don't: devaluation --

But a cheaper lats won't magically revive the U.S. and Western Europe export markets that are suffering recessions of their own. Latvians would have to repay euro-denominated loans with more lats than before, squeezing household budgets. Default rates inevitably would rise, perhaps to as high as 30% or 40% of total loans, estimates economist David Roche of London-based Independent Strategy. That would be a blow in particular to the Swedish banks that have loaned so heavily in the Baltics.

A Latvian devaluation could also put pressure on Lithuania and Estonia to follow suit.

The alternative as the WSJ sees it is large borrowing from the EU and IMF to permit large cuts in public spending. Since Ireland is already in the eurozone, devaluation is not an issue. So is that also their implicit recommendation for Ireland? This low tax mania and the deregulatory ethos that accompanied it doesn't seem to have worked out especially well for either country. Could it be that the public was confronted with the full implications of the WSJ economic recipe -- i.e. the need for slash and burn fiscal policy in a recession -- it might not be so popular anymore?

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