The paper by Blanchard, Griffiths, and Gruss is here (pdf). Some bemusement among the non-international-macro types about why a long session devoted to a country roughly the same size as either Nebraska or Brooklyn, take your pick. But a good discussion all the same. My take:

What to Make of Latvia?

Paul Krugman

Blanchard, Griffith, and Gruss have given us a terrific paper on Latvia, welcome for its tone as well as its content. Latvia has become a symbol in the fiscal policy wars, with austerity advocates elevating it to iconic status; the temptation must have been strong either to validate that elevation, or turn the paper into an exercise in debunkery. Instead, the authors give us a detailed, balanced account – one that highlights, in particular, just how odd, how inconsistent with orthodoxies of either side, the Latvian experience seems to be.

So let me dive right in to the two big issues the paper raises: the puzzle of Latvia’s output gap, and the puzzle of its internal devaluation.

Here’s what we know for sure: Latvia suffered a huge, Depression-level economic contraction after 2007, followed eventually by a fast but as yet incomplete bounce-back – which the latest data suggest may be slowing – that has left unemployment much higher than it was pre-crisis. Actually, Latvia’s numbers from 2007 to 2013 look fairly similar to those for the United States from 1929 to 1935. Today, everyone considers America 1935 to have been still in the depths of the Great Depression, so that if we look at Latvia through the same lens it doesn’t look very good – better than, say, Greece, but not good.

However, the Latvian authorities tell a very different story, and BGG basically agree. They argue that 2007 is a misleading base – that the Latvian economy on the eve of crisis was wildly overheated, with a positive output gap of something like 12 percent. And they correspondingly conclude that Latvia has in large part already recovered more or less fully.

BGG don’t arrive at this conclusion lightly. But I do think we want to ask how plausible it is.

First of all, on a conceptual level, how does an economy get to operate far above capacity? We understand operating below capacity: producers may fail to produce as much as they want to if there isn’t enough demand for their products. But how does excess demand induce producers to produce more than they want to?

OK, New Keynesian models actually have a sort of answer: the economy is monopolistically competitive, so that producers in general charge prices above marginal cost and are hence willing to produce more given the demand. But there has to be some limit to this margin; is 12 percent really plausible?

Second, how often do we see the kind of huge positive gap posited for Latvia? Or to ask a question we can actually answer, how often does the IMF estimate output gaps that big? I’ve gone through the IMF’s World Economic Outlook Database, looking at all advanced countries since 1980, to identify double-digit positive output gaps. Here’s the full list:

Estonia 2007

Greece 2007

Italy 1980

Luxembourg 1991

I have no idea what was going on in Italy 1980 or Luxembourg 1991. I doubt that anyone believes that Greece was operating 10 percent above capacity in 2007; surely what we’re seeing is the problem with the methods the Fund uses to estimate potential output, which basically use a weighted average of actual output over time. These methods automatically interpret any sustained decline in actual output as a decline in potential, and they cause that re-estimate to propagate backward through time. So the catastrophe in Greece ends up producing the basically silly conclusion of a hugely overheated economy before the crisis.

Oh, whatever is going on in Estonia presumably bears some relationship to what’s going on in Latvia.

The point is that if Latvia really was as hugely over capacity as they claim – and to be fair they don’t use the filtering method, they use careful assessment of unemployment and inflation – it represents a more or less unique case.

And arguing that Latvia was vastly over capacity in 2007 has another, perhaps surprising implication: it makes much of the debate over both austerity and internal devaluation moot.

On austerity: if we were really looking at an economy with a double-digit inflationary output gap, even the most ultra-Keynesian Keynesian would call for fiscal austerity. Grant the output gap interpretation, and the fiscal policy debate evaporates.

So, to an important degree, does the internal versus external devaluation debate. Here’s a plot of Latvian growth, at an annual rate, versus the one-year change in the current account balance as a percentage of GDP:

Photo

There was a strong relationship both before and after the crisis, but if anything stronger before the crisis. One way to say this is that that given the slump in Latvian output after 2007, you should have expected a huge external adjustment from that fact alone. Maybe Latvia didn’t need a devaluation of any kind, external or internal. Maybe it wasn’t overvalued, just overheated.

That said, BGG also provide evidence of a substantial internal devaluation, at least as measured by unit labor costs. Oddly, however, almost none of this comes via lower wages: wages in manufacturing have been every bit as flat as those of us who warned about downward nominal wage rigidity would have predicted. Instead, what we see is a rapid rise in productivity, which they suggest is the result of eliminating X-inefficiency.

There is, however, an alternative interpretation. Latvia is a relatively poor European country playing catch-up, and it had rapid productivity growth before the crisis. Here’s aggregate labor productivity from Eurostat:

Photo

Maybe Latvia just had an impressive productivity trend, owing to its particular position in the European system, and simply returned to that trend after a brief setback.

How does this bear on the internal devaluation debate? Well, if Latvia had very high productivity growth for whatever reason, the big thing advocates of currency flexibility worry about – the downward rigidity of nominal wages – just wasn’t a binding constraint.

So, suppose we go with this story: Latvia was a hugely, perhaps uniquely overheated economy that even a Keynesian would agree needed a lot of fiscal austerity, with very high rates of productivity growth making wage stickiness irrelevant. I’m not sure I believe this story, but if you do, what lessons does Latvia hold for other countries, and the euro in general?

And the answer, in brief, is none. Latvia’s story as I’ve just told it looks nothing like anything we’ve seen in the past, and probably not like anything we’re likely to see in the future – including, by the way, Latvia’s future. So I’m a little puzzled by the authors’ sanguine view about a Latvian entry into the euro; the next time there’s a euro crisis – and there will be another one, someday – there’s no reason to believe that anyone will be able to adjust in the way that Latvia, maybe, has.