Trapped By Your Past?

I was asked a question on the radio yesterday about economic policy choices, in this case between letting the exchange float or to keep it fixed. In truth, the question was posed more pointedly as it looked at why some Caribbean countries had devalued their currencies while Barbados had maintained a fixed rate against the US dollar. What struck me about my reply was the nagging question, "Would I have chosen to devalue if I knew then what I know now?" Unfortunately, it is hard to experiment with certain elements of economic policy.

I saw an interesting article in today's Gleaner that looks at the varied economic experience of Barbados and Jamaica (see article). What it highlights for me is how a country gets trapped by a decision: you develop institutions and ways of thinking that are geared to that choice, and it is very hard to break away from that choice. For example, Jamaica has experienced much higher inflation and lower economic growth than Barbados--a deadly combination in economic terms, as you usually want to avoid each of these and often experience one, but to suffer both is terrible. People have developed expectations of prices rising fast and of economic activity floundering, even to the extent that when data suggest that prices are not rising or even falling, or that growth is not slow or negative, people have a hard time believing the data. That reluctance may be justified to the extent that those who think they are feeling the pain really are feeling some pain. What it suggests is that Jamaicans may need to experience a bigger positive shift for people to be convinced that things have moved forward.

By contrast, Barbados has developed a mindset that seeks to keep prices under control (even price fixing) and wage negotiation arrangements that do not allow for a lot of large increases. The country may be more sensitive to small movements in prices and growth so reacts more speedily if it appears to be headed in the wrong direction.

Now, if a politician or technician wanted to make the case for a major change in economic policy, for example, to change the exchange rate policy, it would not be a series of arguments that would stand or fall on their technical merits. An economy is full of moving parts and where it stands now is where it has reached after adjusting to the various winds of policy changes (domestic and international, determined by humans) and natural events (originating within the country or outside). Even if you looked at the outcome of those two types of things you can see that there are many possible positive and negative outcomes. Also, people's experience with a floating exchange rate tends to lead them to believe that a fixed rate cannot be sustained--the country has had a hard time holding the rate stable for any sustained period. Those who say that the movement of the exchange rate is reflecting the real economic situation may also believe that the rate has a way to go before it can reach a stable level. Those who are committed to a fixed exchange rate will show all the merits and benefits that seem to have flowed from having that.

Because experimenting with policy is difficult, we often have to look at the experience of those who made different choices. So, for Barbados and Jamaica, people often look across the Caribbean and see a 'success' (Barbados) and a 'failure' (Jamaica) and attribute that to a certain policy stand.

But good policy choices can also turn out bad. I worked in two of the Baltic countries--small countries with no natural resources but highly educated populations--some 15 years ago (Latvia and Estonia), when they were moving from being a part of the Soviet Union to become independent nations in the mid-1990s. Put simply, each country decided to fix its exchange rate; one decided to do so in a fairly conventional way (Latvia using the Special Drawing Right [SDR] as its peg, initially), the other (Estonia) decided to have a currency board, whereby the rate is fixed and the country holds at least an amount of foreign exchange to cover a certain amount of domestic currency that is in circulation. Each choice depended on following some rules about how policy should be conducted, and relied much on controlling the government budget. Both countries wanted to become members of the European Union within a decade. Each liberalized its economy and made it easier for foreign investors. Both started to borrow abroad. Both grew very fast and saw inflation at relatively low levels.

I remember the discussions with each country in those early days. The Latvians thought that ' IMF policy proposals were 'too soft' and wanted to see more fiscal adjustment and faster; the mission urged caution. The Estonians were often told that a currency board would not work and the budgetary discipline was hard for a fledgling economy with many development needs; they would have none of that. Both countries tried to simplify their tax regimes, with single rates but rigorous enforcement, hoping to discourage evasion, and that broadly worked in raising government revenue. Both countries gained accession to the EU in 2004 (in the process, Latvia changed its peg to the Euro). They were viewed as economic 'rising stars'.

Then the world changed, and if we fast forward, we now see these countries on the brink of economic collapse and financial sector crises. The heavy reliance on foreign capital and borrowing is now turning sour. Investors in the form of western European banks are pulling out and the costs of borrowing have risen dramatically; the large deficits on the balance of payments current account are now becoming a major burden.

The economic problems have quickly been complicated by political crises and major protests by citizens in general and workers in particular as wage restraint policies were resisted. One of the countries, Latvia, has had to turn again to the IMF in recent weeks for emergency support of their 'stabilization' policies (see IMF press release). As is said clearly, 'The program is centered on maintaining Latvia’s exchange rate peg while recognizing that this calls for exceptionally strong domestic policies and substantial international financial assistance.' Latvia wants to maintain its currency peg and eventually adopt the Euro, but will have to endure some harsh measures for that to be possible. These include a tough incomes policy. The country will also try to protect social spending. Put together, the need for fiscal tightening brings the possibility that recession could be protracted. Then to add insult to injury, Standard & Poor's, the credit rating agency, downgraded the country's bonds to 'junk' status today (see report) – rare for a sovereign state – and said it may reduce its creditworthiness ranking for sister republics Lithuania and Estonia. It also said it may further cut Latvia's credit rating later this year or in 2010. Talk is now rife that the country may default on its debt. The PM resigned earlier this week. The EU is talking about needing to bail out the country. Aie, caramaba!

Estonia has so far not had to turn to the IMF but faces similar economic policy challenges (see IMF press release). It too wants to retain its currency peg and currency board, but will have to make some tough decisions in its 2009 budget as the current fiscal position is not viewed as sustainable, given a desire to adopt the Euro.

Both countries believe that they adopted the right path nearly 20 years ago, and so far discussion has not focused on reverting to another policy regime.

While you cannot set up an experiment with economic policy it is always a living experiment.

Rough days ahead are for these particular countries, but also rough days are ahead for Jamaica, Barbados and most other countries whatever choices had been made in the past.