Baltic Protests and Financial Meltdowns: Part II

In October 2008, Latvia asked the IMF for a stand-by program to manage its foreign account. The big question was whether Latvia should devalue or not.

Usually, a country escapes a cost crisis and external imbalance by letting its exchange rate float, which mostly leads to a substantial depreciation. This would have been very costly.

The Latvians strongly opposed devaluation. They seemed prepared to take substantial social costs, including large wage cuts, and the Latvian labor market is very flexible. An early euro adoption remains their goal, with the government determined to reach the Maastricht criteria and adopt the euro by 2012.

With mortgages predominantly in euros, depreciation would lead to an avalanche of bad debt and mortgage defaults, which would aggravate inflation and the output contraction. Given that Latvia is a small, open economy, the positive effect would be comparatively limited, which would aggravate the depreciation. If Latvia were to devalue, Estonia and Lithuania would be forced to follow, which would make IMF programs with co-financing also necessary.

As a member of the EU, Latvia can count on European support. The European Union itself and the Nordic countries (but also Estonia, Poland, and the Czech Republic) contributed substantial co-financing to the IMF package, which amounts to $11 billion for a country with a GDP in 2008 of only $32 billion. Latvia's small size makes this comparatively massive support possible.

But what about the public protests? The Latvian government is highly unpopular for having stifled investigations into high-level corruption and it does not enjoy much authority. Worse, it is one of the few incumbent governments in Eastern Europe to have been reelected.

It should call for new elections, especially because it could hardly be replaced by anything but another center-right government.

Fortunately, the arrested rioters were to equal extent Latvian and Russian, so the protests had no ethnic tinge. Nor was any foreign influence apparent, apart from the protesters' copying the Greek youth riots.

In Lithuania, by contrast, a conservative government was just elected in October, and it has inherited its economic problems. In Estonia, discontent appears less. So far, the ruling rightwing parties remain popular there as the Estonian reformers have been most explicit in their explanations of their policies, probably making their population less inclined to protest.

Overall, even at this time of upheaval, my positive assessment of the Baltic political and economic reforms holds true. Democracy is not in danger. Nor are the free market policies. The big question is not regime change, but whether the Baltic economies will be able to pull through by cutting costs — or whether devaluation will be necessary.

Another question is in which other post-communist countries may social unrest erupt. After a decade of very high economic growth, they all encounter their first serious recession.

The main peculiarity of the Balts is that they faced the downturn first. Most incumbent governments are likely to lose the next elections, and some countries will probably opt for regime change. It remains to be seen which they will be, democracies or dictatorships. I bet they will be dictatorships.

Virtually all countries in the world are currently being hit by big declines in standard of living. The situation is worse in countries, such as Latvia, where the government has not prepared the population of the possibility of a severe downturn. But Latvia benefits from a functioning democratic system that gives voice and leverage to the dissatisfied.

It is far worse in Russia, where Prime Minister Vladimir Putin denied the existence of a crisis until his Davos speech a week ago. Russians are hit hard, but they have neither voice nor influence. Their only option is to take to the street.

According to the Russian police, Russia saw no less than 407 social protest actions around the country last weekend. The Russian regime seems far more fragile than the Latvian, where people only protest against the incumbent government.

Editors Note: The author is a senior fellow at the Peterson Institute for International Economics. His most recent book is “How Ukraine Became a Market Economy and Democracy” (Peterson Institute, 2009).