Latvia’s Recession: The Cost of Adjustment With An “Internal Devaluation”

The Latvian recession, which is now more than two years old, has seen a world-historical drop in GDP of more than 25 percent. The IMF projects another 4 percent drop this year, and predicts that the total loss of output from peak to bottom will reach 30 percent. This would make Latvia’s loss more than that of the U.S. Great Depression downturn of 1929-1933. This paper argues that the depth of the recession and the difficulty of recovery are attributable in large part to the decision to maintain the country’s overvalued fixed exchange rate, because it prevents the government from pursuing the policies necessary to restore economic growth.