On financial storms

There had been some comparisons between Latvia's economy now and that of East Asian countries (e.g. Thailand) before 1997 Asian financial crisis. In both cases, the country experienced very fast economic growth and had a big current account deficit (10% of GDP in 1996 Thailand, over 20% in Latvia now). As we now know, Thailand's boom ended with collapse of its currency, baht and a severe economic crisis in the following years. Similar things happened in several other Asian countries, shortly after Thailand.

What does this mean for Latvia? Discussions with Edward Hugh lead me to exploring what economists think about the causes of 1997 crisis in Thailand. In particular, it lead me to this paper by Paul Krugman, written a few years after 1997.

Interestingly, I can relate Krugman's theory to what has happened in Latvia over the last 10 years. Krugman develops a mathematical model of country's economy which leads to a conclusion that it can be in two stable states:

• high-trust state in which investment takes place and banks lend money freely;
  
• low-trust state in which domestic businesses are nearly bankcrupt and banks are unwilling to lend them money.

The low-trust state sounds very much like Latvia of mid-1990s in which credit was mostly unavailable. The high-trust state is Latvia of today. In 1997, a sequence of unfortunate events lead Thailand's financial system to collapse from the high-trust state into the low-trust state. The consequences were felt for a long time: in 2005, the average income in Thailand was less than in 1997.

The positive message from Krugman's paper is that crises of this form are not inevitable. They don't automatically happen once the current account deficit exceeds some magic number. Rather, current account deficit (and also large debt in foreign-currency, another similarity between Thailand'97 and Latvia'2007) are signs that the economy is vulnerable and might be less able to withstand a sequence of unfortunate events ("financial storm") pushing it into a downward spiral.

I've tried to think if such a financial storm could occur in Latvia now. I think no. There are some substantial differences between Thailand and Latvia. I will write on those in another post tomorrow but the most important one is that Bank of Latvia has the reserves to maintain the current exchange rate between the Latvian lat and EUR. (Thailand's crisis started with Baht plunging from 25 baht/dollar to 56 baht/dollar.)