Paul Krugman is wrong

I found out this weekend that Paul Krugman is wrong about Latvia.

For months, mainstream luminaries like Krugman have been telling me that Latvia is the next Argentina, and that the country is on the verge of economic collapse… wait, stop– what does this even mean? Have the lights suddenly gone out? is the garbage is piling up in the streets? has McDonalds stopped selling Big Macs?

Since I was already close by in neighboring Lithuania, I had to go find out for myself… so I jumped in the car and sped towards Riga, Latvia’s capital city, to get some boots on the ground and find out what’s happening.

As it turns out, Latvia has more similarities to the United States than anywhere else… and the lessons are important.

You see, for several years, Latvia was one of the fastest growing economies in the world; when Latvia pegged its currency to the euro, foreign investors saw a goldmine– they could invest in a privatized, emerging nation with no currency risk.

Foreign investment flooded the country, and Latvia became awash with cash. Large Swedish banks rushed in to set up branches and quickly came to dominate local capital flows. With so much money available to lend, consumer credit exploded. In fact, domestic consumption amounted for the most of the growth during the boom years.

GDP grew by double digits year after year, and (here is where the similarities start) everyone thought the good times would last forever.

In classic US-subprime form, Latvian bus drivers were able to obtain mortgages for homes that were totally out of their price league.

Lenders made it easy for consumers to spend more than they earned, and nobody cared because they had confidence in the currency and confidence in the government.

Naturally, economic growth based on confidence in two very shaky and corruptible institutions– government and currency– is totally unsustainable. As Mises said, “There is no means of avoiding the final collapse of a boom brought about by credit expansion.”

The bubble burst when people realized that that a bus driver’s salary cannot possibly afford a 600,000 euro apartment. World credit markets contracted, and as Latvia was among the most overleveraged, it has fallen the most. So far this year, GDP has contracted by an annualized rate of roughly 20%, and the worst is yet to come.

Last month, the government desperately held a Treasury auction to sell $100 million worth of notes. Total sales? Zero. Nada. No one is willing to loan the government money anymore.

This is where I part ways with Krugman… this is not the story of Argentina– this is the story of California:

* During the boom, the state’s largest contingent of economic growth was domestic consumption

* Consumption was driven by ever-expanding credit that was extended rashly and irresponsibly

* Credit expansion led to significant asset-price inflation

* Basic cost of living eventually exceeded average wages, but banks continued to lend

* Meanwhile, the government increasingly force-fed the state into a bloated beast

* Post-bubble, asset prices are now deflating, unemployment is well into double digits, and no one wants to loan the government any money

Sound familiar? Latvia will give us a lot of clues for how the story ends for California.

Today, confidence has completely eroded in Latvia’s currency and its government; the former government was ousted in a popular uprising several months ago, and the current government can’t find two nickels to rub together.

In response to last month’s auction failure, Latvian politicians have announced a budget austerity plan that involves cuts to pension benefits and massive salary reductions for state workers.

Furthermore, despite the housing market falling by 50%, home prices are still too expensive for locals. Food, fuel, and other staples are also more expensive based on local wages than in neighboring countries… so Latvia has a long way down, and there will be no government safety net.

Is there opportunity here? Absolutely. Tomorrow I’ll tell you what I’ve found.

About the Author

Simon Black is an international investor, entrepreneur, and founder of Sovereign Man. His free daily e-letter Notes from the Field is about using the experiences from his life and travels to help you achieve more freedom, make more money, keep more of it, and protect it all from bankrupt governments.