Jeremy Warner: Latvia must bite the bullet and devalue

Outlook The sooner Latvia and other fringe European nations that peg their currencies to the euro grasp the nettle and devalue, the better it will be for both them and the Western banks that have recklessly been funding their growth. There was talk yesterday of more money from the International Monetary Fund and the European Union, but it will only buy time. These currencies need to revalue.

I don't share the commonly held view that Eastern Europe is the next shoe to drop in the unfolding financial and economic crisis. True enough, devaluation is going to prove painful and disruptive for some, and may even tip banks with particularly high exposures to the emerging market economies of Europe over the edge. But the process is also likely to prove cathartic, allowing bad loans to be properly recognised, and much as with Britain's exit from the European Exchange Rate Mechanism back in the early 1990s, for economic growth to resume.

There is nothing basically wrong with these economies. Indeed they continue to have well above average growth potential, notwithstanding the stomach-churning double digit falls in GDP some of them are predicting for this year. But to reboot, they must give up the deluded ambition of joining the euro and re-establish some competitive exchange rates. It will take time, but eventually this will produce a powerful reflationary effect, as well as giving renewed access to international capital markets. Right now, few will lend to Latvia or the other Baltic states because of the risk of devaluation.

The alternative to devaluation is extreme fiscal austerity and deflation. Latvia and its neighbours would be wearing the hair shirt for years to come. The Baltic states can either stick with the peg and suffer endless economic pain, or by devaluing, shift the suffering on to others. It is a bit of a no-brainer, really.

I don't underestimate the disruption this will cause. A domino effect of competitive devaluations across the fringe EU economies is certain, and banks in Sweden, Austria and Greece that have lent heavily to these regions will suffer extreme distress. Many will have to be bailed out. But one way or another these loans were set to turn sour anyway. Write-offs are inevitable. If devaluation doesn't cause them, deflation will.

Devaluation would also put further pressure on weaker members of the euro, such as Ireland, Portugal and Greece. But these countries are going to require assistance in any case.

To save face, Latvia will begin the process by first opting for the 15 per cent band allowed under ERM II. The Latvians are desperate to avoid sacrificing the promise of eurozone membership. Unfortunately, a 15 per cent devaluation is unlikely to be enough. National pride will suffer, but a free floating currency looks to be the inevitable end game.

Valdis Dombrovskis, the Latvian Prime Minister, has become like Norman Lamont just before Britain crashed out of the ERM in insisting that there will be no devaluation. With a young David Cameron behind him, Mr Lamont similarly stood on the doorstep of the Treasury to insist that the Government and the Bank of England stood full square behind the pound. With interest rates at 15 per cent and the Bank of England's reserves of foreign exchange virtually exhausted, it was only a matter of hours before he was forced to eat his words.

Yet it was worth the humiliation. Britain's ignominious exit from the ERM marked the start of a sustained economic renaissance. The same is true of the Asian economies forced to abandon their dollar pegs in the late 1990s. After a period of severe economic contraction and austerity, a trade-led rebound established itself.

It is time for Mr Dombrovskis to bite the bullet. As for the fall-out, we'll see, but I doubt it will prove as severe as imagined.