4.6.7 Methods to correct a persistent current account deficit (HL only) Notes

Addressing Persistent Current Account Deficits. Turkey and Latvia

A current account deficit occurs when a country imports more goods, services, and capital than it exports. While short-term deficits may not be problematic, persistent deficits can lead to rising external debt, currency depreciation, and economic instability. Countries use different strategies to correct these imbalances, including expenditure reducing policies, expenditure switching policies, and supply-side policies. This case study examines how Turkey (2023–present) and Latvia (2008–2012) implemented these policies and assesses their effectiveness.

Turkey’s Approach (2023–Present)

In 2023, Turkey faced a severe current account deficit of approximately $60 billion, driven by high import demand and weak exports. Inflation had surged to 85% in late 2022, and the Turkish lira had lost over 40% of its value against the US dollar in two years. The government, initially hesitant to use contractionary policies, was forced to shift its economic strategy following the 2023 elections.

To reduce excessive domestic spending on imports, the Turkish central bank increased interest rates from 8.5% to 50%within nine months. This sharp monetary tightening aimed to lower inflation, slow down consumer demand, and stabilize the Turkish lira. In addition, the government implemented fiscal measures such as tax increases and reduced public sector hiring to curb excess spending.

The results of these expenditure reducing policies were mixed. Inflation fell significantly, reaching 21.3% by the end of 2023, and the current account deficit narrowed. However, higher borrowing costs slowed economic growth, as businesses struggled to afford loans. The Turkish lira appreciated due to high interest rates, making exports less competitive, which counteracted some of the benefits of reducing import demand.

To encourage exports, Turkey had previously relied on expenditure switching policies, allowing the lira to depreciate in 2021–2022. This initially made Turkish goods cheaper internationally, boosting exports and tourism. However, depreciation also made imported raw materials and capital goods more expensive, contributing to cost-push inflation. By 2023, inflationary pressures had become severe, forcing the government to reverse its approach.

Although Turkey’s supply-side policies were limited in the short term, the government prioritized industrial development and investment incentives to improve productivity in export sectors. However, such policies take time to show significant results and did little to immediately reduce the current account deficit.

Overall, Turkey's reliance on expenditure reducing policies helped stabilize inflation and reduce import demand, but at the cost of economic slowdown. Meanwhile, currency depreciation as an expenditure switching policy had previously boosted exports but fueled inflation, forcing a policy reversal. Supply-side measures were less effective in the short run but could support long-term external balance.

Latvia’s Approach (2008–2012)

In the mid-2000s, Latvia experienced rapid economic growth fueled by cheap credit and foreign capital inflows. However, by 2008, the country had developed a current account deficit of 22% of GDP, one of the largest in Europe. When the global financial crisis hit, foreign investment dried up, and Latvia was unable to finance its deficit. The government turned to the International Monetary Fund (IMF) and the European Union (EU) for a bailout, agreeing to implement strict austerity measures in return.

Latvia pursued expenditure reducing policies through fiscal austerity, cutting public spending, reducing public sector wages by 30%, and increasing taxes. The aim was to reduce aggregate demand, lower imports, and restore external balance. These policies succeeded in eliminating the current account deficit within two years, as domestic consumption fell sharply. However, the adjustment was painful, unemployment surged to 20%, and tens of thousands of Latvians emigrated due to declining living standards.

Instead of using currency depreciation as an expenditure switching policy, Latvia pursued internal devaluation by lowering wages and production costs. Since Latvia was part of the euro-pegged exchange rate system, it could not devalue its currency. Instead, the government allowed wages to fall, making Latvian exports more competitive. Over time, exports increased, helping to restore economic growth by 2011.

Latvia also implemented supply-side policies, focusing on labor market flexibility and reducing bureaucratic barriers to investment. These reforms helped improve the country’s long-term competitiveness, but their effects were gradual and did not prevent the short-term economic hardship caused by austerity.

Ultimately, Latvia's expenditure reducing approach was highly effective in eliminating the current account deficit but came at the cost of deep recession and social consequences. Its expenditure switching strategy of internal devaluation also helped, but only after years of painful wage cuts.

Evaluation and Comparison

Both Turkey and Latvia implemented expenditure reducing policies, but their outcomes varied. Turkey’s approach helped stabilize inflation but slowed growth and made exports less competitive due to currency appreciation. Latvia’s drastic austerity measures rapidly eliminated its deficit but caused severe unemployment and social distress.

Regarding expenditure switching policies, Turkey initially relied on currency depreciation, which boosted exports but fueled inflation, forcing a policy reversal. Latvia, unable to devalue its currency, relied on internal devaluation, which eventually improved competitiveness but caused wage declines and emigration.

Finally, supply-side policies played a minor role in both cases. While Turkey focused on industrial investment, Latvia’s labor market reforms improved competitiveness over time but did not prevent the short-term economic pain caused by austerity.

Both cases highlight the trade-offs involved in correcting a current account deficit. Policies that effectively reduce deficits may also cause economic contraction, inflationary pressure, or social hardship, requiring governments to carefully balance their choices.

Questions

1. Explain how expenditure reducing policies were implemented in Turkey and Latvia. To what extent were they effective in correcting the current account deficit?
2. Compare the impact of currency depreciation in Turkey with internal devaluation in Latvia as expenditure switching policies. Which approach was more effective?
3. Discuss the potential long-term benefits and drawbacks of supply-side policies in addressing a persistent current account deficit.
4. Evaluate the social and economic trade-offs that countries face when implementing contractionary policies to correct a current account deficit.
5. Based on the case study, do you think currency depreciation is always an effective tool for reducing a current account deficit? Justify your answer.