After an email exchange with Marshall Auerback, and thinking more about the cross-section of Europe, I now see a very scary trend emerging across Europe: the fight for exports.
To be sure, Latvia's efforts are of note, as the acceleration in hourly labor costs dropped from a 22% pace spanning 2007-2008 to just 2.8% in the first three quarters of 2009 compared to the same period in 2008 (the Eurostat data are truncated at Q3 2009).
But look at the similar wage-cutting behavior occurring across the European Union, especially in the Eurozone hopefuls (Latvia, Lithuania, and Estonia are preparing to adopt the euro in coming years).
The battle for exports has begun. Compared to the same period in 2008, Q1-Q3 2009 annual hourly labor costs
Latvia's model: drop wages to increase export income. Greece: drop wages to increase export income. France, Germany, Spain, Portugal, etc., etc. It's impossible that the whole of the Eurozone will drop wages to increase export income. It's especially bad for countries like Latvia or Hungary, where the lion's-share of trade occurs withing the boundaries of Europe.
And what happens when export income does not provide the impetus for aggregate demand growth? Well, there's not much left. Can't devalue the currency (via printing money), and tax revenues will fall faster than a ten-pound weight: rising deficits; rising debt; rising debt service (via surging credit spreads). Sovereign default seems like a near-certainty somewhere in the Eurozone!