Latvia, was the austerity worth it?

Prime minister of Latvia Valdis Dombrovskis (CC BY-NC-ND Valtsts kanceleja)

Over the last few years Latvia has become a poster boy for advocates of the benefits of harsh austerity policies, with fans of the Baltic nation pointing out that after slashing government spending in 2009, the country is now one of the EU’s strongest performers.

But the Baltic pin-up is also attracting skepticism over whether its domestic environment is unique – allowing for a much tougher austerity policies than in most other European countries – and whether the country’s boom-and-bust-and-back-to-boom economy actually serves as a decent model for the crisis-stricken eurozone.

Leszek Balcerowicz puts Latvia in with his BELLs countries – Bulgaria, Estonia, Lithuania and Latvia – examples, he says, of the benefits of following conservative economic policies and focusing much more on reducing government spending than on increasing taxes to make up budgetary shortfalls.

In an interview with The Wall Street Journal, Balcerowicz stresses that the BELLS saw V-shaped economic growth curves, with steep falls in output followed by robust rebounds.

He is echoed by Anders Aslund, a leading economist with an interest in central and eastern Europe, who writes for Bloomberg that the performance of the Baltic countries shows: “Northern Europe is sound, thanks to austerity, while southern Europe is hurting because of half- hearted austerity or, worse, fiscal stimulus. The predominant Keynesian thinking has been tested, and it has failed spectacularly.”

He looks specifically at the contrast between Greece and Latvia, noting that, although Latvia’s economy contracted by more than 24 per cent in 2009 and 2010, it saw growth of 5.5 per cent in 2011 and probably about 5.3 per cent in 2011.

“Meanwhile, Greece will suffer from at least seven meager years, having endured five years of recession already. So far, its GDP has fallen by 18 percent. In 2008 and 2009, the financial crisis actually looked far worse in Latvia than Greece, but then they chose opposite policies. The lessons are clear,” he writes.

But the Latvian lesson is a lot more complicated than simply extolling front-loaded fiscal reforms such as cutting public spending, including public sector wages. During the first wave of the crisis many economists felt that it would be impossible for the Lat to stick to its peg against the euro and that a currency devaluation would be needed to make Latvia competitive again.

But Latvia defied expectation and stuck to its peg, instead undertaking a very difficult internal devaluation that restored competitiveness by slashing salaries and benefits. The scale of its adjustment was even larger than what Greece is now attempting.

As a result, Latvia’s unit labour costs are now less than 80 per cent of their level in 2008, while the eurozone’s are slightly higher. That has led to a rebound in exports.

But despite Latvia’s recovery, even the International Monetary Fund, which helped rescue Latvia, is now squeamish about the costs of austerity.

In a remarkable new paper entitled Growth Forecast Errors and Fiscal Multipliers, the IMF’s chief economist Olivier Blanchard, and a colleague Daniel Leigh, notes that economists appear to have underestimated the adverse impacts of austerity policies.

“Economies with larger planned fiscal consolidations tended to have larger subsequent growth disappointments,” they note.

Marek Belka, the governor of the National Bank of Poland, also says in a recent interview that theories arguing that fiscal cuts in a time of very low interest rates will spur faster growth are wrong and nothing more than “intellectual dilletantism”.

The IMF is also increasingly worried that Latvia’s austerity policies have had a major social cost. In one example, the guaranteed minimum income was cut at the beginning of this year. The IMF has also expressed concern about quickly rising inequality in Latvia.

When examined over the medium term, the benefits of austerity are also arguable. It is true that Greece has suffered a severe economic contraction, but Latvia has still not yet recovered from the 2009 crisis. Its economy is only about 84 per cent the size it was when the crisis hit.

“If Latvia can continue five percent annual growth for five more years, then by 2018 they should have re-obtained their 2007 peak output level. Which is to say they’ll basically have had a lost decade, except instead of 10 years of stagnation it’ll have been four years of terrifying collapse followed by six years as not-fast-enough bounceback,” writes Matthew Yglesias, a columnist at Slate, the US online magazine.

In the end, what mattered for Latvia was politics and sociology rather than strict economics. The memories of being a Soviet colony are still very fresh, and the country’s overriding goal it to integrate as closely as possible with the EU for security reasons; Latvia still intends to join the euro in 2014, something that would have been impossible in the event of a massive depreciation of the Lat a few years ago.

“Latvian society remembers different times,” says Belka, who helped craft Latvia’s rescue while an IMF official. “Their common memory goes back to Soviet times. When we would ask Latvians about the crisis and how they were doing, they would respond: `What crisis? For us a crisis was when the Russian were deporting our people to Siberia. We’ll survive this.’ The Greeks have no similar memory – they have been living well for decades.”

There is also a question of how much of a model Latvia serves for Poland because Poland has steered clear of Latvian-style austerity.

When the crisis hit, Warsaw did the opposite of Riga and made few efforts to defend its currency – the resulting steep fall in the zloty’s value was one of the main factors in the resulting export boom that kept the economy from falling into a recession in 2009.

The government also made few efforts to rein in spending in 2009 and 2010, allowing the budget deficit to balloon to 7.9 per cent of GDP by 2010. Even Poland’s recent fiscal cuts have been much less ambitious than in Latvia. There the deficit is about 2 per cent in 2012, while Poland had to allow its own goal of reducing the deficit to 3 per cent of GDP to slip because of the economy’s unexpected slowdown.

“… in the real world, Poland’s economic performance has been vastly, almost comically, superior to Latvia’s despite the fact that the country didn’t make any “hard choices,” writes Mark Adomanis at Forbes.

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