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Well, those who recommend a hefty dose of austerity to get countries going have touted Latvia, one of three Baltic republics that gained independence from the Soviet Union in the early 1990s, as a shining example.

Keynesian economists argue that in the present crisis the public sector should increase spending, not decrease it. Especially in present conditions in which the private sector is deleveraging because it took on too much debt and the asset prices that underpinned that debt collapsed, and monetary policy is already exhausted because rates cannot go any lower.

So it isn't much of a surprise that the most public of these Keynesian economist, New York Time columnist Paul Krugman, has blasted any positive claims about Latvia. However, the facts turn out to be somewhat more complicated.

First off though, for those who tout Latvian style "internal devaluation" (that is, lowering wages and prices rather than devaluing the exchange rate) as a solution for the competitiveness problems in the periphery of the eurozone have to consider the following.

Lowering domestic wages and prices (especially considering the deep depression and accompanying fall in GDP that are needed to bring these about) increase the real value of outstanding debt. Clearly, this isn't a viable solution for the likes of Spain, Ireland, Portugal, Italy and Greece, where debt levels are high.

At first (and even second) sight it is curious why Latvia was willing to undergo the biggest recession in modern times (with cumulative output decline from 2007 reaching 24%) in order to keep its currency pegged to the euro of which it is not (yet) a member, especially now that the whole euro project seems such a folly to many.

Indeed. If it were costless to leave the euro and introduce one's own currency, we think that quite a few countries might have left already, rather than go through the excruciating process of "internal devaluation" and austerity. Yet Latvia is the mirror image of that, going through extreme versions of that when they're not even members of the euro and could have simply devalued their currency to restore competitiveness!

There are two explanations for this curiosity:

  • Geopolitical: Latvia was only liberated from the Soviet Union in the early 1990s, it has a strong preference to be part of the West in general, and the European Union in particular
  • Strong market preference as their experience with communism wasn't a happy one. Free market thinking is quite popular amongst large sections of many former Communist countries

Indeed, not to endanger the peg with the euro, the country let the current account deficit run up to 20% of GDP, out of fear of breaching one of the entry criteria for joining the euro. One of the persons extolling the Latvian case (apart from, equally predictable, US conservatives) was Jürg Asmussen, the German member of the executive board of the ECB:

Let me start with fiscal consolidation. The Baltic experience shows clearly that speed is of the essence. In all three Baltic countries, the government reacted swiftly to the deterioration of public finances and front-loaded fiscal adjustment. With a budget consolidation of around 9% of GDP in 2009 alone, Latvia's effort is unparalleled in Europe.

That's extremely hefty, no doubt about it. Asmussen argues that frontloading austerity measures (that is, implementing massive austerity as soon as possible) has three advantages:

  • Gaining credibility (or confidence, as Asmussen calls it) before "adjustment fatigue" sets in
  • Enabling an earlier return to the capital markets
  • Enabling growth to bounce back from after "exceptionally severe output contractions"

Asmussen is also pointing out the fact that despite the very harsh austerity measures and the rather unprecedented slump, the Prime Minister actually managed to get re-elected twice, escaping the Junker curse. The latter points to a remark by Prime Minister of Luxemburg who argued that all the politicians know what to do to save the euro, but the problem is to get re-elected on such a platform.

But Latvia is probably the exception to the rule here, for the historical and geo-political reasons set out above. And indeed Asmussen himself points out the difference:

Last but not least, an important lesson from the Baltics relates to the existence of a broad consensus in society. In my view, beyond economic specificities, the key difference between, say, Latvia and Greece lies in the degree of national ownership of the adjustment programme - not only by national policy-makers but also by the population itself. I cannot but emphasize this again: national ownership and public support for the adjustment programme - these are key lessons from the Latvian experience which are of the utmost relevance to the current situation in Greece.

The critics
Well, there is another side of the debate. In a newspaper article and, more thoroughly, a CEPR paper, Mark Weisbrot (the paper is written together with Rebecca Ray) is particularly scathing. He wonders how this can be called a success when:

  • The country experienced the worst output losses in the world in 2008-9
  • Unemployment shot up from 5.3% to over 20% even when 10% of the workforce emigrated the country
  • While growth has returned, IMF projections show Latvia taking a full decade to reach its pre-crisis GDP
  • Latvia did not even have a successful 'internal devaluation' as "it didn't move its real exchange enough for this to cause its exports (or reduced imports) to pull it out of recession. In fact, the country's trade balance contributed very little to the recovery." [Weisbrot]

The latter is nicely demonstrated by the figure below.

(click to enlarge)

Now, it's certainly true that Latvia, unlike Spain, Greece, Portugal, Ireland, and Italy, recovered from the terrible crash they experienced. However, as Weisbrot is pointing out:

So, how did Latvia finally recover from its deep recession? The main thing was that in 2010 they didn't do what they promised the IMF and the European authorities. They had promised to tighten their budget by a huge amount, but they didn't do it.

His conclusion is quite devastating:

So, the lesson for the eurozone is the very opposite of what Lagarde is preaching: if you do what the Troika is prescribing, you will have a devastating recession with vast unemployment - witness Greece and Spain. "Internal devaluation" does not work. And yes, if the eurozone countries were to ditch the budget austerity, their economies might begin to recover.

We think that conclusion is too harsh though. Economic growth in 2011 was a whopping 5.5% (although this year a more moderate 2%+ is expected), and the country has emerged from a deep slump. Nevertheless, there is something to be said for frontloading all measures and get it over and done with, rather than let it fester.

IMF chief economist Oliver Blanchard has weighed in, with a very balanced article. He pointed out that the Latvian wage flexibility (which is unlikely to be reproduced anywhere in the eurozone) manifested itself mainly in the public sector, rather than in the private sector. The latter explains the limited gains in competitiveness.

He also points out that Latvia didn't experience anything like a public debt issue. The public debt/GDP ratio was just 10% at the start of the crisis and is now around 40%, quite enviable figures. It also didn't experience much of a banking crisis:

The Latvian financial system was largely composed of relatively friendly foreign banks-better than unfriendly foreign banks, or friendly but weak domestic banks. For the most part, the Swedish banks recapitalized their banks and maintained their credit lines to the Latvian subsidiaries, reducing the intensity of the sudden stop and of the credit squeeze. [Blanchard]

With no public debt or banking crisis, two of the most aggressive euro zone crisis elements were not present in Latvia. The country also experienced the biggest slump of all countries, and is further favored by wage flexibility and a political cohesiveness that is unlikely to be matched anywhere in the euro zone.

So it's quite a stretch to celebrate Latvia as a showcase for austerity, and people should be careful to clamour for immediate cuts to public spending on the basis of this single, and quite singluar example.

However, the economy is growing again, so there is something to be said for frontloading all the austerity and structural reform measures. It's not the complete failure that Weisbrot and Krugman make out it is either.

Source: Lessons From Latvia, Austerity's Showcase?