Six Conclusions from the Conference of 5-th June

Or Why Latvia's Success Story Is Not Easy to Replicate

The international conference which took place June, 5 in Riga was most significant of its kind so far. After all it is not very often that the Executive Director of IMF visits Latvia. From the economic point of view, most important and also interesting was the conclusion of Olivier Blanchard, the Chief Economist of IMF, that Latvia's way out of crisis with keeping its exchange rate peg is actually feasible. Has this journey been a pleasant experience? Of course not. Yet the other possible ways would not have been more pleasant: outright devaluation would have reduced the level of income in the country just as well. It is telling, however, that some of the world's leading economists (and Olivier Blanchard is, without a question, one of them) conclude now that the so called "internal devaluation" has worked in Latvia.  In 2007-2008 many economists did not believe that it could. Yet Latvia has proved that it can be done. The academics and economic experts who predicted that Latvia would become Argentina No. 2 were wrong, no doubts about it now.

There is also no question, however, that Latvia's success formula cannot be copied entirely and used in other countries that find themselves in a situation similar to Latvia's in 2008-2009. Latvia (and the other two Baltic countries) differs from the current problem countries of Europe both in terms of the macroeconomic conditions and implemented economic policies. The discussions that took place at the conference are available in their entirety here. But in short, the basic elements of Latvia's success story seem to be the following.

First, there are outside factors that certainly affect the chances of success of any stabilization policy.

  1. Latvia and the other Baltic countries are small and (almost crucially) also open countries. It means that in these countries the export sector is an important engine of growth. It also means a higher capacity to absorb at least part of the redundant labour which has been freed by the construction and other sectors that were booming previously. Thus in 2009, the goods and services exports in Latvia, according to Eurostat data, amounted to more than 44% of GDP. In Greece this figure was 19%. It is rather straightforward to conclude in which of the two countries the export-led recovery is more easier to generate (moreover, Latvia benefits from a relatively favourable export structure as the bulk of Latvian exports are sold to countries that are doing reasonably well at the moment)...
  2. In Latvia, as in the other Baltic countries, the economic overheating was truly almost unprecedented, yet it did not last long. The party was wild, but only for a couple of years. When it came to a stop, almost everyone here understood that it could not have lasted for very long anyway. The correction/hangover was inevitable. Parties don't last forever – that's life. The other side effect of this rapid overheating is that even the economic downslide that followed did not throw us back too far. Even after a 25% drop in economic activity, Latvia's average incomes are currently at the 2005 levels. Back then life was of course not as good as in 2007 on average, but it was also far from tragic.  To a degree, this explains the phenomenon of "flexible labour markets" here – i.e. why wage declines in nominal terms was possible. In Greece, on the other hand, the party was not as wild yet it lasted several years and even decades, with the governments constantly spending money in excess of what they collected in taxes. Over time, this became the new perceived equilibrium, with the general sense being that this is what the economic development is all about. If rising welfare implied increasing indebtedness, then so be it. Now that the debt ceiling can no longer be raised, it is very difficult to convince the Greek society that the last ten or more years were actually a bubble, and the existing development model is not sustainable. Moreover, in contrast to Latvia, the necessary economic adjustment will likely throw back the Greek standard of living not just by a few years. It is plain to see that these factors make the implementation of any reforms very complicated.  
  3. Latvia entered the crisis with a much better fiscal position. The total government debt in Latvia in 2007 was 9% of GDP, whereas in Greece it was above 100% of GDP. The relatively low level of debt allowed the Latvian government to implement counter-cyclical fiscal policies (in 2009, the budget deficit in Latvia reached close to 10% of GDP), thus avoiding an immediate fiscal drag on the already contracting economy. Of course, it had a cost, and the price we have paid is substantial: the government debt (which will have to be paid by all of us that live in the country) has grown to 44% of GDP within a few years, and the interest payments on the public debt have tripled. Conclusion: a low government debt is a nice bonus that allows softening the blow from the economic crises, and we were lucky we had it. Now, however, that we have used this "silver bullet", we may not enjoy this advantage next time (unless we have cut the debt to a low enough level by then). All one has to do is to observe the torment Greece is going through to appreciate the advantages of the low public debt. High debt levels (as in Greece) means high interest rate burden (Greece currently pays more than 6% of GDP in interest on its government debt every year), which basically takes away the possibility for a country to implement a counter-cyclical fiscal policy. That in turn makes the already harsh economic situation in the country even worse. It is a nightmare that's best to avoid.  

Second, three additional factors that help explain Latvia's success story are related to the way in which the economic stabilization programme was implemented.

  1. The fiscal stabilization in Latvia was carried out at a rapid enough pace. Within three years (from 2009 to 2011) the budget deficit was cut from almost 10% of GDP to 3.5% of GDP. Textbook economics tells that larger budget deficits in times of economic crisis help to boost demand, and thus support economic recovery. However, if the problem involves not only the lack of demand but also problems on the supply side, boosting demand by fiscal stimulus does not necessarily imply more economic growth: if the supply side does not react, extra demand translates into worsening of the country's balance of payments.  Moreover, if growth of the supply is related to the overall confidence in the government policies (including the sustainability of the budget and debt policies), then a greater budget deficit can do the opposite: it can impede the economic recovery. It seems that Latvia and Greece are a case in point: cutting the budget deficit, Latvia has managed to achieve an improvement in the current account balance (from a deficit of over 22% of GDP in 2007 to a surplus in 2010) and an economic growth rate that is the most rapid among the EU countries. The Greek budget deficit remains substantial (above 10% of GDP in 2010), and the economy continues to stagnate.  In spite of the economic recession, however, the current account of Greece maintains a substantial deficit: more than 12% of GDP in 2010.
  2. For successful implementation of economic policies both positive motivation (gains from the implementation) and risks related to non-implementation play an equally important role. In the case of Latvia both were apparent: by carrying out the programme, Latvia has a good chance to enter the euro area (the related advantages for the Latvian economy still exceed the possible losses), whereas if it did not do so, there was always a possibility of default. This clearly helped the policy makers to make the right choices.  In the case of Greece, however, the negative scenarios seem to be predominant at the moment (if Greece does not stick with the programme, it runs the risk of being banned from the euro area or even the EU). Apparently it's too little for the much needed reforms to garner wide support.
  3. Finally, the sequence of economic adjustments is also important.  In the process of fiscal consolidation it is relatively easier to take measures that involve raising taxes and more difficult to reduce the budget expenditures.  This is exactly why adjustment should start with the most difficult and least popular measures: cutting expenditure. Latvia did it: budget consolidation was initially carried out primarily by cutting expenditure and the importance of tax changes grew only gradually over time.  It is the exact opposite in Greece: taxes were raised in the initial stages of economic adjustment and the cutting of budget expenditure has become more important now, particularly in the socially sensitive areas. If Latvia's example is to be believed, this is the most complicated way of carrying out economic reform. All that we can do now is hope that the Greeks manage to show the rest of the world (as Latvia did) that what most consider as close to impossible can be done after all...
APA: Bitāns, M. (2021, 27. nov.). Six Conclusions from the Conference of 5-th June . Taken from https://www.macroeconomics.lv/node/2738
MLA: Bitāns, Mārtiņš. "Six Conclusions from the Conference of 5-th June " www.macroeconomics.lv. Tīmeklis. 27.11.2021. <https://www.macroeconomics.lv/node/2738>.
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