Stimulus >< austerity

Austerity – procyclical fiscal policy – is thus needed in Latvia exactly because it was procyclical and unsustainable during the boom

One of the interesting – and rather scary – features of the world-wide macroeconomic debate these days is the massive disagreements that exist concerning how to handle the recession. In one corner you have the pro-stimulus people arguing for good old Keynesian countercyclical fiscal policy i.e. increase government spending now to create more jobs and then pick up the tab later when the economy is back on track. In the other corner we have the austerity bunch arguing that budget consolidation is needed i.e. budget deficits must be slashed to avoid unsustainable debt accumulation. Such fiscal policy is procyclical since it follows the economic cycle and exacerbates it, or in other words, a downturn is worsened; unemployment created by lack of demand in the economy is followed by more unemployment as schools and hospitals are closed etc.

The former so obviously sounds enticing but the latter is pursued here in Latvia and I support that. Here’s why:

1) Judging by interest rates (low) countries like the US, Germany and others seem trusted by lenders and can actually pursue fiscal expansion and I think they should do so.

2) Latvia’s fiscal policy track record, however, has about the same credibility as a 3-lat bank note. A country that had an ultra-procyclical fiscal policy in the boom years and later had to obtain emergency loans from the IMF and EU to avoid default, currency collapse and a banking sector collapse is, ahem, just not the darling of financial markets.

Below I show a graph that displays the irresponsible fiscal policy of the ‘fat years’. Please notice the ‘budget seasonality’ – 4th quarter spending is always substantially higher than third quarter spending, in 2006 no less than 71.3% higher! What happened? High economic growth of the time led to massive increases in tax revenues – that obviously ‘had’ to be spent. I can only be puzzled by Finance Minister of that time, Oskars Spurdziņš, claiming in Diena 8 July 2010 (p.3) that “there is no reason to argue that we had no fiscal discipline” (my translation). I think there is all the reason in the world to argue that fiscal discipline was completely absent!

Quarterly General Government Spending, Q1 2004 = 100

Source: Central Statistical Bureau of Latvia

3) Latvia is thus much more like Greece where financial markets punish that country with very high interest rates since they do not believe in its ability to repay its vast government debt (~ 115% of GDP and increasing). Try to widen the budget deficit in Latvia via more government spending than agreed with the international lenders and the same would happen here.

4) Austerity – procyclical fiscal policy – is thus needed in Latvia exactly because it was procyclical and unsustainable during the boom. This exacerbated growth in the good years and exacerbate the decline now and Latvia indeed continues to be the rollercoaster economy of the EU.

5) I am convinced that in Latvia credibility is of the utmost importance. When the IMF/EU loans one day soon have to be refinanced it better be at low interest rates but such will only prevail if Latvia is perceived as having adopted a sustainable fiscal policy which can loosely be translated into “follow the IMF/EU programme” – as I have said about a million times, I know.

6) And other countries need austerity, too and I think it can be explained rather simply. Too few countries are willing to also use countercyclical fiscal policy in the good times i.e. slash government spending when private sector spending booms. Charlie McCreevy, former finance minister of Ireland and former EU Commissioner once said it very well: “When I have the money I spend it, when I don’t, I don’t” – procyclical fiscal policy par excellence.

7) But let us at the end think positively:About the EU structural funds. They provide around 6% of GDP (back-of-the-envelope calculation) this year or more, in relative terms, than the so-called Obama stimulus package for USA. And also a seldom (if ever) mentioned positive feature of the presence of the IMF in Latvia: Whoever wins the election in October and whoever forms a new government will not end up in a situation like in Greece or Hungary where the fiscal books looked much worse than what the public were told. 

Morten Hansen is the Head of Economics Department, Stockholm School of Economics in Riga.