Still got the budget blues

Latvia has a high proportion of public sector employees

The Latvian austerity measures are now about two years underway and the consolidation so far has been of epic proportions but still more is needed. Why not start by reminding ourselves exactly how reckless spending was in the ‘fat years’ and thus why so much consolidation is needed now, see graph below.

Latvian budget seasonality!
Expenditure of the general government sector, quarterly data, 2004 – 2007,
mill. LVL (nominal)

Source: Statistical Bureau of Latvia

Back then, with dizzying growth rates, tax revenue flooded into the Ministry of Finance – just to be spent as quickly as it entered. Look e.g. at the fourth quarter of 2006. Spending there rose by no less than 71% compared to the third quarter – record fiscal incontinence if you ask me and we know that even at these unsustainably high growth rates with their record tax revenue avalanches, the government still recorded budget deficits.

It should thus not be surprising that having revenue and expenditure more or less meet in normal times as well as recession times requires massive consolidation. I still recall the best description I have heard of Latvian fiscal policy in those days: Out of whack!

We should also recall the exit strategy for this consolidation effort: Euro adoption by 2014. Given the fixed exchange rate, fiscal policy must be guided towards the internal devaluation via ‘intelligent’ measures, which certainly does not include an increase in the social tax that would reduce competitiveness.

This is an anti-tax country – OK, then expenditures also have to be low and I am sure that there is still a lot of scope for expenditure cuts. Look e.g. at page 13 in this presentation from last year’s Bank of Latvia conference – Latvia has a far higher proportion of public sector employees than most countries in the EU and also much higher than in our neighbouring countries. Why so?

Many have considered it some sort of victory that consolidation might be just 280 mill. LVL next year instead of the originally proposed 400 mill. or so. But there will still be massive consolidation left for 2012. Is it wise not to bring some of this on already now?

If Latvia really wants to join the eurozone by 2014 it must be within the 3% budget deficit criterion by 2012 – and not just at 2.9%. The EU could easily argue that this cannot be interpreted as sustainable; thus the deficit has to be well within the limit, requiring yet more effort.

But does the country really want to do what it takes to join the eurozone by 2014? Officially yes, I guess, but I am starting to doubt whether this really holds. The first budget proposal does not point in that direction as I pointed in my previous post. I’ll have one yardstick by which to measure the real seriousness: Pensions. Whatever the Constitutional Court says, I don’t see pensions continue on current form.

Latvia has been hailed as a model for the so-called PIGS countries (Portugal, Ireland, Greece, Spain) for how to undertake austerity and internal devaluation. But it should also take seriously the lessons coming from these countries: That if financial markets don’t find fiscal policy sustainable they punish countries by high interest rates. That, combined with renewed uncertainty about the exchange rate, which would undoubtedly prevail, is not really what Latvia needs when it soon has to start to refinance some of the international loans. Thus, no time to play Russian roulette with the economy, no reason to become the new Argentina.

Morten Hansen
Head of Economics Department
Stockholm School of Economics in Riga