More about what they have in common later…..
Everyone agrees that the past few years have been a rollercoaster experience: During 2004-07 Latvia had the highest GDP growth in the EU; then between the fourth quarter of 2007 and the fourth quarter of 2009 the economy contracted 25.1%, also the biggest recession in the EU.
When it comes to who is to blame (politicians, commercial banks, central bank, IMF, you name it…) points of view differ, just as they do with respect to what should have been done to contain the boom and/or to soften the recession and this has been discussed ad nauseam and is thus not the topic of this article.
Rather, I would concentrate on another issue where I imagine quite a lot of agreement should prevail but an issue that has not (?) received that much attention: The pervasive uncertainty that such a rollercoaster development implies for the business environment – what can we expect from economic growth next year? What can we expect from price developments next year? – and, from that, wrong economic decisions and thereby a misallocation of economic resources prevail.
Just a quick but very well-known example: “Panorama Plaza” tower # 3. Should never have been built, has zero economic value and is thus a waste of cement and labour.
No doubt foolish economic decisions were made during the “fat years”, but it also must have been quite difficult to be your average entrepreneur or businessman.
As an example I have taken data from the hotel and restaurant industry, which is a quite cyclical sector of the economy; it performs very well in good times, is quite hard hit in bad times (due to high income elasticity as we would say). This cyclical behaviour is indeed present from the two graphs below but it is not just present, it is insane! Massive growth 2004 – 2007, then a huge slump wiping out almost half of the income generated previously, making the general development of the economy, already the most spectacular in the EU, look puny by comparison. Similarly with price developments – prices rising much faster than in the economy in general, then a severe deflation as empty rooms force drastic price cuts.
Your average hotel guy responded to the good times by carpet-bombing Riga with hotels, hostels and B&Bs. Should he/she have known that this was a bubble?
What too much alcohol and too low interest rates have in common is that they make people do things they tend to regret later. No doubt that there was dubious hotel investments resulting from what was labelled “excessive optimism” at the time. But we cannot demand that these business people can perfectly read the data and deduce that there will be major crisis some years down the road – most economists didn’t see it. Rather these and other business people were provided with a too-good-to-be true economic environment that partly fooled them into making wrong economic decisions.
Lesson: One of a government’s many tasks is to try to provide a sustainable and “reasonable” economic development creating certainty around economic fundamentals such GDP, inflation etc. All of this was grossly neglected in the “fat years” and the result is a massive waste of economic resources in terms of unemployed labour and misallocated capital. Not exactly what a relatively poor country needs.
P.S. Perhaps “Panorama Plaza” tower # 3 has some economic value after all: It serves as a reminder of what happens when the economy applies a “pedal to the metal” approach.
Morten Hansen is Head of Economics Department, Stockholm School of Economics in Riga
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