Latvia as the model country for successful austerity?

The terms ‘internal devaluation’ and ‘austerity’ were not much used until rather recently, indeed, ‘internal devaluation’ seems to have been coined just a few years ago, but these days both are synonymous with Latvia.

Following the IMF – Bank of Latvia conference on 5 June 2012 a hefty debate on whether or not internal devaluation had been successful in Latvia emerged. I tried to cover both sides here and my own view is that a high degree of success cannot be dismissed but it has not been an outright victory – it is not either black or white as most of the debate unfortunately has been.

Very much the same can be said about austerity. This piece, by Michael Hudson and Jeffrey Sommers, which I addressed here for its unfounded allegations e.g. concerning crime rates in Latvia, claims that in no way or form might Latvia be a model country for others. Anders Aaslund, of the Peterson Institute, comes to the exact opposite conclusion, writing e.g. that “Latvia’s crisis resolution is a political economy success story”.

My own take is again that I find that it was more of a success than not but that there were casualties along the way and, crucially, parts of the austerity programme should have been different. I present a few arguments below, some of them perhaps even new to the debate.

As with internal devaluation there is no agreed-upon set of criteria by which one can judge whether austerity has been a success or not. Nobody would claim that everybody should heap praise on this policy for it to be a success. Austerity hurts many individuals and in many places; thus rather widespread dissatisfaction should be expected. The current Prime Minister of Latvia has been reelected twice during the austerity period – to me that is a sign of (perhaps grudging) accept of the necessity of these measures. Hudson and Sommers argue that these reelections can be mostly explained by ethnic politics. To me that rings hollow – even Harmony Center was willing to accept the IMF-EU package for a place in government, thus creating very broad consensus around the austerity measures. Governments have fallen in all the other major crisis-ridden countries – Ireland, Portugal, Spain, Italy, Greece – but not here.

They also argue that people have voted against austerity with their feet (or, perhaps better, with one-way airBaltic tickets) by emigrating. True, emigration seems to have been massive (for me the far by best coverage of this issue is here, by Mihails Hazans of University of Latvia) but it was also substantial before the crisis. Then I think it is fair to say that people mainly emigrated because of the wage differences between Latvia and, say, the UK. During the crisis I am perfectly happy to admit that high unemployment has been the major driver of emigration. But what would have been the alternatives to austerity? The most discussed policy is devaluation of the lat – perhaps it would have brought activity to the economy faster and resulted in less migration although the evidence from Iceland, an economy that devalued heavily is not so strong – Iceland’s recession lasted even a bit longer than Latvia’s. But an argument that I haven’t really seen is that with a devaluation, Latvian wages, in terms of euros, would have been significantly reduced – wouldn’t this have created incentives for emigration of the same sort as during the boom? I think so (and would almost have been a necessity for those with euro-denominated mortgages).

Or what about just letting fiscal policy carry on without austerity? In no way possible – Bank of Latvia estimates that the budget deficit would have approached 20% of GDP in 2009 without some sort of consolidation, something that would have been impossible to finance, not least given the credit markets of late 2008.

In short, there were not many options available and none of them would have been without pain.

And there are several signs that austerity has worked:

• The recession was deep but rather short – around two years. Greece is in its 5th year of recession and counting.

• Growth has resumed; in fact Latvia is the fastest growing EU economy (5.1% for the second quarter of 2012 over the same quarter of 2011). OK, this is on a cheap background with an anemic Eurozone…..

• Public finances have been stabilized.

• Financial markets find the austerity measures both credible and sufficient: Latvia is again investment grade and no longer rated ‘junk’ by any of the big rating agencies. The country has been able to tap financial markets at reasonably low interest rates and in general interest rates are lower than in e.g Greece and Spain.

This evidence just cannot be dismissed. But does it provide lessons for other countries? I know that for some Anders Aaslund is like a red piece of cloth in front of a bull but his piece offers 20 arguments for the apparent success in Latvia and some of them are useful lessons also for other countries. For me the main reasons for why Latvia’s performance cannot so easily be copied are his points 12 and 18: Heavily front-loaded measures and, crucially, implemented early. Many of the Southern European countries have been very indecisive and have dithered for very long with no serious measures taken. As such, austerity fatigue began almost before austerity and pursuing more austerity now should be expected to be very hard – you may say that the lesson from Latvia is a negative one.

Still there are lessons from Latvia, e.g. Aaslund’s point 15 and where I disagree with him. He claims that “Latvia designed its adjustment program so that the burden fell disproportionately on the well-to-do”. I don’t think the programme was all that equitable – sure, some new taxes were introduced that targeted mainly better-off people (tax on interest income for instance) but lower incomes have been hurt quite a bit via the reduction of the non-taxable minimum. Something that caused more migration than otherwise would have occurred? I don’t know but this is the kind of discussion that would be much more valuable: Not whether austerity was the right thing to do (it was but of course it hurt some groups) but rather whether the right austerity measures were taken. And perhaps other countries might take this into account in their own austerity efforts.

As a PS I would like to add: Whether austerity or not was the right thing to do, as a tax payer I am very happy that now we actually know how many people work in the public sector and also that there has been introduced a wage grid. One wonders if that would have happened without austerity measures?

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

PS Hudson and Sommers write that “… much of the labour force elected to emigrate”. This made me consider the following pretty far-out thought experiment in what seems to be referendum-happy Latvia: What if people could be given the choice between the current economic situation and an ‘Icelandic alternative’ – devaluation of some 50%, imposition of capital controls but an unemployment rate of only 7-8% (which would be very low for Latvia – the average for the past 10 years is above 10%)? How would people vote? In no way or form can I prove this but my gut feeling says for austerity. (The closest evidence I can provide is polls from Greece that consistently speak of 75-80% in favour of keeping the euro instead of abandoning it and allow a new currency to devalue).