Of ‘smart austerity’

 

Latvia’s Economics Minister, Daniels Pavļuts, had an article in the Wall Street Journal on 22 November; an article which deserves merit for various reasons.

It is much better than the often stereotypical ‘austerity vs. stimulus’ debate and I think his term ‘smart austerity’ is here to stay!

A couple of good points from the article: 1) That the strategy had a focus on future growth (structural reforms, leaner government) and was not just aiming at austerity for austerity’s sake. 2) That removing macroeconomic imbalances was necessary to restore confidence, which was so obviously at an all-time low in June 2009 (the time of the really big devaluation scare). USA (and the UK and some other countries) may not have lost investor confidence but Latvia certainly did, just witness the drop in its credit rating at the time. Restoring this has been essential.

But I also have to address what I think is a somewhat more dubious claim: Decreasing the non-taxed minimum, as was done during the crisis, and increasing VAT are both highly regressive measures and do not contribute to “safeguarding social stability”. I agree that e.g. the 100-lat programme has done so but wasn’t it then prematurely stopped?

Overall, I am not happy if the standard narrative becomes one where “the burden of [adjustment] fell disproportionately on the well-to-do” as e.g. argued (point 15) in this otherwise useful piece by Anders Aaslund. I think reality is quite a bit more nuanced than that.

But the plusses outweigh the minuses in minister Pavļuts’ article and he is certainly right when criticizing Paul Krugman for asserting that since Latvia’s GDP is still below its pre-crisis peak, its economic policy is not a success. I would like to elaborate on that since it gives me an opportunity for some graphs.

Paul Krugman has made his points on various occasions, here is just one link. Below is a graph similar to the first one he provides. GDP peaked in Q4 2007, then collapsed 24.6% until Q3 2009 after which it has grown consistently but is still now, Q3 2012, 13.5% below its peak.

Figure 1: Latvian GDP, quarterly, 2004 – 2012, seasonally adjusted. 2007 Q4 = 100.

Source: Central Statistical Bureau and own calculations

But so what? Q4 2007 and Q3 2012 have very little in common. At the end of 2007 the economy was extremely overheated and GDP was 16% above its equilibrium level as estimated by the European Commission. Such a degree of overheating will hopefully never take place again so why compare with it? Furthermore, employment in Q4 2007 was 1.107 million (see Figure 2) out of a labour force of 1.171 million whereas today’s employment is 0.882 mill. out of a labour force of just 1.023 mill. Thus, Q4 2007 can never ever be reached again in terms of employment, given that the labour force is now less than employment was then*.

Figure 2: Labour force and employment in Latvia (1000s), quarterly, 2004 – 2012

Source: Central Statistical Bureau

Note: 2011* refers to the numbers adjusted for the latest census

OK, refer to this dramatic fall in the labour force as a failure in itself since a lot of it is due to migration but even this is not the whole story. As everyone here knows demographics has started affecting the labour force. As Figure 3 shows, inflows into the labour force are now coming from the very small cohorts of young people born around 20 years ago. This in itself lowers the labour force and will do so for many years to come. Blame this on transition but you cannot blame it on the recession and its economic policy.

Figure 3: Number of live births in Latvia, 1980 – 2011

Source: Central Statistical Bureau

Summing up, at the peak of the boom the Latvian economy was employing more people than it ever again will and it was more overheated and imbalanced that it ever has been and hopefully never will be again – why on Earth should the current GDP level be compared to this outlier to judge success or failure of Latvian economic policy???

* Even with possible adjustments due to the census this will not happen.

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