Delusions in the Eurozone

Lessons for Latvia – prudent fiscal policy and strange definition of realism

It is no secret that I am in favour of Latvia joining the Eurozone. It is no secret either that at times I find that very zone rather delusional. Here one example of such delusion and what it should imply for Latvian economic policy.

Greece’s adjustment programme with the Eurozone and the IMF envisages a fall in Greece’s government debt-to-GDP ratio from 176% to 124%, i.e. some 50 percentage points, in the seven-year period of 2013 – 2020, see e.g. the EU Commission report or this latest news from Bloomberg. That is a massive decrease in the debt burden but not unprecedented – Ireland reduced its debt-to-GDP ratio by a similar size (from some 80% to around 30%) in the period 1995 to 2003 and by even more if one takes a longer time period but this was at a time of 8.8% annual average growth in Ireland.

The debt-to-GDP ratio may decline for four reasons: Lower interest rates, higher inflation, higher economic growth or a bigger budget surplus/smaller deficit. Greece has no prospects of high(er) inflation since it is part of the Eurozone and can no longer inflate away its debt. Given its 27% unemployment rate the country has strong growth potential and the country will return to growth relatively soon – GDP has been compressed to such a low base that a reversal of some sort will soon happen – but it is hard to imagine dizzying growth rates given the fact that many firms and consumers are overleveraged and banks are not exactly on a lending spree. The Eurozone and IMF offer somewhat lower interest rates (and longer maturities) on new loans to Greece but it is the budget position that the Troika focuses on. Greece is supposed to have a surplus on its primary balance (that is when interest payments on existing debt are excluded) of no less than 4.5% of GDP. And Greece, believe it or not, is actually moving in that direction, see Figure 1, which displays actual budget balance and primary balance for Greece since the Eurozone was created.

Figure 1: Actual budget balance and primary balance for Greece, 1999 – 2013

Source: IMF

Note: 2013 is an estimate, of course.

4.5% surplus is not unprecedented in the EU either, actually far from. Since 1999 it has happened at times in at least eight countries and as can be seen even Greece was close back in 1999 (the figure then was 4.4%). But moving towards a stronger primary balance requires (more) austerity and a primary surplus of 4.5% implies that tax revenue has to be some 110 EUR for every 100 EUR of government expenditure (still excluding interest payments). Can the Greek government accomplish this and will Greek tax payers accept this? Yes, indeed a rhetorical question…

What if Greece could at least achieve primary balance? The IMF has no forecast for the primary balance for 2013, see Figure 1, but it does not seem to be impossible to reach. If so, and if it could keep this balance until 2020 (another big if) and if, say, annual inflation would be 2% then some quick and hopefully not too wrong calculations require that annual economic growth in Greece must be 2 percentage points higher than the interest rate on government debt. Hmmmm…

Lessons for Latvia? Very simple – ultra-simple, actually – prudent fiscal policy and that is of course what the new Fiscal Discipline Law aims at. Below in Figure 2 a similar graph as Figure 1 but for Latvia. Latvia has already achieved a primary surplus. Given its relatively low level of debt (just over 40% of GDP or less than a quarter of Greece’s) no further austerity is needed to maintain this debt-to-GDP level or even see it decline. Not bad. Not bad at all.

Figure 2: Actual budget balance and primary balance for Greece, 1999 – 2013

Source: IMF

Note: No data on primary balance before 2003.

But a second lesson for Latvia must be that it is about to enter a zone that at times has a strange definition of realism…

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