It’s alive! 2004-2007 is back!

Remember 2005? The Latvian economy started to overheat with high growth rates, ultra-low unemployment, runaway wage growth and high inflation; all fuelled by a massive credit boom that ended in a huge bust.

A mini-2005 or “2005-light”, if you will, seems underway. Better try to control it this time instead of inflating it as was done then with recklessly loose fiscal policy.

The EU seems finally to be growing steadily again after the financial crisis, see Figure 1. 2.3% growth (2nd quarter 2017) may not sound like much but it is the highest for six years.

Figure 1: Annual growth rates in EU28, 2007 Q1 – 2017 Q2

Source: Eurostat

And for an open economy like Latvia’s, this is good for exports and for growth, see Figure 2.

Figure 2: Annual growth rates in Latvia, quarterly data, 2000 Q1 – 2017 Q1

Source: Central Statistical Bureau of Latvia

After some four years of rather anaemic development, growth is again taking off and the latest 4% is more than the current estimate for potential growth, i.e. to sustain this amount of growth, extra labour is needed and this is exactly what is happening, see Figure 3.

Figure 3: Unemployment rate, Latvia, monthly data, 2002-I – 2017-VI

Source: Central Statistical Bureau of Latvia

Unemployment in Latvia keeps declining, slowly but steadily, and at 8.3% (June 2017) it is at a nine-year low. In fact, only the 2 ½ year period of February 2006 to August 2008 has seen lower unemployment rates.

And then the story is the usual: Such a quite tight labour market creates competition for able labour; this bids up wages; first firms will let profits suffer but eventually prices will be raised to compensate for higher labour costs, inflation will be higher and external competitiveness will come under pressure with, eventually, some internal devaluation needed to restore competitiveness. This was highly painful last time (2008-2010) and should be avoided this time.

What to do? Two options are immediately available: 1) Raise capacity/productivity and thereby the economy’s potential growth rate. This may be underway with the part of the tax reform that lets reinvested profits in firms remain untaxed. If this creates a permanent raise in investment the economy will indeed raise its potential. Some have mentioned up to one percentage point of extra growth per year indefinitely – I remain rather sceptical: If this measure is so fantastic why was it not introduced earlier? And all around the world? But let us see. 2) When the private sector of the economy, consumption, investment and exports, starts booming, hold back in the public sector to avoid competing for the same, scarce labour; classical counter-cyclical fiscal policy to dampen the growth fluctuations in the economy. But signs here are not good – according to LETA on 18 August 2017, the Finance Minister reports a fiscal space (= possible spending) of 60 million EUR, which, if used, will add to labour market problems and not ameliorate them; pro-cyclical fiscal policy instead of counter-cyclical.

And add to this various other signs of “new optimism” for lack of a better word: The developments of New Hanza City and Teika and the new tram line in Riga as well as banking credit finally awakening from its long slumber. All of this feels like 2005. 2005-light, but still. Some short-term pleasure to be gained while scrapping under the carpet/ignoring some longer-term pain.

I had really hoped for policy to have become somewhat more far-sighted.

Morten Hansen is Head of Economics Department at Stockholm School of Economics in Riga and a member of the Fiscal Discipline Council.

Points of view expressed here are my own and not necessarily those of the Fiscal Discipline Council.