Latvia vs. Greece – some comparisons, part III

This column is the third part of a series of three with ten observations on the Latvian and Greek economies to determine similarities and differences and to see who – if any – can learn from whom. 

Part I is here, part II is here.

Once again I allow myself to continue numbering from the first and second part; this makes it easier to refer to previous graphs if necessary.

This part is for a few reflections on the open economies of Greece and Latvia and some looking ahead.

9) When the Latvian economy came out of the doldrums in 2010 it was due to a sharp increase in exports (see Figure 12, later) due to increased demand from trading partners but also increased competitiveness vis-à-vis trading partners. This is seen in Figure 11 as a drop in the Real Effective Exchange Rate (REER), meaning costs and prices falling faster in Latvia or not rising so fast as in trading partner countries. Latvia lost competitiveness during the boom times but regained a considerable amount afterwards (the “internal devaluation”). For comparison I have added, as a benchmark, Germany, that super-competitive economy, to the graph. What we have is that Greece has by now a slower cost development than Germany when compared to 2002, which should mean much-earned competitiveness – internal devaluation works in Greece and not surprisingly so: With 28% unemployment there is no upwards push on labour costs, quite the contrary. But has this helped Greek exports, as the increased Latvian competitiveness after 2008-09 helped Latvian exports and the Latvian economy? Turn to Figure 12.

Figure 11: Real Effective Exchange Rate (REER) based on Unit Labour Costs (ULC) for Germany, Greece and Latvia, 2002 = 100

Source: Eurostat and own calculations

And as Figure 12 reveals, increased labour cost competitiveness has not really had much impact in Greece – Latvian export growth has consistently outperformed Greek export growth with the exception of 2013 and 2014 where either the advantages of Greek competitiveness really kick in – or Latvia is just underperforming due to sanctions and counter-sanctions vis-à-vis Russia. It is argued here that Greece’s poor export performance may be the result of increases in non-labour costs (such as energy) but, even so, competitiveness is not as important for Greece as it is for Latvia. Greek exports are a paltry one third of GDP whereas for Latvia the figure is close to 60%. A 10% increase in exports thus has about twice as much impact on the economy in Latvia than in Greece. And an economy cannot just “learn” to be more open, certainly not in the short run.

Figure 12: Export growth (%), Greece and Latvia, 2002 – 2014

Source: IMF

10) My tenth and last point does not seem to attract much discussion elsewhere where the debate is mostly about austerity, unemployment and Grexit but it should receive much more attention since it points to an abysmal future for Greece – and in the context of Latvia vs. Greece marks yet another major difference. Physical capital formation, i.e. investment in factories, offices, equipment etc. is what helps create tomorrow’s GDP. It was one of the major factors in the Latvian boom when cheap access to financing created a construction boom, see Figure 13.

But in an economy that continues a slow downward spiral (23 quarters of recession, see Figure 1), who wants to invest since the prospects for growth and thus for more goods to be sold in the future is so low? Rather, the downward spiral continues: Recession leads to higher unemployment, which means less income, which means less consumption, which means even less growth, which means even worse prospects for the future, which means even less investment, which means etc. etc…..

And capital formation in Greece is horribly low – at just 12% of GDP it is the lowest figure in the European Union and indeed in all of Europe and in the world for which the IMF has numbers (I checked…) it is only ahead of such stellar performers as the Central African Republic, Eritrea, Guinea-Bissau, South Sudan, Swaziland and Yemen…..

Latvia’s investment rate fell from an unhealthy high of 34% of GDP to just half of that but has recovered with the help of economic growth to a respectable, if not satisfactory, 21%.

Figure 13: Investment as a share of GDP

Source: IMF

Conclusions, part III

a) Greece is far from as open an economy as Latvia; thus competitiveness matters a lot less.

b) Once again, the speedy boom-bust-recovery of Latvia seems to be the by far best outcome; in this case in terms of investment. Investment in Latvia has recovered to a respectable level, in Greece it is abysmally low with dire consequences for the future.

Overall conclusions

So what are the lessons from Latvia for Greece and the lessons from Greece for Latvia from these ten points? A few, at best, and lessons for Latvia are more important than the other way round.

a) The two economies are very different; thus fewer lessons should be expected.

b) If austerity is to be imposed, then better fast and front-loaded than slowly. But it is too late for Greece to learn from this since years of decline have passed already.

c) There is much more to learn for Latvia – in a single currency zone don’t get anywhere near the fiscal problems that Greece has and has had. And, overall, avoid macroeconomic imbalances. Rather simplistic, perhaps, but I don’t think many – if any – had expected how severe Greece’s economic imbalances would turn out to be for its economy.

Summing up, many more points could be discussed – I have just chosen some that I find relevant and interesting and with the view that, although many ask what Greece can learn from Latvia, the answer is not all that much…. Rather, it is the other way round.

Note: Points of view expressed here on fiscal policy issues may not necessarily be those of the Fiscal Discipline Council.

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