I spent a few short days in Latvia last week. My meetings centered on industrial policy, which Latvia is serious about – quite interestingly for a country that is often viewed as a hotbed of conservative economics. But my time there also gave me an opportunity to reflect on the country’s much discussed response to economic crisis.
Briefly, Latvia rejected much external advice and did not devalue, despite a huge current account deficit that exceeded 20% of GDP in 2007. The lat had been pegged to the euro in anticipation of Eurozone entry and the government refused to do anything that would jeopardize that goal. The IMF were told to go home if they were going to insist on devaluation.
In the end, the country implemented a radical fiscal contraction that pushed the country back into external surplus. The shock produced a loss of output of almost 20% of GDP in one year, and a rise in unemployment to 18.4% (from 6% in 2007). By 2011, the worst seemed over and the economy grew at a healthy rate of 5.5%, one of the highest in Europe.
If you listen to advocates of fiscal austerity, such as central bank governor Ilmārs Rimševičs, Latvia is a huge success -- an example for Greece, Spain and others on how to do it. On the plus side, growth has returned faster than most anticipated, exports are up, unemployment has come down, and the political system appears more stable than it has been for some time. Despite complaints about the legal framework and poor implementation, foreign investors are reasonably satisfied. Eurozone entry is still planned for 2014.
On the negative side, the collapse in GDP was the deepest any country experienced during the present crisis. Even though a recovery seems apace, the country is still far from recuperating to output levels prior to the crisis (see chart). Iceland, which was hit with an even larger financial crisis, imposed capital controls, devalued its currency, and avoided as sharp an economic contraction as Latvia. When I brought up this counterfactual, Rimševičs cut me short and argued that Iceland benefited from special export conditions.
Even though Latvia’s external imbalance was eliminated, it is not clear that there has been a sizable improvement in competitiveness. The much vaunted internal devaluation has been small. Wage cuts have been mostly in the public sector, where they don’t really help with export competitiveness. Private sector wages have been surprisingly resilient. As the next chart shows, the unit labor costs-based measure of the real exchange rate has come down (depreciated) only moderately, following a huge rise over 2004-2008. Consequently, it is not at all clear whether Latvia has regained sufficient competitiveness to sustain growth without running sizable external deficits yet again.
To an outsider what is the most striking aspect of the Latvian experience is the relative absence of political conflict and social strife during what must have been a catastrophic economic crisis. When I brought up the news articles that mentioned Lativa’s largest street protests since the Russian occupation at the height of the crisis, my hosts assured me that these were in fact minor. Just a few hundred people, acting up for the cameras, they said. Greece this was not.
Why? Not because the political system is particularly functional (there are in fact too many small parties) or there are no ethnic cleavages (the Latvian-Russian divide remains deep). I was told that Latvians are stoic people, that they keep their problems to themselves.
The main lesson I take from all this is the need to avoid easy generalizations that do not respect country peculiarities. Fiscal austerity missionaries are surely off base when they say Latvia’s experience decisively proves Keynesians and advocates of currency depreciation wrong. It is too early to judge the Latvian experience a success. But it is also too early to say Latvia has been a failure. Growth may continue, in which case the country will look better and better.
One thing we can say for sure, however, is that the kind of drastic fiscal austerity that proved feasible in Latvia would not be possible in many other countries. Rimševičs and others stress that Latvian policy was successful because they took it on the chin and implemented the fiscal measures with speed and determination. Perhaps. But it is also true that they got away with vastly underestimating the costs of their measures. Latvian policy makers had expected a 10% fall in GDP in 2009; instead they got one that was nearly twice as large. The real secret of their success is that they did not have a revolution on their hands.