What I learned in Latvia

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.  

Comments

[Macgupta123]

Prof. Jeffrey Sommers, who has spent years in Latvia, had this to say that is relevant to Latvian stoicism:

"Moreover, the airbrushing of Latvia's recent history by Samuelson and other pundits claiming the population has supported austerity is contradicted by the massive protests early on in its crisis. When these protests failed to bring about change, the public's response was to vote with their feet and exit the country. Indeed, when combined with its low-birth rate, this emigration from Latvia is creating a kind of demographic euthanasia that risks the very disappearance of this nation. "

http://www.guardian.co.uk/commentisfree/cifamerica/2011/sep/16/latvia-anders-aslund-austerity

[Macgupta123]

It is also worth noting in this several part youtube
Panel Discussion - Fiscal Austerity, Rainer Kattel, Jeffrey Sommers, Karsten Staehr, Tallinn University of Technology, Estonia, 2011

(URL to part 5
http://www.youtube.com/watch?v=1qx0iEA9XuY
)

Karsten Staehr notes that in Latvia the freedom ranking has fallen, see around 9:00 of this youtube:
http://www.youtube.com/watch?v=sRoabZRV-ik

that if someone writes in the newspaper convert your Lats into Euros, devaluation is imminent, they will be visited by the secret police.

[Macgupta123]

Sorry, in the previous comment, security police, not secret police, and they can go to prison.

[Gilberto42]

The ideologues of austerity are desperate to find positive examples, while, in fact, the question is, to be very generous, still open.

[Aivisindans]

Exports are up, so the trade deficit should decrease, right? In fact, it is increasing as the imports are growing quickly! Latvia's unnaturally strong currency isn't helping local companies as importing is cheaper for Latvians than exporting. This doesn't help job creation at all. Although I hardly ever speak bad about Latvia, I really think this "recovery" is good...look at the high unemployment and 300k+ that hve left the country.

Things are doomed, total reform is needed in Latvia - starting with the Lats.

[Aigarius]

I was living in Latvia and still am. There were no 'widespread protests'. There was exactly one notable protest, organised by a political party, after which a hundred or so people made a shouting match at the Parliament building while a another hundred or so hooligans used the confusion to burn a couple cars and loot liquor shops. It was over in a couple hours. There were no significant protests since.
And most of the people that left the country plan or have returned, with extra capital and new experience. I recently talked to a glass pane installer that had 15 years experience in Riga, then worked a couple years in Germany because of the crisis and there found out how wrong all his work has been, how inefficient, how bad on long term quality.
Our immigrants will learn a lot and come back to make our country better.
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[Macgupta123]

Population chart for Latvia:
http://www.indexmundi.com/g/g.aspx?c=lg&v=21

[Macgupta123]

...a hundred or so people made a shouting match at the Parliament

The New York Times, Jan 14, 2009, records 106 arrests at a protest where

"The rioting broke out Tuesday when around 10,000 people gathered in Dome Square for a protest that focused on political and economic grievances.

Most people dispersed, but several hundred protesters remained and started throwing snowballs and cobblestones at government buildings."

[Macgupta123]

And here is news of another protest from Feb 3, 2009, via the BBC:

http://www.bbc.co.uk/blogs/thereporters/markmardell/2009/02/riga_latvia_since_dawn_the.html

[Macgupta123]

And here is news of a trade union protest from June 2009.

http://dalje.com/en-world/latvia-unions-protest-deep-budget-cuts/266189

"Several thousand people protested on Thursday against harsh Latvian budget cuts needed to win more international loans..."

[Macgupta123]

There is even a paper:
http://www.etd.ceu.hu/2010/kalacinska_diana.pdf

SOCIAL PROTEST IN LATVIA 2006-2009: POLITICAL DISENCHANTMENT AND IDENTITY FORMATION
By Diana Kalainska
Submitted to Central European University Department of Political Science

In partial fulfilment of the requirements for the degree of Master of Political Science

Supervisor: Professor Bela Greskovit

[Janiszalitis]

Macgupta, isn't the end of your quote saying EXACTLY the same Aigarius said?

"Most people dispersed, but several hundred protesters remained and started throwing snowballs and cobblestones at government buildings."

Yes, there were protests, but these were nowhere on the scale to what happened in other countries.

Much of the (temporary) emigration was in large part caused by many people having high mortgage loans which they were not ready to default upon.
That's not to say there weren't other reasons, of course.

[Martin Mattsson]

Prof. Rodrik, please see the following thoughtful post by Simon Wren-Lewis explaining why a devaluation would have been the least costly policy option. Furthermore barring deflation Latvian style - aggressive deflationary policy is more costly than a more gradual deflation (at least in theory, SWL is not that concerned about riots which you may argue are more likely in a drawn out gradual downturn).

http://mainlymacro.blogspot.com/2012/06/what-is-it-about-latvia.html

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I am really glad that you said it as part of your observations, but it is so true, that Latvia and its way of handling all the different issues, that the country went through and their thriving now, in compare with the situations, not just in Spain and Greece, but Italy and France too, should be an example on how to do it!Thanks for sharing with all of us, your in-depth outlook on the so pressing issues today, revolving in the so called Eurozone.
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There is another, and potentially far more serious dimension to the Latvian economic crisis - and one that has gotten far less mention than emigration (which is far from insignificant, as the most recent Census counted 2.07mn instead of the expected 2.22mn; regardless of Aigarius' anecdotal evidence to the contrary).

That is the almost complete collapse of the total fertility rate. The TFR had recovered to 1.45 in 2008, its biggest showing since the early 1990's depression; since then, however, it collapsed to 1.14 by 2011. A modest demographic recovery in the mid-2000's was cut short and this will translate into far fewer workers two decades down the line.

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Quote "when I brought up this counterfactual [Iceland], Rimševičs cut me.."

counterfactual seems like academic jargon; could have left out the polysyllabic word

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Portugal has just announced further austerity in part through a type of fiscal devaluation : small reduction in corporate contributions to social security and large increase in employees contributions (equivalent to a month salary). While I like the idea of innovative measures to boost export competitiveness in the absence of exchange rate policy I wonder if this is the way to go? In fact would it not be preferable to have a lengthier adjustment process with reduction in corporate taxes but without further reductions in disposable income? This would just require a greater focus on growth rather than a pure short term credit perspective. In addition would it be possible to think more out of the box and seek to negotiate options for direct support to exporting corporations with aome sort of carrot and stick approach ?

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I was in Latvia a while ago, too. And, I have to confess, it was really surprising that such a small country is so well-heeled in terms of the economy. Just consider this: the Latvian currency's rate against the Euro (or USD, for that matter,) is staggeringly high. Frankly, I wouldn't expect that of a post-Soviet country!
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