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For the last three years, Latvia has been one of the fastest growing economies in Europe. Its GDP grew by 5.5 percent in both 2011 and 2013. This performance is a remarkable turnaround after its GDP declined by one-quarter in 2008–09, when Latvia was most badly hit by the global financial crisis. The question raised by Latvia's extraordinary success is what conclusions to draw.
Fortuitously, Olivier Blanchard, the chief economist of the International Monetary Fund (IMF), has written a perceptive factual analysis together with his colleagues Mark Griffiths and Bertrand Gruss, former and current IMF mission chiefs for Latvia (for simplicity: BGG).
Paul Krugman, who long has seen Latvia's policies and their success as a threat to his advocacy of fiscal stimulus in the United States, has written a surprisingly sensible response to this excellent analysis. As Latvian economic success is evolving, we are gradually arriving at some consensus, which is approaching the view I came to in my book a How Latvia Came through the Financial Crisis, coauthored with Latvian Prime Minister Valdis Dombrovskis in 2011.
Both BGG and Krugman limit their discussion largely to the output gap and productivity growth, but I shall add the extreme liquidity freeze and the Latvian government's sensible political economy.
BGG point out that in 2007 Latvia operated at 12 percent above its potential GDP. This means that its actual GDP was 12 percent more than output capacity. Krugman questions this premise. First, he considers it conceptually dubious. But if you have resources that are borrowed in the short term you receive more value added throughout the economy because the calculation is based on a percentage of the resources used, whether in retail, banking, or construction.
Second, Krugman rightly poses the question: "How often do we see the kind of huge positive gap posited for Latvia?" Very seldom, he rightly answers with empirical evidence. The Latvian situation was extreme. In 2006 and 2007, Latvia had an extraordinary current account deficit of no less than 22.5 percent of GDP. Any current account deficit beyond 4 to 5 percent of GDP is usually considered unhealthy, and this was extreme. One consequence was that Latvia had an average annual GDP growth of 10 percent from 2005–07. As the IMF rightly pointed out at the time, there was nothing normal in this situation, while the more euphoric than competent Latvian government of that time actually used the slogan: "The pedal to the metal!" Both conceptually and statistically, Latvia had a large positive output gap, which must be recognized.
A second point that BGG emphasize is that austerity was not the cause of the output decline in Latvia but the consequence. Austerity took root only in mid-2009 after almost all of the output fall had occurred. Latvia was exposed to the most extraordinary liquidity squeeze of any country, though Estonia and Lithuania faced similar liquidity squeezes because the European Central Bank (ECB) did not offer any swap credit lines to these countries, as the Federal Reserve did for many solvent countries.
Swedish and Danish banks held most of the Baltic banking assets, but neither country belongs to the euro area, so neither had access to ECB liquidity. Therefore both Denmark and Sweden felt compelled to raise interest rates in the fall of 2008. The Baltic countries suffered the worst from liquidity squeeze. This explains why the Baltic states were hit by much larger output contractions than Bulgaria, which had very similar conditions, with a currency board and a large current account deficit similar to that of Latvia. Ironically, Bulgaria was saved by having Austrian, Greek, and Italian banks, which all had access to abundant ECB credits! I would suggest adding this point to the BGG paper.
Impressively after all his previous criticism of Latvia, Krugman makes this statement: "Latvia was a hugely, perhaps uniquely overheated economy that even a Keynesian would agree needed a lot of fiscal austerity..." Thank you! This has been our point all along.
A third point that I consider the greatest new achievement of the BGG paper is its illumination of the development of wages, productivity, and unit labor costs (ULCs) in manufacturing from the end of 2008. Latvian productivity in manufacturing rose by an incredible 9 percent a year throughout the crisis. From 2008–10, unit labor cost in manufacturing plummeted by 30 percent, which is good, while wages in manufacturing were back at their 2008 level in late 2010, which is also good. As BGG put it: "The adjustment of ULCs and prices was surprisingly fast. In contrast to expectations and the textbook adjustment, it came largely from productivity increases, and has been reflected in larger profit margins rather than lower prices." This is a truly intriguing conclusion and worth further study. Labor-shedding is of course part of the answer, but manufacturing expanded during the crisis, while construction, financial services, and public administration contracted.
Krugman makes the suggestion: "Maybe Latvia just had an impressive productivity trend, owing to its particular position in the European system, and simply returned to that trend after a brief setback." True, Latvia had a wonderful productivity improvement until 2007, which Krugman shows, but then it stagnated for two years when the construction, finance, and public sectors overheated and crowded out manufacturing and export industries. Therefore, major reforms were required to restore the prior trend. Otherwise Latvia would have been a typical middle-income trap country.
But Latvia undertook extraordinary structural reforms, such as cutting one-third of the civil servants and closing half the state agencies in one single year. Most probably, the outstanding Latvian productivity development since 2009 is a result of all these structural reforms. That would contradict the absurd and unsubstantiated view that it takes years for structural reforms to become effective. Yet, this remains to be properly measured.
My fourth and final observation relates to the political economy of reform or financial adjustment. Valdis Dombrovskis became prime minister in March 2009 when the economy was in free fall. Today, he is the longest serving prime minister in post-communist Latvia, having been reelected twice. Naturally, political sustenance depends on personal skills and luck, but he has done many things correctly, according to the lessons taught by Samuel Huntington and John Williamson. He did whatever he could as early as possible; he made sure to have an agreement with all available social partners before he launched his cure; he explained that there was no better alternative; he mobilized sufficient foreign assistance; he suffered with his people and took many of the costs of the nation upon himself and his ministers.
Latvia—as well as Estonia, Sweden, Finland, Poland, and Germany—shows that it is not necessarily politically costly, even in the short term, to pursue sound economic policies (aka austerity), while all the profligate anti-reform countries in southern Europe show that it is politically very costly to pursue irresponsible policies of slow economic adjustment.
The broader conclusion from the Latvian crisis experience is that early and comprehensive structural reform and radical fiscal adjustment pay off both economically and politically.
