Latvia Shows the Way, Proving Some Famous Merchants of Doom Wrong

May 23, 2012 1:00 PM

Today, the Latvian government can claim victory. In the first quarter of this year, Latvia’s annualized GDP grew by 6.8 percent, the highest growth rate in Europe, and last year Latvia recorded a growth rate of 5.5 percent, the third highest in Europe. Four years ago, GDP plummeted by a total of 24 percent because of the sudden stop of international financing in September 2008. But that decline lasted only two years. Unemployment has fallen from 21 percent in early 2010 to 16 percent two years later.

How times can change. In December 2008, Paul Krugman claimed, “Latvia is the new Argentina.” In June 2009, Nouriel Roubini asserted that “devaluation seems unavoidable” and that the International Monetary Fund (IMF) and the European Union were “throwing good money after bad” in their support of Latvia’s stabilization program.

But Latvia did not devalue. Instead it carried out a vigorous “internal devaluation,” with large cuts in public expenditures and wages as well as structural reforms, while supported financially by the IMF and the European Union. Many argue that Latvia is special, but the Latvian government did exactly what it was supposed to do and the Latvian people understand that. Remarkably, Valdis Dombrovskis, who became prime minister in the midst of the crisis in March 2009 and led the cure, has been reelected twice in parliamentary elections since then.

Latvia’s crisis resolution is a political economy success story. The only strange feature is that, to the surprise of people who should have known better, everybody in Latvia did more or less what they were supposed to do and they did so in time. The government managed to carry out its policy in a cohesive fashion and restored both domestic and international confidence at an early stage. Latvia’s achievement boils down to five crucial principles, which the South Europeans have ignored—and continue to ignore—at their peril.

First and perhaps most important, Latvia used the grave sense of crisis in the fall of 2008 to take action. When a country is in a serious crisis, any delay of crisis resolution is harmful.

Second, the government composed swiftly a comprehensive anti-crisis program, which was heavily front-loaded and thus restored confidence early on.

Third, the program contained more expenditure cuts than revenue increase measures, which helped restore confidence early and drove structural reforms, and which are likely to promote economic growth. The crisis forced Latvia to trim its public sector, rendering its already efficient economic system even more competitive. The front-loaded Latvian anti-crisis programs encountered minimal social resistance. The Latvian government proved that radical spending cuts and structural reforms are perfectly possible in well-functioning democracies.

Fourth, the IMF and the European Union provided early and sufficient international financial support, making the crisis resolution financially sustainable.

Finally, the government managed to sell its adjustment program to the electorate, by clarifying how severe the crisis was and by making sure that more of the burden of the crisis was borne by those who were better off.

The governments in Southern Europe could have followed in Latvia’s footsteps, but they chose not to. They have satisfied none of these five crucial conditions. It is true that their public debt burden is far larger, but proportionately they have been offered far greater financing than Latvia, while they have done far less. Their actions have not been commensurate with their conditions. It is time to realize that the question is not whether the Latvian lessons are relevant to Southern Europe, but when the Southern European governments will face up to reality.