On January 13, 2009, 10,000 people protested in the center of Riga, Latvia's capital, against the government's austerity policies and the country's program with the International Monetary Fund (IMF).
The demonstration was followed by riots. Three days later a similar demonstration took place in Lithuania against its government's austerity policy-and it too ended with riots. What is happening with the previously so calm and successful Baltic states?
The three Baltic countries-Estonia, Latvia, and Lithuania-have long been among the leaders in postcommunist reform. In fact, in my book, How Capitalism Was Built, I concluded without any hesitation:
The Baltic states... are the star performers [among postcommunist countries]. They are full democracies with normal market economies and predominant private ownership. They have a steady, high growth rate of around 8 percent a year. Their corruption is low, and their budgets are close to balance. The Baltic governments are small and well-run.
Most of all, I praised Estonia, which is the postcommunist country with the least corruption.
I was not directly engaged as an economic advisor to the Baltic countries, although I was a member of the nongovernmental International Baltic Economic Commission in 1991-93. Yet I have visited them frequently over the last three decades and been a strong supporter of their reform policies.
Today, however, the three Baltic economies are in a deep economic crisis. Estonia and Latvia experienced a decline in their GDP of about 2.5 percent last year. And this year the Baltic economies are expected to contract by at least 5 percent.
These economies have suffered from one key problem: excessive current account deficits. Latvia took the prize with a deficit of 23 percent of GDP in both 2006 and 2007, but Estonia and Lithuania were also above 10 percent of GDP, with a current account deficit exceeding 5 percent of GDP generally considered unhealthy. But much of the deficit, 8-9 percent of GDP, was financed healthily with long-term foreign direct investment.
The problem, however, has been short-term capital inflows, largely from foreign (mainly Swedish) banks, which has led to overheating of the Baltic economies. Latvia had an average GDP growth of 11 percent in 2005-07.
Because all three countries maintain fixed exchange rates to the euro, the inflows boosted the money supply and drove up inflation, which reached 15 percent in Latvia last year. High inflation, combined with a fixed exchange rate, raised production costs, pricing the Baltic countries out of the market, especially as neighboring Russia, Sweden, and Poland let their currencies depreciate.
The expansionary bank lending stimulated housing purchases for mortgages, which grossly inflated real estate prices. The currency inflow resulted in excessive imports and a large trade deficit. Finally, all this private borrowing left Latvia with a foreign debt of 137 percent of GDP at the end of 2008.
The Baltic's bubble burst in 2007, when foreign banks belatedly slowed their lending. Housing prices started declining, and with them investment and private consumption, reducing GDP growth and boosting unemployment.
And yet the Baltic countries have been quite prudent in their fiscal policy. Until 2008, Latvia and Lithuania had almost balanced budgets, while Estonia was very conservative-with a budget surplus of 3 percent of GDP in 2006 and 2007. These countries have hardly any public debt, and Estonia has even accumulated a reserve fund from its budget surpluses.
The single policy mistake causing their hardship was the fixed exchange rates, which attracted the excessive capital inflows that caused the overheating. Because of the fixed exchange rates, the Baltic countries could not pursue an independent monetary policy, as interest rates were determined by the market.
Even if these countries could have hiked their interest rates, the result would not have been monetary contraction, but rather greater inflows of short-term foreign capital due to the fixed exchange rates. Bulgaria is in a similar bind, and Ukraine and Russia were so as well until their recent devaluations.
Ideally, the Baltic states should have abandoned their currency boards with fixed exchange rates four or five years ago to preempt overheating, but this was politically impossible at the time. The Baltic populations were happy with their stable exchange rates, and after joining the European Union in May 2004, they wanted to adopt the euro as soon as possible.
The European Central Bank demands two years of a fixed exchange rate plus the meeting of a number of Maastricht criteria before a country can be accepted into the Economic and Monetary Union. The Baltics were reasonably close, until their rising inflation disqualified them in 2006.
In hindsight, it was not wise to maintain the fixed exchange rates, but the correct policy choice was not obvious, and few countries committed fewer policy mistakes.
The fact remains that the Baltic countries have pursued more virtuous economic policy than virtually any other country in Europe. In a time of hardship, the Baltics can and should be helped. Fortunately, the international community has agreed.
In October 2008, Latvia asked the IMF for a stand-by program to manage its foreign account. The big question was whether Latvia should devalue or not.
Usually, a country escapes a cost crisis and external imbalance by letting its exchange rate float, which mostly leads to a substantial depreciation. This would have been very costly.
The Latvians strongly opposed devaluation. They seemed prepared to accept substantial social costs, including large wage cuts, and the Latvian labor market is very flexible. An early euro adoption remains their goal, with the government determined to reach the Maastricht criteria and adopt the euro by 2012.
With mortgages predominantly in euros, depreciation would lead to an avalanche of bad debt and mortgage defaults, which would aggravate inflation and the current output contraction. Given that Latvia is a small, open economy, the positive effect would be comparatively limited, which would only aggravate the depreciation. If Latvia were to devalue, Estonia and Lithuania would be forced to follow suite, which would make IMF programs with cofinancing also necessary.
As a member of the European Union, Latvia can count on European support. The European Union itself and the Nordic countries (but also Estonia, Poland, and the Czech Republic) contributed substantial cofinancing to the IMF package, which amounts to $11 billion for a country with a GDP in 2008 of only $32 billion. Latvia's small size makes this comparatively massive support possible.
But what about the public protests? The Latvian government is highly unpopular for having stifled investigations into high-level corruption and it does not enjoy much authority. Worse, it is one of the few incumbent governments in Eastern Europe to have been reelected.
It should call for new elections, especially because it could hardly be replaced by anything but another center-right government.
Fortunately, the arrested rioters were to equal extent Latvian and Russian, so the protests had no ethnic tinge. Nor was any foreign influence apparent, apart from the protesters' copying of the Greek youth riots.
In Lithuania, by contrast, a conservative government was just elected in October, and it has inherited its predecessor's economic problems. In Estonia, discontent appears less severe. So far, the ruling right-wing parties remain popular there, as the Estonian reformers have been most explicit in their explanations of their policies, probably making their population less inclined to protest.
Overall, even at this time of upheaval, my positive assessment of the Baltic political and economic reforms holds true. Democracy is not in danger, nor are their free-market policies. The big question is not regime change, but whether the Baltic economies will be able to pull through by cutting costs, or whether devaluation will be necessary.
Another question is: In which other postcommunist countries may social unrest erupt? After a decade of very high economic growth, they have all encountered their first serious recession.
The main peculiarity of the Baltics is that they faced the downturn first. Most incumbent governments are likely to lose their next elections, and some countries will probably opt for regime change. It remains to be seen what form these regimes will be: democracies or dictatorships. I bet they will be dictatorships.
Virtually all countries in the world are currently being hit by big declines in their standard of living. The situation is worse in countries, such as Latvia, where the government has not prepared the population for the possibility of a severe downturn. But Latvia benefits from a functioning democratic system that gives voice and leverage to the dissatisfied.
It is far worse in Russia, where Prime Minister Vladimir Putin denied the existence of a crisis until his Davos speech a week ago. Russians are hit hard, but they have neither voice nor influence. Their only option is to take to the street.
According to the Russian police, Russia saw no less than 407 social-protest actions around the country last weekend. The Russian regime seems far more fragile than the Latvian, where people only protest against the incumbent government.