Commentary Type

Why Austerity Works and Stimulus Doesn't

Op-ed in Bloomberg


After five years of financial crisis, the European record is in: Northern Europe is sound, thanks to austerity, while Southern Europe is hurting because of half-hearted austerity or, worse, fiscal stimulus. The predominant Keynesian thinking has been tested, and it has failed spectacularly.

The starkest contrasts are Latvia and Greece, two small countries hit the worst by the crisis. They have pursued different policies, Latvia strict austerity, and Greece late and limited austerity. Latvia saw a sharp gross domestic product decline of 24 percent for two years, which was caused by an almost complete liquidity freeze in 2008. This necessitated the austerity that followed.

Yet Latvia's economy grew by 5.5 percent in 2011, and in 2012 it probably expanded by 5.3 percent, the highest growth in Europe, with a budget deficit of only 1.5 percent of GDP. Meanwhile, Greece will suffer from at least seven meager years, having endured five years of recession already. So far, its GDP has fallen by 18 percent. In 2008 and 2009, the financial crisis actually looked far worse in Latvia than Greece, but then they chose opposite policies. The lessons are clear.

A successful stabilization program must appear financially sustainable so that it can restore confidence among creditors, businesses, and people. Usually, a sound stabilization program can revive economic growth within two or three years, as Latvia's did. A few rules of thumb need to be followed. Latvia did them all; Greece not at all.

Regain Confidence

To regain confidence fast, reforms should be front-loaded. In 2009, Latvia carried out an arduous fiscal adjustment of 9.5 percent of GDP, 60 percent of the total needed, while Greece foolishly tried to stimulate its economy, as Spain, Slovenia, Cyprus, and other southern crisis countries did at the flawed advice of the International Monetary Fund under Dominique Strauss-Kahn, who was then the managing director.

In a severe crisis, it is much easier to cut public expenditures than to raise revenue. Moreover, taxpayers think the government should tighten its belt when they are forced to do so. Cuts in public spending accounted for two-thirds of the Latvian fiscal adjustment. It decreased government expenditures from a high of 44 percent of GDP in the midst of the crisis to a moderate level of 36 percent of GDP this year. Latvia has kept a flat personal income tax now at 21 percent and a low corporate profit tax of 15 percent.

Greece, by contrast, maintained high public expenditures of 50 percent of gross domestic product in both 2010 and 2011, when it was supposed to be pursuing austerity. It should cut its public spending to 40 percent of GDP to become financially sustainable. Then the Greek crisis would end. Greece has carried out a fiscal adjustment of 9 percent of GDP to date, but that is too little and too late. It is less than Latvia did in the first year, and Greece needs to do more.

An advantage of sudden and sharp cuts in public expenditures is that they can't be even, as some items can't be cut. Therefore they drive reforms. The Latvian government hit hard at the stifling bureaucracy that swelled during the preceding boom. It fired 30 percent of the civil servants, closed half the state agencies, and reduced the average public salary by 26 percent in one year.

It prohibited double-dipping by officials, who had earned more in fees from corporate boards of state-owned companies than in salaries. The ministers took personal wage cuts of 35 percent, while pensions and social benefits were barely reduced. The cuts prompted deregulation, and Latvia saw a boom in the creation of new enterprises in 2011.

'Most Corrupt'

By contrast, Greece has allowed clientelism and corruption to thrive. During the purported austerity, Socialist Prime Minister George Papandreou increased the number of civil servants by 5,000 from 2010 to 2011, because they were his power base. Transparency International ranks Greece the most corrupt country in the European Union.

A serious financial crisis requires international emergency funding. Latvia received substantial credits from the International Monetary Fund (IMF), the European Union, and neighboring countries. Altogether, the committed funds amounted to 37 percent of Latvia's GDP in 2008, but Latvia used 60 percent of the credits committed. In late December it paid back all its IMF loans almost three years earlier than necessary because it can borrow more cheaply on the market. Its six-year bond yields have plummeted to 1.7 percent, while the Greek 10-year bond yields are 11 percent.

In May 2010, Greece received far more help than Latvia did—the largest IMF credit ever—but its stabilization program was neither credible nor executed. The Greek public debt has been excessive, and it remains so after two substantial, yet insufficient, debt reductions. The government needs to seriously cut its spending, reduce its bureaucracy, and prosecute corrupt leaders, and the IMF and European Union have to become adamant about their conditions.

Furthermore, a front-loaded austerity program shows people that the government is up to the task. Latvia experienced violent riots in January 2009, but in March 2009 Valdis Dombrovskis became prime minister. He stated that there were two alternatives, one bad and one worse, and he preferred the bad alternative. He reached agreement on his stabilization program with the trade unions and employers. Nothing works like success. Dombrovskis (with whom I co-wrote a book on the Latvian crisis) was re-elected in 2010 and 2011.

Greece has suffered from huge demonstrations and riots, and for good reason. For too long, public employees have maintained their privileges while others expressed frustration with an irresponsible government. Since June, it appears the new Greek government is finally becoming serious.

IMF Warning

Recently, the IMF warned that cutting government spendinghad more negative effects than previously thought. But the fund focuses on one single year. What really matters is how quickly a crisis can be resolved and the long-term growth trajectory, as Latvia shows so elegantly.

Last June, the IMF's managing director, Christine Lagarde, went to Riga to celebrate Latvia's success and did so in no uncertain terms: "We are here today to celebrate your achievements, but also to make sure that you can build on this success as you look to the future."

Now, however, the IMF complains that Latvia has cut social spending too much. Unemployment remains the main concern, but it has fallen substantially from 20.7 percent in early 2010 to 13.5 percent in the fall of 2012. Latvia is undergoing a major structural change, as an oversized construction sector has collapsed, and new manufacturing companies are expanding. Real adjustment takes time. Another complaint is the country's inequality, but that can only change gradually.

The US situation is quite different. As the world's biggest economy issuing the dominant reserve currency, it doesn't feel the pressures from the international credit market that a small economy does if it has a public debt exceeding GDP, as the United States now has. With Treasury yields at record lows and a required fiscal adjustment of only 3 percent to 4 percent of GDP, the US fiscal problem might be perceived as too small to solve. That is the great danger for the country.

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