Latvia provides a poor example to Greece and others

The IMF’s Christine Lagarde has been the latest to praise the Latvian austerity drive, holding it as an example for other countries to follow: “It’s important for other crisis-ridden countries to learn from Latvia. The programme there was a success”. She even went so far as to claim: “All the three Baltic countries have pursued similar economic policies and the results are similarly spectacular”. Meanwhile, economist Anders Aslund has claimed “the Baltic countries, on the contrary, have seen a stunning expansion of exports and manufacturing after the crisis that not even the greatest optimists predicted”. Aslund has even written a book on the Latvian recovery, co-authored with Latvia’s right-wing Prime Minister, Valdis DombrovskisHow Latvia Came Through the Financial Crisis. Increasingly the country is becoming the poster boy for the pro-austerity lobby, looking for successful examples.

Does the Latvian example provide a successful example of a country undergoing austerity, tackling its key structural problems and returning to the path of economic growth? An analysis of the evidence gives a very different picture.

Latvia’s crash was the most spectacular of any of the countries to suffer from the recession, with GDP cumulatively falling by 25% and unemployment tripling, from around 7% to a peak of 20.7%. Nils Muiznieks, a University of Latvia social scientist has claimed that Latvia slumped even faster than Great-Depression-era America. This period followed an extraordinary boom in the Baltic states: in the three years prior to the crash, Latvian GDP grew by a third in just three years, and salaries doubled. The government responded faster than any other country in imposing harsh austerity measures.

Latvian fiscal adjustment, around 16%, has been faster and deeper than any other country. Desperate to join the Euro in the near future, the government refused to devalue the currency, instead pegging it to the Euro, and pursuing a policy of “internal devaluation”, now being imposed on Greece. Between 2008 and 2012, the budget deficit has been cut by an impressive 12% to 3% of GDP. Public sector wages were cut by 40%. Civil servant numbers were cut by almost a third. These deep cuts almost certainly deepened the recession, but since then there has been modest growth, and unemployment has fallen to 14%- though this is still high, even by European standards, and double its pre-crisis value.

Latvia GDP growth

Latvia Unemployment

Despite the claims of the pro-austerity lobby, it’s obvious such growth doesn’t amount to a miracle. Latvia and the other austerity-driven Baltic states have seen essentially no increase in total industrial production in five years, GDP remains some way below its 2008 value. Even neighbouring Russia has managed to increase total production overall in the same period. Nonetheless, Latvia has fared better than other countries suffering under austerity and it’s worth understanding why.

Latvia began with a number of key advantages: the post-Soviet economy has a large, poorly unionised Labour force and relatively low wages compared to Western Europe. This has allowed wages to fall far more quickly than in other European countries- an advantage for keeping employment high, but it has led to sharp declines in standard of living. Latvia also began with relatively low public sector debt.

But perhaps more significant has been the huge EU and IMF rescue package: amounting to some €7.5bn, which amounts to a staggering third of Latvian GDP in return for its severe austerity program.  The EU contributed €3.1bn, the IMF €1.7bn and a further €2.7bn from other lenders. In 2009, the IMF held back loans whilst pressing Latvia to make more reforms. Nonetheless, its clear that the huge rescue package has allowed Latvia to weather the crisis more successfully than most austerity-laden countries. Repayment of these loans will soon be due to begin.

But perhaps the most important- and shocking- factor in explaining the relatively high decline in unemployment has been emigration. Census figures reveal only around 2 million people in a country that officially thought it had 2.2m. It is believed some 10% of Latvians have emigrated to escape the country’s plight. Overwhelmingly, this has included the most educated and highly skilled segments of the Latvian labour force. Such a decline is more than sufficient to explain the high fall in unemployment.

Meanwhile, birthrates have been falling (as with almost all countries experiencing austerity drives), and the government is now trying to intervene to encourage higher birth rates. The company is at risk of falling into a demographic trap, the elderly being stuck in the country as the young and mobile labour force emigrates. The social consequences of the austerity program have been severe. Professors Michael Hudson and Jeffrey Sommers who have been advising the Latvian government on alternatives to austerity write:

It has among Europe’s highest rates of suicide and of road deaths caused by drink driving. Crime is high because of prolonged unemployment and police budget cuts. There is less accessible, lower-quality education and there is a soaring brain drain alongside blue-collar emigration.

How has Latvia been able to impose such cuts politically? The People’s Party broke from the ruling coalition in 2010 over the issue of tax cuts, but Valdis Dombrovskis remains in power. According to Michael Hudson and Jeffrey Sommers, this is largely due to ethnic politics: the anti-austerity parties are largely seen as pro-Russia. Whilst most voters dislike the austerity program, the ruling party is best seen as being able to resist their looming Russian neighbour.

Latvia then, does not give a good model of successful austerity. At best, it shows that a country can experience modest growth after austerity only if it receives huge international support, in this case in the form of loans. A small country can cut its unemployment due to wide-scale emigration- but with the whole of Europe experiencing high unemployment this is not a viable model, and the long-term implications for Latvia may be very damaging indeed.

The IMF would do well to choose better examples. European countries should look at the evidence very carefully before choosing to adopt a Latvian-style austerity program. To quote Paul Krugman:

The bottom line is that while Latvia’s willingness to endure extreme austerity is politically impressive, its economic data don’t support any of the claims being made about its economic lessons.

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