Why austerity doesn't work, Latvia edition

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By:
Kanika Saigal, Euromoney Skew
Published on:

Commentators argue that Latvian-style austerity would not work for countries such as Italy and Spain. For some, this is because Latvia is a special case; for others, Latvia isn't even the exception and the dark side of austerity is showing its head.


Much ink has been spilt in recent months on the Latvian example for the eurozone.

First, the context. Advocates of fiscal authority, not least Latvia’s own central bank governor Ilmārs Rimševičs, casts the country as Europe’s austerity poster child – an example of how countries such as Italy and Spain can turn their economies around via internal disinflation in a contracting economy that does not benefit from exchange-rate flexibility.

Latvia's exceptional growth rate was crushed after the global financial crisis in 2008. GDP growth contracted by 18% in 2009 after highs of 12% in 2006. Determined to keep its currency peg because of its commitment to join the euro, Latvia underwent a period of fast front-loaded fiscal adjustment. While austerity led to a loss of output of almost 20% of GDP in one year, and a rise in unemployment to 18.4% – from 6% in 2007 – by 2011, Latvia appeared to be out of the darkness and GDP grew 5.5%.

However, in recent weeks, two instructive commentaries have surfaced that argue Latvia's policy of austerity was a special case. International Monetary Fund chief economist Olivier Blanchard – who was a cause of much tension in Riga given his bearish stance over Latvia’s economic policy mix – in a recent blog post, highlights several points for why the country is an outlier:

"The [front-loaded fiscal] adjustment was preceded by an unusually strong boom, so there was wide acceptance on the part of people that part of the downward adjustment was a return to normal. Some of the tough measures were seen as undoing the excesses of the past, for example the very large increases in nominal wages during the boom... ...There was support for fiscal consolidation, and the acceptance of pain. Parties which argue for stronger fiscal austerity often did better than the others at the polls. Pedagogy, a factor emphasized by the prime minister was surely important. But historical reasons, including the painful transition from central planning in the 1990s, surely played an important role. The Latvians could take the pain...

... Public debt was very low to start, less than 10% of GDP. Even today, public debt remains around 40% of GDP. This more or less eliminated foreign investors’ worries about default on sovereign debt, and allowed for a quicker return of Latvia to international financial markets."


So, for Blanchard, it wasn’t austerity measures in themselves that supported Latvia’s economic recovery, but the context in which they were introduced. Fiscal adjustments were propped up by a combination of economic, political and social factors favourable to austerity. He says, in that case:

"The sad truth is that many of these conditions are not satisfied elsewhere. True, the adjustments that these countries have to make are smaller than those Latvia had to make. But their economies are less flexible, less open. They have less obvious potential gains in productivity, at least in the tradables sector. They had much higher public debt to start."
Other commentators have adopted a more bearish stance and say Latvia is yet to feel the full consequences of its recent economic policy. Two of those include economists Michael Hudson and Jeffrey Sommers


"Latvia is not a model for austerity in Greece or anywhere else. Both the impression that neoliberal policy has been a success and the claim that Latvians have voted to support this failed model are incorrect."
The dire consequences have begun to rear its ugly head in Latvia, but the worst is yet to come, they argue:

"Why have so many left Latvia if it is such an economic success, with such popular support for austerity as the advocates claim? Birth rates fell during the crisis – as is the case almost everywhere austerity programmes are imposed. Only now is Latvia seeing the social effects of austerity. 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."
And Latvians are far from having a culture fit to contend with the restrictions that austerity brings. Instead, they say its culture dictated the populations’ political choices:

"The resulting austerity programme is anything but popular. Latvia’s parliament often polls approval ratings in the single digits. Yet the government has survived two elections. How is one to read this?

Chiefly by ethnic politics. The biggest party opposing the austerity programme (Harmony Centre) largely represents ethnic Russians and had no chance of winning given its focus on rights for Russian speakers. The smaller parties run by post-Soviet oligarchs also are seen as being in league with Russia and are widely resented for fiscal imprudence during the boom years, when oligarch-controlled parties were part of the governing coalition. So the only political force left is the “austerians”. While most voters dislike their economic policy, a majority are convinced that they are best able to resist Russia’s embrace. All other issues come a distant second for Latvian voters."


Either way, both Blanchard, and Hudson and Sommers, reach the same conclusion. 

Time for plan B.