Failure of Austerity in Europe? What Does the Latvian Exception Prove?
Writing in The New York Times this week, Paul Krugman argues that austerity has failed in Europe. Budget cuts and tax increases were supposed to provide the confidence needed to get troubled EU economies back on track, but the “confidence fairy” hasn’t shown up. Austerity has not just failed to work, says Krugman—it has made matters worse. He shares the view, held almost universally outside official circles, that doubling down on austerity will not save Greece, Ireland and Portugal from eventual default in one form or another.
Meanwhile, there is the case of Latvia, where a stringent austerity program, supported by the EU and the IMF, predates those of Greece, Ireland, and Portugal. Austerity brought on a stunning 18 percent drop in Latvian GDP in 2009, but now the country is returning to growth. Unemployment and the budget deficit are still high, but falling. Is Latvia the exception that proves that austerity is a good idea after all?
First some numbers to back up the general impression that Latvia is pulling out of its slump, in contrast to Greece, Ireland, and Portugal, which have not yet hit bottom:
- Real GDP growth for 2010/2011: Latvia -0.3/+3.3; Ireland -0.1/+0.6; Greece -4.5/-3.5; Portugal 1.3/-2.2.
- Unemployment, most recent level and trend: Latvia 17.3, falling; Ireland 14.7, rising; Greece 14.1, rising; Portugal 11.1, flat for now, likely rising soon.
- Ratings: Latvia’s sovereign debt was upgraded from junk to the lowest investment grade; Greece, already deep in junk territory, has recently been downgraded further; Ireland and Portugal have not yet fallen below the lowest investment grade, but they are on the way down and have received warnings that even the softest restructuring of Greek debt could push them into junk territory.
All three countries had large current account deficits at the height of the boom, reflecting heavy borrowing by the government sector, the private sector, or both. Latvia’s current account swung to surplus for 2010, as did Ireland’s in the second half of 2010. The current account balances of Greece and Portugal remain deep in deficit. Latvia’s currency, the lats, is pegged to the euro, but core inflation has been negative since mid-2009, allowing real appreciation of the lats relative to the euro. Rising productivity has further improved competitiveness. According to central bank data, the wide gap between wage and productivity growth that had opened in the boom years from 2005 through 2008 had closed again by mid-2009. Export growth has been strong.
What is the explanation of Latvia’s relative success? Policy makers deserve their share of credit for designing a plausible program and sticking with it, but it must also be pointed out that Latvia went into its austerity program with advantages not shared by others.
One advantage was a very low level of government debt going into the crisis. In 2007, Latvia’s gross government debt was only 9 percent of GDP, lower even than Ireland’s 25 percent, and far better than Portugal (68 percent) or Greece (105 percent). The severe recession sent Latvia’s debt soaring, of course, and it is expected to top out at 50 percent of GDP next year. Still, that is far better than the other three countries that are receiving EU and IMF emergency aid, all of which will soon see debt rise above 100 percent of GDP. Very few countries in history have recovered from government debt ratios over 100 percent without default.
A second advantage was that Latvia had little by way of a domestic banking sector. Banks based in neighboring Scandinavia dominate the Latvian market. All of them took hits from the collapse of the Latvian property bubble, but none failed. More importantly, few banking losses showed up on the balance sheet of the Latvian government. Parex, the country’s one large domestic bank, was the exception. Parex failed and was nationalized in 2009, but its market share going into the crisis was only 14%. By contrast, the government of Ireland assumed losses from the failure of its big banks that ended up dwarfing the modest national debt with which it entered the crisis.
A third plus for Latvia has been a fairly stable political situation. It would be an exaggeration to say that austerity has uniformly been welcomed by Latvian voters. Nonetheless, they reelected their government in October 2010, a fact cited positively by credit rating agencies. Violent demonstrations have been a rarity. In contrast, austerity programs brought down the governments of Ireland and Portugal, adding to uncertainty. National elections in Greece are not scheduled until 2013 and the government has so far resisted calls for early elections, but its political position has been weakened by threatened defections, strikes, and frequent demonstrations.
Taken together, do all of these considerations mean that austerity was the right path for Latvia? Not necessarily. Latvia differs from Greece, Ireland, and Portugal in yet another important respect: It is not a member of the euro area. Although its currency has been pegged to the euro since 2005, the link is purely voluntary. While there is no easy way for a member of the euro area to return to its own currency, Latvia could end its fixed exchange rate policy at any time.
Other EU members that maintained floating exchange rates, like Poland and the Czech Republic, were not as badly hit by the financial crisis. Their competitiveness, like that of Latvia, had suffered during the years of rapid growth and strong financial inflows that followed their 2004 entry into the EU. However, when the crisis came, the floating rate countries were able to restore competitiveness quickly by allowing their currencies to depreciate. Fixed rate countries, in contrast, were able to restore competitiveness only through fiscal austerity and deflation, a painful combination known in Latvia as internal devaluation. (For additional details comparing fixed and floating rate countries, see this earlier post and slideshow.)
What, then, are the lessons we can draw from the Latvian case? Is Latvia the exception that proves that austerity is a good idea? Only, it would appear, in a very qualified sense.
Yes, Latvia does show that a stringent austerity program can restore growth and solvency if it enjoys majority political support and if the country has not yet gone beyond the point of no return in its accumulation of public and private debt. Without the needed political support and with too much initial debt, austerity may well fail.
However, Latvia does not convincingly demonstrate that adjustment through internal devaluation (a fixed exchange rate plus austerity plus deflation) is better than the alternative of adjustment by way of a floating exchange rate. To say this means neither that countries already in the euro should leave it, nor that floating rate countries like the United States have no need for fiscal discipline. It does mean than floating rate countries have an important added degree of freedom in coping with external shocks. With a little common sense, they should be able to avoid the stark choice between forced austerity or insolvency.
Finally, the very success of the Latvian experiment underlines how difficult it is to maintain a currency union without fiscal or political union, especially among a group of highly diverse, highly indebted countries like the members of the euro area. Latvia’s willingness to walk over hot coals in its determination to join the euro is admirable. Let’s hope the euro survives long enough for them to make it in.
16 Responses to “Failure of Austerity in Europe? What Does the Latvian Exception Prove?”
Thanks for this clear explanation Ed. I really feel strongly that a sovereign nation must have its own currency. I have to research the whole impetus behind the EU because if it was just to facilitate trade then I would have really opposed it. Not having control of the currency seems like building a country (which is a wonderful feat) and having someone else run it.
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As a former student of yours I must say that this is a very good read like many of your previous articles!
I'd still like to throw in just a few more additional points to consider about Latvia (and also Estonia & Lithuania)
First of all, any of these countries is much smaller economy than Greece or Portugal, and much more export oriented. It just happens that next door we have Sweden and Finland which are both experiencing real estate booms right now. Economic activity there is just very strong. Baltic countries export all sorts of things to the Nordics, and we now have a export led recovery – exports and industrial production going through the roof – this is something Greek and Portuguese surely would love to have.
Secondly, I'd say that there are at least some signs of the 'confidence fairy' showing up. Take a look at the Latvian government bond yields, which are not even investment grade by S&P. These yields are LOW. OK, they are higher than Germany or France, but much lower than any of the indebted periphery countries.
Finally, perhaps the debt burden we got ourselves in, was not that big after all. There is very strong delevering going on, and yet Estonia posted 8% GDP growth in first quarter. If we continue at the current pace, private sector will have all debts paid off by 2014.
All in all, my point is that for very small open countries a lot of things can happen over fairly short periods – and it is sometimes hard to foresee these things.
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