Baltic countries no role model for austerity

The idea that suffering is good for both the soul and the economy is widely held. To “austerians”, a financial crisis is a mark of moral turpitude, to be redeemed only by suffering. But an economy exists on Earth, not in the afterlife.

Those who advocate the path of austerity need to show that it is not just moral, but effective. How is this to be done? By pointing to successful examples.

In Europe, that example is often the Baltics and, above all, Latvia, a crisis-hit country that was rescued and is now – we are told – blooming. Is it? And, if it is, does this bring lessons for others?

The answer to both questions is: only up to a point.

All three small Baltic states – Estonia (population 1.3 million), Latvia (two million) and Lithuania (three million) – enjoyed credit-driven booms before the financial crisis.

In 2007, Latvia’s current account deficit was 22 per cent of gross domestic product, Estonia’s was 16 per cent and Lithuania’s 14 per cent. The domestic counterparts of the capital inflows were huge private-sector financial deficits: 23 per cent of GDP in Latvia, 19 per cent in Estonia and 13 per cent in Lithuania.

As usual, the booms flattered fiscal positions: Estonia’s net public debt was minus 4 per cent of GDP in 2007, Latvia’s 5 per cent and Lithuania’s 11 per cent.

Then came the four horsemen of financial crises: “sudden stops” in capital inflows, asset price collapses, recessions, and fiscal deficits. In reply, the Baltics decided to stick to currency pegs and embrace austerity.

A substantial rescue package was also negotiated for Latvia in late 2008, with generous support from the EU, the International Monetary Fund, the Nordic countries and others. Yet some doubted whether the programme would work.

'Recipe for disaster'
Olivier Blanchard, the IMF's economic counsellor, stated last June that "many, including me, believed that keeping the peg was likely to be a recipe for disaster, for a long and painful adjustment at best, or more likely, the eventual abandonment of the peg when failure became obvious". He has been proved wrong.

According to the IMF, Latvia tightened its cyclically adjusted general government deficit by 5.3 per cent of potential GDP between 2008 and 2012, to achieve a small surplus of 0.8 per cent in the latter year.

Over the same period, Lithuania tightened its cyclically adjusted deficit by 3.3 per cent of potential GDP. (The IMF does not provide this data for Estonia.) But Greece’s tightening was 15 per cent of potential GDP between 2009 and 2012.

How has the strategy worked? Defenders point to recent rapid growth. Latvia’s economy, for example, grew 16 per cent between its trough, in the third quarter of 2009, and the fourth quarter of 2012. But it shrank by 25 per cent between the fourth quarter of 2007 and its trough.

In the fourth quarter of 2012, Latvian GDP was still 12 per cent below its pre-crisis peak. This is worse than in Ireland, Italy, Portugal and Spain. The other two Baltic states have done better, though also after huge slumps.

These huge recessions do matter. For Latvia, the cumulative loss from 2008 to 2012 adds up to 77 per cent of the country’s pre-crisis annual output.

On the same basis, the loss was 44 per cent for Lithuania and 43 per cent for Estonia. In the fourth quarter of 2012, Latvian GDP was 41 per cent below where it would have been if the 2000-2007 trend had continued.

Estonian and Lithuanian GDP were 34 per cent below trend. Unemployment has been falling but it was still 14 per cent of the Latvian labour force in December 2012, as it was in Ireland.

Historic depression
In brief, Latvia, worst-hit of the Baltic countries, suffered one of the biggest depressions in history. It is recovering. But it has not yet fully recovered. Are its policies a model for others? In a word, no.

These states have four huge advantages in pursuing the strategy of expansionary contraction.

First, according to Eurostat, Latvian labour costs per hour in 2012 were a quarter of those of the euro zone as whole, 30 per cent of those in Spain and half those of Portugal.

Given the potential for further rapid rises in productivity, the country did not need a big real depreciation to become competitive.

Second, these are very small and open economies. The more open the economy, the larger the portion of output not dependent on recession-hit domestic spending. This makes external adjustment a more potent alternative to domestic stimulus than in larger economies. Between 2007 and 2012, Latvia’s current account deficit shrank by 21 per cent of GDP.

The same adjustment would be just 0.3 per cent of Italian GDP. Its trade partners hardly notice Latvia’s adjustment. But they would notice a comparably large Italian one.

Again, Latvia’s population shrank by 7.6 per cent and Lithuania’s by 10.1 per cent between 2007 and 2012. That has to flatter the unemployment picture. If Spain and Italy had lost the same proportion, it would have been 11 million.

Third, foreign-owned banks play a central role in these economies. For the euro zone, this is the alternative to a banking union: let banks with fiscally strong host governments take over the weaker financial systems.

Finally, the Baltic states have embraced their European destiny as an alternative to falling back into Russia’s orbit. Their people have reason to prefer painful adjustment to displaying any wavering in this political commitment.

Other crisis-hit countries also have reasons for the commitment to Europe, but to a far smaller extent. That makes their acceptance of austerity weaker.

Expansionary contraction
Are the Baltic states and, particularly, crisis-hit Latvia a model of expansionary contraction? In the short run, the answer was surely no: the contraction was contractionary.

Subsequently, they were able to combine a huge external adjustment with restoration of growth, though, in Latvia, output is still well below its starting point, joblessness is very high and emigration was huge.

Is Latvia a plausible model for others, particularly for far bigger countries? Of course not. What is possible for very small and open economies is close to impossible, economically – and so socially and politically – for large and relatively closed economies.

The idea that we should view all countries, let alone the euro zone, as if they were small open economies that did not interact with one another is an intellectual disease.

It is why euro zone policymakers seem happy to ignore demand. It is also why the adjustment process has been so grim. One can argue that Latvia is a model for tiny countries. But it is simply crazy to think it a model for Europe. – (Copyright The Financial Times Limited 2013)