Latvian Lessons

The Baltics are growing after austerity—and they resent Mediterranean bail-outs

It is hard to believe, walking past gleaming mansions along the sand dunes of Jurmala, that Latvia has endured a crisis as deep as Greece’s. Latvia’s over-exuberant boom was cut short by the global financial crisis in 2008, bringing a banking crash, a huge budget deficit, a bail-out by the European Union and IMF and one of the harshest austerity regimes in Europe. Unlike Greece, Latvia made the wrenching adjustment with striking speed, and has since returned to robust growth (its prime minister, Valdis Dombrovskis, even managed to be re-elected).

Latvia’s neighbours, Estonia and Lithuania, are also recovering. And the Baltic trio managed it while keeping fixed exchange rates. They offer an example to troubled euro countries of how to carry out an “internal devaluation”. Where Greece may soon have to leave the euro, Latvia wants to join in 2014. Touchingly, some people still think of the single currency as a good thing.

At a time of acute gloom, EU and IMF bigwigs see hope in this Baltic resilience. At a conference in Riga this week, Christine Lagarde, the IMF’s boss, called Latvia’s achievement a “tour de force”. Her chief economist, Olivier Blanchard, said his scepticism about the currency peg had been proved wrong. For Anders Borg, the Swedish finance minister, Latvia was enjoying a “graduation day”; if it did not qualify for the euro, who could?

It is easy to forget the economic and social cost. Latvia lost more than a fifth of its GDP in two years. Unemployment shot up to 20% (and remains high). Emigration has risen in a country already struggling with a declining population. Productivity is low. And Latvia has some of the EU’s most glaring inequalities. Still, the Baltic states are growing faster than any other part of the EU, more than can be said for the recession-hit Mediterranean.

The reasons are complex. The Baltics are in a catch-up phase of development. The Mediterranean has suffered a triple blow: low-tech industries hit hard by globalisation, cost competition from ex-communist members of the EU and the loss of their habitual escape valves of inflation and devaluation. Competitiveness can now be regained only by painfully pushing down wages and prices. Speaking recently in Brussels, the IMF’s Nemat Shafik compared such a process of internal devaluation to painting a house. “If you have an exchange rate you can move your brush back and forth. If you don’t have an exchange rate you have to move the whole house.”

So can the chilly Baltic teach the balmy Mediterranean this superhuman feat? “We have shown the world there are better solutions than devaluation,” says Ilmars Rimsevics, governor of Latvia’s central bank. Rather than making adjustment harder, he says, the currency peg was essential for credibility. In any case, devaluation would have pushed up inflation and increased the burden of euro-denominated loans and mortgages.

The IMF thinks that, where possible, deficits should be cut gradually over the medium term. But Latvia believes that deep, front-loaded austerity is the best way to win back market confidence. In Greece politicians of all stripes blame the EU and IMF, to a greater or lesser extent, for their misery. In Latvia, though, it is international lenders who warn Latvia against too much austerity, and against hastily removing emergency social safety-nets.

As small and open trading economies with flexible labour markets, the Baltics were able to push down wages faster than more rigid and closed Mediterranean countries. The Balts’ main trading partners are northern countries that are doing well. And for all their suspicion of Keynesianism, they were helped by the stimulus policies around them. Now Mediterranean countries must try to recover at a time when most others are tightening their belts as well. Moreover Baltic states benefited by having friendly foreign-owned banks that did not pull out of the region; although Latvia’s Parex bank went bust, Sweden provided a vital backstop to most Baltic banks.

In drawing such north-south comparisons, there is a danger of falling into stereotypes and romanticising, say, Germany’s influence through the old Hanseatic League. Post-Soviet Balts face problems with corruption as deep as those of any Mediterranean country. That said, a history of occupation and hardship may have made the Balts more willing to put up with austerity. What sticks in the craw for Estonia, which is now in the euro, is having to bail out much richer Greeks.

All this may mean the Baltic is more of an exception than a model for the euro zone. Still, there are valuable lessons. First, low debt helps. Latvia’s contraction more than quadrupled its debt burden to about 45% of GDP, but that is still less than half the debt ratio of Italy and Greece before the crisis. Second, international lenders need to be clear-eyed: if a country cannot repay its debts, they must be restructured early and decisively. Fudged assessments condemned Greece to unsustainable debt and inadequate financing, which fed the constant fear of a chaotic default. Latvia, by contrast, was allocated more money than it needed.

Spain and Ireland show that preserving stability requires more than sound public finances. Private-sector debt can be ruinous, too. But both countries would be helped if, like Latvia, they had external support for their banks. This suggests a third conclusion: the need for a “banking union”, a European-level system to regulate, restructure and directly recapitalise ailing banks.

Lastly, the Latvians say the promise of euro membership was vital to keep them on course. The idea of the euro as a haven may seem laughable. Yet besides a fear of collapse, voters need the promise of a better future to underpin austerity. For euro members, this can come only from some future promise—such as joint-liability bonds for those on a credible path of reform.
The Ukrainian Week