Although I don’t usually mention Latvia along with the four large bubble markets of the UK the US, Spain and Ireland, Latvia went through a housing bubble and bust that was just as severe. The policy response in Latvia was austerity. But because Latvia, like Ireland has re-emerged from economic contraction, a debate has now developed whether the country is an example of the success of austerity or further proof of its failure.
What is now clear to policymakers is that austerity in a post-crisis environment has a severely negative impact on private demand and growth. In the euro zone in particular, many economists were surprised at how much economies in the periphery contracted due to economic austerity in the form of spending cuts and tax hikes. Readers of this site were not surprised as I have been saying for a long time that indebted private sectors do not have any capacity to meet government spending cuts with anything but cuts of their own due the debt stress associated with the post-credit bubble environment. Using the sectoral balances approach, it becomes clear quickly that when a credit bubble pops, leaving behind an indebted private sector, public sector cuts are amplified because of this debt stress and the private sector’s need to increase net savings to alleviate it.
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