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.
The result of austerity then is what economists call large negative fiscal multipliers which create a debt deflation scenario in which private sector agents are forced to cut spending in response to debt stress from falling asset prices and then forced to cut even more because of a loss of income due to austerity. This feeds reflexively and negatively into asset prices whose value is undermined by falling incomes and spending, increasing debt stress and forcing further private sector spending cuts. Greece is the worst current example of how debt deflation leads to depression and worsening economic fundamentals.
Latvia is an example of how the debt deflation cycle has been arrested and growth has resumed even without currency depreciation or further government stimulus. The result is that Latvia has become a controversial economic symbol in the ideological war that has developed during the financial crisis about appropriate economic responses. Below are several articles dating back to Late 2011 that feature differing views on how to understand Latvia. I highly recommend reading them all to get a sense of both what’s going on in Latvia, but also the degree to which the country’s economic performance can be extrapolated to other situations.
My post here was precipitated by a German-language article in the Austrian newspaper Kurier that I read last night in which the Latvian Prime Minister defends his country’s economic performance. In euro zone core countries like Austria and Germany, the Latvians are considered a success by many and used as an example for the periphery to support current policy. Latvia is about to join the euro next year as it fulfills all the macro economic criteria. The Latvian premier tells Austrian newspaper Kurier why and why he believes no referendum is necessary to do so. Please translate that article and read it.
Valdis Dombrovkis, the Latvian premier, talks about how he believes the Latvian austerity approach has been a success. This is a good wide-ranging interview that I recommend highly. And note, on the issue of austerity, I am more interested in the political outcomes than anything else because politics are what is now driving the policy response since the economic results are subject to different interpretations.
When a credit-fueled economic boom turned to bust in this tiny Baltic nation in 2008, Didzis Krumins, who ran a small architectural company, fired his staff one by one and then shut down the business. He watched in dismay as Latvia’s misery deepened under a harsh austerity drive that scythed wages, jobs and state financing for schools and hospitals.
But instead of taking to the streets to protest the cuts, Mr. Krumins, whose newborn child, in the meantime, needed major surgery, bought a tractor and began hauling wood to heating plants that needed fuel. Then, as Latvia’s economy began to pull out of its nose-dive, he returned to architecture and today employs 15 people — five more than he had before. “We have a different mentality here,” he said.
“Most pieces written and published on economic topics in our newspapers are morality tales rather than economic analysis. Economic analysis is boring and thus only a few people are going to read it. By contrast, morality tales pull at the heartstrings like a Hollywood script. They contain words and phrases that most readers can identify with – sentiments that they too have felt, either in the past or in the present.
Without understanding this it is simply impossible to grasp articles such as the one published on the New York Times website on New Year’s Day which depicts the extreme austerity experiment undertaken in Latvia over the past few years as a success. After reading it I initially made my way over to Eurostat to look at the data and see if the facts led to a different narrative of Latvia’s experience with austerity.”
“A generation ago the Chicago Boys and their financial supporters applauded General Pinochet’s anti-labor Chile as a success story, thanks mainly to its transformation of their Social Security into Employee Stock Ownership Plans (ESOPs) that almost universally were looted by the employer grupos by the end of the 1970s. In the last decade, the Bush Administration, seeking a Trojan Horse to privatize Social Security in the United States, applauded Chile’s disastrous privatization of pension accounts (turning many over to US financial institutions) even as that nation’s voters rejected the Pinochetistas largely out of anger at the vast pension rip-off by high finance.
Today’s most highly celebrated anti-labor success story is Latvia. Latvia is portrayed as the country where labor did not fight back, but simply emigrated politely and quietly. No general strikes, nor destruction of private property or violence, Latvia is presented as a country where labor had the good sense to not make a fuss when faced with austerity. Latvians gave up protest and simply began voting with their backsides (emigration) as the economy shrank, wage levels were scaled down, and where tax burdens remained decidedly on the backs of labor, even though recent token efforts have been made to increase taxes on real estate. The World Bank applauds Latvia and its Baltic neighbors by placing them high on its list of “business friendly” economies, even though at times scolding their social regimes as even too harsh for the Victorian tastes of the international financial institutions.
Can this really be a model for the United States or Europe’s remaining social democracies? Or is it simply a cruel experiment that cannot readily be emulated in larger countries un-traumatized by Soviet era memories of occupation? One can only dream …”
“So we’re looking at a Depression-level slump, and 5 years later only a partial bounceback; unemployment is down but still very high, and the decline has a lot to do with emigration. It’s not what you’d call a triumphant success story, any more than the partial US recovery from 1933 to 1936 — which was actually considerably more impressive — represented a huge victory over the Depression.”
“Latvia hopes to join euro in 2014 – and other eastern European countries with similar ambitions are watching carefully”
“Austerity’s advocates depict Latvia as a plucky country that can show Europe the way out of its financial dilemma – by “internal devaluation”, or slashing wages. Yet few of the enthusiastic commentators have spent enough time in Latvia to understand what happened. Its government has chosen austerity, its people have not. Finding no acceptable alternative, much of the labour force has elected to emigrate. This is a major factor holding down its unemployment rate to “just” 15 per cent today.
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 opening of European borders, combined with the effects of the crisis, has meant that smaller towns in these countries are quite simply dying as young people leave to look for work elsewhere. One of Europe’s smallest countries, Latvia, has suffered more than most.”
“Germany believes the only solution to the euro crisis is painful austerity measures – but if everyone’s slashing and burning, who is buying?”