Europe, World — January 8, 2013 2:12 pm

From Riga to Athens: Can the Baltic Model Be Applied Elsewhere?

 Night falls upon an empty town square in Riga, Latvia.

Night falls upon an empty town square in Riga, Latvia.

Latvia is usually quite unremarkable: in the words of The Economist, “Even Latvians’ fans rarely call them exciting.”  Yet the obscure Baltic nation has recently drawn attention, along with its neighbors Estonia and Lithuania, for its quick recovery from the financial crisis through strict austerity and internal devaluation. Indeed, Christine Lagarde, IMF Managing Director, has held Latvia up as a model for other crisis-ridden countries like Greece.

There are certainly many factors that separate Latvia and the Baltics from Greece and the struggling countries of southern Europe.  Among these are the differing origins of the crisis, divergent economic structures, and opposing political and social climates. Despite these differences, however, the Latvian recovery and so-called “Baltic model” hold valuable lessons for the troubled Eurozone periphery, and Greece in particular.

Origins of the Crisis

It is difficult to understand the crisis and its subsequent management without examining the pre-meltdown economic situation. In Estonia, Latvia, and Lithuania, the 1990s and 2000s were marked by huge strides in economic growth. All three countries profited greatly from the introduction of market-oriented policies after the dissolution of the Soviet Union. Jeffrey Anderson, director for European Affairs at the Institute for International Finance, points out that Latvia gained from Russia’s strong recovery after the Russian devaluation of 1998, and from a reorientation of exports towards Western Europe. During the previous decade, large inflows of credit and foreign direct investment led to easy borrowing conditions and a spending boom by consumers, especially in real estate. Current account deficits mushroomed, growing from an already significant 6.6 percent of GDP in 2003 to 22.5 percent by 2007.

Toms Silins, ex-CFO of the Latvian arm of Swedish bank giant Swedbank, told the HPR that although some overheating was visible in the form of relatively high inflation, both the banking sector and Latvian policymakers were “overly optimistic on how to solve the issue.” In general, according to Silins, everyone expected that a convergence of living standards to Western European norms and the timely joining into the Eurozone would iron out any difficulties.

In Greece by comparison, there was a similar boom and optimistic expectations. However, unlike in Latvia, investors’ expectations for tangible benefits were realized very quickly. Because Greece joined the Eurozone starting in 2001, investors perceived minimal risk with Greek assets, and its borrowing costs were almost as low as Germany’s. Government and consumers alike took advantage of low interest rates to go on a spending spree, running budget deficits averaging 5.7 percent of GDP between 2001 and 2007, while Latvia’s deficits only averaged 1.2 percent.

The Crisis Hits Latvia

In the Baltics, the crisis started in late 2007 when foreign banks started pulling back the easy credit.  It was then exacerbated exponentially by Lehman Brothers’ bankruptcy in September 2008. Latvia was hit hardest. Its government was forced to nationalize the largest domestic bank, Parex Bank, to prevent the collapse of the financial system. This in turn caused Latvia’s budget deficit to balloon and forced the nation to seek a bailout loan from the IMF and European Commission in February 2009.

Latvia refused to follow the IMF’s advice to devalue the Latvian currency (the lat) relative to the Euro, choosing internal devaluation and austerity instead.  Anders Åslund, an expert at the Peterson Institute for International Economics, told the HPR that a “small economy [like Latvia] can’t safeguard itself with a floating exchange rate” because of volatility concerns. Hence, a currency peg is necessary. Had Latvia followed the recommendation to devalue its currency, he argues, the fall in the lat’s value would have been devastating, leading to “mass bankruptcies of banks” and a large risk of hyperinflation. Silins, who was working closely with the Latvian Central Bank at the time, notes that though a sharp devaluation could have led to a “quick adjustment,” it would have only masked the economy’s structural problems temporarily.

Åslund and Silins concur that the only way for Latvia to address its structural problems was through internal devaluation, which necessitated real structural reforms. Wages were drastically cut, often by 50 percent, controlling labor costs, which had been “shooting through the roof.” Government expenditures were significantly reduced and substantial tax and judicial reforms were pushed through. The sharp and frontloaded austerity led to a whopping 17.7 percent decline in real GDP in 2009, and unemployment rose to 21 percent.

These drastic measures would have been impossible without significant political and social support. On the political front, Mark Griffiths, head of Latvia’s IMF program, noted in a recent interview with the IMF Survey Online that the Latvian government took “strong political ownership of the program” from the very beginning and, despite the hardships, was “determined to show us [the IMF] and the world that their program would succeed.”

On the social front, Silins tells the HPR that Latvians have “got[ten] used to some pain.” Silins notes that “people remembered how things were before,” and Latvian policymakers did a good job of explaining that the boom of the 2000s was unsustainable. The efforts of policymakers, combined with the IMF’s discussions during the crisis with stakeholders like trade unions and pensioner groups, allowed for the creation of what Anderson calls a “broad-based social consensus” for austerity and structural reform.

Citizens recognized that these measures were necessary, allowing Latvia to avoid large-scale social unrest. Thanks to this broad support, Latvians even twice re-elected the main implementer of austerity, Prime Minister Valdis Dombrovskis. Latvia remains the only country in Europe enforcing austerity to have done so.

While unemployment still remains extremely high, 15.8 percent as of June 2012, Åslund notes that it is largely a specific problem relating to the way wages are taxed, and does not negate the fact that overall, austerity has put Latvia’s economy on a more sustainable path, with a return to strong positive growth. Griffiths argues that Latvia’s economy is much less vulnerable, and that the “banking system is more stable.” Indeed, “Latvia today,” Åslund asserts, “is very competitive.”

Contrasts with the South

Latvia’s “success story,” as outlined above, contrasts quite markedly with Greece’s economic descent. Anderson argues that Greece’s crisis did not really start until the second half of 2009, partly because of its reliance on tourism, but more importantly because the Greek crisis was triggered by the revelation that the deficit and debt numbers previously reported had been falsified. The revelations widened Greek and German yield spreads from approximately zero to over nine percentage points, as investors belatedly realized that a substantial risk premium did exist. As soon as Greek bond yields increased, the Greek government had no more “margin of error,” as Anderson tells the HPR, because their debt burden was an already substantial 110 percent of GDP, compared with Latvia’s pre-crisis level of 19.8 percent. Prohibitive yields drove the government to seek bailouts from the EU and IMF.

Being a member of the Eurozone, Greece obviously had no way to initiate currency devaluation, and hence had to adopt internal devaluation and austerity. Åslund notes that Greece’s initial progress in reforms was slow: in the first year, the already bloated Greek public sector actually increased by 5,000 workers. Whereas Latvia carried out its austerity through a mix of spending cuts and revenue increases, Greek austerity has been overwhelmingly dominated by tax increases, leaving public spending at 50 percent of GDP compared to 38 percent in Latvia.

Anderson argues that the flexibility of labor markets and the degree of openness of the economies represent the two key differences. Latvia’s flexibility allowed both the price and quantity of labor to adjust. Greece’s markets, however, do not allow for wage cuts because of union resistance and various other structural factors; thus, Greece can only adjust its labor quantity, causing unemployment to rise substantially higher and dimming the prospects for recovery. Furthermore, whereas Latvia capitalized on the global recovery due to its heavy reliance on exports that comprise 60 percent of GDP, Greece is heavily reliant on its small domestic market, with exports accounting only for 25 percent of GDP.

Politically and socially, Greeks had become habituated to unsustainably high levels of debt-financed public services. Furthermore, throughout the early 2000s, Greece’s vested interests retained costly privileges. Hence, Anderson notes that although Greece has so far carried out more fiscal consolidation than Latvia, it is nearly impossible to sustain any political support for reforms that affect powerful interest groups. Politicians have also done a poor job of explaining the need for austerity and creating consensus. It is unsurprising then that there has been much social opposition and unrest in Greece against austerity.

Yet overall, the differences between the two cases serve largely to highlight what must be changed in Greece, rather than constituting an argument for why the Latvian model cannot be applied. For example, nearly all economists agree that open economies are preferable, and that the more flexible the labor market, the better the economy functions. Thus, Greece and the other southern European nations need to implement structural reforms and make their labor markets look more like Latvia’s. Government debt must be manageable to maintain investor confidence; hence, Åslund also argues that structural reforms in Greece should have been tied to debt restructuring.

For Åslund, the difference between Latvia and Greece boils down to willingness to carry out bold ideas. He lauds the frontloading of Latvia’s painful measures, which allowed Latvia to start recovering quickly and regain investor confidence. Åslund maintains that Greece only initially required a fiscal consolidation of similar magnitude, around 20 percent of GDP, but because it was not carried out decisively, Greece was stuck in a quagmire of “too little, too slow, with no structural reforms.” Even if one does not argue, as Åslund does, that Latvia provides a model for “exactly what should be done” in such a crisis, Greece is the counterexample of “how to do everything wrong.”

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