Foreign and Defense Policy, Europe and Russia

Latvia as a cautionary tale for Europe

Image Credit: motiqua (Flickr) (CC BY 2.0)

Image Credit: motiqua (Flickr) (CC BY 2.0)

In a measure of how desperate Brussels has become for success stories in the ongoing European debt crisis, the European Commission holds up tiny Latvia as the poster child for how countries should cope with their external and public finance imbalances. For in 2008, rather than take the easier route of devaluing its currency to deal with a balance of payments crisis, Latvia rigidly stuck with its exchange rate peg. And instead of devaluation, Latvia chose to go down a path of severe IMF-EU imposed austerity, including very large cuts in public wages, aimed at securing an “internal devaluation”.

According to the European Commission’s narrative, this approach has paid off handsomely. Over the past two years, the Latvian economy has staged an economic recovery, regained international competitiveness, and is now meeting the conditions for Euro membership. This prompts the Commission to ask why other troubled European countries do not follow the Latvian model of budget austerity with the same determination as did Latvia.

A basic problem with the Commission’s narrative is that it glosses over the extraordinarily high economic and social price that Latvia has paid for eschewing exchange rate devaluation as a means to restore external imbalance. From its peak in 2008, the Latvian economy contracted by 25% while its unemployment surged to over 21% of the labor force in 2010, making its recession by far the worst suffered in Europe during the 2008-2009 Lehman-crisis. And even now, after the economic recovery has got under way, Latvia’s economic output remains more than 15% below its peak level, while its unemployment rate remains at 13.5% even after a very large amount of emigration.

A counterfactual as to what might have happened in Latvia had it chosen to abandon its exchange rate peg is provided by the recent Icelandic economic experience. In 2008, Iceland suffered a financial and economic crisis similar in severity to that of Latvia. However, unlike Latvia, it chose to abandon its currency peg as part of a heterodox policy approach to restoring external and internal balance. And it did so with considerable success. By 2011, the Icelandic economy was also recovering with relatively low inflation while at no point did Iceland experience a cumulative output loss of more than 10% or unemployment in excess of 8 ½%.

An ironic twist in the Latvian saga is that its prime minister is now acknowledging that the majority of Latvians have lost their appetite for Euro membership. It seems that in pursuit of the holy grail of Euro membership the Latvian population has now got cold feet. This has to raise the basic question as to what purpose was the extreme suffering through which the Latvian economy went in order to preserve its exchange rate peg. It also has to raise the question whether the Latvian experience is indeed something that Cyprus, Ireland, Portugal, and Spain might want to repeat.

2 thoughts on “Latvia as a cautionary tale for Europe

  1. This is silly. Spain and Greece are in worse shape and have no hope of any recovery. The last I saw, Spian’s unemployment rate was in the 20-25% range and Greece’s unemployment is probably too high to accurately measure. How is Latvia worse than the Southern Euros?

  2. If you want to check the numbers (I’m looking at index mundi) you can see that from 2000 to 2008 the average population loss for Latvia was 19900 people per year. Over the years 2008 to 2012 the average population loss was 13500 people per year. So this so called “austerity” program in 2009 must have involved a time machine, to encourage all those people to emigrate back in 2000, right?

    I think Latvia will continue to improve, but there’s no particular reason to believe it should already be back to peak after only four years. The United States during the Great Depression took from 1929 to 1936 to recover the same GDP level, and even that recovery was temporary. It seems pretty clear that most of the worldwide prosperity of 2007 and 2008 was an unsustainable bubble anyhow (that’s why it was NOT sustained in just about every country on Earth).

    The word “austerity” as used by Keynesians means nothing more than any country that declines running up a massive government debt. As a taxpayer who cares about future generations, I refuse to count debt-fuelled growth as growth at all until that debt is repaid.

    We can compare the full cycle and see how long it takes for the US and Greece have their total government debt back to manageable levels, and only then shall we compare growth figures.

    Suppose there was a company and you were thinking about buying shares in this company. They just got a big loan from the bank and the CEO has a new sports car, the company has a bright shining office with a huge boardroom table, the staff have all the best sporting facilities and the biggest Christmas party. Would you buy this company? You would check the cash flow first and the debt situation, and suppose you find the debt is bigger every year, would you still buy it?

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