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Austerity Worked for Latvia

Leonid Bershidsky is a Bloomberg View columnist. He was the founding editor of the Russian business daily Vedomosti and founded the opinion website Slon.ru.
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Latvia, the poster child for austerity, has won an important distinction. It has been invited to join the Organization for Economic Cooperation and Development, the club of the world's most developed nations. Not bad for a country whose economy declined the most in Europe in 2009. This success also defies the predictions of the Nobel laureate economist Paul Krugman, who has dismissed Latvia's success.

The OECD is quite selective. Latvia will be its 35th member and only the second among post-Soviet nations (Estonia, another austerity champion, was invited in 2010). To get in, its policies had to be reviewed by 21 committees. Membership carries few benefits except being invited to contribute to the search for the best economic, environmental and social policies, but it is probably the highest form of recognition for a developing nation. 

Latvia's path to the honor wasn't straight. It had an economic boom in 2000-2007, with growth averaging 8.8 percent a year. The country had been poor, and its Soviet-era industries had fallen apart, but it was on track to join the European Union, and Latvians had every reason to be optimistic. Growing domestic consumption, mostly satisfied by imports and funded by banks from neighboring Nordic countries -- the local currency was pegged to the euro, so interest rates were low -- fed the rapid growth. The economy overheated; the price of Riga apartments quadrupled between 2004 and 2007.

Then, between the peak in the last quarter of 2007 and the trough in the third quarter of 2009, Latvia's  economic output shrank by 25 percent. There was a run on the banks, yet the government defended the currency peg. It may have had no other options: By 2007, 85 percent of all outstanding loans in Latvia were in foreign currencies, as noted in a 2013 paper by former International Monetary Fund Chief Economist Olivier Blanchard and his collaborators. A devaluation, which Krugman called for, would have crushed the economy and the financial sector in particular.

Besides, as a country hoping to put as much distance between itself and its Soviet past, Latvia had to prove itself as a good European citizen. By avoiding devaluation, which would complicate its bid to join the euro zone, and by keeping state finances tight, it showed that it was not nostalgic for socialist profligacy. Instead, it deregulated, abolished half of its government agencies, slashed the public workforce by 30 percent, raised consumption taxes (the value-added tax rate reached 21 percent) and introduced flat income taxes, 15 percent for companies and 23 percent for individuals. In effect, it told its citizens to become creative and entrepreneurial.

That wasn't an easy task in a tiny country with an unemployment rate that had rocketed from less than 5 percent in 2007 to 17.3 percent by March 2010. So Latvians headed for the exit. According to the Latvian economist Mihails Hazans, 80,000 people, or 3.7 percent of the pre-crisis population, emigrated between 2009 and 2011, many of them to Ireland and the U.K. In all, according to Hazans, 230,000 Latvians left between 2000 and 2015.

On paper, however, the government's plan worked. Growth returned in 2011 with a 6.2 percent rebound. For the last two years, it has held steady around the respectable 2.5 percent mark. In 2014, Latvia joined the euro. Unemployment was back to 8.8 percent in April. "Privatization, competitive taxes and stable currencies are oft-cited remedies for economic malaise, but the Latvian experience shows that they work," the Manhattan Institute analyst Preston Cooper wrote. "Latvia should be proud of its OECD accession -- the country has earned it."

Krugman and like-minded economists, such as another Nobel laureate, Joseph Stiglitz, still dismiss Latvia's success. Both point out that the country is tiny: it has the population of Brooklyn, Krugman has quipped and Stiglitz says it's easy for an economy of that size to replace lost government spending with exports. In a column last year, Krugman also pointed out that Latvia hasn't been doing as well post-crisis as Iceland, which has implemented neo-Keynesian policies, going for a deep devaluation and increasing government expenditure. Here's the chart he published as proof:

Eurostat

Here, however, is a chart showing how Latvia's post-crisis economic growth compares with Iceland's:

Rebound Artists
Real GDP growth rates in Latvia and Iceland
 
Source: OECD

One could also point out that on a per-capita basis, Iceland's gross domestic product (taking into account purchasing power parity) increased by more than 18 percent between 2008 and 2014, and Iceland's grew 7 percent. That wouldn't be quite fair because of the emigration from Latvia -- there are fewer people, many of whom would have been unemployed and unproductive, to share in the growth. 

There are no universal recipes for economic revival. Relatively rich and pampered Iceland wouldn't have taken kindly to Latvia's harsh medicine, and the policies favored by Krugman did the job for it. Gritty Latvia yearned to leave its Soviet past behind and be more European, despite a 37 percent Russian-speaking minority, which is often nostalgic for the Soviet Union and sympathetic toward Russia. It did austerity, and that worked, too. Both nations can now serve as models of the respective sets of economic policies. The OECD includes both -- and also Greece, for which nothing seems to work. A good mix for research into best practices.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

To contact the author of this story:
Leonid Bershidsky at lbershidsky@bloomberg.net

To contact the editor responsible for this story:
Max Berley at mberley@bloomberg.net