In 2008, Latvia was widely seen as an economic "basket case," a textbook example of a boom turned to bust.
From 2005 to 2007, average annual growth had exceeded 10%, the current account deficit had increased to more than 20% of GDP. By early 2008 however, the boom had come to an end, and, by the end of 2008, output was down by 10% from its peak, the fiscal deficit was shooting up, capital was leaving the country, and reserves were rapidly decreasing.
The treatment seemed straightforward: a sharp nominal depreciation, together with a steady fiscal consolidation. The Latvian government however, wanted to keep its currency peg, partly because of a commitment to eventually enter the euro, partly because of the fear of immediate balance sheet effects of devaluation on domestic loans, 90% of them denominated in euros. And it believed that credibility required strong frontloading of the fiscal adjustment.
Many, including me, believed that keeping the peg was likely to be a recipe for disaster, for a long and painful adjustment at best, or more likely, the eventual abandonment of the peg when failure became obvious.
Nevertheless, given the strong commitment of both Latvia and its European Union partners, the IMF went ahead with a program which kept the peg and included a strongly front-loaded fiscal adjustment.
Four years later, Latvia has one of the highest growth rates in Europe, the peg has held, and the fiscal and current accounts are close to balance.
The mechanics of adjustment have been straightforward—a further sharp decrease in output, followed by increases in competitiveness due initially to decreases in wages, but increasingly due to productivity gains. Growth has come initially from external demand, but is coming increasingly from domestic demand. Unless Europe has a meltdown, growth should continue.
Is it a success? The economic and social cost of adjustment has been substantial. Output further contracted by 16% in 2009, and is still 15% below its 2007 peak. Unemployment increased to more than 20% and still stands at 16% today, far higher than any reasonable estimate of the natural rate.
Was there another, less costly, way of adjusting, through floating, and a slower fiscal consolidation? The truth is we shall never know. What is true though is that the adjustment looks likely to succeed under the peg, something that many of us thought nearly impossible, that the economy is growing, and that there is optimism in the air—a feeling quite unusual in Europe these days.
This surely satisfies some definition of success.
Why has it worked? Preparing for the conference I just attended in Riga in which we tried to draw lessons, and reading the evidence, I could think of seven reasons (at the conference, some, including the Prime Minister, had other lists. The reasons were more general; for example, ownership of the program by the Latvians, a clear exit strategy, namely the promise of entry into the euro. My list is more prosaic, closer to an analysis of the plumbing, of each of the parts of the adjustment mechanism).
Latvian policymakers would surely want me to add yet another reason—the strong front loading of fiscal consolidation: over the first two years of the program, the cyclically adjusted primary balance was increased by 11% of GDP. I am not sure. Growth was negative and large in 2009. Whether a slower adjustment would have led to less of an overall output loss just cannot be assessed.
But I still draw two conclusions from what happened.
While the decrease in output was dramatic, the recovery has been relatively more V shaped than I expected, although I still worry about the effects of long term unemployment.
And the Latvian experience makes a strong political case for taking into account adjustment fatigue. While the large initial budget cuts went through relatively easily, taking much smaller steps proved much more difficult in the 2011 budget. The political argument for front loading thus strikes me as fairly strong. So does the political argument for focusing on spending cuts initially. Targeted spending cuts are typically more costly politically than general tax increases; thus it may be better to keep those tax increases in reserve for later, if and when fatigue is settling in.
If my list is about right, one cannot avoid the question of how many of these conditions apply to Europe’s southern periphery countries.
The sad truth is that many of these conditions are not satisfied elsewhere. True, the adjustments that these countries have to make are smaller than those Latvia had to make. But their economies are less flexible, less open. They have less obvious potential gains in productivity, at least in the tradables sector. They had much higher public debt to start.
So, the lessons are not easily exportable.
And we should be under no illusion that the adjustment in the South will be difficult and painful. In that context, the argument for a social pact, and faster joint adjustment of wages and prices than implied by market mechanisms and the downward pressure from unemployment, remains, in my mind, a very strong one.