## Lessons from Latvia

_IMF Blog, June 11, 2012_

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## Bibliographic details
- Authors: Olivier Blanchard
- Published: June 11, 2012

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### Background and crisis context
- Author: Olivier Blanchard; Date: June 11, 2012.
- 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 the boom had ended; by the end of 2008:
  - output was down by 10% from its peak,
  - the fiscal deficit was shooting up,
  - capital was leaving the country,
  - reserves were rapidly decreasing.

### Policy choice and program design
- The government chose to keep the currency peg rather than pursue a sharp nominal depreciation because of:
  - a commitment to eventually enter the euro,
  - fear of balance sheet effects of devaluation on domestic loans (90% denominated in euros).
- The IMF-supported program kept the peg and included a strongly front-loaded fiscal consolidation.
- Latvian commitment and support from European Union partners were decisive in maintaining the peg.

### Outcomes and mechanics of adjustment
- Subsequent outcomes:
  - Four years later, Latvia had one of the highest growth rates in Europe.
  - The peg has held.
  - The fiscal and current accounts are close to balance.
- Mechanics described:
  - Initial sharp decrease in output,
  - Increases in competitiveness due initially to decreases in wages, increasingly due to productivity gains,
  - Growth initially from external demand, increasingly from domestic demand.
- Projection qualifier: "Unless Europe has a meltdown, growth should continue."

### Economic and social costs
- Output dynamics:
  - Output further contracted by 16% in 2009,
  - Output is still 15% below its 2007 peak.
- Labor market:
  - Unemployment increased to more than 20% and still stands at 16% today.
  - Concern about long term unemployment effects.
- Assessment: The economic and social cost of adjustment has been substantial, but the adjustment looks likely to succeed under the peg.

### Seven practical factors that supported adjustment (plumbing of the mechanism)
- Preceding boom: the adjustment was seen partly as a return to normal because of the unusually strong boom.
- Political and social acceptance:
  - Support for fiscal consolidation and acceptance of pain;
  - Parties arguing for stronger fiscal austerity often did better at the polls;
  - Pedagogy and historical experience (painful transition from central planning) helped acceptance.
- Wage flexibility:
  - Dramatic reduction in public sector wages improved the fiscal position and put pressure on private sector wages,
  - Caveat: private sector wages adjusted much less than public sector wages; nominal wages have started to increase while more adjustment may be needed.
- Productivity catch-up potential:
  - Latvia has income per capita of half the European Union average, implying substantial room for productivity increases.
- Openness of the economy:
  - Exports around 50% of GDP, so competitiveness improvements have large effects on imports, exports, and GDP.
- Low initial public debt:
  - Public debt was very low to start, less than 10% of GDP.
  - Even today, public debt remains around 40% of GDP — this helped alleviate foreign investor concerns about sovereign default and facilitated a quicker return to international markets.
- Financial sector structure:
  - The financial system was largely composed of relatively friendly foreign banks (notably Swedish banks) that recapitalized and maintained credit lines, reducing the intensity of the sudden stop and credit squeeze.

### Fiscal front-loading and political economy lessons
- Fiscal consolidation intensity: over the first two years of the program, the cyclically adjusted primary balance was increased by 11% of GDP.
- Political economy observations:
  - Large initial budget cuts were implemented relatively easily; smaller subsequent steps proved more difficult (2011 budget example).
  - The political argument for front loading is described as fairly strong.
  - The political argument for focusing on spending cuts initially is also emphasized:
    - Targeted spending cuts are typically more costly politically than general tax increases,
    - It may be better to reserve tax increases for later, if and when adjustment fatigue sets in.

### Applicability to other European countries
- Many supportive conditions present in Latvia are not satisfied in Europe’s southern periphery.
- Comparative constraints in the South:
  - Adjustments required are smaller than Latvia’s but economies are less flexible and less open,
  - Less obvious potential gains in productivity in tradables,
  - Much higher public debt to start.
- Conclusion: The lessons are not easily exportable; adjustment in the South will be difficult and painful.
- Policy implication for the South: a social pact and faster joint adjustment of wages and prices than implied by market mechanisms remains a very strong recommendation.

*Source: Olivier Blanchard, "Lessons from Latvia", June 11, 2012.*

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## References

- [IMF](http://www.imf.org/external/pubs/ft/survey/so/2012/int020712a.htm)
- [Latvia](http://www.imf.org/external/pubs/ft/survey/so/2012/CAR061112A.htm)
- [growth should continue.](http://blogs.imf.org/2012/06/01/latvia-beat-the-odds-but-the-battle-is-far-from-over/)
- [conference](http://www.imf.org/external/np/seminars/eng/2012/latvia/index.htm)

_Source: https://www.imf.org/en/blogs/articles/2012/06/11/lessons-from-latvia_