When the financial crisis hit Latvia in 2008 what followed was a huge budget deficit that needed to be rectified. In stepped the IMF and the European Union to assist but, unlike Greece, the Latvians didn’t hold back with severe austerity measures. Since then the Latvian economy has returned strong growth levels as it climbs out of the trough of the cycle.
What were the conditions in Latvia after the 2008:
1. It lost over 20% of its GDP in two years
2. Unemployment reached 20%
3. Emigration rose as this is in a country with a declining population
4. Levels of productivity are low
So why the Baltic states growing so much faster than those in the Mediterranean?
1. According to The Economist the Baltic states are in catch-up phase
2. Their competitiveness can be regained by pushing down wages and prices by devaluation.
The IMF’s Nemat Shafik compared such a process of internal devaluation to painting a house – “If you have an exchange rate you can move your brush back and forth. If you don’t have an exchange rate you have to move the whole house.”
Interestingly enough the IMF think that deficits should be cut by a gradual process in the medium-term. Latvia believed that deep fronted-loaded austerity was the best way to achieve confidence from the markets. But with more flexible labour markets the Latvians were able to reduce wages compared with their Mediterranean colleagues. Furthermore Keynesian stimulus in northern countries had the benefit of stimulating demand in Latvia.
What is there to be learnt from Latvia
1. Low debt – debt-burden is about 45% of GDP, less than half that of Greece and Italy before the crisis.
2. International lenders need to be under no illusions – if a country can’t repay its debts it must face early restructuring. Latvia was actually allocated more money than it needed.
3. Banking union – a European-level system to regulate and restructure and refinance struggling banks.