FOR a place long marched over by warring armies, there are worse fates than being fought over by economists. Latvia has a population of 2m and its annual GDP is a mere €23 billion ($30 billion). But the tribulations experienced by this small Baltic country since 2008, as it kept the lat, its currency, fixed to the euro while fiercely tightening fiscal policy, have sparked a big dispute among dismal scientists.
Latvia is now the European Union’s fastest-growing economy. But the recovery has come after an epic recession, that was at its most savage in 2009 (see chart). Does its experience show that countries can cope with harsh austerity and adjust costs without devaluation? Or could a different policy, featuring a lower exchange rate and a gentler fiscal tightening, have spared much unnecessary pain?
In this section
When Larry sparked rally
This spreadsheet is different
Smoke and mirrors
The next frontier
A study* published this week for the Brookings Institution by a trio of IMF economists—led by Olivier Blanchard, the fund’s chief economist—tries to answer these questions. It is especially pertinent because the IMF’s usual remedy for a country with its own currency that needs help (it contributed to an international rescue of Latvia in late 2008) is to combine a budgetary squeeze, which lowers domestic demand, with a devaluation, which provides an offsetting stimulus from net trade. Mr Blanchard admitted last year that he thought the Latvian government’s disavowal of depreciation would be disastrous. He also believes that austerity has inflicted more damage on European economies than expected.
The study’s conclusions are nuanced. Latvia did achieve a hefty internal devaluation remarkably swiftly, but the improvement in unit labour costs came mostly through unexpectedly big productivity gains rather than a more unpalatable fall in private-sector wages. Whether the same can be done in other crisis-stricken economies is far from clear.
As for the bitter controversy about austerity, the IMF economists point out that much of the Latvian programme was implemented after the main fall in output. They reject as “unwise” the notion that the country’s fiscal consolidation helped growth. But they do accept that austerity did not prevent the recovery, although this was from a very low starting-point.
The Latvian case study matters not just for economists but for policymakers trying to deal with troubled countries within the euro area. European and especially German officials believe that Latvia vindicates the tough approach they have taken when bailing out economies like Greece and Portugal. The Baltic state is returning the compliment by joining the euro next year.
But there is a danger of reading too much into the experience of any one economy. Precisely because it is so small, Latvia had more scope than larger countries to adjust through emigration: its population has shrunk by almost a tenth since 2007. The fall in output, which took away only a portion of the catch-up growth after it had won independence in 1991, may have been easier to endure for a citizenry hardened by a harsher existence under Soviet rule. One reason why the government is prepared to disregard public opposition to joining the euro is a strategic objective of reducing Russian influence by embedding Latvia in the currency zone. Latvia’s relevance may be limited because politically and economically it is an outlier.
* “Boom, Bust, Recovery: Forensics of the Latvia Crisis”, by Olivier Blanchard, Mark Griffiths and Bertrand Gruss