After recent elections in Greece and France, it looks like the Eurozone consensus in favour of austerity might be coming to an end. We pointed out that this might be a good thing. Bond markets, the apparent customers of austerity policy, aren’t buying what the eurozone is selling.There’s one notable exception to the policy’s failure, Paul Krugman pointed out that Latvia is “back in the graces of the bond market”. Latvia enacted fiscal cuts worth a massive 18% of its GDP over 3 years and cut public sector wages by up to 40%. Latvia’s GDP dropped 25% in 2009, which was Europe’s worst recession. Despite all of that, they managed to grow 5.5% in 2011. Here’s the kicker; they did all of this with a currency pegged to the Euro. Why has austerity worked in Latvia, but driven governments out of power and countries into recession in the Eurozone?
Business Insider spoke to Daniels Pavļuts, the Latvian Minister of Economics. Here are the key points:
- Austerity succeeded in Latvia because the country is small, and measures were front loaded early in the crisis. Large government service and wage cuts were combined with structural investment and reform designed to improve the business environment.
- Currency devaluation was not seen as an option, the vast majority of the country’s loans are denominated in Euros.
- Much of the Latvian electorate lived through Soviet rule or the difficult transition out of it, and remember tougher times than these.
- They voted the party seen as driving the credit crisis out of power, then elected and reelected a government committed to the austerity program.
- Unions are weaker in Latvia, allowing a precipitous drop in nominal wages that would be more difficult to achieve in the Eurozone.
- The key for Europe is to balance needed austerity and restructuring with pro-growth policies.
- It will be more difficult for the Eurozone because of its large size and the lack of political consensus.
Here’s a lightly edited transcript of our whole conversation with Daniels Pavļuts:
BI: Why is it that Latvia in particular has had a good experience with austerity when its been negative for the rest of the Eurozone?
Daniels Pavļuts: Well first of all, it remains to be seen what it will be like for the rest of the Eurozone, it has to be viewed in context. Now, with how Latvia has done, really there are a number of factors that have to be taken into account. We first of all decided to front load austerity measures. It really felt at the time like we had no choice, because we had difficulties in our treasury meeting our budget financing needs, and we had rescued one of our banks which had spectacularly failed. This had not been the experience of our neighbours, Lithuania or Estonia. So essentially nobody would lend to us, it was the time, the end of 2008 and early 2009 when markets were really frozen. So, at that time it seemed like the only option forward was to ask for the IMF to intervene which they did with the European Commission. There was really no other way but to try and create a strategy to rebalance our public finances which were out of balance. But, more importantly our economic structure was also very unbalanced. Over the fast growth years from 2000-2007 we had accumulated massive imbalances such as the current account deficit, which was running around -20%. You could say tough decisions were taken not only by the policymakers, but by stakeholders involved because of a lack of any alternatives. Now another part of the story really is that our society, the electorate, has seen tough times within living memory, times which have probably been even tougher than this.
BI: That’s why your government was able to stay intact through the austerity measures, unlike what we’ve seen in Greece and France?
Daniels Pavļuts: Well yes and no. On one hand you can say that our society is patient and has living memory of times of tough times and restructuring. So there is a feeling that there are certain things that need to be done for things to get better, and sometimes an understanding that things have to get worse before they can get better. But, I can’t really agree that there’s been no political change. There has, in fact, been a massive political shift. It has been directed in a different direction than elsewhere in Europe certainly. There were political parties which the general population felt had misled them, and had led into the society into crisis without responding adequately to the overheating of the economy, which became apparent in the last two years of 2006-7. There were warning voices all over the place, but the government wouldn’t respond at the time. So these people who stepped on the accelerator, they really got kicked out of the government and then they lost parliamentary representation in the next parliamentary elections.
BI: What year was this?
Daniels Pavļuts: The change of government did take place, but it took place very early into the crisis. Not after prolonged deliberations and suffering but rather very quickly into the crisis. If we count that the beginning of events as September 2008, then the government change happened in March 2009. From that moment onwards the government was installed under Prime Minister Dombrovskis, he has remained Prime Minister in the subsequent governments. The general course taken has also been supported by the electorate by essentially re-electing the coalition which would stick to the austerity and restructuring plans. There is a very important comment that has to be made, in Latvia’s case we’re not only talking about austerity. It’s not like we’re looking at the economic debate of today in Europe where it seems like there are two extremes dominating the agenda. One side is austerity which is often portrayed almost like choking your economy to death. On the other hand you have a fiscally liberal pro growth strategy. Its not like that, its not like we chose this first option. Actually, we did massive fiscal austerity, probably more than anybody else. It was like a cumulative 18% of GDP in public spending cuts over a 3 year period. But, at the same time we did invest in our economy. We had structural funds, a lot of money to be invested in our society and our economy. We spent this money to increase energy efficiency, to insulate our buildings, to refurbish industrial buildings, to replace outdated technologies in our manufacturing industries, and on a number of other things. So essentially there has been a combination of pro-growth investment with massive fiscal austerity, as well as a substantial focus on cutting red tape and improving the business environment.
BI: If you were doing all of this structural spending, where in particular did the fiscal cuts take place?
Daniels Pavļuts: Fiscal cuts really took place in two directions. One was public services and spending on public sector wages. Public sector wages were cut on average 25 to 40%. Now much public spending was cut in terms of some availability, physical availability of some public services, like reducing the number of frontline government offices. Now that’s not always a bad thing, of course it limits the availability of public services, but we could focus on key government services on which we’ve worked very hard, and are quite available. At the same time it has allowed us to cut some of the unnecessary spending and move into the direction of establishing so called one stop shops or one stop agencies, where there would be the principal front office for a number of government services rather than each institution having its own office in various parts of the country. So none of that is really that simplistic. There is one more thing I have to say and that’s that there’s been a really big focus on improving the business environment we’ve done a lot of things that were needed. There were a lot of defaults of private sector loans both corporate and household, so we had to reshape much of our legislative framework, which was unable to deal with those sorts of issues efficiently enough. So we, for example, passed a new insolvency law which was seen as big progress. It was one of the reasons why Latvia jumped 10 places in the world ease of doing business index in 2011, we jumped 10 places from 31 to 21. We are the 21st best business environment in the world now.
BI: If this worked in Latvia, or has started to work, do you think that’s a unique product of the political environment, the patience of the Latvian people? Is it something that other countries in the Eurozone might be able to replicate?
Daniels Pavļuts: I think the way forward for Europe really is balancing fiscal austerity, I actually don’t like that word, I think its been stigmatised by now. So, basically rebalancing their public finances, getting them under control is one important part. But the other important part is having smart, pro-growth policies in place. Having smart pro-growth policy does not necessarily mean fiscal irresponsibility, you can combine these things. I think where Europe really struggles is given that our society is a small, mobile, adaptive society which has gone through a lot, it is far more resilient in terms of fast and difficult change. Some of the societies in Europe I think are not that flexible which is a huge issue. So, actually getting them to adapt to this new environment is much more difficult due to the huge size and the stability these societies have enjoyed over time. So I think its a matter of how civil society, how policy makers and stakeholders can get together and actually form consensus. In many countries we’re very far from this. Now one specific issue which in our case has been ironically helpful is the lack of organisation in civil society. For example trade unions have not been really that strong in our country. In most European countries you simply cannot imagine the sort of nominal wage cuts like have been made in our country, mostly in the public sector but also in the private sector. It is simply something that wouldn’t be accepted by the trade unions, by unionized labour. Yet again, I think its a matter of dialogue and seeking consensus that there are certain things that need to be done to regain competitiveness of the countries. But then again, there’s no one recipe that works for all.
BI: So many other countries are trying to devalue internally, one of the benefits of not being in the Eurozone is the ability to devalue your currency and make exports more competitive. Why the decision to keep your currency pegged to the Euro?
Daniels Pavļuts: Well first of all that decision is still being debated. Not in the sense that we would change our minds, but its still being debated as to why we’ve done it and whether its been good or not. So the jury is still out there discussing the pros and cons. Practically, when you make that sort of decision and choice you should really be pragmatic about what benefits of such a devaluation might bring about. Now, the obvious expectation is that that would increase the competitiveness of exports. Now, the analysis at the time showed that the benefits to the exporting industries would actually be short lived and not sufficient in scale to justify the cost that would create to other parts of the economy. It wouldn’t really offset the costs to the rest of the economy. For example, there is a very high proportion of imports in our export structure, so basically the value added was not sufficiently large to justify devaluation because the inputs would have to be bought at world prices and the devaluation would not help. So, essentially without adjusting the wage structure, without reducing the value of inputs, it wouldn’t work either. And, devaluation would have caused also one of two things. Either massive defaults since the vast majority of wealth in our country is Euro denominated, so there’s a currency mismatch. Or, the second option would have been that we basically did something like Hungary has done or Argentina has tried to do in the past, to change the denomination of our loans at artificial rates and basically default on our external obligations to the international financial institution that has provided those funds. Now what consequences that would have for a small open economy like ours would depend on the extent of financing, the choice was made. I wasn’t in government then, but retrospectively this is the logic which has underlied the decision to devalue internally by cutting nominal wages and cutting spending.
BI: How does the future look like for Latvia? Are you still interested in joining the Eurozone after everything that’s happened?
Daniels Pavļuts: Joining the Eurozone is certainly one of our main objectives. Now I frequently get asked, with what’s happening to the Euro, why would you still have this as an objective? I always say this we have been effectively been a part of the Eurozone by being pegged to the Euro, without all of the limitations on being able to devalue, but without the benefits of being in the Eurozone in terms of the cost of financing, in terms of the additional impetus and incentives to incoming FDI etcetera so this is something we want to do. On the other hand, all the things we have to do to get into the Eurozone, putting our fiscal house in order, doing a number of other things, being conservative about our sovereign debt levels which are very low. All of this is actually good for our economy, look at the rating agency’s reactions. The things we’ve done have resulted in all three major credit ratings agencies moving us into investment grade, Standard and Poors being the most recent last week or a fortnight ago. So, in that sense its a reward. Now getting into the Eurozone is the final step that we want to make in order to have availability of reasonable cost of finance, of having access to greater FDI flows, greater attractiveness of our country as an investment destination.
BI: Was there anything else you wanted to add?
Daniels Pavļuts: I think there was a part of your question I didn’t respond to, the last question. Ah, how we feel about the future. We feel quite good, we’re cautiously confident. If you look at the performance of the Latvian economy it really runs contrary to trend and to the rest of Europe. As the European economy was slowing down at the end of last year, our economy continued storming ahead, we grew by 5.7% in the last quarter of 2011 with an average 5.5% growth in 2011 aggregated. And now, just yesterday the first quarter initial assessment came in, we had grown 6.8% in the first quarter of this year. And this is not a bubble, this is not something that would be creating imbalances. This is thanks to our tradeable industries, both commodities and services actually growing very well and continuing to exploit the competitive advantages, which is not only cost advantage, we can offer in many areas and many sectors products and services of comparable quality with lower costs. So in that sense we’re looking ahead with cautious optimism. Actually our ministry, the Ministry of Economics, has upgraded the expectation the forecast of GDP growth for this year from 2.5 to 3%, and we expect to be growing quite well into the future. Of course we rely on and have to be cautious about growth elsewhere. But our partners, the trade partners we have are primarily the growing countries in Europe as well as CIS countries and other markets which seem to be growing very well. If you look at our export structure its 70% European Union, but its really the growing part, Scandinavia, Germany, our neighbouring countries. 15% is CIS countries which seem to be doing ok, and the other 15% are the other countries such as BRICS and others which seem to be doing really well. Well, in that sense of course I’m optimistic.
BI: Finally, do you have any comment on what the political situation in the Eurozone might look like after the recent elections? Now that there’s a different President in France, Germany’s dominance of Eurozone policy matters might change.
Daniels Pavļuts: I think I’ll come back to something I’ve already said. First of all, it remains to be seen what the policy will be of the new administration in France. I think that Europe might benefit from combining, at least in the public discourse and public communication, from adding the austerity paradigm to the concept of smart growth. In my eyes there is no contradiction. Of course some of these societies still needed to be persuaded to be very serious about getting their fiscal house in order. At the same time its extremely important that we see the strategy for economic growth as a way out. With Greece, we’ve heard so much about fiscal austerity and the need to do work on the fiscal front. We’ve heard far too little about the economic exit strategy, how is Greece economically on a micro level actually going to get out of this situation they’re in? I think in the general economic debates in Europe would benefit from a balanced conversation on fiscal and on growth agendas. Growth for me is not fiscally irresponsible.