Austerians on the Counterattack: The real Lesson from Latvia

Despite the fact that many European economies are facing an austerity-induced recession, the ‘Austerians’ are already back on the attack. When travelling this week to Riga, Christine Lagarde, head of the IMF, rediscovered that Latvia, back in 2009, had been one of the Troika’s first guinea pigs in Europe to test out the policy of ‘competitive austerity’. Lagarde, according to RTE News, is now hailing Latvian austerity not only as a success story, but also as a solution for the eurozone crisis. According to Christine Lagarde, Latvia quickly decided to go for a package of hard and painful austerity and was rewarded for this by getting the economy back on track towards growth. Crisis-ridden countries, and Greece in particular, should learn from this and accept austerity as the cure to a deep recession.

What is indeed correct is that the Troika’s adjustment programme was indeed extremely brutal, especially in the first year when fiscal cuts squeezed between 8 and 9% of GDP out of the economy. The total fiscal adjustment over the whole three years is reported to have amounted to 15% of GDP. Public sector wages in particular were hit very hard, with wage cuts ranging from between 16 to 26% in administration, health and education. The impact on the economy was predictable: Economic activity contracted in 2009 by close to one fifth (!).

However, the deep 2008-2009 recession was followed in 2010 by a stabilisation of economic activity and the economy started to grow again in 2011. But does this mean that austerity, even if it is painful, is the road to stabilisation and recovery, as is claimed by Christine Lagarde? To answer this question, a close reading of the IMF programme reviews for Latvia is quite revealing.

The first review, written at the end of 2009, reads like a ‘wake-up call’. Over the course of that year, Latvia had been hit by a double blow: Exports had fallen by 15% and domestic demand had collapsed because of the huge 9% GDP fiscal cut. The IMF was therefore looking at an economy in total shambles: GDP had contracted by 18%, employment by 8% and unemployment had doubled to 15%. Meanwhile, and despite the 9% fiscal cut, the deficit was calculated to have risen from 3.3% in 2008 to 13% of GDP in 2009, with the negative second round effects on public finances coming from the impact of fiscal austerity on economic activity playing a major role in this.

On top of that, the IMF review carried out at the end of 2009 estimated that the 2010 deficit would be even worse, at a record high of 18% (!) of GDP. This represented a huge gap from the official deficit target of 8.5% of GDP, as set by the ECOFIN council, implying a second massive fiscal squeeze of 10% of GDP or more.

At that moment, the IMF started to have serious doubts. The IMF review from the end of 2009 (point 28) stated: “The massive fiscal contraction required would put additional pressure on output, with significant risk of a downward spiral”. In view of this concern, what the IMF actually then did, was relax the deficit target, replacing the ECOFIN’s 8.5% deficit target with a 12% deficit objective.

This still represented an additional and huge fiscal cut of (more than) 6% of GDP. In practice however, the 2010 fiscal ambitions were drastically revised downwards. According to the second IMF programme review published mid-2010, the Latvian government limited the 2010 fiscal cut to a net 2.5% of GDP (also thanks to a Constitutional Court ruling invalidating previous pension savings to an amount of 1.5% of GDP). The IMF again allowed this further relaxing of the austerity strategy, calling the 2010 budget a ‘strong’ budget.

In other words, the story which the head of the IMF is now telling the press is not correct. Latvia’s economy did not end its freefall because authorities continued to cut public budgets in order to reach tough and immovable deficit targets, even if this inflicted major immediate damage upon the real economy. What actually happened was the opposite. The economy managed to stabilize over 2010 because the government abandoned the policy of fiscal orthodoxy. It was loosening the deficit targets that the economy avoided a third year of contraction. If authorities had pursued the initial IMF recommendation of a 6% fiscal cut or, even worse, if they had tried to reach the ECOFIN deficit target by administering what would have been a lethal 10% GDP cut, the economy would not have stabilised but would have continued its steep fall into the abyss. This would also have resulted in higher than planned deficit targets which then, predictably, would have been used to argue the case for even more cuts. Latvia, thanks to a rare moment of lucidity by the IMF, avoided getting caught in the austerity trap by using deficit targets in a highly flexible way.

In 2011, the economy strengthened further, courtesy of a continued strong export demand but also because of the 120,000 workers that had left Latvia to work abroad (10% of the labour force!) feeding part of their foreign earned income into the domestic economy. With the economy growing again (4% growth in 2011), deficits have started to fall almost automatically and the deficit expected for 2012 is down to around 2% of GDP.

To conclude, the real lesson that Europe should learn from Latvia, and in particular Greece, where according to a study from the IMK/OFCE fiscal contraction has now reached a devastating 25% of GDP, is that deficit targets need to be handled in a flexible and realistic way. If the ‘madmen in authority’ are allowed to continue with their austerity policies, the recession will intensify and deficit targets will be missed and public debt rates will go up anyway.

Europe should indeed do what Latvia did in 2010 and abandon the catastrophic policy of austerity. To give growth a chance, Europe should install a moratorium on new fiscal austerity measures and postpone the 3% deficit target from 2013 to the 2016/2017 time horizon.

This text is inspired on a paper written by Mark Weisbrot and Rebecca Ray from the Washington CPER.