The credit bubble continued to expand and the realization that it was built upon unrealistic expectations for economic growth came too late. The massive lending that took place in a matter of a couple of years increased consumption, yet it did not equally improve the future prospects of production. In late 2007 and in 2008, it became apparent that the economy was overheating.
The fall of the ‘‘Baltic Tiger’’
The fast growth of the economy created significant macroeconomic imbalances. The consumption boom in the country built grounds for the strong growth of imports, which led to a massive current account deficit of a staggering 25 percent of GDP already in 2006 (Hansen, 2010).The overheating housing market was accompanied by imbalance and tensions in the labour market as well. The demand for labour in the booming economy was high, yet the supply was decreasing due to large-scale emigration after joining the EU in 2004. Thanks to such pressure, Latvia hit another record number for the EU: an annual wage increase up to 30 percent. The wage growth by far exceeded productivity growth, forcing companies to increase prices, leading to 17.9 percent y-o-y price inflation in May 2008.
As a consequence, Latvia’s currency sharply appreciated, sending worrying signals about the decreasing competitiveness of the country (Hansen, 2010). These large macroeconomic imbalances, worries about sustainability of credit growth rates, inflation, property price bubble as well as the high risk of deterioration in the quality of loan portfolio motivated Scandinavian banks to finally tighten the lending standards (Klyviene and Rasmussen, 2010). Once the credit from the Nordic countries froze and housing prices started to fall, construction and retail sectors stagnated. Pessimism replaced unwarranted optimism, negatively impacting consumption and suppressing the entire economic activity (Hansen, 2010).
The ‘‘Baltic Tiger’’ crashed, and it crashed hard. The most rapidly developing economy among the EU countries, experiencing a double-digit growth of 12.2 percent in 2006, was shaken by the steepest GDP contraction of 18 percent in 2009.Unemployment peaked at 20.7 percent, consumption dropped by 22.4 percent and gross fixed capital investments plunged by 37.7 percent.
In December of 2008, the IMF provided a e1.68 billion rescue package to help Latvia fill in the gapping hole in its budget deficit and calm its capital markets. Even though the injection may have convinced the markets for a while, in June 2009 the Central Bank of Latvia had to sell almost e1 billion in exchange of Lats in order to defend the currency.
Is the government to blame?
Even though before the accession to the EU Latvia was undergoing a period of intensive reforms, due to successful growth of the economy the policy makers lost the urgency to reform as everything already seemed to be heading in the right direction (Erixon, 2010). Due to the currency’s peg to Euro, the monetary policy in Latvia was restricted; hence the supply of credit was out of control. Therefore, only fiscal policy tools could be used to regulate the economy. It seemed, however, that instead of using this tool wisely the government further fuelled overheating through massive public spending (Klyviene and Rasmussen, 2010).
Tax revenues were growing as the economy expanded. Instead of following the standard counter cyclical fiscal policy in a time of favourable macroeconomic environment and decreasing fiscal expenditure in order to accumulate a budget surplus, Latvia chose to follow a pro-cyclical fiscal policy (Hansen, 2010). Government spending relative to GDP increased from 35.6 to 37.7 percent over 2005-2007 (Karlsson, 2009). Not surprisingly, such pro-cyclical fiscal policy increased the demand for credit, consumption and supported the biggest boom in the EU. Excessive government spending did not allow accumulating a budget surplus which could serve as a buffer in times of crisis.
In 2007 the Latvian government adopted a ‘‘Stabilization plan’’ aimed at developing the budget surplus, reviewing effectiveness of government spending and implementing reforms necessary for increasing long run productivity and competitiveness (Gerhards, 2008). The plan came too late. By 2009 even the Latvian president Valdis Zatlers was questioning the appropriateness of the actions taken and the fate of the country: ‘‘We had no political will, we lacked economic and entrepreneurial foresight, the government was pathetic. Now we face the existential question: will Latvia survive?’’ (Hansen, 2009).
Policy decisions today
A. Should the Lat be devalued. . .
For countries with a fixed exchange rate regime, devaluation is roughly the only monetary policy tool that can be considered for targeting economic stability. A deliberate devaluation of the Lat would make the currency cheaper. Consequently, imports would become more expensive and exports to other countries – cheaper, thus reducing the trade deficit. By the end of 2009, the international community was voicing a strong opinion that Latvia should devalue. For some economists (including Professor Paul Krugman) it looks like a case of Argentina: a fixed exchange rate, an excessive current account deficit, substantial foreign bank lending, and a burst of an overheated economy. They believe that there is no other way for Latvia to regain competitiveness without a devaluation.
Devaluation, however, might turn out to be very costly and may not be as effective as intended. During the credit boom, Scandinavian banks provided cheap capital with considerably lower interest rates for loans denominated in Euro as compared to loans in Lat. As a consequence, in 2008 around 70 percent of bank deposits and nearly 90 percent of loans were issued in Euro. Devaluation of the Lat would thus pose a serious risk of insolvency.
B. . . .or should Latvia take the ‘‘hard road’’ instead?
As an alternative to external devaluation, Latvian politicians have started to talk about an ‘‘internal devaluation’’: keeping the currency fixed to Euro, but undergoing structural reforms to improve productivity and public sector efficiency, and reducing wages. While currency devaluation can happen overnight, internal devaluation may take months or years of structural reform and may lead to public unrest.
As a matter of fact, the government started to introduce austerity measures already in 2007 12 percent (or 115) state schools were closed, because budget financing was shifted from inputs-based (number of teachers) to output-based (number of students). In 2008 the government abolished half of state agencies, which reduced the number of civil servants by 30 percent. In October 2009, the government slashed budget deficits to meet targets imposed by the European Union for an additional e7.5 billion support package. About 75 percent of the expenditure cuts were thus done in 2009, bringing some positive hopes that austerity measures were carried in time.
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