Lessons from Latvia

By Olivier Blanchard

In 2008, Latvia was widely seen as an economic "basket case," a textbook example of a boom turned to bust.

From 2005 to 2007, average annual growth had exceeded 10%, the current account deficit had increased to more than 20% of GDP.  By early 2008 however, the boom had come to an end, and, by the end of 2008, output was down by 10% from its peak, the fiscal deficit was shooting up, capital was leaving the country, and reserves were rapidly decreasing.

The treatment seemed straightforward: a sharp nominal depreciation, together with a steady fiscal consolidation.  The Latvian government however, wanted to keep its currency peg, partly because of a commitment to eventually enter the euro, partly because of the fear of immediate balance sheet effects of devaluation on domestic loans, 90% of them denominated in euros.  And it believed that credibility required strong frontloading of the fiscal adjustment.

Painful adjustment

Many, including me, believed that keeping the peg was likely to be a recipe for disaster, for a long and painful adjustment at best, or more likely, the eventual abandonment of the peg when failure became obvious.

Nevertheless, given the strong commitment of both Latvia and its European Union partners, the IMF went ahead with a program which kept the peg and included a strongly front-loaded fiscal adjustment.

Four years later, Latvia has one of the highest growth rates in Europe, the peg has held, and the fiscal and current accounts are close to balance.

The mechanics of adjustment have been straightforward—a further sharp decrease in output, followed by increases in competitiveness due initially to decreases in wages, but increasingly due to productivity gains.  Growth has come initially from external demand, but is coming increasingly from domestic demand.   Unless Europe has a meltdown, growth should continue.

Big costs

Is it a success?  The economic and social cost of adjustment has been substantial.  Output further contracted by 16% in 2009, and is still 15% below its 2007 peak.  Unemployment increased to more than 20% and still stands at 16% today, far higher than any reasonable estimate of the natural rate.

Was there another, less costly, way of adjusting, through floating, and a slower fiscal consolidation?   The truth is we shall never know.   What is true though is that the adjustment looks likely to succeed under the peg, something that many of us thought nearly impossible, that the economy is growing, and that there is optimism in the air—a feeling quite unusual in Europe these days.

This surely satisfies some definition of success.

Why has it worked?   Preparing for the conference I just attended in Riga in which we tried to draw lessons, and reading the evidence, I could think of seven reasons (at the conference, some, including the Prime Minister, had other lists.  The reasons were more general; for example, ownership of the program by the Latvians, a clear exit strategy, namely the promise of entry into the euro.  My list is more prosaic, closer to an analysis of the plumbing, of each of the parts of the adjustment mechanism).

  1. The adjustment was preceded by an unusually strong boom, so there was wide acceptance on the part of people that part of the downward adjustment was a return to normal.   Some of the tough measures were seen as undoing the excesses of the past, for example the very large increases in nominal wages during the boom.
  2. There was support for fiscal consolidation, and the acceptance of pain.  Parties which argue for stronger fiscal austerity often did better than the others at the polls.   Pedagogy, a factor emphasized by the Prime Minister (in his book with Anders Aslund, which gives a detailed account of the crisis and of the adjustment) was surely important.  But historical reasons, including the painful transition from central planning in the 1990s, surely played an important role.  The Latvians could take the pain.
  3.  Wages were flexible, at least relative to the generic European labor market.  The initial adjustment came with a dramatic reduction in public sector wages, and thus a direct improvement in the fiscal position.  Together with unemployment, lower public sector wages put pressure on private sector wages to adjust.  A note of caution is needed here however: private sector wages, which are the wages which matter for competitiveness, have adjusted much less than public sector wages (by how much is a matter of some disagreement).  Indeed, I worry that nominal wages have started to increase, while more adjustment still has to come to maintain current account balance as output recovers.   One has to hope that increases in productivity will do the trick.  This takes me to the next point.
  4.  There was—and, looking forward, there still is—substantial room for productivity increases.   Latvia has income per capita of half the European Union average.  Being far behind the technology frontier, it has a lot of room for catch up.
  5. Latvia is a small, open economy---although less so than its Baltic neighbors.   With exports around 50% of GDP, improvements in competitiveness can have large effects on both imports and exports, and in turn on GDP.
  6. Public debt was very low to start, less than 10% of GDP.  Even today, public debt remains around 40% of GDP.   This more or less eliminated foreign investors’ worries about default on sovereign debt, and allowed for a quicker return of Latvia to international financial markets.
  7.  The Latvian financial system was largely composed of relatively friendly foreign banks—better than unfriendly foreign banks, or friendly but weak domestic banks.For the most part, the Swedish banks recapitalized their banks and maintained their credit lines to the Latvian subsidiaries, reducing the intensity of the sudden stop and of the credit squeeze.

Latvian policymakers would surely want me to add yet another reason—the strong front loading of fiscal consolidation:  over the first two years of the program, the cyclically adjusted primary balance was increased by 11% of GDP.   I am not sure.  Growth was negative and large in 2009.   Whether a slower adjustment would have led to less of an overall output loss just cannot be assessed.

But I still draw two conclusions from what happened.

While the decrease in output was dramatic, the recovery has been relatively more V shaped than I expected, although I still worry about the effects of long term unemployment.

And the Latvian experience makes a strong political case for taking into account adjustment fatigue. While the large initial budget cuts went through relatively easily, taking much smaller steps proved much more difficult in the 2011 budget.  The political argument for front loading thus strikes me as fairly strong.  So does the political argument for focusing on spending cuts initially.  Targeted spending cuts are typically more costly politically than general tax increases; thus it may be better to keep those tax increases in reserve for later, if and when fatigue is settling in.

Wider application?

If my list is about right, one cannot avoid the question of how many of these conditions apply to Europe’s southern periphery countries.

The sad truth is that many of these conditions are not satisfied elsewhere.  True, the adjustments that these countries have to make are smaller than those Latvia had to make.  But their economies are less flexible, less open.  They have less obvious potential gains in productivity, at least in the tradables sector.  They had much higher public debt to start.

So, the lessons are not easily exportable.

And we should be under no illusion that the adjustment in the South will be difficult and painful.  In that context, the argument for a social pact, and faster joint adjustment of wages and prices than implied by market mechanisms and the downward pressure from unemployment, remains, in my mind, a very strong one.

2017-04-15T14:07:12-05:00June 11, 2012|


  1. anguscunningham June 11, 2012 at 10:48 pm

    Thank you, Mr. Blanchard, for this post. It struck me as one I had not the slightest doubt the writer was fully invested in it.

    I have never been to Latvia, so I do not know the culture there. What I do know is that its culture will be, to some degree, affected by the severity of the country’s weather: in other words, people know that, in difficult times — like those of mid-winter or those of a sharp economic slump — they must pull together. That means that they can become interested in the necessity of being both more authentic and more empathic with each other.

    In relation to this, I want to recommend a very recently published book: “The (Honest) Truth about Dishonesty”, by Prof. Dan Ariely of Duke University where he is the James B. Duke Professor of Psychology and Behavioural Economics. It’s been very recently reviewed by the Wall Street Journal.

    Honesty is not an easy subject to discuss. But my own experience as an executive coach tells me that, done in a sensitive way, and in the special circumstances of the client being truly in a “burning platform” condition (referring to author Darryl Conner’s book “Managing at the Speed of Change”), a discussion of honesty can be a powerful tonic to a struggling organization or, indeed, an entire culture.

  2. […] a ‘breakout nation’, Business Day Russia-Poland on Euro 2012: The Preoccupation of Poland, WSJ Lessons from Latvia, iMFdirect How Cubans Try to Tweet Their Way to Freedom, Moscow Times Posted in Global | […]

  3. Wouter Nauta June 12, 2012 at 6:09 am

    Dear Oliver Blanchard,

    Realizing that too many pundits have their own, diverging, opinions about key topics such as these. Austerity versus stimulus.

    However, it would be good if some more discussion would be held around facts. I saw Krugman posting some blogs about this exact topic — would it be possible to address his attack on the above-mentioned analysis. What valid and what invalid arguments does Krugman provide us (in your view)?

    There seems to be not enough discussion between pundits. Perhapds the iMF blogosphere can start making the discussion theirs?

    Posts by Paul Krugman:

  4. Blanchard on Latvia - NYTimes.com June 12, 2012 at 8:25 am

    […] Blanchard, the IMF’s chief economist (and a former colleague of mine at MIT), has a post on Latvia’s economic experience. Given his position, and the sacred status Latvia has acquired among the austerians, he is […]

  5. wanderer June 12, 2012 at 9:43 am

    Another minor detail…

    There were about 20% fewer births in Latvia in 2011 than there were in 2008.

    Deaths now exceed births in Latvia by more than 1.5 to 1.

    So yeah, there’s growth now.

    But wait 20 years and see if there’s a labor force there. Or customers.

  6. J.V. Dubois June 12, 2012 at 11:08 am

    I would add one very important political factor — Russia. In Latvia, with almost 30% Russian minority and big brother always there watching over the shoulder, seemingly economic decisions like sticking to euro peg are more politically loaded.

    It is easier to convince Latvians that painful adjustment is needed as another step towards integration into Western structures and to gain more independence from former partners in Soviet Russia.

  7. Economics Link Roundup « socialempirics June 12, 2012 at 1:11 pm

    […] Blanchard on Latvia […]

  8. Mark A. Sadowski June 12, 2012 at 2:04 pm

    Blanchard wrote:
    “There was support for fiscal consolidation, and the acceptance of pain. Parties which argue for stronger fiscal austerity often did better than the others at the polls.”

    Once is not often

    Yes, the antidevaluation/proausterity party Vienotibato was returned to power in the October 2010 elections. But Latvia’s 2010 election really came down to chauvinism and nationalism. The prodevaluation/antiausterity party Harmony Centre put forward a plan to rebuild the economy and unite ethnic Latvians and ethnic Russians. In the end, however, manipulation of fears over Harmony Centre’s links to United Russia by Vienotibato led to an election that predictably split along ethnic lines.

    However, in the year that followed, Latvia’s largely pro-austerity parliament saw its public approval ratings fall as low as of 5-15%. Harmony Centre’s victory in the September 2011 elections was the first for a pro-Russian party since Latvia’s independence in 1991. Meanwhile Vienotibato finished a distant third.Unfortunately Harmony Centre was unable to come to an agreement to form a coalition, and despite his party’s stunning rejection at the polls, Valdis Dombrovskis retained his position as prime minister ostensibly “to keep markets stable.”

  9. marksadowski June 12, 2012 at 3:10 pm

    Blanchard wrote:
    “Pedagogy, a factor emphasized by the Prime Minister (in his book with Anders Aslund, which gives a detailed account of the crisis and of the adjustment) was surely important.”

    Pedagogy is a polite way of putting it.

    Aslund is a banking industry-funded travelling economic policy consultant. The 2008 crisis hit hardest those countries that followed his neoliberal economic policies, which he trafficked in the post-Soviet bloc during the 1990s. The 2008 crisis in Latvia provided Aslund the opportunity to find “doctors,” such central bank governor Rimsevics and prime minister Dombrovskis, to administer his antidevaluation austerity medicine to address the economic crisis.

    Latvians are paying their private debts (largely to the Swedes, Aslund’s home country, helping to ensure that Sweden has faced no economic crisis). The cost, however, came at a 25% GDP contraction and a 30% reduction in public-sector salaries, with unemployment from public spending cutbacks driving down private sector salaries. Meanwhile, the Latvian public will have to bear the cost of this program through the future debt payments required on the more than 4.4 billion euro borrowed from the EU and IMF for its implementation.

    Aslund’s book serves as a manual of style of sorts, on how to successfully implement a program of antidevaluation and austerity through a combined one-two punch fear campaign of central bank economic talking points and government fueled ethnic hatred.

  10. […] Earlier today, Krugman posted a link to a piece by Oliver Blanchard, the IMF’s chief economist on Latvia. Blanchard suggested that what had worked for Latvia is unlikely to work for the rest of Europe. […]

  11. FT Alphaville » Further reading June 13, 2012 at 3:15 am

    […] Some lessons from Latvia by Olivier Blanchard, the IMF’s chief […]

  12. […] Lessons from Latvia: Os it a success?  The economic and social cost of adjustment has been substantial.  Output further contracted by 16% in 2009, and is still 15% below its 2007 peak.  Unemployment increased to more than 20% and still stands at 16% today, far higher than any reasonable estimate of the natural rate. […]

  13. […] is if they will remain in the EUR once they have re-defaulted. The IMF’s Blanchard just posted to the fund’s blog on the lessons from Latvia, which suggests that the IMF are pulling for a […]

  14. Javed Mir June 13, 2012 at 10:38 am

    With the following policy measures, including:

    – drastic reduction in public sector wages
    – still having enough space for productivity
    – being a small open economy with further improvements in
    – friendly attitude of foreign banks by keeping credit lines available
    during economic shocks
    – low public debt — around 40% of GDP

    and subsequent to the above measures mixed with fiscal consolidation and austerity, improvement in Latvia’s economic outlook is commendable. Painful medicines (tough measures) if taken properly, cause reduction in pain.

  15. Gisela Höfler June 13, 2012 at 11:19 am

    Isn’t Latvia a blind alley? The country was flooded by Swedish banks with hundreds of loans. Swedish funds were literally pumped into the Baltic states — mainly to Latvia. Now a lot of the country faces bankruptcy — private and corporate creditors (Greetings from Iceland!).

    National insolvency and a greater devaluation of the currency could then only be prevented through emergency loans. And who pays? In this case, the Swedish taxpayers

  16. […] Latvia, a Baltic country of 2.2 million that most people could not find on a map, has suddenly gotten more attention from economists involved in the debate over the future of Europe and the global economy. I responded in a column last week to remarks by Christine Lagarde, IMF Managing Director, who on June 5 said that Latvia’s policies in response to the economic crisis had been a “success story.” Paul Krugman has also weighed in several times, and has been joined by Harvard international economist Dani Rodrik, and now by the IMF’s Chief Economist Olivier Blanchard. […]

  17. […] Paul Krugman has also weighed in several times, and has been joined by Harvard international economist Dani Rodrik, and now by the IMF’s Chief Economist Olivier Blanchard. […]

  18. […] Oliver Blanchard IMF chief econ) […]

  19. […] Olivier (2012), “Lessons from Latvia“, iMFdirect, 11 […]

  20. […] a recent one by the IMF’s Olivier Blanchard (“Lessons from Latvia”, iMFdirect, June 11, 2012 http://blogs.imf.org/2012/06/11/lessons-from-latvia/ ), are the exception. Several economists, Paul Krugman perhaps being the most visible of them all, […]

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