'Smart Austerity' and the Latvian Turnaround

Smart austerity is economic stimulus, but not of the "borrow and print money" sort

An economic policy that combines growth—setting correct incentives—and austerity—getting rid of wrong and excessive spending—was key to our economic recovery

By DANIELS PAVLUTS

The recent trend-defying economic growth in Latvia is good news for our country. It is not good news for those who decry the Latvian government's policies of radical fiscal consolidation and sweeping structural reforms as too focused on "austerity" and not focused enough on "growth."

I think "smart austerity" is a much more accurate description of our policy. Smart austerity is economic stimulus, but not of the "borrow and print money" sort. Smart austerity means reviving the business environment by making it more competitive. It means creating a macroeconomic framework that restores confidence and directs the economy away from debt-driven financial services and construction. It also means safeguarding social stability and protecting education spending from cuts, thereby preserving our long-term competitiveness.

Struggling euro-zone countries could use their own dose of smart austerity. Since reaching a trough in the second half of 2009, Latvian output has grown for 12 consecutive quarters. In 2011 Latvia's GDP grew by 5.5%, and in the first half of 2012 it grew by 5.9%. Since the last quarter of 2011, Latvia has had the highest year-on-year GDP growth rate in the EU, and is likely to be the fastest growing EU economy in both 2012 and 2013. Unemployment is high but steadily in decline.

Yet critics like New York Times columnist Paul Krugman challenge the foundations of Latvia's success. They assert that because Latvian GDP is still 10% below its pre-crisis peak, our recent policies cannot be judged a success.

This criticism relies on the wrong benchmark. The supercharged growth of Latvia in 2005-07 was not representative: Massive inflows of cheap money worked as a performance-enhancing drug for our small and open economy. The result was full employment and windfall revenue for the state budget—and a real-estate bubble.

During this period, wage and real-estate price growth peaked at around 40% annually, the current account deficit exceeded 20% of GDP, and inflation reached 18%. The economy overheated rapidly, with growth driven by domestic consumption and wage increases. Investment flowed into nontradable sectors such as real estate, retail and internally consumed services, while manufacturing output and export revenues increased slowly. With the financial crash, credit stopped, the consumption bubble burst, and trade fell, pushing our economy into freefall.

Since then, smart austerity has effected a structural change in our government. Between 2009 and 2010, the number of state agencies was reduced to 97 from 148. The number of government employees has been cut by 24% since 2008, and government wages have been slashed by 30%. State-owned enterprises are better-governed, and with less political interference.

Other changes target private-sector growth. Red tape has been strongly reduced for businesses and public administration. Incentives were introduced for entrepreneurship and employment, including relief on corporate income tax for certain businesses and faster refunds for value-added tax. Generous support has also been made available for business start-ups and development, employee training and export promotion.

As a result, the role for manufacturing and exports in the Latvian economy has been substantially increased. Balance sheets of households and businesses have improved significantly; net external debt has fallen by a third. Both exports and industrial output have now exceeded their pre-crisis peaks. In the first half of 2012 exports have continued to grow despite the slowdown in external demand.

In a post on his Times blog dated June 10, Mr. Krugman argued that Latvia's competitiveness has not improved and that "internal devaluation" hadn't worked. "Has Latvia shown that it is possible to have wages that are downwardly flexible, so that you really don't need exchange rate adjustment?" Mr. Krugman asks. His answer is no.

But Mr. Krugman's argument is flawed because it relies on a comparison of hourly labor costs that do not account for changes in productivity. Adjusted for productivity, Latvia's unit labor costs have indeed fallen, accounting at least in part for our improved export competitiveness. (See the nearby chart.)

Unlike the boom that ended in 2007, Latvia's current economic growth is based on healthy—if demanding—diet and exercise, not on steroids. I do not claim that policies that worked in a small and open economy such as ours will necessarily work in other countries. Flawed growth and austerity policies will fail everywhere. But smart policies that include elements of both growth—setting correct incentives—and austerity—getting rid of wrong and excessive spending—were a success beyond doubt in Latvia.