Latvia gives Greece a lesson in austerity

Greece and Latvia are two small countries hit worst by the financial crisis and which pursued different policies in trying to escape from the mire. The outcome has produced stark contrasts.

After five years of financial crisis, the European record is in: northern Europe is sound, thanks to austerity, while southern Europe is hurting because of half-hearted austerity or, worse, fiscal stimulus. The predominant Keynesian thinking has been tested, and it has failed spectacularly.

The starkest contrasts are Latvia and Greece, two small countries hit the worst by the crisis. They have pursued different policies, Latvia strict austerity, and Greece late and limited austerity. Latvia experienced a sharp GDP decline of 24 per cent for two years, which was caused by an almost complete liquidity freeze in 2008. This necessitated the austerity that followed.

Yet Latvia's economy grew by 5.5 per cent in 2011, and last year it probably expanded by 5.3 per cent, the highest growth in Europe, with a budget deficit of only 1.5 per cent of GDP. Meanwhile, Greece will suffer from at least seven meagre years, having endured five years of recession already. So far, its GDP has fallen by 18 per cent. In 2008 and 2009, the financial crisis actually looked far worse in Latvia than Greece, but then they chose opposite policies. The lessons are clear.

A successful stabilisation programme must appear financially sustainable so that it can restore confidence among creditors, businesses and people. Usually, a sound stabilisation programme can revive economic growth within two or three years, as Latvia's did. A few rules of thumb need to be followed. Latvia did them all; Greece not at all.

To regain confidence fast, reforms should be front-loaded. In 2009, Latvia carried out an arduous fiscal adjustment of 9.5 per cent of GDP, 60 per cent of the total needed, while Greece foolishly tried to stimulate its economy.

In a severe crisis, it is much easier to cut public expenditures than to raise revenue. Moreover, taxpayers think the government should tighten its belt when they are forced to do so. Cuts in public spending accounted for two thirds of the Latvian fiscal adjustment.

It decreased government expenditures from a high of 44 per cent of GDP in the midst of the crisis to a moderate level of 36 per cent of GDP this year. Latvia has kept a flat personal income tax now at 21 per cent and a low corporate profit tax of 15 per cent.

Greece, by contrast, maintained high public expenditures of 50 per cent of GDP in both 2010 and 2011, when it was supposed to be pursuing austerity. It should cut its public spending to 40 per cent of GDP to become financially sustainable.

Then the Greek crisis would end. An advantage of sudden and sharp cuts in public expenditures is that they can't be even, as some items can't be cut. Therefore they drive reforms.

The Latvian government was hit hard at the stifling bureaucracy that swelled during the preceding boom. It fired 30 per cent of the civil servants, closed half the state agencies, and reduced the average public salary by 26 per cent in one year.

It prohibited double-dipping by officials, who had earned more in fees from corporate boards of state-owned companies than in salaries. The ministers took personal wage cuts of 35 per cent, while pensions and social benefits were barely reduced. The cuts prompted deregulation, and Latvia enjoyed a boom in the creation of new enterprises in 2011.

By contrast, Greece has allowed clientelism and corruption to thrive. During the purported austerity, the socialist prime minister George Papandreou increased the number of civil servants by 5,000 from 2010 to 2011, because they were his power base. Transparency International ranks Greece the most corrupt country in the EU.

A serious financial crisis requires international emergency funding. Latvia received substantial credits from the IMF, the European Union and neighbouring countries. Altogether, the committed funds amounted to 37 per cent of Latvia's GDP in 2008, but Latvia used 60 per cent of the credits committed.

In late December it paid back all its IMF loans almost three years earlier than necessary because it can borrow more cheaply on the market. Its six-year bond yields have plummeted to 1.7 per cent, while the Greek 10-year bond yields are 11 per cent.

In May 2010, Greece received far more help than Latvia did but its stabilisation programme was neither credible nor executed. The Greek public debt has been excessive, and it remains so after two substantial, yet insufficient, debt reductions. The government needs to seriously cut its spending, reduce its bureaucracy and prosecute corrupt leaders.

Recently, the IMF warned that cutting government spending had more negative effects than previously thought. But the fund focuses on one single year. What really matters is how quickly a crisis can be resolved and the long-term growth trajectory, as Latvia shows so elegantly.

Last June, the IMF's managing director, Christine Lagarde, went to Riga to celebrate Latvia's success. Now, however, the IMF complains that Latvia has cut social spending too much. Unemployment remains the main concern, but it has fallen substantially from 20.7 per cent in early 2010 to 13.5 per cent in the autumn of last year. Latvia is undergoing a major structural change, as an oversized construction sector has collapsed, and new manufacturing companies are expanding. Real adjustment takes time.

Anders Aslund is a senior fellow at the Peterson Institute for International Economics. He is the co-author with Valdis Dombrovskis, the prime minister of Latvia, of How Latvia Came through the Financial Crisis.