Latvia and the politics of permanent austerity

In 2008 Latvia was hit by the economic crisis that saw its economy shrink substantially. In the fourth quarter of 2008 alone, Latvia’s GDP slumped by 10.5% compared to the same period in 2007. Prior to the financial crisis, the Latvian economy had been growing rapidly for a number of years.

In response to its economic problems, the Latvian government turned to the International Monetary Fund (IMF) for economic assistance in the form of a €7-billion loan. Naturally, the IMF rode into town with its usual offer of assistance tied to conditionality (i.e. austerity).

While Latvia is hailed as the poster child of how successful austerity programmes can be, the reality is a bit different. As a result of the economic crisis, the Latvian population has shrunk from nearly 2.2-million people in 2008 to about 2-million people in 2012. In effect, the Latvian population is back (in terms of size) where it was in 1957.

Whereas the collapse in the size of the Latvian population could be explained by deaths (in 2012 alone there were more deaths than births), the biggest factor in the reduction in the size of the Latvian population is the migration of people out of Latvia as a result of the economic crisis. Since Latvia is a member of the EU, Latvians have been able to escape the economic crisis as a result of EU rules around the free movement of people within the bloc.

As one indicator of the success of the austerity policies, austerians point to a fall in the Latvian unemployment rate from approximately 9.5% in 2008 to nearly 5% in 2012. That certainly is a success. But to credit the austerity programme is misleading. I would argue that the reason why the Latvian unemployment rate has dropped so dramatically is because people have left the country.

However, even with economic growth returning to Latvia (GDP growth was 5.5% in 2012), unemployment in Latvia is still high (bearing in mind the size of the population). It’s also import to bear in mind that the Latvian age dependency ratio has increased from 45.5% to nearly 46.78% in the period 2008 to 2012 alone. All of this would suggest, that the current levels of economic growth in Latvia are not enough to get people working and the economy growing again.

But Latvians, it seems, are suckers for punishment…

On 1 January 2014, Latvia joined the euro and ditched the Lat. That’s potentially good news, you would think. But the problem that Latvia will have is that, by joining the eurozone, the pain of austerity will continue for many, many, many years to come. How come?

Any government that issues its own sovereign currency (such as the Latvian government before 1 January 2014), when faced with an economic crisis has four choices:

Induce inflation by printing money;
Deflate the economy through austerity measures;
Devalue their currency; or
Default

Default is never a pretty option. However, by joining the Eurozone, the Latvian government will be giving itself only two choices, when faced with the next economic crisis:

Deflation; or
Default

The option of inducing inflation or devaluing their currency are taken away since these functions are handled by the European Central Bank in Frankfurt. Default is not an option for eurozone members. This means that Latvians, when faced with an economic crisis in the future will be left with three choices – austerity, austerity and more austerity.

The problem that Latvia has, however, is more than economic. As you would appreciate, given the size of its population, it will always be dwarfed by its much bigger neighbour – Russia. Given the history of Latvia and its absorption into the USSR at the end of World War II, this has resulted in a distrustful political elite that worry about when Russia might try to dominate Latvia again. This is, given the history of the place, understandable.

So when the option of joining the EU arose, naturally Latvia would chose to secure its political and economic future (free of Russian domination) by joining the EU. However, that membership has come at a cost, since one of the terms of its accession to the EU was that Latvia would need to join the Eurozone. At the time of joining the EU, this move probably made sense.

However, since the advent of the 2008 economic crisis, I would argue that one of the worst things that Latvia could have done on 1 January 2014 was to join the eurozone. A better policy choice, I think, given its commitments, would have been to delay joining the Eurozone until the economy was growing again and unemployment was under control (the optimal policy choice would have been to stay outside the Eurozone, but this isn’t really an option given the rules of joining the EU).

Unfortunately, this is not to be and instead Latvia will be heading down a path, starting 1 January 2014, that can only be described as politics of permanent austerity. If history is anything to go by, the future will not be pretty for Latvians.