Thursday, August 25, 2011

Lessons from the Latvian Crisis for Greece

As I read this wonderful little book called How Latvia Came through the Financial Crisis by Peterson Institute economist Anders Åslund and the Latvian PM, Valdis Dombrovskis, I could not help but think of what Greece could learn from Latvia. Strictly speaking, the Latvian and the Greek crises are very different. But there is something about how Latvia dealt with its crisis – a combination of competence, clear-headedness and a sense of purpose – that is both humbling and inspiring. The authors offer their own “lessons to the world,” which I recommend reading, but here is what I took away from the book.

First, a disclaimer. Latvia and Greece faced very dissimilar crises. Latvia had a “sound economy” that suffered from a capital-inflow induced bubble. Its politics were center-right and there was a strong commitment, political and public, to markets. Budgets had been balanced and public debt was low. There was also a national consensus in favor of macroeconomic policies that would support the country’s entry into the Eurozone, which served as the end-game “prize.”

By contrast, Greece had an unsound economy with numerous distortions, public and private. Budgets had been chronically imbalanced and public debt had been uncomfortably high for at least 15 years. The electorate has been center-left, at least since 1981, and hostility to markets has been pervasive. And as part of the Eurozone, Greece has so far articulated only negative targets: “avoid default” and “not leave the Eurozone.”

In that sense, the lessons to draw from Latvia are more generic, but are no less valid for that. To begin with, there are economic lessons – these are now almost accepted principles for dealing with a crisis, but they are no less deserving to repeat here. First, better to achieve fiscal consolidation by relying on spending cuts rather than revenue hikes. Second, better to implement reforms sooner rather than later. Third, an international aid package should be big and frontloaded. Besides those narrower economic lessons, I would take away the following.

First, currency “depreciation is an overadvertised cure in current macroeconomic discourse.” As the authors note further, “when a country needs to address underlying structural inefficiencies in the economy, internal devaluation is preferable to exchange rate devaluation, which offers only temporary relief from cost pressures while avoiding long overdue reforms.” This is a view that I subscribe to – as I have written, “A weak currency in itself is a poor foundation for export-led growth. Greece had a free floating drachma before the euro but with no export-driven industries to show for. Just becoming cheaper only gets you so far” (here).

Second, “the international macroeconomic discussion was not useful but even harmful. Whenever a crisis erupts somewhere in the world, a choir of international economists proclaim that it is ‘exactly’ like some other recent crisis - the worse the crisis, the more popular the parallel. Soon, prominent economists led by New York Times columnist Paul Krugman claimed that ‘Latvia is the new Argentina.’ The fundamental problem is their reliance on a brief list of ‘stylized facts,’ never bothering to find out the facts.” 
This is a view I also share strongly – hence my post against Nouriel Roubini or against the Argentina analogy as characteristic of how international economists are wrong on Greece. As someone trained in political science and economics, I have always been shocked by how little economists understand of politics. Of course, they understand politics in the abstract, but they fail to connect the political links with the economic dots. In Latvia’s case, they under-estimated just what the politicians were willing to do and the public willing to accept. In Greece, they under-estimate the political economy that has driven Greece to this mess and, as a result, have no appreciation of what needs to change.

Third, equity matters. The Latvian PM, the book’s co-author, spends considerable ink to talk about policies that “might not have saved us much money, but they showed that the government was serious about distributing the cost of the adjustment also to the privileged.” Or, put eloquently by the PM, “we will ensure that the cuts do not apply only to policemen, teachers or the health care sector.” There was also a strong effort to bring in constituencies such as professional associations and unions to enlarge the stakeholder base. 
Greece has failed in that task. In April 2011, I noted that the government seemed to be losing support just when it demonstrated a willingness to cushion the effect of the reforms on vested interests: “The PASOK government now faces a fundamental question: will all Greeks be forced to change or will some Greeks have to change more than others? In 2010, the government was saying all Greeks would change. In 2011, it has pulled back from that commitment. This may please some special interests but the silent majority is watching closely. And they are disappointed by what they see” (here). The effort to deal with tax evasion and tax arrears is meant to address that issue, but that may be too little, too late.

Fourth, government competence matters. One Latvian (coalition) government fell months after agreeing to a bailout with the external creditors. The government failed chiefly because it was not up to the task. The shenanigans of the finance minister, Akis Slakteris, are particularly memorable and make Joe Biden seem benign by comparison. His answer to the question, why did had Latvia gotten into this mess (“Nothing special” was the answer) seems to have sealed his fate. But there are other positives too – President Valdis Zalters was relentless in pressing the government to take action and was ready to dissolve parliament when it was failing. As the PM notes on the event of his reelection, “These elections appear to be a textbook example of how a serious and competent government can win elections even with severe austerity policy, if it convinces the voters.”

Fifth, communication matters, as do long-term goals. The Latvian government went out of its way to explain the crisis, what needed to be done, and how its actions would resolve problems. More crucially, it clung to a vision that Latvia should stick to the Maastricht criteria so that it could join the Eurozone by 2014. In Greece that has been a major deficit – almost two years since this government took charge, no politician is  articulating either a strong understanding of what happened or a coherent vision for where Greece needs to go next. Use whatever cliché you want – light in the end of the tunnel, eyes on the prize, the final destination – but Eurozone entry helped keep Latvia focused, while the absence of such goal in Greece shows an inability to galvanize popular support towards something as opposed to merely against something – toward reform rather than mere avoidance of default.

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