Reduce friction or it might break: Lessons for euro members from Latvia's exchange rate and fiscal policies

Posted by on 29 June 2012

By Thomas Grennes, North Carolina State University, and Andris Strazds, Nordea Bank

Relevance of Latvia's experience to other countries

The Latvian government responded to a severe economic shock in 2008 and 2009 by implementing a fiscal austerity program that has received praise from some outside observers and criticism from others. Olivier Blanchard expressed mild approval, but he expressed reservations about whether it would be possible to export the lessons from Latvia. Critics, such as Paul Krugman and Charles Wyplosz were more negative about what happened in Latvia and its applicability to other countries. We agree that what was successfully implemented in Latvia need not be the best policy for all other EU countries, but it is possible that some aspects of the experience can be usefully exported to other countries with similar economic and political characteristics. Historically, countries with initial differences in economic and political institutions have responded to common shocks in different ways (Acemoglu and Robinson 2012).

Boom and bust in Latvia

An unsustainable economic boom in Latvia was fueled by large capital inflows (Grennes and Strazds). Although not yet a member of the EMU, Latvia pegged its currency to the Euro at the end of 2004, in anticipation of EMU membership by 2008. In addition to the lending boom, the government was implementing a pro-cyclical fiscal policy, running large structural deficits despite the budget nominally being close to balance. The huge capital inflows fuelled inflation and the Maastricht price stability criterion was missed by a wide margin in 2007.

A large combined shock of financial inflows stopping abruptly in the fall of 2008 and reduced demand in main export markets ended the boom and resulted in a sharp decrease in real GDP and an increase in unemployment in 2009. A rapidly deteriorating budget situation combined with a balance of payments crisis resulted in the Latvian government being forced to ask for international financial assistance from the IMF and the European Commission at the end of 2008. Latvian authorities rejected devaluation in favor of wage reduction (now also called 'internal devaluation') and implemented immediate fiscal austerity by cutting public sector expenditure and raising taxes, most notably the Value Added Tax.

As a result of the timely but painful action, Latvia experienced one of the fastest recoveries in Europe. A quick recovery was made easier by the fact that Latvia’s main trading partners are Baltic rim countries that suffered less from the economic shock. Productivity increased, unit labor costs decreased, and competitiveness increased (Grennes and Strazds). Sometimes early and decisive fiscal action can be more effective than delayed action, and expansionary fiscal policy does not always contribute to long-run economic growth (Canuto ; Uhlig; Caner, Grennes, and Koehler-Geib). Alesina has pointed to cases in which governments have not been penalized for implementing austerity policies. This Latvian case fits that pattern, as the party of the prime minister who led the country through the severe adjustment in 2009 won the elections in the fall of 2010 and he kept his position.

Economic and political institutions and friction

Latvia’s response to the shock may have been influenced by its distinctive economic and political institutions. It is a small, open economy with fewer labor market restrictions than Greece, Italy, and some other European countries. Laying off workers for economic reasons is relatively easy (according to the Labor law, one-month advance notice and a compensation amounting to one or two months’ pay is sufficient in most cases) and labor unions are weak. Although the country had largely adopted the legislative framework of the EU by 2004, economic and political institutions still continue to evolve. For example, the court system is still inefficient and there is apparently a gap between the insolvency law and its implementation (FICIL).

The central bank might have resisted devaluation in 2008 or 2009 partly to smooth the transition to membership in the Eurozone. However, due to the overwhelming majority of Latvian debts being expressed in Euros, including in the corporate sector, devaluation would have resulted in an instant wave of bankruptcies following devaluation that the court system would have been unable to deal with efficiently. Thus, a substantial part of productive assets would have been taken out from the economic system for a prolonged period of time. Furthermore, devaluation is only effective if it changes relative prices and the real exchange rate, but openness and dependence on imported capital goods and sources of energy made it likely for most prices to rise in terms of domestic money (lats).

One way how to think about potential adjustment options is to try to anticipate, which option would encounter less friction during implementation. From the above it becomes rather clear that the option selected by the Latvian government encountered relatively little friction as labor legislation was lax and labor unions weak, wages were flexible, there was room for considerable productivity improvement and the freedom of labor movement within the EU meant that the unemployed could go and look for jobs elsewhere in the EU. Devaluation, on the other hand, would likely have resulted in a clogged up court system and productive assets being taken out of the economic system for a prolonged period of time, while the reduction in real wages would have been short-lived due to subsequent inflation and the common labor market in the EU.

Absence of a common European fiscal policy

EU members responded to the common shock in different ways that reflect differences in their economic and political institutions and the anticipated friction during implementation. Within the EU there are vast differences in country size, degree of openness, productivity and labor market flexibility that conditioned fiscal responses to shocks. Latvia has more similarities with small, open economies, such as Estonia, Slovenia, Slovakia, Malta, and Cyprus, than it has with Greece, Portugal or Spain, and the latter have major differences among them or with Italy, France or Germany. Given these cross-country differences, is it possible to impose the same fiscal policy on all EMU members?

Stable and unstable fiscal relationships in a monetary union

The EMU has moved into a fiscal situation that is unstable. By bailing out Greece, the members have abandoned the original Maastricht Treaty by implicitly accepting collective liability for at least some of the debts of other members. But this collective liability is not tenable without a tighter fiscal union that restricts the actions of debtor countries. Current EMU rules do not effectively require a common fiscal policy for all members, however, there is now strong support from some EMU members as well as outsiders, to adopt the so-called “fiscal compact”, which among other things would strictly limit the structural deficit that a country is allowed to have, and to move toward a tighter fiscal union. One way to make the situation stable would be for the EMU to tighten the fiscal union by restricting spending and borrowing, aligning taxation and assigning more regulatory control to central authorities in the EMU. Such a fiscal system is logically consistent, but it reduces national sovereignty and it will be difficult to enforce. Failure to enforce longstanding rules related to budget deficits and debt ratios has already created a credibility problem for officials. Since most EMU members currently have budget deficits in excess of 3% and debt ratios above 60% of GDP, there is reason to doubt that more restrictive rules would be enforced more effectively than the older, less restrictive rules.

The EMU could, however, require a substantial change of policy by the ECB and possibly even an amendment to the Basel III framework of banking sector regulation. In particular, the ECB would have to stop relying on rating agencies and replace their assessment with an internal rating system, link the eligibility of government bonds as collateral for its refinancing operations to fulfillment (or initially the degree of violation) of Maastricht criteria and the conditions set forth in the new “fiscal compact” or as a minimum introduce a sliding scale of differentiated haircuts. The Basel III rules might also have to be adjusted by the EU authorities so as to require banks to hold more capital against the government debt of those countries that are violating the Maastricht criteria by a substantial margin and are not adhering to the rules of the “fiscal compact”. There would also have to be a lengthy transition period during which the ECB might need to implicitly guarantee that the yields on government debt of individual countries do not exceed certain critical thresholds. The EMU could also allow “fiscal devaluations” that substitute value added taxes for payroll taxes (Gopinath).

Another element of a tighter fiscal union in the EMU that has recently been discussed is making each member country responsible for at least a part of the debts of all member countries. In defense of the common liability bond, some proponents have cited the United States as a successful fiscal union that allows transfers among the states, but the analogy is misleading. Some fiscal transfers do occur, but only with the approval of Congress. More fundamentally, the US federal government is not responsible for the debts of the states (or cities). Congress set a precedent in the 19th century by rejecting requests by states to bail them out (Sargent). Furthermore, nearly all the states (49 out of 50) have chosen annual balanced budget requirements that limit their ability to borrow. The United States has no collective liability and a loose fiscal union in the sense that the federal government does not restrict state budgets. The EMU is considering a move toward the opposite fiscal system with collective liability and a tighter fiscal union. Both these systems are stable in contrast to the current EMU arrangement in which there is implicit collective liability but no effective fiscal union.

Currently the EMU appears to be stumbling and staggering toward some kind of greater fiscal union without a clear idea of exactly where they will end up, or what the overall economic consequences will be. Pressure on the European Central Bank to take a greater role in bailing out struggling debtors without agreeing on a clear path of how the fiscal and debt situation will be addressed risks reducing the independence of the central bank and is likely to conflict with the Bank’s inflation target in the future. Opposition in Germany, but also such countries as Finland and Estonia, to having to bail out countries that have been running large structural budget deficits and continue doing so even despite having lost or being close to losing bond market access is on the rise and should not be overlooked, as suggested by Ilves (2012)

Exporting Latvian policy and broader lessons

Latvian economic policy cannot be successfully exported to all EU countries, but it can provide useful guidance to certain countries in similar situations and the broader lessons could be used to speculate about the options available to others. Estonia has had a similar experience to Latvia’s,and Estonian President Toomas Ilves has defended his policies forcefully against the criticism of Krugman and others who see no role for austere fiscal policy. The EMU currently includes other small, open economies, such as Malta, Cyprus, Slovenia, and Slovakia, and the broader EU includes other small, open economies that are candidates for the Eurozone, such as Lithuania and Bulgaria. These countries are likely to be able to thrive without having devaluation in their economic policy tool kit provided that they keep the flexibility that allows them to adjust to adverse shocks in other ways.

Other countries such as Greece, Portugal and Spain basically face two options. They can considerably increase the flexibility of their economies and carry out a set of product and labor market, tax and education sector reforms that make them more competitive globally while also reducing government expenditure to eliminate structural deficits. In the meantime they would need help from the European Financial Stability Fund and the European Stability Mechanism and the European Central Bank, however, that support should not be granted unconditionally. If these countries fail to substantially increase the flexibility of their economic systems and eliminate structural deficits in the near future, it would mean that an exit from the Eurozone and devaluation become the only alternative to implementing agreed reforms. Collective liability ends when reasonable economic conditions are not satisfied.


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