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Some reflections on different interpretations of Latvia's economic 'slowdown' 13

Couple of weeks ago I had the pleasure to attend early part of the conference on "The Baltic States' Economies: Development Scenarios" at Stockholm School of Economics in Riga.

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The first part would be rather uneventful, if it were not for the presentation of Willem Buiter, professor at the London School of Economics, former chief economist at EBRD, etc. Intellectually, Prof. Buiter was clearly the star of the whole conference. His talk featured words like "the credit orgy", "macroeconomic mismanagement", "crash". In other words, not a very rosy picture for the short-term future of the Baltic States. In stark contrast, the other presentation by (mostly) local experts could be summarized as "everything is going to be just fine". The difference in how the situation is interpreted is striking. Interestingly, this is by far not the only time when the local and Western economists have such different interpretations of what's going on. Vastly different growth forecasts of Latvian GDP between IMF and the local economists come to mind. As an economist (but no macroeconomist) myself, I am aware that differences in opinion among different economists are unavoidable. However, I find the magnitude of the difference, and the fact that the split is along the 'Western' vs 'local' dimension, to be rather curious.

What has happened to the economy seems to be well understood now. The story is being told in a more or less similar way by both the 'Westerners' and the 'locals'. Briefly, it would go something like this. The "credit orgy" of 2004-2007 led to massive capital inflows and played important role in substantial wage increases. Unprecedented credit expansion led to skyrocketing real estate prices and, in turn, sharp increase in the volume of new construction. Eventually, excess demand in the construction sector, combined with increased labor migration, exerted upward pressure on wages and prices. Thus, we ended up with wage growth far in excess of productivity. That's economists' way of saying that wages are too high for the exports to be competitive in the world markets. So here we are, with overvalued assets (e.g. real estate), and excessively high wages. It's not quite clear whether the landing will be 'soft' or 'hard'. Most 'Westerners' seem to think things will happen the hard way and most 'locals' believe in the soft landing. Whatever it will be, an important question right now is what can be done to make the landing a bit softer.

The official policy response can be broadly grouped into three categories: (i) reduce fiscal spending, (ii) lower business taxes, (iii) promote "high value-added sectors". Yet none of these measures can withstand closer scrutiny. Reducing government spending would be nice, not only for macroeconomic reasons. However, so far the government has failed to do so. A 'nearly balanced' budget for 2007 is a disgraceful cover-up. Huge (419 million Ls) budget deficit of central and local governments was covered from the social budget. No wonder the pensioners are so angry. Further, it is far from clear whether additional reductions in corporate tax (already one of the lowest in the world) would have a substantial effect. It is also highly doubtful whether relieving businesses of the burden of paying sickness benefits (and other small concessions) will save the economy. I doubt that the "high value-added sectors" story can be a working solution, especially in the short-term. After all, this has been a policy "priority" for quite a few years , but with little, if any, effect so far.

What I find particularly interesting is that none of the above 'solutions' was featured in Prof. Buiter's talk, except for the need to contain and reduce public spending. His recipe was to keep restraining private lending to the economy. In his own words, "do what you do already, but three times more". In particular, in addition to requiring positive proof of incomes (i.e. from the tax authority), he also suggested curtailing provision of credit denominated in foreign currency to households whose incomes are in lats. Not exactly a measure advocated by Latvian economists and policy makers…

All in all, the difference in how situation in Latvia is interpreted by "Western" economists (when they care to pay attention to this country) and local 'homegrown' economists is quite striking. As someone who has seen how economists are trained here (undergraduate program at the University of Latvia) and there (graduate program in U.S.), I would bet on the Westerners.

In Latvian here

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Komentāri (13) secība: augoša / dilstoša

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Komentētājs

x 14.05.2008 16:34
perhaps anything allowing firms to stay above water could help(except everlasting growth of credits, energy costs and regulatory provisions)?

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B to Vyacheslav Dombrovsky 14.05.2008 13:00
> If you insist on public policy in this area, start by identifying what economists call "market failures".

But this is exactly the point. Technological spillovers that you mentioned are a market failure – they are not fully internalized by firms. These externalities are naturally stronger in R&D-intensive sectors, so I think some tax incentives for them should at least be considered. And there are learning-by-doing effects as well.

Sure, this is not a short-term solution, but frankly, I don’t see many short term solutions. Restraining private lending may keep inflation down, but IMHO it should have been done before the growth slowdown began. By now, I think, the big problem is low output growth and the contraction of the manufacturing sector – and I can’t see how these can be helped except by supply-side instruments like tax cuts (and a reduction of the associated bureaucratic hurdles).

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B 14.05.2008 12:46
rb,

>Something that will have an effect in the long run cannot be part of the policy response to the current crisis.

Sure, it cannot. I just don't see what can be a response to the crisis. I mean, you aren't saying that spending cuts and a crackdown on lending can relaunch GDP growth in the short term, are you?

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Vyacheslav Dombrovsky 14.05.2008 11:58
I appreciate the discussion stimulated by my entry and thank all the participants. Couple of comments on the tax policy. Clearly, tax policy is not an effective tool for short run macroeconomic stabilization. I'll not comment on this. However, using tax policy to promote certain sectors is quite controversial.

I don't think the corporate income tax plays large role in attracting FDI, especially the 'high-tech' one. Lets take a rather extreme example for illustration's sake. A firm like Cisco is very unlikely to choose Latvia for its operation regardless what the corporate tax is here. It does care about the taxes it pays, but it cares more about the benefits offered by being in the Silicon Valley (that's where it is), such as availability of skilled labor, venture capital, and the opportunities offered by exchanging ideas with other hi-tech firms. Setting all taxes to zero will not bring it to Latvia. Or take 'simple' manufacturing of e.g. clothes, or assembly of computers. The companies in this industry care about corporate taxes, but they probably care more about labor costs. And nobody can beat China and India in this. I can have many more examples but the point should be clear. Corporate tax is only one of many factors that companies care about, and in many cases it is not a very significant one.

Overall, my advice is as follows. If someone really wants to do something about hi-tech industries in Latvia, he or she should get a decent education in relevant area and start such a company. Do it yourself, no need to involve the government as it's not what governments should do. If you insist on public policy in this area, start by identifying what economists call "market failures". For example, do something about protection of intellectual property right, above all its enforcement. If you think it's enforced, check whether the software on your computer is 100% legal, and ask what you're able to get away with this.

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rb to B 14.05.2008 07:13
You answered you question yourself at the end. Latvia is facing a rapid deceleration in output growth RIGHT NOW. Something that will have an effect in the long run cannot be part of the policy response to the current crisis.

Having said that, I am all for when it comes to lower taxes. In fact, in the longer term expenditure cuts is the other side of the same coin. But why include discussion of tax policy in a 'meeting' that is supposed to tackle the current crisis?

btw, I have not seen convincing evidence that low taxes for exporters lead to the Irish growth miracle. At best it was one of many contributing factors. Furthermore, if I remember correctly, tax breaks were introduced at least a decade before Ireland took off.

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rb to B 14.05.2008 07:11
You answered you question yourself at the end. Latvia is facing a rapid deceleration in output growth RIGHT NOW. Something that will have an effect in the long run cannot be part of the policy response to the current crisis.

Having said that, I am all for lower taxes. In fact, in the longer term expenditure cuts is the other side of the same coin. But why include discusion of tax policy in a 'meeting' that is supposed to tackle the current crisis?


btw, I have not seen condincing evidence that low taxes for exporters lead to the Irish growth miracle. At best it was one of many contributing factors. Furthermore, if I remember correctly, tax breaks were introdued at least a decade before Ireland took off.

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B 14.05.2008 01:25
rb,

>Tax policy should not be discussed in the context of current crisis

Why not?

>"high value-added sectors" is a pretty meaningless grouping of words

Well, you can say R&D-intensive sectors, for example.

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B 14.05.2008 01:23
Thank you for the blog. It is a cool start!

I agree with most of what you say; however, I am somewhat more supportive of the use of tax incentives. It is true that the Latvian corporate income tax is very low, but in some EU countries, it is lower still – IIRC, it is 12.5% in Ireland and 10% in Bulgaria. There is really no reason why the Latvian tax cannot be the lowest in the EU, and for an economy with few barriers to trade and capital transfer, corporate income tax should be a pretty important determinant of FDI.

And moreover, tax policy can be used to promote specific sectors. I agree that the government has been paying lip service to “high value-added sector promotion” for a few years with no tangible results – but this doesn’t mean that the whole idea is wrong. A cut in corporate tax for e.g. manufacturing (or a few industries within it) can be quite effective – this, by the way, is what Ireland (everyone’s favorite success story) has done at some point.

And after all, corporate income tax reduction is not such a big deal. I took a brief look at the 2008 budget, and it appears that CIT contributes less than 15% of the income side of the budget revenues – compared to over 50% of income that various commodity taxes generate. So any loss of revenue can be easily offset.

I agree with you that all of that cannot be a short-term solution. But over a longer term, there should be some effect.

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Komentētājs

Krish 13.05.2008 21:23
Great stuff, but thanks to the so called western professionals the worlds economy is what it is now.

Im a bit sceptical on reducing govrn.spending at this point, as it could be the kick-start the economy need right now.

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Mark Case 13.05.2008 20:17
This difference of opinion is one that has fascinated me for months. It is so pleasant t note that other people who are better qualified than a teacher living in two worlds have also noted the difference. I tend to agree that the Westerners with their experience and expertise are more likely to be right, but continue to hope that the local optimists are right about their "soft" landing.

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rb 13.05.2008 19:25
Concerning the three policy responses you mention, I agree with the first one. Reduced fiscal spending should be a permanent prescription for Latvia. Tax policy should not be discussed in the context of current crisis, unless there are plans to move to "GDP growth indexed' taxation or something like that. I really fail to understand why tax policy keeps coming up in the local debate on crisis. Finally, "high value-added sectors" is a pretty meaningless grouping of words, especially if it’s supposed to be related to 'export promotion'. The best export promotion policy would be to reduce the size of government, i.e. see the first policy response above.

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AJ 13.05.2008 17:56
Great start, Slava!

While agreeing on most of the thoughts, the only comment on my side refers to the "high value-added" concept. When some of our policy makers use this concept, I am not sure they know what they are talking about. In the US in the 90's Paul Krugman once did some really simple calculations to show that the top 2 "highest value-added" categories in the US are cigarettes and oil refining (e.g. not really what people normally mean by high-tech). Would be interesting to see similar calculations for LV (and I am sure some policy-makers would be really surprised). OK, but that's perhaps food for another blog.

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DaceA 13.05.2008 16:01
Thank you for the excellent blog! Finally a local economist with Western education writing in Financial Times language about the situation in Latvia!! I certainly hope to read more soon, maybe an analysis of the latest inflation data?

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