Foto: Michael Dawes
A prudent government would have kept a cap on its spending and invested into reserves in order to cushion the inevitable heavy blow that would follow the 'credit orgy'. The Latvian government did none of it
“Nothing special” – was the hapless reply of Atis Slakteris, Latvia’s finance minister, when a journalist from Bloomberg Television asked him what happened to the Latvian economy. Strikingly, in a certain way he was right. I will not be surprised if, in a few years time, new editions of standard macroeconomics textbooks will come equipped with the story of Latvia in 2008. It will probably be one of those little boxes, designed to illustrate the theory with real-life examples. Millions of future students will read about the Latvian crisis and think of it as nothing special – a rather straightforward application of basic economic theory. “How come these guys did not see it coming?” they will gasp shortly in disbelief, before turning to the next page. Yet, sadly, a lot of people did not see the crisis coming, including Mr. Slakteris. Moreover, many people are still trying to grasp with the situation. What follows is a modest and tentative attempt to lay down my version of what has happened and what may happen.
The basic facts are known. After much denying that something might be wrong with the economy, the government asked IMF for a 5 billion euros emergency loan. It appears that the IMF made the loan conditional on the stabilization plan, comprising a number of stringent measures designed to reduce fiscal spending and increase the tax revenues. Why did the government ask for a loan? The main reason is simply the government’s failure to predict drastic fall in tax revenue, which resulted when the economy took a sharp nose dive. It appears the government could not borrow (at affordable rates) from the international financial markets because of financial crisis and lack of lenders’ confidence. Another reason is likely to be the need to protect the exchange rate after the Bank of Latvia had spent a considerable portion of its foreign exchange reserves. Then, of course, there is the matter of nationalized Parex bank and the need to repay its syndicated loan of one billion euros. If more banks will wander into trouble, the government will need the money to help them, too.
How did we get here?
In a nutshell, the story would go something like this. In 2004, when Latvia joined the European Union (EU), two notable things happened. First, there was a widespread upsurge of optimistic expectations, which were a missing ingredient for an explosion in long-term borrowing. Simply put, a growing number of people thought it was OK to take loans for 15-30 years to buy new homes. Second, it was a rather unfortunate coincidence that, at the same time, the UK and Ireland, which also experienced their own construction booms, opened up their labor markets for migrant workers from the new EU member states. As a result, an increase in demand for the construction of new housing coincided with the mass migration of unskilled labor to Ireland and the UK. This excess demand for housing combined with the shortage of labor to build houses resulted in a rapid growth in both real estate prices and wages in the construction sector. Growth in real estate prices made lots of people think it is a great idea to buy real estate now, before it gets even more expensive (irresistible logic, is it not?). The ensuing rush to the real estate further increased demand for housing, construction workers, and inflated their wages even more. Given the competitive pressure from the construction and real estate sectors, other industries were forced to increase wages as well. This fed into increases in prices across the economy, as businesses had to compensate for the rising labor costs. Inflation, in turn, increased demands for yet higher wages, which would result in higher prices, and so on. All this could work while more people took more loans and the foreign-owned banks were willing to pump in money from abroad. Yet surely it had to end since no-one can borrow forever. The rest is history. Latvian economy got itself to a point where its wage and price level was too good to be true.
Who is to blame?
Could something be done to avoid all this and who could have done it (but did not)? In other words, who is to blame? Something could be done, indeed. First, the ‘credit orgy’ of 2006-2007 should not have been allowed to happen. Someone had to rein in apparently reckless lending by the banks. That ‘someone’ was the Financial and Capital Market Commission (FKTK), which, obviously, failed to do its job. The banks, of course, eventually woke up to what was happening, but it was too late. Second, the rapid growth in wages could be cooled off by bringing in migrant workers from non-EU countries. Alas, the xenophobic nature of Latvian politics ruled out this possibility. Who is to blame for this if not ourselves? Third, a more competent government should have understood the temporary and largely illusory nature of economic ‘growth’ spurred by the ‘credit orgy’. A prudent government would have kept a cap on its spending and invested into reserves, which could be used to help cushion the heavy blow that would come when the orgy would inevitably end. The government of Kalvitis has done none of it. Fourth, we have to ask how many of our numerous ‘economists’ and ‘experts’ cried wolf when these events were unfolding. Some did but there were very few of them. On the contrary, many of the so-called ‘experts’ proclaimed Latvia was “different” and that it will catch up with the rest of Europe in some 15 years. These voices have surely contributed to the confusion of both the government and ordinary people. I am not going to give any specific names here, but it could be done. Thus, in the end we are talking about a serious failure of economics research capacity in this country.
Do we have a good plan?
Clearly, the main strategic goal of the Plan is to introduce euro as soon as possible. To do this, one need to satisfy the Maastricht Criteria. The ones that are most tricky to meet (in today’s context) are those on inflation (should not exceed average of three lowest inflation rates in the euro area) and budget deficit (should not exceed three percent of GDP). Hence the fiscal austerity, i.e. cuts in spending and increases in taxes. These are likely to ensure a balanced budget and keep the economy down with a low inflation rate, if not outright deflation. Are there any alternatives?
I risk spending Christmas talking to the Security Police, but the main alternative to the Stabilization Plan is to devalue the national currency, lats. Much has been said about the pros and cons of such a step so I am going to just briefly recount them. In theory, devaluation will boost exporting sectors and increase the demand for locally produced goods and services, at the expense of imports. On the negative side, devaluation will hit the non-exporting sectors that rely on imported intermediate goods and energy. Naturally, it will also increase prices for imported goods. Its most dangerous effect, in Latvia’s context, is that it will make it much harder to repay the loans in foreign currencies. And more than 70 percent of Latvians’ loans are denominated in euros. Devaluation may result in defaults on the loans and rapid deterioration of banks’ credit portfolios. In this case, arguably, the authorities would have to rescue failed banks. The consequences of devaluation will not be pretty, but it may result in a faster recovery because export sectors will gain. I have to emphasize that I do not know whether devaluation is a better alternative. The Bank of Latvia says it is not. Maybe that is true. And yet I do not like it that there really was no discussion of this (except with the Security Police, of course). Don’t get me wrong: I think (seriously) that the Bank of Latvia is one of the most competent institutions in this country and I have much respect for the people who work there. And yet, in my mind, better and more informed policies appear only in environments where there is a free competition of ideas. What we have now smacks more of intellectual censorship and outright intimidation of any opposition. This may have implications for the quality of the policy solutions.
What will be the effects of the Stabilization Plan? I am afraid it is hard to have any degree of optimism. The only way forward now seems to be through a painful recession, a super-hard landing. To see this, note that most of the world is fighting the impending recession with a fiscal expansion. In contrast, Latvia’s plan prescribes a fiscal contraction, which will further exacerbate the downward spiral of the economy. What we will be going through is what the economists call a “real adjustment” (devaluation is a “nominal adjustment”). In theory, real adjustment might not be too painful if the economy if flexible enough. If businesses can cut both wages and prices (and workers will accept this), then in some time Latvia may regain its competitiveness in the international markets. Yet most likely this will also be accompanied by bankruptcies and shedding of labor, as some sectors (e.g. real estate, construction, and banking) will shrink. We will definitely see sharp increase in unemployment. It is hard to predict for how long the recession will last. In the end, it will depend on how fast the ‘unemployed entrepreneurs’ will pull themselves back together, see new profit opportunities, and mobilize the unemployed resources. Then, the economy will bounce back.
I guess the best thing about the Stabilization Plan is that it was approved by the IMF and that its implementation will be supervised by the IMF experts. I am afraid I now have little faith in the capabilities of Mr. Slakteris & Co, but I respect the professionalism of the IMF people. Yes, it seems that the IMF mission in Latvia, which was pompously closed some time in 1998, will be re-opened again. Some people may think it would symbolize Latvia’s return to the status of a banana-republic, deemed incapable to conduct competent economic policy on its own.
Winners and losers
In my view, the biggest problem with the Stabilization Plan is that it has some serious issues with fairness. For instance, I subscribe to the simple view that it is fair when people incur costs for the mistakes that they have committed. And vice-versa, I think it is not fair when innocent by-standers pay for the mistakes committed by other people. By this simple criterion, what we see is a pretty unfair plan.
For example, according to the Plan, the taxpayers will pay hundreds of millions LVL for the mistakes made by the management of Parex Bank. There will be a huge cost to the taxpayers, but I have a feeling that the Plan will have a pretty small impact on the lifestyles of Mr. Kargins and Mr. Krasovickis. Most likely they will even keep their luxurious cars. This is not fair.
Taking a step further, the People’s Party presided over most of this mess and bears substantial responsibility for what has happened. Yet they seem to be getting away with most of their pet projects in construction. They have built one of the most expensive bridges in the world and, in spite of all the talk to reduce fiscal spending, they look set to build one of the most expensive libraries in the world. I suspect the library will be built at before-the-crisis prices. There are rumors that it is a common practice for construction companies to pay kick-backs to their sponsors… This would not be fair.
Generally, it is clear that an average taxpayer will shoulder the burden of ‘stabilization’. The pensioners and the poorest will, as usual, be the biggest losers because of sharp tax increases for the commodities that make up a substantial part of their budget: heating and medicine bills. And yet, talking about population groups at large, the pensioners did not get us into this. The ‘credit orgy’ occurred because many people engaged in excessive borrowing (in euros) expecting their future incomes to rise at 30% per annum forever. For lack of a better term, let me loosely call them Generation G. Most of these people can be seen driving nice cars with license plates beginning with the letter G. Then, of course, there are all the banks that happily lent to those people. Now, of course, neither Generation G, nor the banks meant any harm for the others. They were just doing what they thought was best for them under the circumstances. And yet, is it fair that the others, e.g. the pensioners, should pay for the consequences of the ‘credit orgy’ unleashed by the banks and Generation G? I think this is not fair.
And yet, in the end, I think there are also positive things about all this. First, I think this will be a great learning experience for this country. Second, I think we will soon see an application of what I would call an “it’s the economy, stupid!” law of elections. This ‘law’ says that the election outcome largely depends on the state of the economy in the election year. Recall that the government of Aigars Kalvitis was re-elected in the times of rapid economic growth. The Plan is likely to make sure that the recession will still be there when the next election comes. My prediction, therefore, is that we will not see much of this Saeima after the coming elections. This would be fair.
 Former CEOs of Parex