Some reflections on different interpretations of Latvia’s economic ‘slowdown’

13. May, 2008

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.

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 raksts

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