This post is an effort to sum up some random thoughts on where we are headed, both in the short-term and in the long term.

Of course, the major short-term challenge is to balance the budget. In spite of substantial cuts and tax increases, we’re still living wildly beyond our means. Donors’ life-support amounts to nearly 823 million LVL in the 2010 budget. Thus, according to the memorandum of understanding with the EC/IMF, the government needs to implement fiscal adjustment of around 700-800 million LVL over the next two years. Most likely, the 2011 budget needs to be consolidated by around 500 million LVL. These are not peanuts. To get a sense of perspective, the revenue from VAT, one of the most effective taxes, for the 2010 is projected to be around 690 million LVL.

Where would the consolidation come from? It would probably be hard to rely on mechanic across-the-board cuts in the public sector salaries alone, given the magnitude of such cuts over the last year. I am also skeptical about the so-called “structural reforms”. As I’ve stressed many times, such reforms require time and competence – both seem to be in very short supply in the public sector. There is little doubt that the government, having learned the lessons of June, will again try to cut a little bit of every expenditure and raise a little bit of every tax, so as not to risk the wrath of some powerful special interest group. And yet, it is not clear whether this would do the trick – there need to be some ‘drivers’ of consolidation. When it comes to taxes, I think the only plausible venue is to drastically increase the real estate taxes. This is not such a bad idea, as I’ve stressed elsewhere. Real estate tax is nearly impossible to evade – even VID (State Revenue Service) should be able to collect it. When it comes to expenditures, it’s hard to imagine how such a consolidation would not affect the social budget, which accounts for about 31 percent of total government spending. In fact, I think pensions need to be cut, regardless of what the Constitutional Court thinks about it. It would also make lots of sense to make deep cuts into the generous payments to farmers.

Then I would stress three long-term challenges. First, the ‘internal devaluation’ does not appear to be very effective. By and large, the firms seem to have preferred to cut their costs by shedding labor, rather than reducing wages. Most importantly, we have not seen substantial reductions in prices. What this means is that domestic demand substitution towards locally produced goods is taking place too slowly. Thus, recovery is likely to be painfully slow. Second, we will have to get used to live with substantially higher levels of public debt. Another result of internal devaluation is a rather long period of adjustment, implying the need to accumulate substantial levels of debt. In just a few years time we’re likely to have levels of external public debt close to 60 percent of GDP. Soon, this debt would need to be re-financed in the private markets, i.e. at substantially higher interest rates. Naturally, taxpayers will incur the costs of servicing the debt. Third, high unemployment level is likely to have pushed many unemployed to seek jobs abroad. Many migrants are unlikely to return in the near future, especially given the slow recovery. The practical significance of this to those who stayed is that the total tax burden of servicing things like the public debt, pensions, etc. is higher for each remaining tax payer.

All in all, these are serious challenges to fiscal sustainability. Even when the crisis would end, there would be no going back to the old ways of doing things. Talking about what needs to be done is beyond a blog post, but I think there is one thing that needs to be understood. This is that solutions require lots of thinking and hard work. Too many people in this country seem to think that producing solutions is only a matter of organizing another “panel of experts” or having a few hours of brainstorming. This notion is ludicrous.

However, we also have the ‘advantage of the follower’. The problems we face are extremely serious but not unique. There are many various policy solutions in the developed world so we don’t need to start from the scratch. However, adapting these solutions to Latvia’s circumstances is not always straightforward. It requires careful thinking, time, and hard work.