Pop quiz, hotshot. Which country below is an economic role model for the others? Is it the United States, with its economy back above its pre-recession peak? Or is it the United Kingdom, stuck in its worst slump in the last century -- worse even than the Great Depression? Or maybe it's Iceland, a country that went completely broke and devalued its currency massively after leveraging itself up like a hedge fund? Or could it be ... Latvia? It did worse than anybody else during the Great Recession, including even Iceland, a country that, again, went completely broke.
Okay, lock in your answers ...
The answer is ... Latvia? No really, some people think the answer is Latvia. That makes no sense, but Andrew Higgins of the New York Times explains why some people think otherwise in a nuanced piece that looks at Latvia's economic experience the past few years.
There are two things you need to know about that experience. First, Latvia had a massive bubble financed by massive foreign borrowing, with its current account deficit hitting a mind-blowing 22 percent of GDP in 2006-07 before the debt music stopped following Lehman's bankruptcy. And second, Latvia didn't do anything to cushion its subsequent crash. It didn't devalue its currency, and it didn't increase government spending. Instead, it kept its currency pegged to the euro, and actually gashed its budget. Now, it didn't have much of a choice when it came to austerity -- that was the condition for its €7.5 billion IMF-led bailout -- but it could have chosen depreciation over deflation. It did not. As Matthew Yglesias of Slate points out, Latvia chose so-called internal devaluation over actual devaluation, because it didn't want to derail its euro entry out of fear of Russia. This calculation may well have been in Latvia's best geopolitical interests, but certainly not its economic ones. The combination of tight money and tight budgets took Latvia's economy from "calamity" to "historical calamity"; its GDP fell by over 17 percent in 2009 alone. That's Great Depression territory.
And then things turned around, kind of. After three years of almost unprecedented pain, Latvia's economy grew 5.4 percent in 2011, and about 4.4 percent in 2012. It engineered this turnaround, in part, by regaining competitiveness through weaker wages, rather than a weaker currency -- in other words, by not giving workers any raises the past few years. In a small, open economy like Latvia's, lower labor costs should translate into better terms of trade, and that seems to be what's happened the past two years. Latvia has gone from its absurd 22 percent current account deficit in 2007 to just 1 percent today, although it's unclear how much of this is due to increased competitiveness, and how much is due to its weak economy. Still, it's been enough that Latvia is getting talked up as something of an austerity success story.
It's a success nobody should envy. Latvia's strong growth the past two years isn't quite as strong as it sounds once you consider the low base it's coming off of. As you can see above, it's still in an economic hole far deeper than anyone else, and likely will be for some time. Even if its recovery doesn't slow down, it will be another four or five years before Latvia is back to where it was in 2007. In other words, a lost decade. And then there's the human cost. Unemployment peaked at 20 percent, and it's only recently fallen to a still-horrible 14 percent, despite substantial emigration since the crash. As Paul Krugman has repeatedly pointed out, if this is success, it defines success down to depressing levels.
But Latvia's economic story isn't really a story about austerity. It's a story about hard money, and the undeniable failure of hard money during a recession. Consider Iceland. It also went through an epic boom and bust, but it defaulted on its debts and let its currency depreciate. Instead of its economy falling 20 percent like Latvia's, it "only" fell 10 percent. That's years of growth, all bound up in a simple question: to devalue, or not to devalue.
If Latvia proves anything, it's that there is eventually gain after pain, but the latter is no prerequisite for the former. Economics is no morality play, no matter how much we may wish it were.