It’s a familiar tale of boom and bust: In 2008, Europe’s most overheated economy, which had been fuelled by cheap credit and rapidly raising wages and real estate prices, collapsed. GDP dropped by 20 percent and unemployment rose to more than 20 percent. But here’s where things take an unexpected turn. By late 2010, the first glimmers of recovery became apparent. Today, the economy is among Europe’s fastest growing, and its GDP is back at pre-crisis levels.
So how did Latvia, the hero of this story, do it? And are there, as Anders Åslund, among others, have suggested, lessons for Greece? To answer those questions, we need to look back at the shape of the Latvian economy on the eve of the 2008 crisis.
After 2004, when Latvia joined the European Union and then pegged its currency, the lat, to the euro less than a year later, the country saw almost four years of unprecedented economic growth. To a large extent, that growth was fuelled by cheap credit from foreign-owned European banks (mainly Swedish). Throughout the boom, the Latvian government failed to balance its budget, even though the budget deficit relative to GDP went down from roughly one percent in 2004 to less than 0.3 percent in 2007; by way of comparison, the Greek deficit was roughly 3.5 percent of GDP in 2014, down from more than 12 percent in 2013. Similarly, as a consequence of rapid economic growth, public debt as a percent of GDP fell to less than ten percent by 2007. As a comparison the German debt-to-GDP ratio in 2007 was slightly higher than 60 percent, whereas the current Greek debt-to-GDP ratio is close to 180 percent. In short, Latvia’s public finances were, by any standards in good shape at the eve of the crisis.
In terms of monetary policy, the Latvian lat had been pegged to the euro since 2005, with joining the eurozone as the country’s overarching goal (a goal it later achieved in 2014). The peg to the euro, together with high inflation and high wage increases without
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