Crisis of Command
America’s Broken Civil-Military Relationship Imperils National Security
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 matching productivity gains, resulted in a rapid loss of competitiveness. But rapid economic growth gave the Latvian government space to put off badly needed, but politically difficult, institutional reforms.
Then all hell broke loose. Following the collapse of Lehman Brothers in the fall of 2008, liquidity froze. The biggest domestically owned bank ran into problems and was taken over by the Latvian government. Faced with running out of cash, Riga called in the IMF to initiate negotiations with, among others, the IMF, the European Commission, the European Central Bank, the World Bank, and Sweden. The parties agreed to provide international assistance in December 2008. Their shared aim was to solve the immediate liquidity crisis, ensure the country’s long-term stability, and maintain the exchange rate peg to the euro.
With devaluation of the Latvian lat immediately ruled out (joining the euro and the European community was too longstanding a goal and a devaluation would have had severe consequences for the banking community, since the credit from the boom years was denominated in euro-linked lat), the Latvian government’s only real option was fiscal policy adjustment, the details of which it unveiled in its supplementary budget for 2009 and its budget for 2010. Both of these saw substantial reductions in social benefits accompanied by long overdue cuts in public employment with close to 30 percent of civil servants laid off. Those who remained in the public sector saw their salaries cut by 25 percent, on average, whereas salaries in the private sector fell by on average ten percent. It is, however, worth noting, that in response to the sharp increase in unemployment, the government extended unemployment benefits.
The Greek internal revenue service has proved incapable of collecting taxes at even the current rates.In all, the reductions made during the crisis years amounted to approximately 11 percent of GDP. Most of the fiscal consolidation was done on the expenditure side of the public budget, even though there were also moderate increases in the flat income tax rate and in the value-added tax. The fiscal consolidation program continued into 2011 and the years following, even though the economy started to grow again.
Meanwhile, the government pursued supplementary measures to increase Latvia’s competitiveness. These included measures to support entrepreneurship and export-oriented business, administrative reform, and infrastructure projects—in many cases partly financed by grants made by the European Union.
Life in Latvia wasn’t necessarily easy in those days, which is why it might have seemed somewhat surprising when, in 2010, the government responsible for austerity was reelected. The public, perhaps understanding that surviving the crisis and keeping the euro peg was the best way of joining the eurozone and reaping the benefits of full European integration, distancing Latvia further from Russia and its Soviet past, had decided to back the government’s tough measures. In late 2010, the first signs of economic recovery were on the horizon.
Latvian medicine will be no remedy for Greece, a much sicker patient.There is little about Latvia’s initial conditions that mirror Greece’s. Latvia’s public finances were strong when the crisis hit. The period of economic mismanagement before the crisis was much shorter in Latvia. The political commitment to staying with the euro was very strong. And once the Latvian assistance program was negotiated, policymakers more or less immediately implemented it. Furthermore, and probably most important, the overall Latvian institutional framework, reformed in the 1990s following independence after almost 50 years of Soviet occupation, was, although far from perfect, much more substantial than ever instituted in Greece.
The importance of the institutional framework cannot be overestimated. To see why, consider a few examples from the most recent Greek rescue package. The deal calls for raising tax rates. That is of little purpose when the Greek internal revenue service has proved incapable of collecting taxes at even the current rates; despite high statutory tax rates, the effective tax rates are considerably lower. And it seems like a fool’s errand to try to sell off the public assets of a country riddled with high corruption, low productivity, and no economic growth. Furthermore, with a legal system incapable of enforcing current legislation and characterized by slow judicial processes, inefficient courts, and weak investor protection, legal reform will be a necessary condition for an economic turnaround.
In other words, Latvian medicine will be no remedy for Greece, a much sicker patient. For a cure, Greece should look further north to Finland and Sweden, which overcame their own crises in the early 1990s. Prior to their deep crises, both countries had about 15 years of poor economic performance characterized by lost competitiveness, fiscal imbalances, and more or less regular devaluations of their respective currencies. A credit boom followed financial market deregulation in the mid 1980s in both Finland and Sweden. The result was two overheated economies and real estate bubbles. The boom in the real economy halted around 1990, and two years later, the banking systems of the countries essentially collapsed.
The crisis was so deep—the drop in Finnish GDP from the peak in 1990 to the bottom in 1993 amounted to about 14 percent and was accompanied by an increase in unemployment from three to almost 20 percent—that policymakers were finally forced to address the fundamental (institutional) problems that had been plaguing the countries for years. The three to four years following the initial economic disaster saw remarkable institutional reform, ranging from decisions in both countries to join the European Union to substantial changes in both welfare systems. Sweden also revised its constitution and extended the electoral cycle from three to four years.
At the same time, both countries pursued austerity and devaluations of their respective national currencies, a remedy that both nations had frequently tried in the 1970s and 1980s without any success. What made the difference this time was that the institutional, and hence the fundamental roots, of the problems were addressed.
The Nordic lesson for Greece is clear: Unless accompanied by substantial institutional reforms, neither austerity nor Grexit will work. However, in a democracy, fundamental institutional change cannot be imposed from outside—it requires strong political will and public support. Despite the deep Greek crisis, the country still seems to lack both. The latest deal for Greece thus appears doomed to fail. Indeed, the most likely outcome is that it will drive the country further into poverty and despair.