Southern Europe Ignores Lessons from Latvia at Its Peril

Policy Brief
June 2012

In the current financial crisis plaguing Europe, Latvia stands out for resolving its financial problems quickly and resolutely. After contracting 24 percent in 2008 and 2009, it grew at the rate of 5.5 percent in 2011. The speed and determination with which the government carried out austerity measures in 2009 and restored confidence after suffering the worst output decline is a crucial lesson for the ailing South European countries—Greece, Italy, Portugal, and Spain. Latvia has proven that internal devaluation—cutting wages and public expenditures—works and that it can turn around an economy quickly. Many policy observers and economists have dismissed Latvia's crisis resolution as irrelevant to the situation in Southern Europe. The Latvian orange, they say, cannot be compared with the South European apples. Åslund argues otherwise.

Latvia's achievement boils down to five crucial political economy principles, which the South Europeans ignored—and continue to ignore—at their peril. First, Latvia made full use of the grave sense of crisis in the fall of 2008. The sudden large output shock and liquidity freeze made the unthinkable possible and necessary. Second, the government implemented a comprehensive anticrisis program that was heavily front-loaded in the first half of 2009, which restored confidence early. Third, the program contained more expenditure cuts than revenue measures, which made it more realistic and drove structural reforms. Fourth, the International Monetary Fund and the European Union provided early and sufficient—not excessive—international financial support, making the crisis resolution financially sustainable. Finally, the government succeeded in its salesmanship of the adjustment program, by clarifying how severe the crisis was and by ensuring that the burden of the crisis was socially equitable. None of these five crucial conditions, which apply to any crisis resolution, have been satisfied by the South Europeans. They took their time to get a handle on their crises, wasting trust, patience, and resources in the process, and now are paying the price for their indecisiveness and leisurely approach.