COMMENTARY

Spring 2011

by Ilmārs Rimšēvičs

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The Baltic countries' economic performance has reassured many sceptics that an internal adjustment strategy is a viable option, thus strengthening the case for other countries to push ahead with much-needed reforms. This requires strong political will, an ability to think out of the box and look for real solutions and not mere pain killers that may improve comfort levels temporarily but do not fundamentally resolve the problem.

To begin with, all three Baltic countries – and my own, Latvia, in particular – suffered from two main problems in the run-up to the crisis. First, riding on the back of easy money, wages outpaced productivity and dented external competitiveness. Second, the by-product of rapid credit expansion was an equally rapid build-up of debt in the private sector, mostly denominated in foreign exchange – in euros. Evidently external devaluation was not a viable strategy – either before or during the crisis. Nor is it a sound path towards post-crisis economic recovery.

Taking a quick look back to the build-up of the crisis, was there really a trade-off between external competitiveness and financial stability, as Erik Berglöf and Anatoli Annenkov seem to suggest? Not necessarily. While floating rates might have helped to dampen inflationary pressures somewhat, competitiveness would still have been eroded through nominal appreciation. The competitiveness problem would still be there, while financial vulnerability issues might have been even greater.

What about the outset of the crisis, when many suggested devaluation was the way out? This was clearly not an option for the Baltic countries given their flexible economies, their dependence on imported inputs, their large foreign-currency-denominated debts and a long history of fixed exchange rate regimes serving as an anchor for macroeconomic stability. The notion that lowering the value of exchange rate can help boost an economy stems from standard economic models which have been neglecting the financial sector (which is quite unfortunate, as we painfully realise now). Add banks to the model, and the results are not so straightforward, but certainly more relevant for countries like Latvia.

The reform agenda in the Baltics has been ambitious: the adjustment burden stands at an estimated 14% of GDP in Latvia for 2009-2010 and 9-10% of GDP in Lithuania and Estonia. We did not devalue, and yet we did not get stuck in the protracted recession the sceptics had forecasted. Exports and manufacturing have recovered, showing double digit growth, and domestic demand is gradually following suit. GDP growth has reached 5% in Estonia with Latvia following suit , and Lithuania is also moving in the same direction.

The contraction of GDP in the Baltics was staggering by anyone's standards, but it was quite comparable to what most other European economies experienced during this crisis in relation to the expansion that had preceded it. What made the various national economies perform better or worse during the recent crisis was largely determined by their different starting positions, the degree of unsustainable developments and the vulnerabilities they had accrued over past years.

So why, some might ask, don't we use devaluation as a short-cut to prosperity? Regaining competitiveness, through either through external or internal adjustments, can only get one so far; it can't solve structural problems. No single level of exchange rate can help the economy to move towards the production of higher value-added goods. I see devaluation as a tool to preserve the status quo in the structure of the economy, and this cannot be the preferred policy option in countries still striving to achieve real convergence. What really matters is improving the business environment and increasing the flexibility of labour and product markets. Given the persistently high structural unemployment figures in many European countries, improving the quality of the labour force in terms of education and skills is absolutely essential throughout the EU.

If there is a lesson to be learned from the Baltic experience it is that structural problems require structural solutions. If income convergence in the EU is the goal of policymakers, productivity convergence is a necessary precondition for that, which in turn requires changes in the structure of the economy. Devaluation cannot be a substitute for genuine economic reforms. Hence our hope that reforms in Europe – much needed and often overdue – will be implemented after all, even if their short-term political implications are not always pleasant.

The viability of reforms will greatly depend on popular support. The boom years that preceded the crisis were not a sound basis for sustainable long-term economic development, and many in the Baltic countries realised that even back then, and most are unanimous about it today. Recent developments elsewhere in Europe have not always been promising in this respect, but my feeling is that Europeans, including policymakers, are becoming increasingly aware of the fact that economic reforms are inevitable if Europe is to remain a competitive force on the global scene.