June 25, 2012 / 10:19 AM / 7 years ago

INSIGHT-Baltic countries' austerity lesson for Europe-Just Do it

By Alistair Scrutton

RIGA, June 25 (Reuters) - Near a former Soviet naval base and dilapidated Cold War-era housing estate, this 84-year-old Latvian plywood factory is the kind of success story of which EU policymakers dream as they struggle with economic meltdown in southern Europe.

Workers in yellow and blue uniforms eye digital camera readings of an endless stream of plywood on conveyers, new automation that has helped this firm survive what many describe as the world’s deepest recession. Steam hisses nearby, part of a novel water recycling scheme that has cut energy costs.

Some 15 percent of workers were fired after sales in 2009 plummeted a third. The remainder saw wages cut and four day weeks. But now production of the company, with more than 2,000 workers, exceeds pre-crisis levels, part of a cog in a Baltic economy that is now Europe’s fastest growing.

“Things were very difficult here,” said Latvijas Finieris manager Arvis Svanks over the din of hot, humming machines in a factory the size of several football pitches. “But you can say with some reason that the crisis made us stronger.”

Three small states, Latvia, Lithuania and Estonia, were known as “Baltic tigers” in the boom years before 2007. But housing bubbles and excessive spending saw economic collapse. Latvia’s economy plummeted 18 percent in 2009.

But there was little talk here of these countries, with their currencies pegged to the euro, devaluing out of the crisis. Latvia and Lithuania kept their pegs. Estonia joined the euro in 2011, when others questioned the value of the common currency. Latvia wants to join in 2014.

Instead, some of Europe’s harshest austerity programs were an act of faith in the idea of “internal devaluation” - those countries could boost growth by cutting wages and increasing productivity rather than allowing their currencies to fall. It is a policy that the European Union sees as the only way out for countries like Greece and Spain.

It was no foregone conclusion. Some IMF officials had urged devaluation in Latvia. But with pressure from an EU worried about contagion, Swedish banks concerned about exposure and a central bank wanting euro membership, austerity was chosen.

Latvia’s economy grew 5.5 percent in 2011, and 6.9 percent in the first quarter of the year. Unemployment, which reached more than 20 percent, has fallen to around 16 percent. It is a similar trend across the Baltics.

“There is this debate about growth versus austerity,” Latvian Prime Minister Valdis Dombrovskis said at his government palace. “Latvia is a country in the EU 27 that has done most about austerity and is currently the fastest growing EU economy. There is probably not so much a contradiction between these terms.”

The other side of the story is not far away from the factory in the housing estate surrounded by overgrown vegetation, in hospitals and schools falling apart, and a fall in wages that has had thousands, including middle class professionals, receiving food parcels from the Samaritans. The Baltics have some of the highest income inequalities in Europe.

The “Baltic model” has become part of a debate about how Europe can survive. It has spilled over into social media. When Nobel laureate Paul Krugman questioned Estonia’s model this month, President Toomas Hendrik Ilves called the economist “smug, overbearing and patronizing.”

Back on the ground, Latvijas Finieris corporate development manager Gatis Kepitis poured over data showing the turnaround. He appeared uneasy mentioning 15 percent job cuts, struggling to find a polite phrase to describe them. He preferred to discuss a 60 percent rise in productivity between 2007 and 2011.

This is the kind of export-dependent company that in theory would have benefited from devaluation. Kepitis is not convinced.

“Exports would have gained something from devaluation but it would have been short term gains,” he said. “The basic issue remains unsolved. You have to get more competitive. You have to be ready to adapt to new conditions. You get none of this with devaluation.”

That experience was echoed across Latvia. Unit labour costs - a rough guide to a country’s staff costs per unit of production - fell 27 points from 2008-2011 (with a base year of 2005), according to Eurostat. That compares to a fall of four points for Spain, and a rise of seven points for Greece.

Policy makers say, diplomatically, they hold no lessons for the rest of Europe. But the temptation is occasionally too much.

“As prime minister I don’t want to use other examples,” Estonian Prime Minister Andrus Ansip told Reuters.

“But let’s say - Spain for example. They started to stimulate their economy knowing the structure of the economy was not sustainable. Now despite all those stimulus packages their unemployment rate is 25 percent.”

Policymakers concede there were many special cases in the Baltics that set it apart. Public debt was far lower and there was a degree of political consensus. Latvia needed a 7.5 billion euro bailout, around a third of its GDP. The equivalent would be unaffordable for southern Europe.

Economic statistics were accurate from the start, meaning the full extent of the crisis was evident, unlike Greece.

“Greeks can learn a lot from Latvians and from Baltic countries” said Martins Kazaks, Swedbank’s chief economist in Latvia. “But that doesn’t mean it can be repeated.”

Nor is it the only path. Iceland, another small economy, chosen devaluation after the 2008 banking collapse.

While Greeks are in their fifth year of a recession, Iceland has bounced back to growth after just two years with capital controls and making foreign creditors rather than domestic ones take the biggest hit.


But if there is one lesson for the Baltics, officials drill in the need of quick cuts and reforms - such as freeing up the labour market - before voter and market fatigue sets in.

“It’s a very pro austerity message,” said Estonia’s new central bank head and ECB member Ardo Hansson.

“Get ahead of the curve, and try and do it rather resolutely. The key is to reach bottom rather quickly. Yet in some other countries it is stretched out so long people are a bit exhausted. Maybe some don’t believe that a bottom exists.”

For countries where public civil servants suffered up to 30 percent wage cuts, the Baltics offer a degree of political consensus unseen in much of southern Europe. Dombrovskis and Ansip even got reelected in 2011.

One international official arriving in Riga in 2009 said he was surprised by how quiet the streets were. He had expected protests, even riots. In Estonia, the biggest protests were not against austerity, but from ethnic Russians over the removal of a Soviet-era Bronze Soldier victory statue in 2007.

Some of this was due to ethnic politics - in Estonia and Latvia the opposition, mainly parties rooted in the ethnic Russian minority, found it hard to widen its reach to protest austerity packages.

“The issue of the social cost has been hidden through the Russian lens,” said Rainer Kattel, professor of public administration and European studies at Tallinn Technical University in Estonia.

The Baltics were also mindful of the days of Soviet rule.

“Yes, there is high unemployment,” said Daiga Auzina-Melalksne, chairman of the Nasdaq exchange in Riga. “But people remember here the Soviet times, when you plotted potatoes in you back garden to survive.”


The Latvijas Finieris factory, with sales of 169 million euros in 2011, is now looking at new export markets to make up for potential lost sales in southern European markets.

Unemployment is still high in Latvia, at around 16 percent. But while at the height of the crisis, the Good Samaritans in Latvia distributed food to 100,000 people, around five percent of the population, that is down to 16,000 parcels.

Dombrovskis expects economic growth to be around 4 percent this year. But there are concerns about the impact of an extended euro zone crisis on exports. By 2014, his government will face payments on Latvia’s public debt, which increased from 10 percent of GDP to more than 40 percent during the crisis. This could act as a drag on growth.

His government is now pushing for five percentage point cuts in income tax, a move that has international officials worried that Latvia is spending more than it should.

The recent resignation of his justice minister to protest moves to repay Jewish organizations from the Second World War has raised some concern that the coalition could split apart.

But overall there is a cautious mood of optimism.

Kaspars Kasparsons was one of the thousands of Latvians who left Latvia, and his family. He is back in a warehouse after a year as a carpenter in Norway. His wage is 10 percent down on pre-crisis salary. But his wife has found work in a bar.

After years they can afford the occasional visit to the cinema, to take their two daughters out for ice-cream.

“Not everyone is happy. Many friends are very bitter and angry at what happened. Some had 50 percent cuts in wages,” Kasparsons said, while his young daughters played nearby in a quiet shopping mall. “But things are getting a better for me.

“Well,” he said, thinking as he sipped a coffee. “A little better.”

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