Latvia has been cited by some as an example of successful austerity. In the large majority of situations where austerity appeared to help improve an economy, devaluation of the currency was also an important part of the economic plan. Latvia embraced austerity without devaluation. Because it has had growth in the last year, it is now being hailed as an example of successful austerity. Dani Rodrik spent some time in Latvia recently, and presents a slightly different picture.
In the end, the country implemented a radical fiscal contraction that pushed the country back into external surplus. The shock produced a loss of output of almost 20% of GDP in one year, and a rise in unemployment to 18.4% (from 6% in 2007). By 2011, the worst seemed over and the economy grew at a healthy rate of 5.5%, one of the highest in Europe.
If you listen to advocates of fiscal austerity, such as central bank governor Ilmārs Rimševičs, Latvia is a huge success — an example for Greece, Spain and others on how to do it. On the plus side, growth has returned faster than most anticipated, exports are up, unemployment has come down, and the political system appears more stable than it has been for some time. Despite complaints about the legal framework and poor implementation, foreign investors are reasonably satisfied. Eurozone entry is still planned for 2014.
On the negative side, the collapse in GDP was the deepest any country experienced during the present crisis. Even though a recovery seems apace, the country is still far from recuperating to output levels prior to the crisis (see chart). Iceland, which was hit with an even larger financial crisis, imposed capital controls, devalued its currency, and avoided as sharp an economic contraction as Latvia.
Rodrik notes that it is too early to determine if the Latvian policy has truly been successful. However, there is a success story. Latvia was able to create 20% unemployment without precipitating a revolt.
One thing we can say for sure, however, is that the kind of drastic fiscal austerity that proved feasible in Latvia would not be possible in many other countries. Rimševičs and others stress that Latvian policy was successful because they took it on the chin and implemented the fiscal measures with speed and determination. Perhaps. But it is also true that they got away with vastly underestimating the costs of their measures. Latvian policy makers had expected a 10% fall in GDP in 2009; instead they got one that was nearly twice as large. The real secret of their success is that they did not have a revolution on their hands.