Conference "Have We Learnt Anything from the Crisis?", 17.10.2014.
Ladies and Gentlemen! It is my pleasure and honour to greet you at this annual international macro-economic conference.
As we meet in Riga in autumn of 2014, the euro area is slowly recovering from the crisis, it is enlarging, and it is in the process of coming closer to a common understanding of future policies to reinforce this recovery.
The euro area is also embracing a new member state, welcoming neighbouring Lithuania from the next January. This makes the euro the common currency for the entire Baltic region. This is a dream we have dreamt since 1989 when the first discussions on the common Baltic currency took place.
Today's theme invites us to revisit conclusions or messages from the recent crisis and the measures taken so far. My remarks today will naturally focus on Latvia's and Baltic experiences which, in my opinion, could enrich the current discussion on the policies supporting growth in the single currency area.
Of course, we have to keep in mind that each country has its own unique story of overcoming the crisis that began in 2008. The differences and the degree of success of these efforts are determined by both the macroeconomic developments during the run-up to the crisis and the decisions made at its outset. This to a large degree determined how serious the crisis would be and pre-determined the potential speed of recovery.
Economic growth before the crisis in many countries ranged from unbalanced to extremely unbalanced. We also had excessively large public expectations of income levels that would rapidly converge with those of the rest of Europe and equally impatient governments that relied on windfall revenue spending, accumulating a large fiscal gap. This only fuelled an economic boom – a few short years before the crisis Latvia was virtually awash with money inflows. If we were to compare this economy with a bathtub, the tap of the central bank remained turned off for the boom years, but there was a lavish flow from a whole range of sources, supporting record levels of growth. These flows of funds included deficit spending, a bank lending spree, EU structural funds, wages sent home by compatriots working mostly in Western Europe and foreign direct investment.
I will briefly touch upon some of these factors.
A large structural deficit accumulated throughout the boom years in Latvia largely defined the severity of the crisis. Experiencing the fastest economic expansion and extremely strong cyclical upturn in tax revenue, Latvia still continued to spend more than it earned. Needless to say, this added extra fuel to the already severely overheated economy. Between 2004 and 2008, expenditure grew 2½ times, and most of that was of a structural nature. While deficits remained moderate in nominal terms, they were extremely large when cyclically adjusted: they amounted to 7%–8% of GDP. It became widely obvious only with the burst of the bubble. Guess, where the extra revenues went. Of course, to large extent they were used for increasing wages.
Wage increases severely dented price competitiveness of companies that worked in Latvia. Pressures of demand in the booming economy and limited supply of workers due to labour outflows after the EU accession gave rise to uncontrolled wage developments. These increases outpaced productivity by far . The temptation to reach the Western European prosperity levels soon prevailed against better judgment: between 2004 and 2008, salaries more than doubled, opening a wide wage-productivity gap.
Having felt the wage increase people started looking for opportunities to borrow that resulted in huge lending expansion.
Speaking about huge lending expansion, Latvia's financial sector had come to be dominated by Nordic capital. These were competing for market shares in this extended domestic market, making use of the ample global liquidity and offering their Latvian clients very low interest rates. Optimistic about a rapid growth of future income after joining the EU, people let the private debt level more than triple in a single decade (since 2000).
The prevailing thinking among policy makers was as follows: this is a poor country, emerging from 50 years of communist rule, we badly need growth to catch up with the living standards of Western European economies: 8% GDP is really good, 10% is better, but 12% is fantastic…
The collapse of the American investment bank Lehman Brothers in September of 2008 provoked the global crisis. It changed risk perception. Financial markets froze, making Latvia's overheated economy extremely vulnerable to global troubles and investor sentiments.
To ensure economic sustainability in the future, Latvia – instead of devaluing its currency – opted for measures which are sometimes referred to as "expansionary consolidation". This is a word we like in our country. In this country it is no longer viewed as a contradiction in terms. Back in 2008, many economists in Europe regarded it with suspicion and still continue to call it "austerity". Latvia's rapid exit from recession was determined by the speed and content of growth-supporting decisions taken at the beginning of the crisis. Latvia saw an internal adjustment of 14.7% of GDP throughout 2009 and 2010, adding another 2.8% by 2012.
The rapid consolidation that came largely on the side of budget expenditure and was based on structural reforms, restored the overall confidence in the country's policies. Two thirds of the total consolidation was generated by cutting expenditure and only 1/3 came from additional revenue, including the increased taxes. If we look at the bigger picture, at the euro area as a whole, it is evident that most countries have likewise prioritised consolidation on the expenditure side. We also see that fiscal consolidation in the euro area peaked in the years between 2009 and 2011, i.e. mostly in the early years of the crisis .
Whether "less is more" in terms of reduced budget expenditure and resulting stimulation of the economy was a hotly debated issue, especially in the early days of the crisis. Some of the public debate back then was dominated by the common wisdom that larger budget deficits in times of an economic crisis help to boost demand and thus support economic recovery. However, if the problem involves not only a lack of demand but also problems on the supply side, boosting demand by fiscal stimulus does not necessarily imply more economic growth.
Today Latvia's experience is worth analysing in an international context to see what the formula that worked so well was.
Speed was one of the key elements in this formula. Procrastination would have led to significant deterioration in the state of the economy: without consolidation the Latvian budget deficit would have reached double digits during the first year of the crisis. Adjustment started with the least popular measures – cutting expenditure and salaries.
Ownership. The set of measures for overcoming the crisis was drafted by Latvian authorities and was not dictated or imposed from outside– either by the EC or IMF. For instance, even though the IMF considered outright devaluation to be the right approach in dealing with the crisis, Latvian authorities insisted on massive consolidation as the only viable option. An outright devaluation in a small and open economy with almost no raw materials would have reduced the level of income in the country, produced massive inflation and bankruptcy waves.
Commitment by the public at large could be mostly attributed to active communication by authorities helping to explain both - the causes of the crisis and the alternative courses of action.
As we saw later, this ensured an overall public support for reducing the budget deficit.
The public expressed its support for government policies in the elections of 2010 and 2011, which was the second consecutive year of the most severe consolidation measures, by repeatedly electing politicians from the governing parties.
Solidarity. Expenditure cuts were applied to all branches of government. The wage and benefit cuts in the public sector were an important part of the common effort and also crucial for closing the wage-productivity gap which had widened during the boom years.
The regained budget sustainability helped Latvia in restoring investor confidence and promoting the restoration of competitiveness. The renewed economic growth opened up opportunities for reducing the tax burden on labour with an attendant positive effect on competitiveness. Latvia has been enjoying the fastest growth rate in the EU for three consecutive years now, with the pre-crisis level reached in 2013.
Ladies and gentlemen! Latvia suffered from the economic crisis – our GDP contracted by more than 20%, but you have to keep in mind, that we are already at the pre-crisis level that is not the case in many European countries.
Our public debt has also kept declining for four consecutive years since 2010 .
Clearly, no two countries are alike and there are no ready-made recipes to replicate from the Baltics. Some of our European partners had amassed a high public debt years before the crisis, others had seen protracted periods of erosion of price competitiveness. As relative newcomers to the club we had largely avoided these issues. Some of the Baltic solutions, however, are relevant to the current policy debate. Namely, we returned to growth in a few short years because of the policy mix activated at the very outset of the crisis. When cornered, Latvia carried out reforms of public finance management and structural reforms, quickly shifting the economy back into motion and onto the path of growth.
The wider economic debate on how to make growth more robust in the euro area is becoming richer in nuance, which is promising. Less time is spent on searching for a single panacea. This quest is increasingly replaced by understanding that economic growth in the future needs to be supported by a combination of policies, including structural changes. There is much less room for over-simplification: ever more cheap money alone from the Eurosystem is cited less and less as the silver bullet to solve everything. Keynesian ideas unfortunately are not working. You know this phrase from the famous book "This Time Is Different". Instead, the monetary stimulus that the ECB is providing, including improvements in financial conditions, is seen to be accompanied by more responsible role of the fiscal and long overdue structural policy reform. And discussions about using "the fiscal space" are very misleading. Monetary policy responses must be supported by improvements on the fiscal or structural reform side.
Speaking about bank lending I have to say that it remains subdued. There are considerable concerns regarding the impact of the consequences of the prolonged lending weakness on growth in Europe. Naturally, it is more pronounced in the countries and sectors where the largest private or public debt overhangs have been accumulated prior to the crisis . Deleveraging in such cases is a necessary structural correction, and it has to continue while appropriate lending stimulus policies are sought. What are the ways of mitigating risks of the slow credit growth?
The TLTROs, ABS programme, CBPP are designed to boost bank lending to the real economy and stimulate an upturn in investments and growth. However, as said, lending development is also closely affected by fiscal and structural policies, shaping overall economic sentiment. Certainly, in the environment where you do not know the future fiscal policy, lending is decreasing.
Needless to say, that if you [banks] have lots of money, but the future policy and taxes are not known, it might affect competiveness, and you most probably will wait and wait, and wait.
The current economic debate in Latvia clearly highlights hurdles which remain to be removed by continued structural reforms. The most conspicuous examples are: 1) the new legislative initiatives with a potential to disrupt business; and 2) the need for more effective courts, especially with regard to processing bankruptcy cases.
No monetary accommodation will be successful, however, if it is not accompanied by the right set of structural changes. They actually need to gain momentum in order to ensure the longevity of the stimulus effect on growth and to increase confidence.
The events of the last and this week have reminded us how fragile economic recovery in Europe and some other countries has been, and the monetary stimulus alone cannot do the job. I do really hope that policy makers will not waste time and will not slip into crisis in order to realise that we need to do more in order to save this fragile recovery.
Ladies and Gentlemen!
Latvia and indeed the Baltic region have done something that we offer for discussion. This experience in managing the recent crisis presents a message that is worth considering in this context as an example of activating the relevant mix of policies in a timely manner. Less deficit spending has meant more economic activity and the reduction of public debt.
The result is rapid recovery and being the fastest growing economy in this region.
Maybe not all of you might share these views but that's why we are having this conference today.
I wish you very interesting and fruitful discussions today. I think we have very interesting panel and keynote speakers, and we will have an interesting time for discussions about these problems we are having not only in the euro area but around the globe.