Published: 15.01.2015

NBP Biannual EU Presidency Lecture; Warsaw, 14 January 2015

Dear Marek, dear colleagues, ladies and gentlemen,

thank you very much for inviting me to be the keynote speaker at the biannual EU Presidency event of Narodowy Bank Polski. It is my great pleasure to address you today.

We are convening not far from the Piłsudski Square, where in 1979 Pope John Paul II celebrated his famous open air Mass, which was attended by hundreds of thousands of people and is often regarded as the first in a series of events that ultimately led to the collapse of the communist regimes in Central and Eastern Europe. Other key events, such as the Baltic Way and the fall of the Berlin Wall in 1989 followed a decade later and culminated in the reunification of Germany and the Baltic States regaining their independence. The old political and economic system in our region was collapsing and a new market-oriented one had to be built.

Building a New Economic System

Now looking back at the beginning of the 1990s, one of the obvious observations to be made is that there were so many burning issues that had to be addressed simultaneously. The legal system, privatisation and monetary reform were only some of the areas that demanded immediate attention. Our countries still had to download some of what the historian Niall Ferguson has called the ”killer apps of prosperity” – competition, private property and a set of institutions incentivizing work and individual responsibility. Those had to replace central planning and the notion that the state would take care of the individual. The reforms had to be carried out fast or frontloaded, to use a word frequently mentioned today. Gradualism was not an option. In the Baltic countries in particular, the newly regained independence was at stake. Ownership of the reform plans by new, democratically elected authorities and communication with and buy-in by the public were other key aspects of the reform effort.

The road was initially painful. The standard of living at first fell significantly. The Hungarian economist János Kornai, who has extensively studied the socialist system, has provided an explanation as to why that was the case. As he put it, our countries had not been undeveloped, they had been wrongly developed. Replacing a wrongly developed economic system with a new one was even more difficult than building something new from scratch, similarly as renovation of an old building can be more complicated than building a new one on an empty plot of land. However, already after a few years the reform effort started bearing fruit. Foreign investment flowed in, exports rose, the economy was growing again and the standard of living improved.

Our road was not always smooth, there were bumps along it. There is certainly much truth in the saying that men only learn from their own mistakes. In Latvia in 1995 we learned that financial liberalization without a developed supervision framework leads to a financial crisis. The Russian default in 1998 taught our business people that relying on a single market even if that market is a large and familiar one, is a very risky strategy, although it can be very profitable in the short run. Our flexible economy recovered quickly from these hits, though. We continued to make progress on the road to prosperity, set ourselves the aim of joining the European Union and worked hard to achieve it.

The End of History

When this aim was achieved in 2004, we in Latvia got trapped by our own success and started believing that ”the end of history” had arrived. Maybe not exactly in the sense the philosopher Francis Fukuyama used this phrase, however, there was increasingly a perception in the society that we had finally made it and that we should now be able to enjoy a similar level of consumption as the most prosperous countries in the EU. We were also starting to act a bit like ”the last man” described by Friedrich Nietzsche and referred to by Fukuyama. Less than a generation after winning the fight for independence, we were increasingly turning into nihilistic consumers with no other aspirations than acquiring the next material thing.

The situation was greatly facilitated by inflows of money from abroad in form of bank lending, foreign direct investment and EU funds. On top of that the government was running a substantial structural deficit. Aggregate demand was increasing fast as a result, which led to rising wages, which in turn led to more borrowing against expected future income, more consumption and further wage growth. However, productivity was improving much more slowly and the gap between wage growth and productivity growth was widening with each year. The growing consumption lacked a strong and sustainable basis. This contradiction was painfully exposed by the global financial crisis in 2008 that dramatically changed the risk perception by investors worldwide. Money inflows that were abundant during the boom years not only dried up, some of them even reversed. Within a few months Latvia was experiencing a serious balance of payments crisis and at the end of 2008 had to turn to international financial institutions for help.

Expansionary Consolidation

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 an expression we like in our country. In Latvia, it is no longer viewed as an internally inconsistent expression. Back in 2008, many economists regarded it with suspicion. The public debate was dominated by the common wisdom that larger budget deficits in times of economic crisis help boost demand and thus support economic recovery. Whether ”less is more” in terms of reduced budget expenditure stimulating economic recovery is still a hotly debated issue. It is still often called "austerity", a term with a negative connotation. However, in an economy that has been growing at rates above its potential growth rate for several years and has a substantial positive output gap and a distorted structure with overweight domestic demand oriented sectors, boosting demand further by fiscal stimulus cannot be a recipe for returning to sustainable growth.

In Latvia, the rapid consolidation came largely on the side of budget expenditure and was based on structural reforms. Two thirds of the total consolidation was generated by cutting expenditure and only one third came from additional revenue, most notably raising the VAT rate by 4 percentage points. Returning to a sustainable fiscal situation helped Latvia restore investor confidence in its policies and regain competitiveness. Export driven economic growth then enabled reducing the tax burden on labour thereby boosting competitiveness further. Growth in export-oriented sectors also spilled over into the domestic economy creating a virtuous circle. Our experience shows that less is definitely more.

The path selected by Latvia also ensured that the pre-crisis imbalances were to a significant extent resolved by pushing the economy towards productivity growth. Wage cuts played a role in rebalancing, but less so than often claimed by those who had proposed the devaluation alternative. Internal devaluation was predominantly about adding more value rather than about earning less. In other words, productivity finally had to catch up with the rapid wage growth of the preceding boom years. It has to be admitted that a sharp increase in unemployment was initially a significant negative side effect of this process. However, as the economy recovered, unemployment fell back to the pre-boom level. At the same time the productivity gains achieved during the crisis and immediately following the crisis remained and the wage-productivity gap closed, thereby laying ground for a sustainable increase in prosperity going forward. A number of empirical studies, including several by Alberto Alesina from Harvard, have also found that expenditure based fiscal consolidation is more sustainable and growth friendly than revenue based consolidation, although the latter is more common.

The experience of Latvia is thus worth analysing to see what the formula that worked so well was. Speed was one of the key elements in this formula. Latvia saw a fiscal adjustment of 14.7% of GDP throughout 2009 and 2010, adding just an additional 2.8% by 2012. Another important element was 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 European Commission or the 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. Commitment by the public at large could be mostly attributed to active communication by authorities explaining the causes of the crisis, the alternative courses of action and the selected option. The final element in the formula was 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 to help close the wage-productivity gap which had widened during the boom years.

The Great Convergence

Let me now turn back to the longer term perspective and address the way forward. Despite the bumps on the road, the East-West convergence attained in Europe during the last generation has been so impressive that it would deserve to be called the Great Convergence. Taking into account the differences in purchasing power the Gross Domestic Product per capita in Poland has improved from 34% of the German level in 1995 to 55% of it in 2013, the respective numbers for Latvia being 24% and 54%. Similar numbers have been recorded by Lithuania and Estonia and significant convergence has been achieved by nine out of 13 Central and Eastern European countries that were relatively poor in mid-1990s, but strived to join the European Union and are EU members now. The global export market shares of most of these countries have risen significantly and continue to rise. Many of our businesses have successfully integrated themselves in global supply chains.

On a personal note, in 1989 when I was serving as the deputy head of the Economic Committee of the Popular Front of Latvia, I could never imagine that less than a generation later my country would be a member of NATO and the European Union, then another ten years later join the euro area and hold the EU Council presidency. I am sure that many of you in the audience who are old enough to have experienced the times of the Solidarność movement would share similar feelings.

The tremendous achievements made so far do not mean that we can now rest on our laurels. Even if I allowed myself to label the impressive improvement in the relative income levels in the Central and Eastern Europe the Great Convergence, it is far from complete. We also see that convergence in the EU is not automatic. The experience of some of the richer Central European countries lately shows a worrying trend – that of renewed divergence rather than continuing convergence. Beyond that, the European Union as a whole is facing a number of serious issues. I started my address by a reference to Pope John Paul II. Just in November of last year, Pope Francis, when addressing the European Parliament, said that despite the enlargement of the European Union in the past decade ”we encounter a general impression of weariness and aging, of a Europe which is now a “grandmother”, no longer fertile and vibrant”. 

Even after a decade of membership in the EU, countries such as Poland and the Baltic countries are still often labelled ”new member states”. However, being new does not have to mean insecure or lacking confidence. It can and should mean fertile and vibrant instead. I believe that our countries increasingly have the possibility to contribute to further development of the European Union. A Pole has become the president of the European Council. Lithuania has just become a member of the euro area and all three Baltic countries are now represented at the euro area table. Latvia is holding the rotating presidency of the EU Council during the first half of this year. We can and should use our opportunities to help shape the future of the European Union.

The Way Forward

What does Europe have to do to become fertile and vibrant again? The Pope in his speech mainly addressed issues that go beyond the economic aspects of EU development. I will stick to economics. The Asset Quality Review by the ECB and the stress tests by EBA followed by recapitalization requirements for some of the European banks as well as various monetary policy measures (TLTROs, ABS PP, CBPP) by the European Central Bank have been important steps aimed at reigniting lending and supporting demand in Europe. However, monetary policy accommodation and recapitalization of the banking sector alone cannot solve the current problems.

Quantitative Easing by the European Central Bank, if implemented, will also not be a magic wand making the euro area return to growth. Economic growth in the future needs to be supported by a combination of policies, including responsible fiscal management by member states and structural changes. The European Central Bank has repeatedly urged other European institutions and national governments to carry out structural reforms and will continue to do so. However, the ECB cannot do structural reforms for them.

Investment in Europe during the last years has been below its long-term trend. Jumpstarting investment would have two positive consequences. In the short-term, it would boost demand and create additional jobs. In the medium to longer term, it would raise the growth potential of the European economy. The investment plan recently presented by the European Commission president Jean-Claude Juncker is an important move to this end.

Increasing tensions between the European Union and Russia last year have reminded us that both energy security and a competitive price of energy are important to maintain the competitiveness of our economies. The work by the European Commission on the so-called Energy Union is key in this respect. Completion of the EU single market for digital services would likewise boost productivity and create new investment opportunities.

A to-do list for Europe also includes negotiating and concluding the Transatlantic Trade and Investment Partnership or TTIP. Trade played an important role in the Great East-West Convergence in Europe over the last generation that I mentioned earlier. Further trade liberalization has the potential to make a significant contribution to economic growth in Europe also going forward. However, TTIP is much more than a trade agreement. It is also about reducing regulatory burden on business and at the same time upholding globally the high standards achieved on both sides of the Atlantic.

Reigniting investment, energy union, digital union and TTIP negotiations are among the key priorities of the Latvian presidency in the EU Council during the first half of this year that will comprise three themes: 1) Competitive Europe, 2) Digital Europe and 3) Engaged Europe. Latvia aims at being a hardworking and dynamic presidency. Or a vibrant presidency, if you prefer the words chosen by the Pope. Ownership of the European reform agenda by both the European institutions and national authorities in the member states as well as clear communication with the public will certainly be among the factors that will determine whether our presidency will also be a fertile one.

Thank you very much for your attention!