Let’s follow John Lennon. Imagine. Imagine a country suffering in 2008 and 2009 a crisis at least as severe as ours but which, thanks to setting in motion a series of deep reforms, grew 5.5% in 2011 and 3.5% in 2012. Imagine that this particular country succeeded precisely by ignoring the recommendations of the usual Keynesian economists, headed by someone called Krugman. Imagine that while they were achieving the “impossible”, almost on their own, the establishment labeled their experiment as “neo-liberal insanity”. Last, imagine that this country deliberately chose the most difficult path deciding not to devalue its currency.
This country is Latvia, one of the three small Baltic republics, crushed for decades under the heavy boots of the soviet socialist paradise. Much of what I am going to say could also be applied to Estonia, but the Latvian case is particularly well documented in a little book titled How Latvia Came Through the Financial Crisis, written by a Swedish economist expert in post-communist economies and Latvia’s Prime Minister. Unfortunately, none of our well prepared politicians will read it because, among other reasons, it is written in English (to put it kindly, our politicians are not exactly fluent in that language).
During the boom years, Latvia surfed the colossal wave of a huge real estate bubble. Prices multiplied by three in five years, which unleashed a great euphoria among the whole Latvian society. The government kept increasing public expenditure to match the ever growing revenue base. Significant budget surpluses were dismissed, considered simply out of the question, very much the same situation we lived in Spain. In the fall of 2008 the financial crisis hit. Parex Bank, holding 20% of the assets of the banking system, suffers a bank run and in just three months loses a quarter of its deposits and must be intervened by the State, which buys 51% of the capital for the symbolic amount of two lats (three euros). The Latvian 10 year bond, denominated in euros, reaches a yield of 12%. At that moment a new government comes into power, decided to confront reality with determination. One of the most radical experiments of internal devaluation is about to take place: the Revolution of Austerity.
In one year, the number of government agencies is cut from 76 to 25. Civil servants are reduced by 30%, setting a goal that they will never amount to more than 8% of the working population (in Spain this figure is more than double). On top of this, the average salary of the still employed civil servants is substantially reduced to match private sector’s salaries, which in turn come down by 10%. One in eight schools are closed, and a new system is put in place to reward efficiency and quality instead of volume of employed resources. Pensions are the only untouched budgetary item, as the Constitutional Court rules they must be kept intact. The whole regulatory system is revamped in order to decrease its burden on entrepreneurship, the true and only wealth generator. In consequence, Latvia ranks 24th in the World Bank Doing Business Index, which measures the easiness of doing business in each country. For the record, Spain ranks 44th in that same index, just below Peru. Lastly and significantly, neither the government nor the banks try to prevent the necessary adjustment of real estate prices, which collapse by 70%, allowing the country to start all over again from firm ground once the previous excesses had been cleaned up
Latvia had a simple flat rates tax system, which the government intended to keep. Wage income was taxed at 23%, dividends at 10%, VAT at 18%, corporations at 15% and payroll tax at 33%. The tax increase affected both VAT and income tax rates, which were raised to 23% and 26%, respectively. Capital gains, exempt in the old system (yes, exempt), began to be taxed at 15%. Spanish taxpayers, please take note of the tax rates paid elsewhere. In Latvia there is no inheritance taxation nor, for that matter, any Wealth Tax, extinguished like the dinosaurs in the developed world, except in socialist France and Spain (which always follows sheepishly its northern neighbor in these issues).
All in all, 75% of the so called fiscal consolidation was based on spending cuts. On the opposite side, our current government, hampered by its untold socialist leanings, has placed the burden of the adjustment on the Spanish taxpayers’ shoulders, making them the most exploited citizens in the whole EU (quite a record), while keeping the gigantic size of the State and the bankrupt and out-of-control autonomous regions’ bureaucracies tenderly untouched. The Latvian government reduced public expenditures by the equivalent of 7% of GDP in its first year in office. Selling it as a bold move, the Spanish government planned to cut it by 0.7%, one tenth, a promise that, in spite of its shyness, will surely join its long list of broken promises.
What has been the result of an austerity policy based on downsizing the State and eliminating the shocking squandering we all know about too well? In Latvia, GDP contracted by 18% in 2009, stabilized in 2010 and grew 5.5% in 2011 and 3.5% in 2012. In the meanwhile, Spain is still suffering from chronic recession. But we already know how questionable a measure GDP is. What about unemployment? Latvia reached a peak of 20% in 2010, and today it is 13.5%, and going down. In Spain, this number is nearly 27%, and going up. Public debt in Latvia was 9% of GDP at the beginning of the crisis. It reached a peak of 44% and is already coming down. In Spain this ratio is more than double. To the Latvian government, austerity means reducing the size of the public sector and deregulating. This policy has worked. On the contrary, in Spain our government understands austerity as raising taxes and keeping the privileges of the ruling class unscathed. This is unfair and, in addition, it won’t work.
This summer the European Central Bank screwed it up when it announced the bond purchase program aimed at reducing the spreads of ailing peripheral countries, because it removed with the stroke of a pen all incentives to reform the public sector. The markets’ truce was foolishly interpreted as the end of hostilities and our government, never too rich in reform impetus, saw no reason to tackle the radical State size reduction we need to survive this crisis.
After the negligent and dismal socialist government that preceded them, the current administration’s lack of will to reduce public expenditure is inexcusable and unforgivable. The Baltic republics have shown the way: a hard one, for sure, but realistic, robust and successful. Either we follow this path or we will default, it’s that simple.