The document examines Latvia's fiscal austerity program following the 2008 financial crisis which saw large cuts to government spending and wages that helped reduce high budget deficits and current account imbalances. Through internal devaluation, fiscal austerity restored Latvia's competitiveness and export-led growth, avoiding a deep and prolonged recession despite an initial sharp GDP decline. The success of Latvia's fiscal austerity program demonstrates that expansionary fiscal contraction can work under certain economic conditions.

1. Lessons from the Latvian
austerity program
Martins Bitans
Bank of Latvia
18 April 2013
1

2. Expansionary fiscal contraction
• Giavazzi, Pagano (1990): The Danish experience shows that cuts in
government spending can be associated with increases in consumption;
• Blachard (1990): Sometimes, decrease in spending or an increase in taxes
indeed increases demand, consumption and output. The questions are that of
when and how;
• Alesina and Ardagana (1997): Fiscal tightening produces (non-Keynesian)
expansionary effects. One interpretation is that a serious fiscal tightening
increases demand;
• Alesina and Perotti (1998): Fiscal corrections relying mostly on spending cuts
that are concentrated on government wages and transfers tend to be
expansionary ;
• Alesina and Ardagana (2009): We uncover several episodes in which spending
cuts adopted to reduce deficits have been associated with economic
expansions rather than recessions.
2

3. Expansionary fiscal contraction :
critique
• IMF WEO (October 2010): Fiscal consolidation typically reduces
output and raises unemployment in the short term. Over the
long term, reducing government debt is likely to raise output.
• DeLong and Summers (2012):Need for considerable caution re-
garding the pace of fiscal consolidation in depressed economies
where interest rates are constrained by a zero lower bound
• Blanchard and Leigh (2013): Stronger planned fiscal
consolidation associated with lower growth than expected.
• Krugman (2010): What sounds like hardheaded realism actually
rests on a foundation of fantasy, on the belief that invisible
vigilantes will punish us if we’re bad and the confidence fairy
will reward us if we’re good.
3

4. Fiscal Policy Changes and Economic Growth in
Latvia
10.0 5
5.0 2.5
0.0 0
Cyclically adjusted
-5.0 -2.5 government balance
(% of GDP), RHS
-10.0 -5
-15.0 -7.5
GDP growth (%), LHS
-20.0 -10
2008 2009 2010 2011 2012 2013 (f)
Source: EC, CSB Latvia 4

5. HAS FISCAL AUSTERITY WORKED IN
LATVIA?
5

6. Main problem of the boom years –
unsustainable current account position
Savings, Investments and Current Account
Balance in Latvia (% of GDP) • Current account (by identity) is
40.0
the difference between
30.0
income and consumption, but
also the difference between
20.0 domestic savings and
investment
10.0
0.0
• Current account deficits can be
-10.0
reduced by increasing savings
(lower consumption) or lower
-20.0 investments
-30.0
2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
• Both approaches imply GDP
Current account Savings Investments
will inevitably decline 6

7. In two years from 2008-2010, GDP declined by almost a
quarter…
Real GDP, 4 quarter moving average (1Q 2007=100)
110.0
105.0
100.0
95.0
90.0
85.0
80.0
2007Q1
2007Q2
2007Q3
2007Q4
2008Q1
2008Q2
2008Q3
2008Q4
2009Q1
2009Q2
2009Q3
2009Q4
2010Q1
2010Q2
2010Q3
2010Q4
2011Q1
2011Q2
2011Q3
2011Q4
2012Q1
2012Q2
7

8. … but much of it was correcting for
previous (unsustainable) excesses
Real GDP, 4 quarter moving average (1Q 2000=100)
200.0
175.0
150.0
Actual GDP
125.0
Long-term
trend
100.0
75.0
8

9. Assessing devaluation options
104
102
100 GDP with fixed peg: IMF
assessment
98
GDP with wider
96
fluctuation bands: IMF
94 assessment
GDP with wider
92 fluctuation bands: BoL
assessment
90
88
2008 2009 2010 2011 2012 2013
9

10. Structure of Domestic Loans (%)
100%
90%
80%
70%
60%
50%
40%
30%
20%
10%
0%
2011
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
LVL EUR USD other 10

11. Impact of devaluation on the banking
system
45 43.6
40
35
30
25
23.8
20 17
15 12 12.4
10 7.2 6
5
0
0
-5
-10 -5.6
Share of loans overdue (more Capital adequacy ratio Number of banks with CAR
than 90 days) lower than 8%
As of 30.06.09 With 15% devaluation With 30% devaluation 11

12. 0
1
3
4
5
6
2
-7
-6
-5
-4
-3
-2
-1
Latvia
Source: Eurostat
Lithuania
Estonia
Poland
Slovakia
Bulgaria
Malta
Austria
Sweden
Germany
Ireland
Romania
Luxembourg
United Kingdom
France
Belgium
Finland
European Union
Denmark
GDP growth in 2012 (% y-o-y)
Netherlands
Czech Republic
Spain
Hungary
Slovenia
Italy
but this time with sound fundamentals
Cyprus
Portugal
Greece
12
Today Latvia is again the fastest growing EU country,

13. Average annual growth in 2004-2014: Latvia 3.4% vs
Iceland 2.3%
GDP growth, %
15.0
10.0
5.0
0.0
Latvia
-5.0
Iceland
-10.0
-15.0
-20.0
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
(F) (F)
13
Source: Eurostat

14. 95
100
105
110
115
120
125
130
135
140
145
150
2004Q1
2004Q4
2005Q3
2006Q2
2007Q1
2007Q4
2008Q3
2009Q2
2010Q1
2010Q4
2011Q3
2012Q2
2013Q1
2013Q4
(1Q 2004=100)
2014Q3
2015Q2
2016Q1
2016Q4
Real GDP: Latvia vs Iceland
Latvia
Iceland
14

15. WHY HAS FISCAL AUSTERITY
WORKED IN LATVIA?
15

16. Blanchard (1990)
• Fiscal consolidation has two effects:
– increases tax burden and reduces consumption (strength depends on how
far economy departs from Ricardian equivalence)
– by reducing deficit today the government eliminates the need for more
adjustments in the future
• When would expect a fiscal consolidation to increase rather than
decrease output?
– when the first effect dominates the second
• This is more likely under two conditions:
– small effects of intertemporal tax reallocation
• consumers more Ricardian if credit markets developed
– when the economy is closer to the brink (of insolvency)
• debt approaching critical levels
16

17. Bond yields vs government debt in
2009
14.00
Government long-term bond yields
12.00 LV
10.00
8.00
(%)
6.00
4.00
2.00
0.00
30.0 35.0 40.0 45.0 50.0 55.0
Government debt (% of GDP)
17

18. Debt projections for Latvia: where
is the critical threshold?
140
120
100
Public sector debt
80
Scenario under the
60
program adjustment
40 Scenario with no policy
change
20
0
18
Source: IMF, First Review under IMF Stand-By Agreement; September 2009

19. 0.00
2.00
4.00
6.00
8.00
10.00
12.00
14.00
2006M01D02
2006M03D08
2006M05D12
2006M07D18
2006M09D21
2006M11D27
2007M01D31
2007M04D06
2007M06D12
2007M08D16
2007M10D22
2007M12D26
2008M02D29
2008M05D06
2008M07D10
2008M09D15
2008M11D19
2009M01D23
2009M03D31
2009M06D04
2009M08D10
2009M10D14
2009M12D18
2010M02D24
2010M05D13
2010M07D28
2010M10D04
2010M12D09
2011M02D16
2011M04D26
2011M07D05
2011M09D08
2011M11D17
2012M01D25
2012M04D03
2012M06D13
2012M08D17
2012M10D23
2013M01D03
bonds: Latvia vs Germany
Yields on long-term government
Latvia
19
Germany

20. General Government budget balance
(ESA’95), % of GDP
0
-2
-0.8 -1.3 -0.9
-4 -1.6
-2.9 -3.1
-6
-5.6
-8
-6.9 -6.4
-10
-12
-14
-16
-18
-20
2005 2006 2007 2008 2009 2010 2011 2012F 2013F 2014F
Consolidation effort Actual (targeted) balance
Structural budget balance (PF) 20
20
Source: Eurostat, F – Bank of Latvia staff estimation

21. Breakdown of budget
consolidation measures, % of GDP
21
Source: Ministry of Finance; Bank of Latvia staff calculations

22. ULC adjustment through lower
wages, but also higher productivity
Unit labour cost index (2000 Q1 = 100; seasonally adjusted)
240
-23%
200
160
-28%
120
80
2000 Q1
Q3
2001 Q1
Q3
2002 Q1
Q3
2003 Q1
Q3
2004 Q1
Q3
2005 Q1
Q3
2006 Q1
Q3
2007 Q1
Q3
2008 Q1
Q3
2009 Q1
Q3
2010 Q1
Q3
2011 Q1
Q3
2012 Q1
Nominal ULC Real ULC
22

23. 20
40
60
80
0
100
20
60
80
40
100
0
Denmark
Austria
Sweden
Belgium
Finland
Slovenia
Cyprus
Portugal
Malta
France
Belgium
Finland
Luxembo…
Sweden
Source: www.worker-participation.eu
Slovenia Netherl…
Austria Greece
Ireland Spain
Italy Denmark
Greece Italy
Romania Cyprus
Slovakia Germany
United… Luxemb…
Czech… Malta
Trade union density, %
Germany Czech…
Netherlan… Ireland
Bulgaria
Collective bargaining coverage (%)
Poland
Hungary Slovakia
16
Latvia United…
Poland Romania
Spain Bulgaria
Portugal Estonia
flexible labour market framework
Lithuania Hungary
20
Estonia Latvia
Adjustment in economy supported by
23
France Lithuania

24. Economic and export growth underpinned by restored
competitiveness as wage-productivity gap has been closed
Wage and productivity index (2005 Q1 = 100, seasonally adjusted)
150
130
110
90
Labour productivity Real wage
70
2000 Q1
Q3
2001 Q1
Q3
2002 Q1
Q3
2003 Q1
Q3
2004 Q1
Q3
2005 Q1
Q3
2006 Q1
Q3
Q3
2008 Q1
Q3
2009 Q1
Q3
2010 Q1
Q3
2011 Q1
Q3
2012 Q1
Q3
2007 Q1
24
Source: Central Statistical Bureau of Latvia data, Bank of Latvia staff calculations (2012 Q4: flash productivity data)

25. Exports in Latvia growing faster than in
countries where currency depreciated
Exports of goods and services (in euros), 2006=100
180.0
160.0
Latvia
140.0 Sweden
120.0 United Kingdom
Iceland
100.0 Poland
80.0 Estonia
60.0
2006 2007 2008 2009 2010 2011
25

26. CAN FISCAL AUSTERITY WORK
ELSWHERE?
26

27. All PIIGS countries had vulnerable
government debt positions
60 IE
LV
Hazard
Expected changes in governmnt debt
50
zone
40
(% of GDP), 2009-2016
PT
30 US
SP GR
20 UK
FR
10 BE IT
0
0 20 40 60 80 100 120 140
-10
-20
Hazard
-30 zone
Government debt in 2009 (% of GDP)
Source: IMF WEO April 2010 27

28. Potential credibility gains before adjustment:
largest in Greece, smallest in Italy
10 LV
Spreads on government bond yields
8
vis-a-vis Germany (% points), 2010
GR
6
4 IE
PT
ES
2
IT
0
0 20 40 60 80 100 120 140
-2
-4
Government debt (% of GDP), 2009
Source: IMF 28

29. 4. Relationship between Government Debt and
Bond Yields in Selected European Countries
8.00
7.00
10 Y Government bond yields
6.00 CEEC
5.00
4.00
.
3.00
Advanced
2.00 EU
1.00
0.00
0 20 40 60 80 100 120
.
Expected gross government debt in 2017 (% of GDP)
29
Source: Eurostat, ECB, IMF

30. When does Keynesianism work?
• Total demand in the economy significantly below total
supply
– in Latvia, both demand and supply contracted
• Extra government spending can be financed
– Latvia had not accumulated budget surpluses during the boom
years
– markets were not able or willing to finance government
spending almost at any cost
• Stable money demand
– in Latvia, national and foreign currencies are close substitutes
• Relatively closed economy
– in Latvia, imports account for a significant share of total income
30

31. How counter-cyclical was fiscal
policy during the boom years
Structural budget deficit (average 2004-2008, % of GDP)
0
-1
-2
-3
-4
-5
-6
-7
-8
Spain Ireland Latvia Italy Portugal Greece
Source: EC 31

32. Countercyclical fiscal policy must be
countercyclical throughout the cycle, not just
during the downturn
7
GR
6
Changes in structural balance 2013-2011
5
IT
4
PT
RO
PL 3
(% of GDP)
FR ES
HU LT SK CY
SI
2 NE
DE
IE
CZ BE 1 BG
UK
MT LV AU EE
0 FI
LU
SE DK
-1
-8 -6 -4 -2 0 2 4
Average structural balance 2004-2008 (% of GDP) 32
Source: EC

33. Labour market flexibility
Collective bargaining coverage (% labour force)
100
90
80
70
60
50
40
30
20
10
0
Latvia Ireland Greece Spain Italy Portugal
33
Source: www.worker-participation.eu

34. Openess to foreign trade
Exports and imports of goods and services (% of GDP)
200
180
160
140
120
100
80
60
40
20
0
Latvia Ireland Greece Spain Italy Portugal
Source: Eurostat 34

35. Estimating chances of
expansionary fiscal consolidation
Debt Spread Flexibility Openness Frontloading TOTAL
before before of labour to trade of fiscal
adjustment adjustment markets adjustment
Latvia HIGH
36.7 9.14 20 126 6.4
Ireland HIGH
92.2 3.0 35 192 6.2
Portugal MEDIUM
93.5 2.66 94 77.9 4.8
Italy LOW
119 1.3 80 59.4 1.6
Greece MEDIUM
148 6.35 85 59 4.1
Spain LOW
61.5 1.51 82 63.8 -0.5
35

36. A LOOK INTO THE FUTURE
36

37. 2.4
2.6
2.8
3
3.2
3.4
3.6
3.8
4
nov.11
dec.11
jan.12
feb.12
mar.12
apr.12
mai.12
jūn.12
jūl.12
aug.12
sep.12
okt.12
nov.12
for Latvia (%)
dec.12
jan.13
feb.13
mar.13
EC
IMF
Forecasts of GDP growth in 2013
37
Consensus

38. Economic growth in Latvia generated by
exports and private consumption
Contribution to GDP growth (% points)
25
20 Imports
15
10 Exports
5
0 Investments
-5
-10
-15 Government
-20 consumption
-25 Private consumption
-30
-35 GDP
-40
2005 2006 2007 2008 2009 2010 2011 2012
Source: Statistics Latvia 38

39. Decline in credit stock reflects still ongoing
deleveraging
Credit to private sector (y-o-y, %)
100
80
60
40
20
0
-20
I 2011
IV
IV
IV
IV
IV
IV
IV
IV
IV
X
X
X
X
X
X
X
X
X
I 2004
I 2005
I 2006
I 2007
I 2008
I 2009
I 2010
I 2012
I 2013
VII
VII
VII
VII
VII
VII
VII
VII
VII
Annual growth of household credit stock
Annual growth of nonfinancial corporation credit stock
Annual growth of resident credit stock (without government)
39
Source: Bank of Latvia

40. Deleveraging in the banking system continues,
limits loan growth
Loan-to-Deposit Ratio in
Latvia (%) Loan growth in Latvia (%)
350 50
40
300
30
250 20
10
200
-
150 -10
-20
100 I VII I VII I VII I VII I VII
VII
VII
VII
VII
VII
VII
VII
VII
I 2005
I 2006
I 2007
I 2008
I 2009
I 2010
I 2011
I 2012
2008 2009 2010 2011 2012
Contribution to lending growth by foreign banks (%
Total Foreign banks points)
Contribution to lending growth by domestic banks (%
Domestic banks points)
Total lending growth (%)
Source: Bank of Latvia 40

41. Confidence indicators strong, but
for how long?
Economic Sentiment Index (ESI)
115
110 Latvia
105
100
95 Lithuania
90
85
Estonia
80
I V IX I V IX I V IX I
2010 2011 2012 2013
41
Source: EC

42. Euro: why now?
42

43. Maastricht reference value for price stability will
be reached with a significant margin in Latvia
Estimates of 12 month average inflation and the Maastricht criterion, %
4.5
4.0
3.5
3.0
2.9
2.5
2.0
1.5 1.6
1.0
V
V
VII
X
XII
VII
X
XII
II
II
IX
IV
IX
IV
III
III
IV 2011
VI
VIII
XI
VI
VIII
XI
I 2012
I 2013
12m average inflation in Latvia Estimated Maastrich criterion*
Sources: Eurostat, EC, Bank of Latvia estimates * - Greece excluded from calculation 43

44. Actual and estimated inflation: Latvia vs
EU best inflation performers (%)
Jan.13 Feb.13 Mar.13 Apr.13*
Annual inflation Latvia(%) 0.6 0.3 0.3 0.4
12 month average inflation in Latvia (%) 2.05 1.81 1.57 1.36
12 month HCPI inflation (%):
Sweden 0.93 0.89 0.84 0.80
Ireland 1.95 1.92 1.78 1.68
Germany 2.11 2.05 2.01 1.98
Denmark 2.22 2.08 1.91 1.78
France 2.13 2.02 1.89 1.78
Maastricht criterion (Greece assumed as outlier)
3.1 3.0 2.9
(%) 2.8
(SE, IR, (SE, LV, (SE, LV,
(SE, LV, IR)
LV) IR) IR)
* BoL forecasts 44

45. Interest rate criterion scenario
analysis
Jan.13 Feb.13 Mar.13* Apr.13*
12 month average interest rates in Latvia (%) 4.35 4.17 4.00 3.84
12 month average interest rates (%):
Sweden 1.60 1.61 1.61 1.63
Ireland 5.88 5.61 5.35 5.09
Germany 1.47 1.44 1.42 1.41
Denmark 1.39 1.38 1.37 1.37
France 2.45 2.39 2.33 2.27
Maastricht criterion (LV, SE, IR), % 5.94 5.80 5.65 5.52
Maastricht criterion (LV, SE), % 4.98 4.89 4.81 4.74
Maastricht criterion (LV, SE, FR), % 4.80 4.72 4.65 4.58
Maastricht criterion (LV, SE, DK), % 4.45 4.39 4.33 4.28
* BoL forecast 45

46. Contribution of main components to the annual average
inflation, pp
3
2.6
2.4
3 2.3
2
Fuel
2 1.3
Unprocessed food
Regulated prices
1
Core inflation
Annual average inflation
1
0
-1
2012 2013 2014 2015
46
Source: Central Statistical Bureau of Latvia, forecast - Bank of Latvia staff estimation

47. Euro zone’s policy response to crisis
POLICY AREA BEFORE THE CRISIS NOW
Monetary policy Liquidity support Lender of last resort
Coordinated financial None European Stability
assiatance Mechanism
Fiscal policy Stability and growth Enhanced SGP (Fiscal
pact (SGP) Compact, European
Semester)
Banking National supervision Coordinated supervision
(banking union in the
future?)
47

48. Policy coordination is good but market
discipline is essential
2008 2012
9.00 9.0
8.00 8.0
Government bond yields (%)
Government bond yields (%)
7.00 7.0
6.0
6.00
5.0
5.00
4.0
4.00
3.0
3.00 2.0
2.00 1.0
1.00 0.0
0.0 25.0 50.0 75.0 100.0 125.0 0.0 25.0 50.0 75.0 100.0 125.0
Government debt (% of GDP) Government debt (% of GDP)
48

49. Summary: costs and benefits of joining
versus waiting
Latvia joins the euro in 2014 Latvia waits
Banking sector problems solved, •Latvia benefits from lower •Higher interest rates hamper
growth in the euro zone picks interest rates, additional growth.
up investment •Risks of marginalization
Euro zone continues “muddling •Lower interest rates •Uncertainty leads to higher
through” the crisis •Participation in EMS, but interest rates
money not lost •Ultimately costs of joining
•Latvia paticipates in designing (EMS) the same or higher
euro zone policies •Will adopt policy framework
which was designed without
Latvia
Euro zone disintegrates •Latvia suffers severe macro •Latvia suffers severe macro
consequences consequences
•Extra costs of currency re-
introduction
•Some payments into EMS may
be lost
49