Go East, young man...

The most acute problems are on Europe's periphery, where many smaller economies are experiencing crises strongly reminiscent of past crises in Latam America and Asia : Latvia is the new Argentina.

Paul Krugman, NYT 15/12/08 (slightly wonkish)

Yesterday, we picked up the following chart of the day from Bloomberg and bearing Krugman's comment in mind, there is something strange going on. The following chart depicts the current state of economic play in various European countries compared to their pre-crisis starting point with 100 being the reference at the start of 2008 :

The point I will try to make is not the Bloomberg message as such - meaning former Eastern Europe beating the Mediterranean - but the fact that the current austerity debate deserves a closer look and a wider scope than the ones pro-austerity or anti-austerity (such as Krugman).

When the financial & economic crisis struck hard in 2008/2009 in the Baltic states, Latvia was the victim par excellence generating a -18% growth in 2009. They nevertheless followed the Argentina route by keeping the currency peg intact (which Argentina had to renounce in the end), in this case pegging the Lat to the EUR. And instead of opting for a free floating exchange rate (euphemism for devaluation), the government opted for fiscal devaluation implying some very strong austerity measures, comparable to the Irish regime and to some extent Greece, that is if completely implemented in the latter case. Unemployment rose to 23% (cfr Spain), inflation @10% and the current account deficit went as deep as 22% of GDP. But now 3 years after the facts, it seems that Latvia produced a narrow escape. Apart from the unemployment level which is still high (16%), its economic outlook according to the OECD May update is not so bad after all and certainly better than the one for core and Southern Europe.

So the question remains : why did it work out quite well for Latvia while for Ireland the jury is still out and for Greece it seems to be game over whatever the scenario ? I would like to touch the following issues to open up the blog debate :

1) International competitiveness, trade and economic structure

Latvia is an open economy with exports and imports reaching nearly 50% of GDP. Like its neighbor Estonia, it has strong trade links with the Nordic block and the East (Russia). Its main EMU trade partner is Germany for a substantial percentage on import & export side. Now when growth is very external trade sensitive, you might be inclined to favor a strategy of weak currency (devaluation) when in trouble. Latvia - also under pressure of Europe and the IMF- did not and opted for austerity/fiscal devaluation in order to improve competitiveness (private and public sector wage cuts etc). And the social acceptance on austerity went smoothly despite all. Time to raise another question : even if a currency adjustment can bring relief (valve to release steam) , is it a recipe for success ? Let's turn over to Greece. Should a Grexit occur accompanied by a 40 to 60% devaluation into the new Drachme, can Greece exports its way out ? Greece's exports amount 10% of GDP while its imports are double this size. But more importantly, also the goods and services it produces are not really fashionable in international trade. So the trade balance requires more than just a harsh devaluation in order to balance the books, meaning an economy starting from scrap with structural measures required as well in order to compete and deliver the goodies the international buyer favors. In the mean time, domestic demand (90% of GDP drive) is in coma and cannot provide miracles. Finally, when slashing the exchange rate, be sure to implement sufficient measures to control the imported inflation as well otherwise you loose all the benefits (cfr Belgium 1982). So resetting the exchange could provide one of the necessary valves but in the case of Greece, my guess is that it will require more than this.

2) The debt starting point

When the crisis struck in 2008/2009 and blew a hole into the structural growth path, it blew a considerable hole as well into Latvian public finances. They took measures but it could of course not prevent the debt/GDP ratio to double up from 20 to 40% (no surprise there when growth takes a 20% dive). And most likely lucky for them that the debt ratio - despite all headwinds - is still at the acceptable and sustainable level of 40% in contrast to the triple digit debt of Greece. In the eye of the foreign investor, it probably means that the Latvian economy can cope in the medium term and still match its liabilities. For Greece, we already passed the point of no return way back in history, even before the 2008 financial Tsunami hit the West.

3) Financial sector

Next to the current public sector sword of Damocles following the various bailouts and lack of international trust, private sector leverage (eg mortgages and banks) has caused considerable damage across various pockets across the globe. With Spain, Ireland and Greece being the major victims within EMU, Latvia nevertheless was in dire straits as well 4 years ago. In fact, in 2009 the world's capitals biggest losers were Riga (house prices down 50%) and Dubai (-43%). So for banks bad news as well in terms of non profitable loans etc. But the big rescue came by friendly neighbors, ie Estonia and Scandinavian banks, especially Swedish banks. These countries swiftly recapitalized their banks and most of all kept their credit lines open for their Latvian subsidiaries. And that of course is a big help in order to maintain credibility in the system and avoid bank runs and capital flight. Sadly enough for Greece and Spain, this is not the case as we speak.

So it seems that one-size-fit-all miracle measures do not exist and that a lot depends on country specific elements. Hence the sad news that for solving the European financial chaos, no miracle cure exists either in view of the fragmented and divergent economic nature of various EMU member. And then we don't even mention the astronomical amounts involved, either for fixing the system or following a chaotic EMU break-up.

One final word on EMU member Estonia, one of the Baltic tigers being the true sweet spot for now in Europe. Estonia today produces a remarkable economic track record (+8% GDP growth 2011 !) . It is virtually debt free (7% public debt ratio, upgrade AA) and has 1 of the lowest tax pressures in developed and emerging markets : leaving the issue of "fairness" aside, it has a flat income tax rate of 21%. True, its economy suffered as well in 2008/09 in terms of GDP slack and unemployment but the prospects are optimistic : with a modern infrastructure and a high degree of international openness (trade= 75% of GDP), the OECD recently painted a very rosy picture on its long term economic outlook : by 2025, GDP/capita could reach the level of the Nordic countries. In addition, by 2050, Estonia could be the most productive country in the EU after Luxemburg ad thus be among the top5 most productive nations in the world. If realized, something we can only envy.