Austerity the Lithuanian Way

“To tighten or not to tighten“—the question to which Europe does not seem to have found an answer yet. Sovereign debt crisis divided Europe not only economically with prosperous and thrifty North on one side and allegedly corrupt and miserable South on the other, but also ideologically with pro-austerity and anti-austerity policy supporters fervently arguing over which path Europe should take to finally escape from the crisis. Nothing strengthens your argument more than evidence and so anti-austerity supporters don’t waste time to remind us time and again about Europe’s austerity-plagued, ever-depressed periphery where even the almighty IMF was forced to admit that austerity failed to work as expected. Yet pro-austerity supporters have no intention to surrender and point fingers at Europe’s Northern periphery—the Baltic countries, which seemingly successfully implemented austerity policies and became economic growth leaders in Europe. But the key question here is whether economic recovery happened “because of” or“in spite of” the austerity policies. To answer this question let us examine the crisis-fighting experience of the best-performing European economy in the post-crisis period—Lithuania.

After a decade of spectacular growth, Lithuanian economy was severely hit by the global economic recession: in 2009 alone GDP fell by 14.8 %, unemployment increased from 6 % to 14 % and those that were lucky enough to stay employed saw their wage bills shrinking by 7 % on average. Recession brought not only economic, but also psychological hardship. The crisis signified the end of “the Lithuanian dream”—a dream to catch up with the West. After joining the EU in 2004, many citizens believed that “the Lithuanian dream”is just about to come true and the easiest way to take part in it was … to invest in real estate. But once the dream shattered, so did the real estate bubble. In 2009 alone, house prices plummeted by as much as 30 %, construction sector activity contracted by 48 % and one out of three construction workers lost their jobs. Thus, Lithuanian economy in effect was hit by a double-crisis: external one, caused by global financial crisis, and internal one, caused by bursting real estate bubble. As the saying goes, trouble never walks alone.

Nothing But Austerity

The situation demanded rapid and decisive action, but neither Lithuanian government nor the central bank could do much. During the “economic summer” in 2003–2007, Lithuanian government acted as if “economic winter” would never come and did not bother to accumulate financial reserves. In fact, Lithuania was managing its public finances no better than southern Europeans that loved to live like a careless and short-sighted piggy “Nif-Nif” from the illustrious fairy tale “The Three Little Pigs.” For example, Lithuania was running budget deficit in 2007—the year when real GDP expanded by an impressive 9.8 % and budget revenue increased by an enviable 21 %. No wonder, then, that when the crisis struck, budget deficit instantly approached hazardous 10 % of GDP mark. Under such conditions, fiscal stimulus was surely not on the agenda so Lithuania was compelled to embark on a full-scale austerity policy with tax increases and spending cuts.

Monetary policy was to no avail either, since by pegging its currency to euro in 2002, Lithuania “de facto” became a member of the eurozone and effectively gave full control of its monetary policy to the ECB. The only alternative was devaluation, but it was never used fearing that it could undermine confidence and deepen recession even further. In fact, keeping the peg was a brave strategy, since under very similar circumstances none of the Scandinavian countries managed to keep their currencies pegged and were eventually compelled to devaluate them during the early 1990’s recession. Keeping the peg gave much needed stability, but at the same time it caused Lithuanian currency to strengthen against the currencies of its major trading partners in 2009: 19 % against Polish Zloty, 18 % against Russian Ruble and 10 % against Swedish Kroner*. Stronger currency weakened Lithuania’s international competitiveness that hurt not only exporters, but also domestic traders as Lithuanians rushed en masse to Poland to buy cheaper products. Moreover, in spite of strong commitment to keep currency pegged, speculations about prospective currency devaluation drove up domestic interbank rates with six month VILIBOR spiking above 10 % mark in the end of 2008. Rising interest rates increased debt burden for households and businesses and further worsened their financial situation. Hence, instead of badly needed expansionary monetary policy, Lithuania de facto was implementing the contractionary one, which deepened recession even further.

Molotov Cocktail

Add one portion of global financial crisis, a few pinches of bursting real estate bubbles, mix it with contractionary fiscal and monetary policies and you will get an excellent Molotov cocktail. It could not be worse—you could say, and you would not be far from the truth. And yet Lithuania managed to recover fast and demonstrate indeed impressive economic performance. Lithuanian GDP per capita increased by a cumulative 31 % in just three post-crisis years—the fastest growth in the whole European Union. As a result, in terms of GDP per capita Lithuania outran Croatia in 2010, Poland and Hungary in 2011, its northern neighbor Estonia in 2012 and it is not going to stop there. Based on the latest European Commission forecasts, Lithuania will overcome Greece and Portugal as soon as in 2014. However, austerity policy supporters should not hurry to celebrate the victory, since the underlying causes of Lithuanian economic growth in fact had very little to do with austerity.

Pitfalls of Austerity

There are two ways to implement austerity: cut spending or increase taxes. The problem is that both of them reduce economic growth, but the former is reducing growth of a public sector while the latter—of a private one. It is not surprising that politicians generally prefer tax increases to spending cuts and Lithuania was no exception here. However, increasing taxes in times of crisis appeared not to be the best idea in a country with comparably low tax morale and high shadow economy. Increased VAT rate from 18% to 19% and later on to 21% as well as other tax reforms did not help to collect more taxes. In fact, instead of rising, Lithuanian tax to GDP ratio fell to its lowest ever recorded level in 2011 and became the lowest in the whole European Union. Companies and individuals became obsessed with “tax optimization” that became a symbol of fight against the austerity policies. Shadow economy increased with the portion of unreported and underreported earnings increasing. For example, “officially” around 40 % private sector employees were earning less than a minimum wage in 2010 while in public sector the number was only 20 %—an indicator that some salaries in the private sector are paid “unofficially.”

Spending cuts were not so successful either: Lithuania managed to cut public expenses by a mere 0.9 % in 2009 whilst budget income declined by a full 14.1 %. The morale here is simple: it is virtually a “mission impossible” to cut budget expenses in nominal terms—the best one can hope for from austerity is keeping expenses fixed or increase them at a slower pace than income. In other words, if there is no economic growth and no inflation that would increase budget revenue, austerity is not likely to reduce budget deficit. Government expenses are like Hydra—if you cut one million here, two million are being spent elsewhere. In Lithuania, rising revenues and not falling expenses allowed to reduce public deficit from 9.4 % in 2009 to 3.2 % in 2012. Expenses decreased by a mere 0.7 % while income rose by 14.1 %.

Seeing that tax increases and spending cuts will not suffice, Lithuanian government reduced annual contributions to private pension funds from 5.5 % to 2 %. In this way, today’s budget deficit problem was effectively solved at the expense of future generation. The future generation will not only have to take care of aging population problem on their own, but will also have to pay back public debt, which increased from 15.5 % of GDP in 2008 to 40.8 % of GDP in 2012. Moreover, in spite of implemented austerity measures and robust economic growth, Lithuanian public deficit is still expected to be close to 3 % of GDP in 2013. Hence, austerity did not seem to work very well in Lithuania.

Austerity kills Consumption

Austerity also produced quite a few side effects. Higher tax rates and continuous threat of potential further increases literally paralyzed local economy. Obviously, one must admit that it is not a wise strategy trying to sustain what is fundamentally unsustainable i.e. consumer and real estate bubbles. But if you ever decide to implement austerity policies you need to communicate it clearly and unambiguously to the society and do it all at once. Any uncertainty left about the possibility of further tax increases in the future makes more damage to the economy than the increase of taxes themselves. That is because if businesses anticipate an increase in taxation they tend to employ “wait and see” tactics: halt their investment activities, stop hiring employees and stop rising wages.

Austerity mindset trapped Lithuania into the so called “paradox of saving,” where more saving was followed by more recession and more recession by more saving. Even though Lithuanian economy showed decent growth rates, wages and investments stalled while unemployment remained elevated. Companies attempted to insure themselves against the potentially adverse policy changes by hoarding cash and increasing their profitability levels at the expense of investments. Companies also hesitated to invest in human capital: as a result, compensation to employees as a share of GDP reached 10-year lows in 2012. Even though Lithuanian nominal GDP already exceeded pre-crisis levels, compensation for employees is still 11 % and investments—even 33 % below the pre-crisis levels.

Sluggish wage growth reduced the middle class whereas weak investment activity did not allow creating new employment opportunities. Seeing no improvement in economic situation, many Lithuanians chose to emigrate: over the last five years, 5.6 % of total Lithuanian population emigrated. If not for emigration, unemployment would have been close to 20 % instead of 13 %. Another big problem Lithuania faces now is structural unemployment. During the crisis the total number of employees in Lithuania declined by 16 % of which one out of three was working in the construction sector. Construction workers found it difficult to change their profession and thus majority of them remained long-term unemployed or chose to emigrate. Lithuania had an excellent opportunity to use this vast pool of relatively cheap and qualified labor pool to implement mass renovation project of soviet- style buildings. Regrettably, this opportunity was not taken advantage of (it is not as easy as rising taxes after all).

Export Miracle

There is no mistake to say that it was exports that saved crisis-hit Lithuanian economy. During the last three post-crisis years, export volumes were growing on average by 14 % whereas domestic consumption—by a mere 1.4 %. Thus, Lithuanian economy was like an aircraft with only one working engine—exports, which, luckily, was enough to uplift the whole economy. Interestingly enough, Lithuanian businesses managed to create this export miracle “in spite of” rather than “because of” restrictive monetary policy. On the other hand, fiscal policy decisions did not have any direct negative effect on export performance, since they were primarily aimed at increasing consumption and excise taxes as well as making minor public spending reductions. But more importantly, by keeping the local market depressed, austerity policies facilitated “internal devaluation” i.e. employee wages increased less than productivity that allowed exporting companies to increase their cost competitiveness vis-a-vis their neighbors. Hence, austerity policy killed domestic market, but at the same time facilitated export growth.

And yet, austerity by no means can be credited for causing export miracle, since the upsurge in exports was more a natural phenomenon rather than triggered by some policy action. After joining the EU, vast consumer market opened for Lithuanian exporters. Well qualified, but cheap labor force, adequate infrastructure and generous EU financial aid were perfect tools for expansion. However, overseas markets were of little interest to most Lithuanian companies. During the pre-crisis period, the primary focus was booming domestic market, powered by growing credit, consumption and real estate bubbles. Businesses were fervently competing with each other on who will build higher skyscraper, bigger shopping mall or fancier amusement park, but manufacturing for exports was certainly not in fashion. After all, why would you bother entering highly competitive Western markets if you can instantly get double, triple or quadruple profits by just selling (or re-selling) products just around the corner? However, the economy was clearly unsustainable and the question was not “if” but rather “when” the domestic consumption bubble will burst. For example, Lithuanian current account deficit reached 14 % in 2007—bigger than in Portugal and Spain and just as high as in Greece. When economic recession finally came it changed the rules of the game: exports became a new fashion while talking about the real estate and retail trade became a sign of bad taste somewhat. Weak demand at home prompted businesses to seek markets for their products abroad and in many cases they proved to be successful. Hence, exports to a large extent naturally became a new El Dorado—without any support from monetary or fiscal policy decisions.

Conclusion

Lithuania will continue to carry out austerity policies and be among the best-performing European economies. But more detailed examination of Lithuanian crisis-fighting experience reveals that austerity supporters have no reason to be cheerful, since export-driven Lithuanian economy is growing not “because of,” but “regardless of” implemented austerity policies. One should admit that by successfully carrying out “internal devaluation” Lithuania improved competitiveness of its exporters, but at the same time austerity measures, primarily based on tax increases, killed domestic market and trapped Lithuania into the vicious cycle of recession and austerity.

The main lessons that could be learned and not to be repeated again are as follows. Firstly, bear in mind that reducing public spending in nominal terms is virtually a mission impossible, hence without growth, inflation or tax increases one should not expect to reduce budget deficit. Secondly, do not increase taxes during the recession, especially in a country with low tax morale and big shadow economy. Thirdly, keep in mind that austerity has many negative side effects: increasing unemployment, falling wages and delayed investments. Fourthly, by increasing emigration and long-term unemployment austerity policies make negative effect on long-term economic performance. Fifthly, control sentiment of consumers and producers—do not panic and do not say that austerity will be here forever. And finally, internal devaluation helps exporters to improve their international competitiveness, but necessary condition for this is to have sufficiently large export markets that are capable and willing to consume your exported products, hence this is only valid for small open economies. The rest is all about quantitative easing.