The Latvia Illusion

The Financial Times columnist Martin Wolf wrote a very good piece recently on attempts to put the Baltic states, Latvia especially, on a pedestal and claim that they prove that austerity works. Mainly he makes points I have made previously: that output is still well below the previous peak, and that unemployment is still very high despite drastic out-migration.

Mr. Wolf adds that in some ways the Baltic states’ adjustment was also made easier by the fact that these are very open economies playing catch-up to the West, so that fast export growth was relatively easy to achieve.

There is, however, an additional point I’d like to raise.

People praising the Baltics tend to brush off observations that unemployment is still high and output is still well below pre-crisis peaks by claiming that high output and employment in 2006 and 2007 reflect the bubble and we shouldn’t expect them to return. I don’t think they realize just how problematic an argument this is.

First of all, the idea that real gross domestic product and employment can be hugely inflated above sustainable levels by a bubble is questionable. We know that economies can operate far below capacity; operating far above capacity is a tougher proposition to defend. In fact, it’s normal to assess trends in capacity by “peak to peak” interpolation, assuming that the peaks are much more similar than the troughs, and that “overfull” employment, while it can happen, can’t be all that large.

Relatedly, think about what this kind of apology would imply for the United States in the 1930s. The American economy plunged from 1929 to 1933, but grew very fast from 1933 to 1936. By 1935 it was already producing more than in 1924; by 1936 it was above its 1929 level. So, was the Great Depression over, and was the United States a great success story? Few would make that claim; surely we were still far short of where we should have been.

But there’s an even bigger logical hole in the Baltic story as it’s told. The claim is that Latvia’s experience shows that austerity works as a response to a deeply depressed economy. But then when you point out that recovery has still left output and employment well below their pre-crisis levels, you’re told that those levels weren’t sustainable anyway. Do you see the problem? The apologists, by claiming that the pre-crisis peak isn’t a realistic goal, are also claiming that Latvia has never been that deeply depressed an economy in the first place.

I think they’re wrong about that. But they can’t have it both ways, claiming that austerity is just what troubled economies need and then excusing Latvia’s performance by saying that the previous boom was an illusion.

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Paul Krugman joined The New York Times in 1999 as a columnist on the Op-Ed page and continues as a professor of economics and international affairs at Princeton University. He was awarded the Nobel in economic science in 2008. Mr Krugman is the author or editor of 20 books and more than 200 papers in professional journals and edited volumes, including “The Return of Depression Economics” (2008) and “The Conscience of a Liberal” (2007).