How to Resolve the Fiscal Problems of Southern Europe?

The Southern European fiscal mess has triggered the crisis on the continent. In January 2010, the European Commission discovered falsifications of the Greek budget statistics (Arganda and Caselli 2012). It undermined investors’ confidence in the country’s debt securities. A sharp increase in bond rates forced Brussels to rescue Greece from default. The Greek government received a multi-billion support package in exchange for structural reforms in the economy. During the time of the first bailout (2010-2012), the country received €240 billion. In October 2011 private investors agreed to write off €105 billion of Greece’s debt. By 2016 the country is to receive yet €130 billion. The effectiveness of these measures is under a big question. Since the outbreak of the crisis, the country’s debt has risen from 133.3% of GDP in the first quarter of 2010 to 156.9% of GDP in the fourth quarter of 2012. The unemployment rate has increased from 10.9% in January 2010 up to 27.1% in January 2013. As a result of the continued slowdown, the economy has shrunk by a quarter over the last five years. The crisis has been accompanied by political instability. Since 2009, four different Cabinets have changed in the country.

Latvia has chosen another model of anti-crisis policy. In 2009 the Baltic republic had the same problems, as Greece. It was the year when the economy shrank by 17.7%, the unemployment rose up to 21%, and the budget deficit totalled 9.8% of GDP. In March 2009 Valdis Dombrovskis headed the country’s government. At that time, some economists thought that the currency devaluation would be inevitable (Krugman 2008). However, the Dombrovskis Cabinet refused to devalue the lat to avoid inflation. In 2008 the inflation rate was recorded at 15.6% – a clear evidence of the economy’s overheating. There was a consensus among the parliamentarians on the entry to the Eurozone. The currency devaluation could have delayed it for years. As a result, the government has implemented the so-called “internal devaluation” (Aslund and Dombrovskis 2011). In 2009-2010 the Dombrovskis Cabinet cut public expenditures by 13% of GDP. Such radical measures became possible thanks to a number of factors. First, the expenditure cuts were applied to all income groups. Thus, the prime minister’s salary was cut by 35%. One third of the civil servants were ousted. Second, the anti-crisis programme was implemented quickly: it peaked in 2009. As the Greek case shows, citizens cannot endure privations for a long period of time. The Latvian government had a short window of opportunity to implement such drastic measures. Third and finally, Latvia has recently overcome the transition crisis. A significant part of the country’s population remembers the hardships of the belt tightening. Citizens of the Western European countries have never had such an experience.

The reforms were a success. The growth of the Latvian economy in 2011 (5.5%) and 2012 (5.6%) proves that. In February 2013, the annual inflation rate dipped to 1.8%. By December 2012, the unemployment had fallen to 14.3%. In 2014 Latvia will become the 18th member of the Eurozone. However, the crisis has caused a significant emigration from the country (Apsite, Krisjane and Berzins 2012). During the last four years, Riga has lost one hundred thousand of its citizens. Latvia is a member of the European Union, and therefore the Latvians have the right to work in any EU country. Such a huge emigration has resulted in the erosion of political support for the Unity party, which had a majority in the government. During the parliamentary elections of September 2011, this party took the third most votes. However, Dombrovskis has held the PM post. The two other Baltic republics, Estonia and Lithuania, have followed Latvia’s path. The Austerity programmes in these counties have not resulted in a mass emigration. Unlike the Southern European countries, all the three Baltic republics have not accumulated a large public debt. At the end of 2012, the debt to GDP rate in Estonia (10.1%), Latvia (40.7%) and Lithuania (40.7%) was below 60%. Thanks to this, Estonia joined the Euro area in 2011. That’s how the republic underlined its status as a leading transition economy. Lithuania may join the Eurozone in 2015 (Aslund 2012). The example of the Baltic republics shows that voters can make a responsible choice in a crisis time.

A possible solution to the fiscal problems of the Southern European countries can be found in reforming their tax systems and cutting their public spending. As the Latvian case shows, taxpayers can support an Austerity programme, but the implementation of anti-crisis measures should not be extended in time. A flat tax reform could also help the countries of the region to overcome the crisis. There’s no secret that the current financial turmoil has been caused in part by the tax evasion practices in the PIGS countries (Portugal, Italy, Greece, and Spain). Russia experienced the same problem in the mid-1990s (Gilman 2012). After the 1998 default, the government introduced a flat income tax of 13%. It has resulted in a radical growth of the budget revenues. Some other transition countries have followed the Russian example. The Brussels officials would probably consider such a measure as a radical solution. However, there is no better time for non-standard measures than a deep crisis.

References

Apsite, Elina, Krisjane, Zaiga and Berzins, Maris. Emigration from Latvia under Economic Crisis Conditions, IPEDR, Volume 31, 134-138.

Arganda, Silvia and Caselli, Francesco. 2012. The Political Economy of the Greek Debt Crisis: A Tale of Two Bailouts. London: London School of Economics.

Aslund, Anders. 2011. Ukraine’s Putin? Washington Post, May 2.

Aslund, Anders and Dombtovskis, Valdis. 2011. How Latvia Came through the Financial Crisis. Washington, DC: Peterson Institute for International Economics.

Gilman, Martin. 2012. No precedent, no plan: inside Russia’s 1998 default. Cambridge, Massachusetts: MIT Press.

Krugman, Paul. 2008. Latvia is the new Argentina. The New York Times, December 23.

http://krugman.blogs.nytimes.com/2008/12/23/latvia-is-the-new-argentina-slightly-wonkish/ (accessed 3 September 2013).

One Response to "How to Resolve the Fiscal Problems of Southern Europe?"

  1. nmmaier   November 27, 2013 at 12:28 pm

    Great article! But it is hard to see how this works for Greece or the USA where the debt to GDP is so enormous. It would seem that Greece would need to exit the Euro, default on some of its debt, institute a flat tax, massively cut government spending. Although, I believe that this is the right path for both Greece and the USA, its hard to envision this type of program being instituted in Greece as long as it is part of the EU. .