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Latvia’s Free Market Success Story

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Latvia’s Free Market Success Story

May 15, 2016

Twenty-five years after the fall of the Soviet Union, one of its former states will receive a major liberal badge of honor. Latvia, a Baltic Sea nation of two million people, will officially join the Organization for Economic Cooperation and Development. Membership in the OECD, a group of developed nations, carries great symbolic value. Latvia’s status as the group’s 35th member is certainly worthy of recognition—and a look back at how it arrived.

Latvia is one of the major post-communist success stories. GDP per capita in 2016 was $22,460 in PPP-adjusted U.S. dollars, just slightly below European averages. This level of wellbeing is all the more remarkable because it only had a quarter-century of national sovereignty to achieve it. With the exception of its Baltic neighbors, most former Soviet states have not seen such substantial growth—and some, such as Ukraine, have seen no net growth at all.

What is responsible for Latvia’s success? Privatization, simple and competitive taxes, and a stable currency—all elements that allow the private sector to flourish. Latvia privatized most industries during the 1990s, and just a few years after its independence from the Soviet Union, two-thirds of all employment was in the private sector. Open markets brought in foreign investment and allowed trade to expand. By the end of the decade, international trade was equal to 82 percent of GDP, and is now over 100 percent.

Latvia’s system of taxation also gives it a competitive edge. The corporate income tax rate is just 15 percent, among the lowest in the developed world. (By contrast, the United States has a combined rate of 39 percent.) Latvia also levies a flat income tax rate of 23 percent—lower than most OECD countries—and a consumption tax (VAT) of 21 percent. While the VAT rate is slightly above the developed-world average, research by the OECD finds that consumption taxes are less harmful for economic growth than corporate or personal income taxes. If Latvia must have a high tax, better for it to be a consumption tax.

Latvia joined the euro in 2014, but prior to that it had a reputation for monetary stability. It kept its own currency, the lats, pegged to the euro. Some argue that the currency was, in fact, too stable: high levels of foreign investment during the mid-2000s would have caused the lats to gain value, tempering the economy’s boom during that period and making the bust less painful.

But Latvia was consistent through boom and bust. During the global financial crisis, Latvia faced a major recession. The definitive account of the Latvian experience has been written by Anders Åslund and Valdis Dombrovskis for the Peterson Institute. During the crisis, Keynesian economists, notably Paul Krugman, encouraged Latvia to devalue its currency. They claimed this would boost exports and generate inflation to bring the economy out of recession. But in reality, devaluing the currency would have made imports (including Russian gas) more expensive and foreign debt repayment more difficult.

Latvia followed the exact opposite of the Krugman-Keynesian prescription. The nation maintained its currency peg and cut government spending instead of increasing it. The medicine worked: with broad public support, Latvia abolished half of its government agencies and cut the state workforce by 30 percent, according to Åslund and Dombrovskis. Coupled with regulatory and education reform, this downsizing galvanized the private sector and brought the country roaring back.

The country still faces economic challenges, mainly corruption and some remaining state-owned enterprises which have problems of inefficiency and poor governance. While 95 percent of government assets have been privatized since independence from the Soviet Union, many of the largest enterprises—including the main airline, Air Baltic—remain in public hands. But reforms here are moving along, with a 20 percent stake in the airline recently sold to a German investor.

Latvia offers guidance for other nations transitioning from socialist economies to free markets—and indeed, for the rest of the world as well. Privatization, competitive taxes and stable currencies are oft-cited remedies for economic malaise, but the Latvian experience shows that they work. Latvia should be proud of its OECD accession—the country has earned it.

Preston Cooper is a policy analyst at the Manhattan Institute. You can follow him on Twitter here.

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