Yves here. This is a meaty post, so get your cup of coffee and settle down for a good read. This essay is based on a chapter in the book, Contradictions of Austerity: The Socio-economic Costs of the Neoliberal Baltic Model

By Michael Hudson, a research professor of Economics at University of Missouri, Kansas City, and a research associate at the Levy Economics Institute of Bard College. His latest book is “The Bubble and Beyond.”

Alice laughed: “There’s no use trying,” she said; “one can’t believe impossible things.” “I daresay you haven’t had much practice,” said the Queen. “When I was younger, I always did it for half an hour a day. Why, sometimes I’ve believed as many as six impossible things before breakfast.” -Lewis Carroll, Alice in Wonderland

The small Baltic republic of Latvia suffered the largest contraction of any European economy following the Great Financial Crisis of 2008. Reckless lending from Swedish banks fueling a Latvian property bubble caused the collapse. Its bubble had to burst, just as similar bubbles were bursting from the United States to other parts of Europe. Making matters worse, Latvia’s debt legacy was primarily denominated in euros, thus reprising the problem of the Global South in the debt crisis of the 1980s when loans had to be paid back in a foreign currency, in that case the then strong US dollar.

What makes Latvia so significant is the sacrificing of their national economic interests to foreign bankers. Having employed a steady diet of neoliberal policies since recovering independence from the USSR in 1991, faced with the 2008 financial shock, Latvia proved obdurate on austerity—or more specifically, austerity for labor and bailouts for banks. To restore Swedish bank ‘confidence’ in its economy, defined as the promise to save banks from their loans gone bad, Latvia slashed employment, government, public-sector wages, and public sector spending generally.

This policy reflected Swedish demands—backed by the International Monetary Fund (IMF) and European Union (EU)—that banks must be repaid first, and in full. All other policies were subordinated to serve that goal. Latvia’s government succumbed to Stockholm syndrome, becoming the chief defender of foreign financial interests that reduced its economy to debt penury, and in so doing went even further in pursuit of austerity than the IMF and Swedes counseled.

Having imposed the austerity needed to make its Swedish lenders whole, Latvia is now the subject of a heated global debate over whether their austerity is a model to emulate, or to be avoided at all costs. As the European financial troika—the IMF, European Commission (EC) and the European Central Bank (ECB)—impose austerity on Greece, Spain, and Italy, they point to Latvia as the poster child for ‘internal devaluation,’ to ‘prove’ that Latvia’s wage and unemployment austerity program adopted after Latvia’s real estate bubble burst in 2008 shows the correct way forward on economic policy. Latvia’s Prime Minister Valdis Dombrovskis and Anders Aslund positioned themselves as having ‘not wasted a crisis’ and seizing the moment to impose the ‘universal advantages’ of austerity:

Latvia’s experience of fiscal adjustment has convinced us of the universal advantages of carrying out as much of the belt-tightening as possible early on. Hardship is best concentrated in a short period, when people are ready to sacrifice, what Leszek Balcerowicz calls a period of “extraordinary politics.” (Aslund and Dombrovskis 2011: 119)

The bloodless technocratic neologism that is now called ‘internal devaluation’ was previously termed the Washington Consensus in the 1990s. Going back further still, from the 1960s through 1980s the IMF’s term of choice imposed on Third World countries was the ‘austerity plan.’ But ‘austerity’ seemed too straightforward and was replaced by the wonderfully Orwellian doublethink term ‘stabilization program’ as a euphemism for the evolving financial exploitation, trade dependency, and low-wage policy advanced by Washington and the international financial institutions. The basic thrust involved setting up client oligarchies, privatizations and, after the Soviet Union was dissolved, kleptocracies that were willing to work against the national interest. This arrangement ensured that commodities flowed out and that production of consumer goods for both domestic use and export were switched out for imports from the West. This increased exports for the world’s rich nations, while also providing them cheap commodity imports.

A century earlier the basic thrust of such practices was put in perspective by speaking of “the ruin of Persia,” “the ruin of Egypt,” and kindred gunboat diplomacy efforts. The complex dynamic was summarized by the French mission civilisatrice (‘civilizing mission’) by colonialist creditor nations (Conklin 1998). So, rather than dealing with merely a contemporary phenomenon, we are dealing with a set of trade and banking policies with a long pedigree. What is new about the so-called Baltic Miracle, however, is that these countries are adopting these policies voluntarily, without intervention by gunboats or military coercion. Indeed, at times the Baltic states’ governments have embraced an extremist austerity agenda that has outflanked the IMF from the political right (Sommers and Hudson 2012).

The idea of financial austerity is one-sided. It means to cut back public spending with the aim of reducing wages (and hence the ability to import consumer goods); to permit creditor nations to buy up the richest domestic properties (land and natural resources, and privatized infrastructure monopolies); and to pay the debts run up as a result of the deepening dependency on industrial creditor nations. What makes Latvia’s experience so appealing in this regard is that after borrowing from foreign banks to fuel a real estate bubble, it then slammed on the economic brakes once this began to spill over into higher domestic wages and consumer spending from 2006 to 2008. Latvia proved adept at stimulating Keynes’ ‘animal spirits’ in finance, but after the stampede into real estate, the only ‘herd’ the Latvians culled was the public sector.

Cutting back government spending after 2008 deepened unemployment and drove public sector wages down by 30 percent. Private sector wages followed suit,1 leaving less to spend on imports, while exports rose from 42 percent of GDP in 2008 to 60 percent in 2012. The trade deficit fell to just 2 percent of GDP—down from 26 percent in 2008. Income was ‘freed’ to pay foreign bankers and other creditors, reducing the country’s external debt from 57 percent of GDP to just 38 percent during these four years (IMF 2012).

When the real estate bubble burst and construction plunged, amortizing the mortgage debt that had been built up was achieved at the cost of slashing Latvia’s social spending. Emigration accelerated as unemployment soared to 21.2 percent by January 2010 (YCharts 2013). Despite GDP growing in 2011–12 by 6 percent, the austerity was so deep that unemployment remains at double digits and GDP is only now in 2014 approaching pre-crisis levels. Latvia’s stringent austerity thus impoverished the economy. But in the process, it succeeded in saving foreign banks and avoided a run by depositors or bondholders. That is the real aim of Latvia’s reforms.

Neoliberals claim that Latvia’s bounce back shows that austerity can restore growth as well as avoid public debt defaults. Its success in reversing the sharp wage increases that occurred during the real estate bubble of 2005–7 is applauded as an object lesson for indebted economies throughout the European Union, and even the United States, to follow suit.

But Latvia’s economy has never really departed from its structural underdevelopment created at independence. Its economic contraction in 2008–10 was brutal, and it remains the most impoverished country in the EU after Romania and Bulgaria, as Richard Milne stated in the Financial Times: “Latvia remains an impoverished country, the poorest in the EU after Romania and Bulgaria, and its GDP is still below pre-crisis levels. Unemployment has fallen from peaks of more than 20 per cent but remains high at 10.9 per cent” (Milne 2013).

This economic collapse was the ‘final stage’ of the then so-called ‘Baltic Tigers.’ The political miracle is that its victims elected to sustain austerity rather than voting the neoliberal coalition parties out of power. While the United States, for example, started to run counter-cyclical deficits to help employment recover after 2008, Latvia ran a budget surplus explicitly to lower employment as a means to reduce wages. The promise was that this would make the economy more efficient and pave the way for prosperity, but is instead sucking the life out of the economy—mainly to pay creditors abroad and at home. Meanwhile, poverty soared and inequality widened the past decade (CIA 2013).

Under these austerity conditions it should be no surprise that there would be a demographic fallout. Both marriage and birth rates fell following the crisis. That is what happens in economic downturns; about 14 percent of the workforce—mainly young adults in prime reproductive years—emigrated in recent years, leaving an aging population at home. As Neil Buckley reports on conversations with Latvian demographer Mihails Hazans:

Latvians were leaving to work abroad even in the boom years. But many were single family members, leaving temporarily. From 2004 to 2008, net emigration averaged 16,000 a year. After austerity kicked in, it mushroomed to 40,000 a year, comprising whole families, many young and educated—and most expressing little intention of coming back. “Well-educated people used to have a clear path, with a stable job, and the future looked fine,” says Mr Hazans. “Suddenly they understood their future is neither fine nor certain.”

(Buckley 2011)

Healthcare and education were drastically cut in the government’s austerity budget as well, thus exacerbating the demographic situation further. Reversing Latvia’s demographic disaster must start by recognizing that the major factor driving young adults to emigrate (although now finally slowing somewhat) is the fact that wages are too low and unemployment too high. Just as important are the country’s tax policies, which serve as a push factor for young workers to abandon Latvia.

The Three Choices: Wage Austerity, Currency Depreciation, or a Shift of Taxes Off Employment

The most widely discussed alternative to the government spending cutbacks and wage austerity of internal devaluation following the crisis was the outright currency depreciation urged most prominently by the IMF and Paul Krugman (Krugman 2008). A problem with this option is that nearly 90 percent of Latvian debts were denominated in euros or other foreign currencies. A lower exchange rate would raise prices for imported consumer goods, and also the domestic currency cost of servicing its debt. This would only work, and could be quite effective, if Latvia first passed a law redenominating all debts in domestic currency. Creditors would scream at this move, as they did in 1933 when President Franklin Roosevelt nullified the ‘gold clause’ in US debt contracts. It would also be against neoclassical orthodoxy for Latvia’s government to take such an anti-creditor step. As it stands, this move would have killed Latvia’s goal of euro entry. Thus, it was never taken under consideration given the commitment Latvia’s political elite had to euro accession.

Latvia’s chief problem lies largely in having taken the advice of bankers and privatizers to adopt a tax policy that benefits themselves more than helping the Latvian economy grow. After obtaining independence from Russia in 1991, Latvia barely taxed property at all—only a fraction of 1 percent, which is much less than the world’s developed nations whose industrial success Latvia hoped to copy. It rejected progressive income taxation in favor of a heavy flat tax on employment, and still has only a minimal property tax on real estate and natural resources, while taxing returns to capital at only 10 percent. This failure to tax real estate and monopoly rents was a major factor spurring the financial bubble, which led to an exploding demand for construction labor that bid up wages—a rise which Latvia’s subsequent austerity program was designed to counter.

The good news is that there is an alternative to Latvia’s regressive pro-property, anti-labor tax structure—a policy to increase competitiveness without cutting wages or depreciating the currency. The classical free market alternative would be to shift Latvia’s heavy taxes off labor onto land rent, natural resource rent and monopoly rent. This alternative to internal or external devaluation leaves substantial room to raise labor’s take-home wage by shifting taxes off employment onto the ‘free lunch’ rent that has so seriously polarized Latvia’s economy.

From the Physiocrats and Adam Smith through John Stuart Mill and the Progressive Era of the United States, the thrust of classical economists was to avoid taxes that add to the cost of employing labor. Bringing prices in line with necessary cost-value was best achieved by shifting taxes off labor, consumers, industry and onto economic rent—and above all rent-of-location as unearned income. Toward this end they defined a free market as one freed from unnecessary income—charges that merely reflect special privilege, not necessary returns to labor or enterprise.

It also removed private appropriation of economic rents, as the United States’ Reform Era and a century of European social democracy did by investing in public infrastructure so as to provide basic services at cost, on a subsidized basis, or freely as in the case of roads, thus lowering overall costs on the economy. But by 1980 (after a dress rehearsal in Chile by the ‘Chicago Boys’ in the 1973 overthrow of the Allende government) rentier interests and their bankers fought back, urging privatization of public monopolies. Progressive taxes were replaced by a flat tax that fell on employment, not property. Taxes on real estate and other potentially rent-yielding property were slashed, shifting the fiscal burden onto employment and consumers. The effect has been to distribute income and wealth upward, in a dual movement (wage down, property prices up) that the classical-era economist fought against.

Today, instead of Keynesian spending to support demand by investing in infrastructure, governments are urged to balance their budgets instead. Reducing deficits when taxes are lowered on finance and property requires cutting back public spending.2 It also means leaving commercial banks so supply the economy’s credit to fuel spending. Banks also help finance the privatization of public assets to buyers, who erect tollbooths to charge access fees—monopoly rents that raise the cost of living and doing business.

To defend these rent-seeking policies, a discursive argument is made by characterizing government spending as deadweight, including public education, health care and medical insurance, and investment in transportation and communications. Taxes are accused of raising the cost of doing business and hence prices, thus making economies less competitive. There is little recognition of the benefits of free public money creation, except to accuse it of being inherently inflationary. So the ‘cure’ is to impose austerity on the economy, but without taxing real estate, monopolists or their bankers. Latvia has become the poster child in this experiment.

The classical path to overcome high-cost labor was the opposite: to shift the tax burden off labor and tangible capital onto financial and property wealth, especially that based on ‘economic rent.’3 This tax shift aimed at minimizing the price of the major cost of living: housing. Taxing site value holds down gains in housing prices by leaving money available for buyers to pledge to the banks as interest. Taxing property in turn enables the government to scale back taxes on employment that would raise the price of labor. This reform makes it unnecessary either to lower wages and living standards or to depreciate the currency.

In seeking to end Europe’s pattern of a landed aristocracy living off its ground rent, classical economists dealt with a similar problem to that which has led Latvia’s economy to polarize between the post-1991 privatizers of public wealth and the population at large. In both cases failure to tax economic rent let property owners keep gains that society or nature created. It thus seems remarkable that despite being the original reform put forth by classical free market theorists, heavier taxation of land rent, natural resource rent and monopoly rent has received little discussion by Latvia’s ruling coalition. Property buyers are obliged to pledge free lunch rent to the banks for loans to buy rent-yielding property. The result is that landlords (or more typically, their bankers) receive property rent that is not technologically or economically necessary, but adds to the cost of living and doing business. The government turns elsewhere for taxes—to labor and industry.

What needs to be discussed therefore is why economies have not followed classical tax policy to create an economy more free of rent charges or tax rent rather than employment. In short, Latvia’s policymakers are not following a classical economists’ program of freeing the market (free market) from rents, but instead a modern neoliberal program that loads markets down with debts and hinders enterprise and markets.

Latvia’s Post-1991 Path of Financial Dependency

The basic assumption of academic economic and political theory is that every nation acts in its self-interest—and is enlightened about how to achieve it. This implies that most nations should follow a similar economic, financial and tax strategy. The aim normally includes raising wages to sustain higher educational levels, health standards and labor productivity. Another typical aim is to avoid trade and debt dependency on foreigners, by achieving self-sufficiency in food and other basic needs, a living wage and low prices for housing and other essentials. At least this is how the United States, Germany and other successful industrial nations achieved affluence—literally a ‘flowing in’ of skilled labor and capital.4

By contrast, Latvia is typical of other post-Soviet economies in adopting policies that have led to emigration of labor, capital flight, debt dependency and demographic shrinkage. Despite its poverty-level wages, the nation’s labor is high-cost and uncompetitive due to its tax disincentives. Meanwhile, the domestic economy is dependent on foreign banking, and the government made little attempt to subsidize the restructuring of Latvian industry and agriculture after the nation achieved its independence from Russia. Instead of restructuring industrial enterprises, they were sold off on the cheap, scrapped or later gentrified into real estate developments.

When the Soviet Union was dissolved, Latvians felt their self-interest was in re-orienting their economy toward that of Western Europe. The USSR’s far-flung economic linkages were torn up, leaving each republic on its own. Most Latvians expected that taking Western advice would enable them to reshape their economy to be like those of other successful industrial nations. The hope was to achieve Western living standards with consumer choice and more productive industry in an economic trajectory that might have occurred if World War II had not cast them into Russia’s orbit.

Like Russians in the wake of 1991, Latvians were so demoralized by their Soviet experience that they gave neoliberals a free hand in designing their economy. As in Russia, the neoliberal swing to privatization and outright opposition to government regulation and central bank money creation was more extreme than in West European economies. One fateful result was the flat tax, which never had a chance of being adopted in the United States or in any social democratic European nation. When the ultra-rightwing Steve Forbes tried to float the idea while running in America’s 2008 US Republican Presidential primaries, he was laughed out of the race. While rejected by developed nations, the flat tax has become fashionable in some Central Asian Republics and other less developed nations.

That anti-labor, anti-industrial, pro-rentier extremism is what gives a cruel character to Latvia’s program to test just how much austerity a society may tolerate before voters fight back. Now running more than twenty years, it is a test for how long voters can be distracted by non-economic factors (e.g., in Latvia, ethnic strains with its Russian-speaking population reflecting resentment against the Soviet occupation) rather focusing on labor, industry, agriculture, or in short, the national interest itself.

Latvian voters seem unaware of how different this neoliberal policy is from that followed by Western social democracies. Part of the confusion stems from the fact that by 1991 the West itself was in the throes of a pro-financial tax shift off property and onto labor, thus generating confusion about the policies that made the West rich.

Gaining momentum around 1980 in Britain under Margaret Thatcher and in United States under Ronald Reagan, the Washington Consensus adopted for industrial economies the IMF austerity logic that had been imposed on Third World debtors in the 1960s and 1970s. Instead of aiming to raise wages, living standards or government investment, the new aim was to shift taxes off finance and real estate onto labor, scale back wages and pension benefits, and weaken labor’s voice in workplace conditions. Governments were urged by international financial institutions to replace progressive taxation of income and wealth with a flat tax on wages, and to scale back taxes on asset price (capital gains).

Despite cutting taxes on the higher income brackets, they aimed to limit their budget deficits, and indeed to balance their budget if possible. This left commercial banks with the task of supplying the economy with credit. Finding their largest market to be real estate, banks inflated a financial bubble that accelerated after the dotcom bubble that burst in 2000, fueled largely by US bank credit spilling over to other economies.

This was the Western policy sphere that Latvia was joining. Instead of making its economy like that of Germany, it became their inverse mirror image: a debtor to European creditors, an importer of European trade surpluses, and a supplier of labor to richer countries. The policy reflected more the relationship of Portugal, Latin America and the Southern United States to England in the nineteenth century than it did the successful development efforts of the US, Northern Europe, and Japan. Eurozone nations for their part defended their own interests, treating the Baltics as a field for exploitation, much as Third World countries were treated a generation earlier. Latvia’s free trade policy left its trade to be shaped by other nations’ protectionist policies, and its economy increasingly dependent on foreign banks (at interest). Rich nations press their self-interest when it comes to geopolitical diplomacy, and press other countries to pursue financial and tax policies that benefit rich nations.

Latvia has missed many opportunities to pursue its national interest. Despite the territory of Latvia’s historic role as a granary for Europe for many centuries, for example, no attempt was made to help restore its historical role in Europe’s grain trade. The Common Agricultural Policy (CAP) had achieved remarkable success in subsidizing crop surpluses in France and other eurozone countries, but did not seek to repeat this in the Baltic—except to the extent that European investors could gain the benefit. Seeing world grain prices rise as US cropland is shifted to gasohol production, foreigners bought Latvian cropland, whose low land taxes deprived the nation of gaining the full value of its export crop earnings.

A similar opportunity was missed when Latvia adopted its extremely low property taxes that left the soaring rental value of its real estate after EU accession to be pledged to foreign banks. Lacking a domestic banking sector to provide mortgage credit, this market was left to foreign banks. That is the essence of neoliberal economic ideology: to run economies to benefit banks and investors, especially international banks and foreign investors—in short the opposite of liberating, or freeing, markets of unnecessary costs. Latvia adopted a mode of privatization and non-taxation of real estate that let Scandinavian banks obtain most of the rental value of its free 1991 endowment of property in the form of interest payments—hence the double meaning of the term ‘Stockholm syndrome.’ Latvia identified its interests with those of its creditors, who became in effect its economic captors. The nation made no attempt to create a balanced, well-rounded economy or even to capture land rent or natural resource rent as its tax base. The value of its economic patrimony was taken largely by foreign interests.

Latvia’s Post-Soviet Economic Profile

Let us start by reviewing Latvia’s options when it obtained its economic independence in 1991 with its free (without debt) endowment of real estate, natural resources (timber and grain land). The most valuable business assets that the nation received were turned over to well-placed insiders often for merely token payments, with no capital gains tax to recapture the benefits—until a 15 percent tax was belatedly enacted in 2010, far lower than the rate in the major eurozone countries and Scandinavia. Latvia’s previously mentioned 10 percent tax rate on dividends and other returns to capital are also extremely low.

Three major linkages remained with the Russian economy. First was the oil export terminal at Ventspils for Russian oil shipped to the West. Largely as a byproduct of this shipment, Latvia had become a center for Russian flight capital already in the early 1990s. This became the basis for the country to elaborate its role as a financial intermediary between Russia and western economies after independence, even after Russians later diverted oil pipeline transit to Primorsk. Over half of Latvian bank deposits are from abroad. However, too little of the Russian outflow remains in Latvia. Much is sent abroad, usually via other offshore banking centers without being mobilized to finance domestic investment and growth.

A third linkage with Russia was Latvia’s beach area at Jurmala, which remains a major vacation spot for affluent Russians. But Latvia’s tiny land tax has deprived the government from recovering anywhere near the free lunch site value to make this land into a tourism base whose revenue would help finance the public budget. A similar opportunity was missed in Riga’s prestigious and now highly expensive Old Town and City Center.

Latvia’s Structural Economic Defects

Financial malstructuring: reliance on unproductive foreign-currency debt

Latvia in 1991 had virtually no debt—zero government debt, zero personal debt, zero real estate debt, and zero business debt. In just twenty years it had debts but without a commensurate modernization of its agriculture and industry. Instead, debt was taken on mainly to inflate prices for homes and commercial real estate.

To make matters worse, domestic banks provided little of this credit. The Soviet republics simply created state credit. Latvia and other republics had little experience of banking in 1991. Thus, Latvia and its Baltic neighbors became dependent mainly on Scandinavian banks. Instead of creating a viable public or private banking system to lend in the domestic currency (lats), Latvian branches extended credit almost entirely in foreign currency: e.g., euros. For Latvians who had not inherited housing from the Soviet era, or who wished to upgrade housing, loans were taken out in foreign currency in order to get lower interest rates.

This has created a structural foreign-exchange dependency. Latvians are paid wages and salaries in lats, but must pay their debts in euros or other currencies that their central bank cannot create, nor can it influence interest rates. If Latvia’s balance of payments weakens and its exchange rate falls, this would raise the domestic-currency cost of paying foreign debts. To avoid this currency risk, every economy should provide its own domestic credit, borrowing abroad only to finance foreign exchange transactions. The prime directive of sound financial policy is to avoid taking on debts denominated in a foreign currency that borrowers do not earn directly (Hudson 2010b). Latvia has violated this principle.

The second prime directive is that loans should be productive; that is, they should provide borrowers with the means to pay (including the interest) out of earnings from investing the loan proceeds. Unproductive loans must be paid out of income borrowers earn elsewhere, e.g., out of wages, or out of profits in the case of speculative loans, business takeovers, or loans to buy up one’s own stock to raise its price. Little of Latvia’s borrowing was to increase productive powers (much less to develop export-industry or to replace imports). Foreign-currency loans were used to bid up real estate prices, raising housing costs while creating foreign-exchange dependency.

The foreign currency inflow resulting from this real estate lending is what enabled Latvia to sustain a trade deficit. But the effect has been to constrain the economy in order to pay this debt by imposing austerity. Foreign banks applauded the rise of this debt dependency, calling the real estate boom that their financial bubble was fueling the ‘Baltic Tigers,’ while each year the World Bank ranked Latvia high on its list of ‘business-friendly’ economies.

Latvia’s central bank philosophy has tied its hands in a way that does not characterize that of the United States, Britain or other leading nations. The Lisbon Treaty forbids central banks to do what they are supposed to do: increase the credit supply by creating credit on their own keyboards to finance government budget deficits. This constraint forces governments to borrow from commercial banks, at interest. The European Central Bank and the central banks of the euro (and euro-pegged) nations, thus is a commercial bankers’ dream by not acting as a central bank. The fact that its banking center is mainly foreign-owned builds in a structural foreign debt dependency. This means that the growth of debt—or countercyclical public spending to maintain employment or invest in infrastructure—raises the risk of instability, which is aggravated by Latvia’s tax structure.

Fiscal malstructuring: taxing labor, not property and resource rents

In addition to violating the prime directives of financial policy, Latvia broke two cardinal rules of classical fiscal policy:

1 tax mainly rent-yielding assets, not labor or man-made capital; and

2 if one must tax income, make the tax progressive.

In as much as most extremely high income takes the form of economic rent, a progressive tax usually falls on rent. This certainly was the case with the first US income tax in 1913, which obliged only 1 percent of the population to file a tax return.

The aim of classical tax doctrine, as previously stated, was to bring prices in line with basic necessary cost-value, by taxing away economic rent (defined as charges that have no counterpart in necessary costs of production). The effect would be not to leave this unearned income in the hands of a landlord class or free to be pledged to bankers as interest. By the same token, it meant that the banking system would not come to base itself on rent-yielding assets, but would be based more (presumably) on industrial credit. The economy’s cost structure would be more debt free, and also more rent-free—and hence lower-priced across the board.

In contrast to taxes on labor and capital—which raise their supply price—taxes on land rent, natural resource rent and other rent are paid out of the free lunch margin of income over necessary outlays. This economic fact helps explain why pro-rentier tax cutters have rejected classical value and price theory in favor of pragmatic marginalist analysis based on consumer demand and ‘utility’ rather than the distinction between necessary and unnecessary (productive and unproductive) production costs. Post-classical analysis of supply prices takes rentier charges as given facts of life rather than as an unnecessary cost on the economy to eliminate.

The chief factor compromising Latvia’s competitiveness is that it has saddled its economy with one of the world’s heavier taxes on labor. Employers must pay a roughly 25 percent employment tax on wages, and a 24 percent social service tax (treating pensions and medical care as user fees rather than being paid out of the normal public budget), while wage earners pay another 11 percent. These three taxes add up to nearly a 60 percent ‘flat tax’5—increasing Latvia’s gross wage cost by one-third, making the nation’s industrial labor high-cost and hence less competitive. In addition, the austerity budget had a value-added tax of 21 percent (raised sharply from 7 percent after the 2008 crisis). These taxes to labor and consumption were devastatingly high for a country that has yet to converge on per capita GDP with the world’s richest nations.

Latvia’s heavy taxation of labor finds its counterpart in the lowest property tax rate of any industrial economy. It was almost nil until finally a modest 0.2 to 0.6 percent tax was levied on residential property (still based on low assessments), which is much lower than that of the West. Latvia had no land-value map when it gained its independence, because the Soviet Union did not charge rent or interest. Latvia’s property tax agency had little more than the 1917 real estate assessment records to go on! Latvia still has no land map, nor do its property valuations distinguish between land and buildings (e.g., as is done in the United States).

Not that it mattered much, because Latvia’s tax structure favoring capital and ‘oligarchic’ interests is among the most inequitable in Europe. Its low property tax is largely responsible for the heavy debt burden on real estate and privatized state assets, because whatever the tax collector relinquishes is available to be paid to banks in the form of interest on the credit that inflates the price of rent-yielding assets. Even as land prices were soaring, Latvia followed neoliberal tax policy that left property almost tax-free.

This is what spurred the nation’s real estate bubble, opening up a profitable market for the proliferation of foreign bank credit. The inflow of lending enabled buyers to bid up property prices. Prices soared for housing, office space and other real estate, because asset prices are a function of how much a bank will lend. Thus was born the Baltic Miracle.

The nation’s neoliberal anti-tax policy of ‘starving the government’ thus benefits mainly foreigners, property owners and speculators—and ultimately their bankers, who advance the mortgage credit to buyers willing to pay the rising site rent as interest. This tax giveaway starves the economy of the public investment needed to promote domestic industry and employment. Also, relying on foreign rather than domestic banks to supply credit creates balance-of-payments dependency over and above Latvia’s basic financial dependency.

Unlike the situation in many balanced industrial economies, the central bank cannot create the credit to rescue defaulting debtors, because central banks cannot create foreign money.

Given the dominance of foreign-branch banking in Latvia, its rising rental value and capital gains have been siphoned off to pay foreigners, not to use as a tax base, as was the case in all the world’s major industrial nations during their economic take-off. Likewise, the largely foreign as well as domestic ownership of Latvia’s lightly taxed timberlands and cropland means that the recent rise in exports of timber and grain where natural resource rent is relinquished by the government.

The irony is that under the rhetoric of ‘free market’ tax policy, Latvia has permitted economic rent to be financialized, that is, capitalized into debt, and paid as interest to banks, mainly foreign-owned. This builds debt service into the economy’s cost structure, and also locks in the flow of economic rent to carry this debt, because income pledged to banks no longer is available to be taxed, without squeezing debtors and forcing widespread default.

A corollary of classical tax policy is to keep natural monopolies in the public domain, headed by transportation, communications and other basic infrastructure to provide as a public option at cost, on a subsidized basis or freely as in the case of public roads. If Latvia and other post-Soviet economies had followed the policies that built up the West from the 1940s through the 1960s, their governments would have progressively taxed wealth and income, using the proceeds to invest in transportation and other infrastructure. They would have introduced regulatory checks and balances to protect consumers, creating a positive feedback cycle to sustain prosperity as rising wages and living standards reflected themselves in higher productivity.

Out of Russia’s Orbit and Into That of Neoliberal Austerity

What Latvian voters have wanted since 1991 are European-style living standards. Their neoliberal path since 1991, however, has been entirely at odds with how West Europe’s social democracies achieved their wealth. Unlike Finland or Germany in the late 1940s and 1950s—when Urho Kekkonen in Finland and Konrad Adenauer in Germany turned politically West but economically East—Latvia has not taken advantage of its long (and admittedly often oppressive) linkages with Russia, trading their Soviet past for what turned out to be neo-colonial status in the eurozone.

The costs of this final stage of neoliberal policy failure have been borne entirely by Latvian taxpayers, sparing eurozone banks and investors entirely from loss. The brutal character of this policy was spelled out on January 26, 2009, in a letter from Joaquin Almunia of the European Commission to Latvia’s Prime Minister spelling out the terms on which Europe would bail out Swedish and other foreign banks operating in Latvia—entirely at Latvia’s own expense:

Extended assistance is to be used to avoid a balance of payments crisis, which requires … restoring confidence in the banking sector [now foreign-owned], and bolstering the foreign reserves of the Bank of Latvia … if the banking sector were to experience adverse events, part of the assistance would be used for targeted capital infusions or appropriate short-term liquidity support. However, financial assistance is not meant to be used to originate new loans to businesses and households. … it is important not to raise ungrounded expectations among the general public and the social partners … Worryingly, we have witnessed some recent evidence in Latvian public debate of calls for part of the financial assistance to be used inter alia for promoting export industries or to stimulate the economy through increased spending at large. It is important actively to stem these misperceptions. (Almunia 2009; emphasis added)

There was no attempt to help Latvia develop the export capacity to cover its imports, nor to preserve domestic government economic and social services. Eurozone credit was provided only for foreign banks, investors and kleptocrats to remove their funds from the economy at the going exchange rate, without the lat depreciating and thus leaving less hard currency to extract.

This was indeed a dress rehearsal for how the European Commission soon was to treat Greece and the neoliberalized eurozone periphery since 2010. The effect of predatory eurozone lending has been especially pronounced in the post-Soviet economies whose debts are owed in foreign currencies that their central banks cannot create and their debtors do not earn.

In Poland 60 percent of mortgages were in Swiss francs. The zloty halved against the franc. Hungary, the Balkans, and Ukraine all suffered variants of this story. As an act of collective folly—by lenders and borrowers—it matches America’s sub-prime debacle. There is a crucial difference, however. European banks are on the hook for both. US banks are not. Almost all Eastern bloc debts are owed to Western Europe, especially Austrian, Swedish, Greek, Italian, and Belgian banks (Evans-Pritchard 2009).

Only now is a response developing in the devastated Central European economies and the PIIGS (Portugal, Italy, Ireland, Greece and Spain). Opposing further cuts to public finances on the ground that this would aggravate unemployment, Slovakia’s Prime Minister Robert Fico has “called for an end to ‘completely counterproductive’ austerity policies and for governments to focus instead on reigniting growth.” The Prime Minister said that he was part of a growing group of anti-austerity government leaders. “We had a conservative government in Slovakia from 2010 to 2012. They had a flat tax, they had a neo-liberal labour code and the unemployment rate increased and economic growth decreased” (Cienski 2013).6

At issue is where one should draw the line to say that impoverishment to the point of driving the labor force out of the country is not “recovery.” Legally, the problem is how to assert the principle that it is not permissible to impoverish an entire population to pay foreign banks, bondholders and capital-flight depositors. This promises to be the economic conflict of the remainder of the twenty-first century.

Ideologically Engineering Austerity Policies

How long can an economy sustain a trade deficit, import dependency, de-industrialization, and an uncompetitive tax structure by running deeper and deeper into debt? Can it really create riches simply by giving away the public domain and inflating property prices on credit, without employing labor and in fact driving it out of the country?

The limit to this process is the point at which all property and personal income above basic subsistence needs is pledged for debt service. As this point is approached, the real estate bubble slows and foreign mortgage lending dries up, causing a crisis; or voters rebel. One way or another, the social costs are so large as to be politically as well as economically and demographically unsustainable.

The Latvian “miracle” perpetuating this neoliberal austerity and self-deprivation poses the question of who will be made to bear the cost of the resulting crash: foreign creditors and domestic resource owners, or debtors and taxpayers. Neoliberal austerity doctrine seeks to survive by insisting that there is no workable alternative to paying debts in full with the entire loss falling on debtors—and when they cannot pay, offload the bill onto taxpayers. However, ethnic Latvians were diverted from voting on austerity by its politicians playing a card that does not exist in other countries: a large ethnic Russian minority and the use of this to divide the population based decades of resentment against Soviet occupation.

Latvian majorities have accepted the Thatcherite insistence that “there is no alternative” (TINA), as long as any alternative can be connected to Russia in the public mind.

No such ability to fight elections on non-economic issues exists for Southern Europe or Ireland, so this ethnic political twist has not been able to be transplanted to Greece or other countries, except for right-wing attempts that blame immigrants generally. Greek and Italian voters rejected the austerity policies imposed when eurozone banks and bondholders appointed “technocrats” to act as their proconsuls. The fact that the past year has seen Greek and Italian voters reject eurozone-imposed technocratic leaders suggests that the Baltic acquiescence in austerity will last only as long as the focus of electoral politics can be kept ethnic rather than economic.

Turning the Baltics Into a Test Case for Neocolonial Austerity

Eastern Europe has been turned into a financial colony. Foreign bank loans for real estate and privatization, as well as European grants and loans for transport infrastructure, have bolstered property values for insiders more than for the population as a whole have made debt levels higher than needed. While overall indebtedness is low (although it grew under austerity), the country is utterly dependent on continued foreign capital inflows.

Why is this? Latvia violated two basic economic principles (in addition to the financial and fiscal principles cited above). First is the economy of high wages doctrine that productive high-wage labor undersells foreign pauper labor (Hudson 2010a). Employees who are well-educated, well-fed and healthy are more productive, justifying their higher wages and salaries. Low wages below a limit do not translate into more competitive prices.

Reiterating the second broad principle is that the key to international trade competitiveness in today’s world is to minimize the overhead paid to the finance, insurance, and real estate (FIRE) sectors. More expensive housing is not better just because it costs more to obtain—especially when the reason it costs more is simply because property taxes are low, enabling the rising rent-of-location capitalized into loans and paid to banks as interest.

Populations are promised that rising real estate prices are the way to get wealthy in debt-leveraged Western-style economies. But the financial and real estate bubble provided a bonanza for the West (and Latvian elites), not for most Latvians. If Latvia’s government really had been ‘Westernized,’ its government would have taxed economic rent from property, natural resources and monopolies. This would have saved Latvia from a real estate bubble and the foreign debt that fueled it. There was no inherent technological or economic need for such a bubble to occur, or for so much foreign debt to be taken on. Just the opposite was the case if post-Soviet economies were to follow the logic of industrial banking that Germany and Central Europe had developed by the late nineteenth century. To be competitive, they needed to keep down domestic costs by avoiding distortions from rent seeking, and to nurture a domestic industry relying on sectors complementary to other European economies.

As noted previously, Latvia’s rejection of a higher property tax on real estate or natural resources (or monopoly earnings of its privatized formerly public enterprises) encouraged the foreign currency borrowing that financed its trade deficit. When the real estate bubble collapsed, foreign lending stopped. This posed an immediate problem of how to pay Latvia’s real estate and other foreign currency debt. Borrowing to fuel a new real estate bubble was out of the question, if only because it would have raised housing costs even further, driving more Latvians to emigrate.

The balance-of-payments task confronting Latvia remains how to replace its former trade with the Soviet Union with new products and services to Europe and other regions. It hopes to specialize in high-technology sectors, computer programming, banking to mediate between Russia and the West, tourism, music, and the arts. But these have been undercut by neoliberal anti-government policies favoring foreign creditors and investors.

The neoliberal solution was self-defeating: trying to squeeze out more foreign exchange by imposing austerity and massive unemployment that drove emigration. Remaining in Latvia are older families and those lacking the work skills most in demand abroad. The result is one of the world’s heaviest demographic overheads: a ratio of nearly three retirees for every four Latvian workers.

Austerity is as self-destructive as was the policy of trying to get rich by asset-price inflation. Unemployment worsens the fiscal position, and leads to loan defaults as families remain on the hook for the mortgages run up during the real estate bubble. The situation is even worse in Latvia than in Spain, Ireland, and other countries, because banks secured their collateral by getting debtors and their parents—and if possible even uncles and aunts—to co-sign mortgage loans, standing with their own personal liability over and above the property being financed. Entire families became liable for the debts attached to properties whose prices plunged into negative equity territory.

The problem in Latvia is thus much like that in the United States, where the Office of Comptroller of the Currency, Federal Reserve and other financial regulators treat the banks as clients to be protected, and not regulated for the purpose of serving the economy and its working population. In such situations it is the banks that end up being saved, not the indebted economy at large. This is the common denominator between Latvia, the austerity-ridden eurozone countries and the US economy. It explains the importance of viewing Latvia as a dress rehearsal for financial austerity in the richer West.

Lessons of the Latvian Experience for International Trade Theory

The neoliberal sequence of turning financial bubbles into austerity programs to pay the debts that have been run up is being defended by a new junk economics. Its first aim is to distract international trade theory away from viewing the financialized costs of production that are built into prices and living costs (e.g., as interest charges on mortgage debt raises the cost housing). The second aim is to ignore the phenomenon of debt deflation, that is, the diversion of wages, corporate profits and even government tax revenues to pay creditors, leaving less available for spending on goods and services in the “real” economy. The financial sector as a cost on the economy is simply ignored.

The post-2000 global bubble economy has transformed the character of international competitiveness. Until the early nineteenth century, food was the largest item in labor’s budget—and hence in the price of labor and the exports it produced. Products were produced by inputs of other products, whose cost ultimately was reduced to the price of labor. The key to international competitive pricing was technology—minimizing the cost of production by innovation, and especially by replacing labor effort by rising energy inputs in production. The driving force was material production and consumption. But steadily over the past two centuries, prices have included a rising element of interest and other financial charges. So the key to international competitiveness is not technology, which is universal. It is the way in which an economy organizes its financial system and the institutional character of its tax policy and, in the case of infrastructure monopolies, public investment and price regulation.

On top of Latvia’s high flat tax on employment, families with mortgages must suffer high housing costs as a result of the real estate bubble reflecting the government’s refusal to tax property at anywhere near normal western rates. This threatens to price Latvian labor and business out of world markets, leaving the nation deeply in debt, unable to export or work its way out of its structural trade deficit. Following the 2008 crash, many Latvians deleveraged and sold off assets at fire-sale prices to foreign interests. The danger arising from another financial crisis would be the need to sell off public utilities, ports and terminals to pay debts owed to foreign bankers and bondholders. This would literally create a debt peonage.

No Western democracy could have sustained the Baltics’ social devastation, declining birth rates, troubling worker injury rates, accelerating emigration, and an oligarchic tax structure. But, precisely through the deleveraging, without military force being used, a new class of foreign appropriators can gain control of Latvia’s national patrimony. It is this that is used to herald Latvia as a neoliberal model and ideal to emulate.7 Latvia’s problem, thus, is how best to extricate itself from the foreign debt and trade dependency into which its neoliberal economic policy has created?

There is an Alternative

The two major dynamics rendering Latvian labor uncompetitive are its anti-labor tax policy, and the high cost of housing inflated by foreign-currency mortgage debt. The most obvious way to cut its labor costs without reducing living standards, as previously stated, is to replace its near 60 percent cumulative set of employment taxes and “Social Security” user fees, as well as the 21 percent VAT, with an economic rent and windfall gains tax on land, finance and other property.

This tax shift would give Latvia an opportunity to recover what it had a chance to do in 1991 with its debt-free endowment of property and natural resources. Taxing the land’s rental value would hold down the cost of housing (and the volume of indebtedness) because it would be paid out of existing rent, not an added cost. That is basic classical price theory. By leaving less land rent to be capitalized into bank loans, this would hold down prices for housing (and also for commercial space), and thus would deter a new real estate bubble from developing.

A particular benefit for Latvia and other post-Soviet economies of taxing economic rent and windfall gains is that it would recover what was lost in the insider dealings that transferred enormous real estate wealth and infrastructure out of public hands. The state can recover the revenue that oligarchs have taken, leaving them with returns to whatever bona fide capital investment they have made.

At issue is who should end up with the economy’s land rent natural resource rent and that of privatized monopolies: the public sector, or the banks. Rejecting the classical free market tradition, neoliberal policy depicts all takings as being ‘earned.’ Wealth creation neoliberal-style aims simply to maximize rent extraction and capitalize it into bank debt. This debt leveraging has fueled the financial bubble that has engulfed the global economy. It is the antithesis of the classical economic aim of minimizing economic rent, by taxing it away where it occurs naturally, as in land and natural resources, or by keeping natural infrastructure monopolies in the public domain.

The result has been to replace Soviet planning with that of European banks, creating a post-Soviet elite of oligarchs and kleptocrats. Latvians have ended up with the worst of both worlds: neocolonial financial and trade dependency on Western Europe, and a lingering resentment against Russia so strong that the nation has not fully developed its natural advantage as an intermediary with the West, except as offshore bankers to CIS oligarchs.

The tax reforms put forth by classical free market theorists have received little discussion in Latvia. If Latvia wishes to change course from the polices that have led to its economic underdevelopment, it must reverse the sharp polarization between creditors and indebted labor, shifting the fiscal burden onto real estate, natural resources and monopolies would prevent a new run up of real estate prices, and would redirect entrepreneurial energies into the real economy of goods and services. This would minimize the cost of labor without impoverishing families, making demographic recovery possible.

Until such a policy is followed, the post-1991 stream of emigration cannot be reversed.

The problem, of course, is how to manage the transition period back to a true free market tax policy that frees Latvia’s economy from rent seekers. For many families, the reduction in employment taxes will more than offset the increase in property tax. But for the most highly indebted owners (especially absentee owners) this tax shift will cause defaults, because rental income paid to the tax collector cannot also be paid to the banks as mortgage interest. This fact is precisely what keeps down housing prices and mortgage indebtedness. One policy response would be to enact a law that defaults must be put up for public auction within two months. Existing owner occupants, renters or government agencies could bid, capitalizing the after-tax net rental revenue into a realistic market price—with preference given to existing occupants.

An active government subsidy policy also is required. Latvia needs to emulate the policies of the US, German, and other rich industrialized economies by protecting agriculture, through providing basic rural extension services, farm credit and public marketing agencies to save Latvian farmers from monopolistic distributors. Latvia needs a similar development agency to promote specialized industries in which it has the best chance to carve out a niche so as to earn the foreign exchange to imports products in which its small economy is not well positioned to compete (autos, heavy industrial mass produced goods, etc.).

To achieve viability, the economy needs the public sector to rebuild its education, health care and other basic infrastructure services. The political precondition for achieving this economic turnaround is that Latvian voters must recognize that neoliberal ­policies have left the economy needlessly high-cost and uncompetitive. Reversing these policies is a precondition to achieve the prosperity that Latvians hoped to achieve by shifting their focus away from Russia toward Western Europe.

Ironically, emulating Europe’s successful post-World War II development calls for not joining the eurozone as currently run by the pro-bank, anti-labor ideologues who designed the Lisbon agreements and created the euro without a central bank to monetize budget deficits to fuel economic expansion. The neoliberal version of a free market is a travesty of the classical economic tradition. It is a road to financial dependency, trade dependency, debt peonage and represents a classic case of capture to a Stockholm syndrome rather than independence.

Notes

1 Measurements are difficult as much of Latvia’s private-sector wages are made by unrecorded ‘envelope’ payments. One gets a better sense of wage cuts from reductions to consumption.

2 Although Latvia’s deficits significantly grew after the crisis, but just not as much as they might otherwise have, or so the proponents of the austerity policy argue.

3 This was the program of many economists in the classical tradition, to name a few: Adam Smith, John Stuart Mill, Francois Quesnay, Anne-Robert-Jacques Turgot, Simon Patton, Henry George, along with many others.

4 See the nineteenth-century works of Henry Charles Carey of the ‘American School of Capitalism,’ and Friedrich List of the ‘German Historical School.’

5 There is some small variation on the tax rate and a small reduction in the tax rate is forthcoming.

6 See also Polychroniou (2013).

7 C. J. Polychroniou (2013: 7) notes the strains that are developing throughout neoliberalized debt-ridden eurozone economies: “a similar ‘brain drain’ has occurred in Portugal, where more than 100,000 Portuguese, mostly young people, emigrated in 2012, an increase of nearly 60 percent over 2011. In Ireland, in the meantime, emigration has reached levels not seen since the Great Famine of the mid-1800s” (citing Peláez 2013; Sheehan 2012).