When Lithuania, Latvia, and Estonia regained independence in the 1990s, the dominant free market ideas were uncritically and sometimes fanatically embraced by Baltic leaders, leading to two decades of underdevelopment, says Jeffrey Sommers, a political economy professor at University of Wisconsin-Milwaukee.
Sommers first arrived in Riga in 1995 and has been following the Baltic development from up close and teaching at the Stockholm School of Economics in Riga. He had been warning about massive speculative property bubbles prior to the 2008 crisis and was a harsh critic of austerity embraced by Baltic politicians in its aftermath.
“Refusal to borrow and spend more engendered so much human suffering,” he says.
In an interview with LRT.lt, Sommers discusses the paths that Baltic leaders took and opportunities they missed in the 1990s, how Latvia became the ‘Bond villain’ of offshore banking and what are the prospects for Baltic development and avoiding the middle-income trap.
“You have to figure out how to organise your national elites to join the national project of national economic development,” he says.
Having studied the Baltic states’ economic development, how successful would you say they have been since transitioning to market economy in the 1990s?
The most successful years have been since 2014 to the present. There has been an increasing complexity of their economies and they have become more included into the global supply chains. There’s been something like real economic development.
In the decades before that, there was almost none, aside from speculative bubble. You just had a twenty-year period of absolute tragedy, much of it unnecessary. Barring war or some kind of natural calamity, it’s hard to imagine how things could have been any worse those first twenty years.
Why was it so?
Part of the reason was timing, just really bad luck. You can’t pick the time when you become independent. This was when these neoliberal ideas were at their absolute peak. It was thought that giving free reign to capital – unchecked mobility, lowering taxes on business – was some kind of magic formula for development.
As we have discovered several economic crises later – 1997–1998 in East Asia and then of course the big one in 2008 – this certainly was not the answer to any kind of economic development. But these ideas were just absolutely unquestioned at the time.
Just to focus on Latvia, though not dissimilar things were happening in the other two Baltic states, there was a very successful effort to train a cadre of economic policy makers. There was this Georgetown University economist, Juris Vīksniņš. He very much operated within the University of Chicago freshwater school of economics and Austrian economics traditions.
He assembled this group of would-be policymakers in 1990–1991 and started bringing them to the US. People like Ivars Godmanis, the first prime minister of Latvia, who was called in again to put out the fire during the 2008 economic crisis. People like Einars Repše, the first head of the Latvian central bank, people like Ilmārs Rimšēvičs, the longstanding head of the Latvian bank. Vīksniņš brought all these people together, saw them as being able to carry forward a set of policies that would remain constant, regardless of who was in power politically.
In fact, Lithuania’s former president and finance minister Dalia Grybauskaitė also went to Georgetown University in 1990.
So, they formed this working group called Latvia 2000. They went to Jūrmala, had eight working group sessions and forged a report in 1991 which stated the objective of creating an economy geared toward foreign direct investment (FDI). So there would be an initial short period of shock therapy – of course it turned out to be quite long – and after this short hard period of transition there would be robust economic growth, led by FDI.
How do you get FDI? The idea was that as long as your macroeconomic fundamentals were solid, as long as people had faith in your currency, investment would come. You didn’t want to undervalue the currency, you wanted to have it highly valued so that foreigners could then take their investments out and get something decent for it. Now the downside of that is that an overvalued currency makes your exports uncompetitive. This was just really deadly for Baltic industry as it made their products unnecessarily expensive.
With that Latvia 2000 idea of drawing investment in – it just never happened. They were waiting for the magic to occur throughout the entire 1990s.
But Latvia then developed a sizable offshore banking sector, still notorious for its illicit transactions and lack of oversight. In fact, you’ve called Latvia a Bond villain of the world economy. How did that emerge?
There was a lot of transit of business, the CIS countries of former Soviet Union were bringing raw materials out, using rail systems and ports of the Baltic states, and Latvia of course was the big one. Especially, Ventspils, which during the 1980s was the biggest Soviet oil port. And this movement of commodities and money created or facilitated the offshore banking sector, which is really big in Latvia. Not inconsequential in Estonia and Lithuania, but bigger in Latvia. It had a lot of influence, a lot of money was made there.
We know some of the figures involved in its creation. You had people like Grigory Luchansky, a very powerful figure, persona non grata now in many countries, including in Latvia. Luchansky was a vice rector at the University of Latvia and was fired in 1982 for corruption, selling university furniture on the black market. And then he went on to become a billionaire. By the late 1980s he was figuring out how to get oil and other commodities at state prices and sell them for global prices. And he continued even after the collapse of the Soviet Union, when it was not so much the issue of state prices as that there was so much of stuff to steal, lots of coloured metals. In the early to mid 1990s, you’d often read a news story about some guys that were found with their hands gripped around tram wires – they were trying to take them down for the metal, but instead got electrocuted.
The offshore banks were in all the three countries, but the big one was in Latvia, Parex. It was started by these two Komsomol guys [Valērijs Kargins and Viktors Krasovickis], very enterprising. They figured out that in 1989–1990 you could make money on the difference of price between currencies in Riga, Saint Petersburg and Moscow. So they were just riding the rails with bags stuffed with money and trading.
The Komsomol [the Soviet communist youth organisation] gave them contacts throughout the Soviet Union. And they got the first approval for a legal currency exchange in the entire Soviet Union that got set up in Riga in 1990. By 1990, the Soviet Union was just falling apart and everyone was making money by setting up some sort of cooperative business or stealing stuff. Either way, they had roubles and needed to get rid of them. People were coming from all over the Soviet Union to these guys to exchange currency in Riga.
And then comes Parex. And they’re not trying to hide what they’re doing, they’re advertising it. They used to have a sign in a window, saying “we’re closer than Switzerland”. And another sign said, “we take all currencies, we ask no questions”. These were the go-go years, they just grew into a monster of a bank, Latvia’s largest until the 2008 crisis.
So, there were plenty of people in Latvia saying that, yeah, things are not probably going as well as we like in terms of the country’s development, but I’m doing pretty well. And as long as that’s happening, I’m not going to be asking too many questions.
The big 1990s shock also came from rapid deindustrialisation. The argument at the time was that the entire Soviet industry was rotten and unsalvageable. Is that reasonable?
No. It has elements of truth to it, but you often hear these extreme arguments that either somehow you could have kept the lights on at all these Soviet enterprises and everything could have continued on as before – of course, it could not – or that none of it was salvageable. That is not true either.
When I first arrived in Latvia in 1995, I was just shocked that no one was inventorying the country’s industrial machinery. I was, as a young academic, interested in it. I toured a lot of factories and I saw a lot of advanced equipment that was manufactured in Western Europe in the 1980s, some really high-end machinery.
The thing to have done was to inventory it all, come up with a plan to then create something, a few competitive industries out of what you had. And some of it was competitive, such as Latvia’s fiberglass works.
But Latvians didn’t want to think about any industrial policy in any serious way. And didn’t at all until after the 2008 crisis. These free-market ideas were so firmly rooted in the policymakers of the Baltic states – that you don’t interfere with the market. If you mentioned industrial policy, the first thing they heard – a little less, actually, in Lithuania – was that it’s about picking winners, so you don’t do that.
In the decade before the 2008 crisis, there were the Baltic tiger years, when their economies were growing at impressive rates. What were the Baltic economies booming on?
Swedish banking capital mostly. Cheap (low interest rate) money from the US.
The US had dealt with its 1999–2000 crisis by just recognising that the way out of it was to inject lots of liquidity into the system. So they made the cost of money pretty much nothing, in terms of borrowing. If you were a Swedish bank, you could buy that money for next to nothing and loan it out in the Baltic states.
If you’re Swedbank or SEB, if you come to Riga, it’s like being a Spanish conquistador in the early 16th century. You see wealth everywhere, all these incredible buildings and none of them have any debt on them, none. And so you can start loading them with debt. You start injecting money into these economies, pretty much anyone could get a loan at the time.
How does that translate into GDP growth?
There’s money coming into the country, it’s not GNP, which would measure the things being made, but GDP is just measuring the amount of money, which is generating jobs in services and is used to purchase all sorts of goods. Mostly, 70 percent of the money that was coming in was just going into real estate and inflating its value. And not much went into new construction – some, but not a whole lot.
So it just represented the inflating of property prices. By 2006, the current account imbalance was a whopping 25 percent. So the Latvians were just buying stuff with Swedish money, which was in turn the money they got from the Americans and, to a lesser extent, the Japanese.
What is a current account deficit and what within bounds should it be kept?
It’s just the difference between the amount of stuff that you’re producing and the amount of stuff that you’re buying, mostly. If you’re buying to create capital or wealth formation, in other words, if you’re building a new factory, which will then be producing new wealth, then fine, your deficits are understandable and acceptable. But if it’s just for consumption, new automobiles from abroad, furniture, fancy clothes etc., that’s not sustainable. That’s exactly what the Latvians were doing.
By 2006, I was already getting very frustrated about this, I just couldn’t figure: why were these banks lending all this money? I knew they were getting the money cheap, but this country is not producing that much, how are they getting all this money back?
I remember in June 2006 I attended a social function at the Japanese embassy in Riga. It had a lot of the country’s bankers there. I spoke with the head of SEB’s property lending department, a fairly young Latvian. I presented my quandary and they said: “You don’t understand, this is much simpler than you make it. This is how it works: the Swedes have no understanding of this market, they put us in charge to handle everything and the incentive structure is as follows: the more loans we make, the more we can take on bonuses. We are not giving any consideration to whether any of these loans can be repaid.” So that was it, the mystery solved.
You know what happened next, it all eventually went bust. The Baltic states had the three worst economic crashes in the world.
The response of Baltic policymakers to the crisis was radical austerity, which you’ve also criticised severely. Although unlike austerity in southern Europe, which was largely imposed by the troika of the EC, the ECB and the IMF, the Balts embraced it themselves.
Yes, many of the Baltic leaders didn’t need to be told to do this, they were true believers, even fanatics. Take a person like Einars Repše who at this time was the minister of finance. We have diplomatic cables, leaked by Wikileaks, detailing his phone conversations with the Americans and the Swedes. They were actually trying to convince him not to impose so much austerity, saying: you’re just going to crash the society, you can’t go this extreme. And he was like: no, this is a crisis that we have to take advantage of. I never met Repše, but he was clearly a true believer.
There was this myth that the Balts are very orderly – and they are – that they won’t be causing much trouble on the streets like the Greeks or the Argentinians. But the truth is that during the first half a year after the crisis hit, they did protest. They may not have made as much noise as other people did against austerity, but they were very unhappy about what was happening. Many of them felt exhausted after having gone through 20 years of this madness.
Latvian farmers had a big protest, healthcare workers, teachers. But Repše in particular was just not budging. And so, I think what happened after half a year was people just said: yes, you’re right, nothing’s going change, so the thing to do is just leave. And they did. Lithuanians too.
In Lithuania, austerity was imposed by a government dominated by the conservatives who, while do lean to the right on economic issues, are nationalists rather than free market zealots. Was there really no other option?
There was definitely a consensus in the international community that some measure of austerity was needed. But the international financial institutions, at least in the Latvian case, thought that what they did was just far too much. It was an ideological thing.
The other option would have been, it’s true, more debt, but government debt levels were very low in all Baltic states.
What was lost by keeping debt levels down was people. I don’t think that at the time emigration was seen as unwelcome, because it was a way to keep unemployment low. But the problem is that this refusal to borrow and spend more engendered so much human suffering and you were losing future taxpayers through emigration and depressed birth rates. There are real long-term economic costs to it. You lose a generation of people who would have otherwise, once the economy recovered, be producing wealth. I think, in many ways, it was short-sighted. I don’t buy that this was the only option.
Unlike Latvia, Lithuania did not even seek a loan from the EC and the IMF.
The chief reason why the Latvians did it was that they wanted to bail out Parex bank and the cost was big. The whole reasoning was that, first, people who had money in Parex were dangerous and they could have started taking it out on politicians in Latvia; and second, even if they lost Parex, the Latvians were keen on keeping the offshore banking sector – and the only way to do that is by making sure no creditors took an economic hit.
You said that real economic development only took off after the crisis. What was different?
The global economy recovered somewhat. What was different [than in the 1990s] in the Baltic states at this time was their ability to better capture some of that growth. They had had 20 years of independence, they had infrastructure, they had become better known to their Western partners, they had gone through EU and NATO accession, so there had been a lot that transpired in those intervening years.
But there was also a move on the part of global manufacturing and even services to further globalise supply chains and back-office operations. The Baltics, because of their relatively cheap labour, being known quantities and seen as stable, benefited from being included more into these global supply chains.
How solid is it as a base for development? One of the celebrated FDI breakthroughs was in 2009 when Barclays set up its service centre in Lithuania – but they left in 2019 and moved to a cheaper location.
The back-office operations are less stable, because they are easier to move. Manufacturing a little bit less so, but yes, still mobile. Some are going to argue that if the coronavirus keeps mutating and becomes an ongoing problem, then European manufacturers may want to keep their supply chains less stretched out over distance. In short, take more parts from the Baltics, and less from China.
Where the Baltic states have not had enough success is in creating their own firms and brands. Not that there is none, but there’s not enough.
Now Lithuania has had the most success of the Baltic states in this regard. You had something of an industrial policy from the start and were able to retain a bit of your industry. The other two Baltic states not so much. Estonia keeps thriving off its relationship with Finland, their geography works for them very nicely. But by GDP per capita [in purchasing power parity], Lithuania is number one of the three Baltic states. That is I think because of the long-run advantages that your industry and agriculture have provided. Everyone likes Estonia, it’s very fashionable, they have very clean government, which is great, and a lot of things to admire about them. But if it’s the proverbial tortoise versus hare race, Lithuanians are the tortoise.
The Latvians have the most work to do. They don’t have the advantages of either Estonia or Lithuania. They have a strong IT sector, they have a lot of timber that has to be better processed within their own borders. And the offshore banking sector is certainly not going to be experiencing growth, especially as the Americans have made it clear that it’s just too reckless. The Americans used to love it in the 1990s, all that money from the CIS countries coming through Baltic banks and ending up in New York stock markets. But when Osama bin Laden started using it, the North Koreans, Putin’s favoured allies – it’s just gotten too much for the Americans.
At the moment, our policymakers are saying their goal is to avoid the middle-income trap. How are we to go about doing that?
The first thing to do is just to recognise that it is indeed a trap. You have to think of how to claw your way to the top of the value-added chain. How you can improve your infrastructure, both human and physical.
Can this be done by cutting red tape and letting the market play its magic?
No, not going to happen. That doesn’t work and it has never worked. Take a look at economic history – the market on its own has never produced economic development, the government has always interceded and done manipulations to the market or at least provided infrastructure, both human and physical, in order to make this happen.
So you have to figure out how to organise your national elites to join the national project of national economic development.
Many nations that have developed quickly, have done so in response to some external threat. For instance, Finland was a relatively poor country before World War Two, but it was really the threat of the Soviet Union that made the Finns into a rich nation. In other words, it gave their government ammunition to use in their struggles with their national elite. You have to say: we must pour more resources into developing the country. In the end, national elites come out better off too, but in the short run it does mean that you have to restrict consumption of the elites, in order to pour more of that into physical and human infrastructure. And you have to make a compelling case why it’s in the national interest to do so.
Do you think the Baltic elites realise that?
No. I think they need to be convinced. Not all of them, but a lot of them. It will be great when the 1990s generation is gone. But then you also have to also get rid of the neoliberal ideologues, even when they’re posing as nationalists.
Jeffrey Sommers is a professor at University of Wisconsin-Milwaukee and maintains a visiting professorship at the Stockholm School of Economics in Riga. He conducts research on the “spatial fixes” to crises of global capital accumulation, with a special focus on the Baltic States. The Contradictions of Austerity: The Socio-Economic Costs of the Neoliberal Baltic Model, a book he co-edited with Charles Woolfson, presents criticism of the Baltic states' response to the 2008 financial crisis.