Page last updated at 22:52 GMT, Thursday, 29 April 2010 23:52 UK

Learning lessons of Latvia's losses

By Nils Blythe
Business correspondent, BBC News, Latvia

The Baltic republic of Latvia has set a lot of unwanted records.

Street scene in Riga, Latvia
Not all Latvia's architecture is this attractive

It had the worst recession in the European Union last year.

It has the highest unemployment, with almost a quarter of working age people out of a job.

And it has seen by far the largest fall in house prices, with average values down by two-thirds.

It is an extreme example of economic decline.

It also has much to teach the rest of the world. So what went wrong?

Extraordinary boom

Latvia had a remarkable boom. With hindsight, it is clear that the boom was caused by a surge in lending as foreign-owned banks - mainly Swedish-based - expanded into what they saw as an attractive growth market.

The availability of credit for home-loans and property development pushed up house prices.

Valdis Dombrovskis
Valdis Dombrovskis says lenders were to blame as well as borrowers

That, in turn, made home ownership seem even more desirable, especially in a country which had many shoddy apartment buildings left over from the Soviet era.

By 2007, Latvia found itself in the midst of an extraordinary boom, both for home prices and the construction industry.

The country's Prime Minister, Valdis Dombrovskis, says part of the blame lies with the Swedish banks which flooded the country with credit: "Latvians were borrowing irresponsibly. But to borrow irresponsibly, you need someone who is lending irresponsibly."

The property boom distorted the rest of the economy. Factory owner Juris Grikis saw it at first hand. His business - Nakts Mebeles - makes bedroom furniture and sells direct to the public as well as through retail chains.

The company did well during the boom, with many people wanting fittings for their new homes. But at the same time, the wages Juris had to pay were pushed up.

"The construction boom sucked in every worker who could carry 20kg," he says. "People told me they were leaving because they could earn twice as much in construction."

Bubble burst

Rising wages and a sense of wealth from rising property prices fuelled a consumer spending boom.

During the boom, Juris found it almost impossible to get space in shopping malls from which to sell his wares. And on the retail outlets he did manage to find, the rent went up twice a year.

Then, in 2008, the property bubble burst and foreign lending suddenly dried up. Deprived of their booming domestic market, Juris and other Latvian manufacturers looked for export orders.

But Juris discovered that his wage costs - pumped up along with property prices - made Latvian goods uncompetitive.

The development path we were on previously was not sustainable
Valdis Dombrovskis, Latvian Prime Minister

He has now cut his workforce by half - and for those that remain, wages have been reduced by 20%.

He is optimistic that his company can now win some big export orders.

Economists have called this wage-cutting an "internal devaluation".

Latvia's currency has a fixed exchange rate against the euro.

And in spite of widespread expectations that it would devalue the currency to try to boost exports, Latvia has stuck to its fixed exchange rate and its ambition to join the euro eventually.

But for now, deep wage cuts have become commonplace in Latvia.

Martins Kapickis is a surgeon working in a hospital on the outskirts of Riga, Latvia's capital. His pay has been cut by 70%. His wife, a teacher, has seen her income drop by almost half.

"We cannot afford the same things that we could before," he says. But his main concern is for patients who are seeing waiting times increase. His conclusion is that "patients are suffering much more than doctors".

Austerity looms

On average, public sector pay in Latvia is down 28%. And with massive redundancies and pay cuts in the private sector, the consumer spending boom is well and truly over.

Two years ago, Juris Grikis was struggling to find retail outlets to rent. Now many shops stand empty.

Valdis Dombrovskis is adamant that his country has no alternative to drastic spending cuts. The plan is to reduce the gap between public expenditure and the income it can now expect from taxation.

There was a violent public protest over a year ago. But, unlike countries such as Greece, there has been little organised opposition to the government's austerity measures.

Riga skyline
Latvia's consumer boom is well and truly over

"There is a certain degree of understanding that these measures were necessary," he says. "The development path we were on previously was not sustainable. A big part of it was a bubble which has burst."

He blames the former government for failing to take steps to rein in the boom.

"Real estate speculation was not taxed, which was adding to the problems," says the prime minister, who originally trained as an economist. "That was helping to divert money from the productive economy into speculation."

One painful lesson Mr Dombrovskis believes has been learned is the importance of governments running a budget surplus during a boom. It would help to avoid the kind of savage spending cuts in a downturn which Latvia is now going through. He is proposing new "fiscal responsibility laws" for his country.

A wider lesson for the rest of the world is the distorting effects of a property boom on the rest of the economy. In recent decades, central banks and governments have focused on controlling retail price inflation and largely left the price of assets - like property - to look after themselves.

The economic devastation in Latvia caused by the property bubble should be a lasting reminder of the damage which asset price inflation can do to the rest of the economy.

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