Lithuania's remarkable recovery

As the bankruptcy of the American investment bank Lehman Brothers in September 2008 caused a global liquidity freeze for half a year, the countries that were hit the hardest were small, open countries without guaranteed access to swap credits from major central banks. In other words, the Baltic countries.

In Lithuania, foreign net savings, that is net capital inflow, swung from 11.9 percent of GDP in 2008 to a net capital outflow of 3.8 percent of GDP, meaning that aggregate demand fell by 15.7 percent of GDP.

As GDP fell, state revenues plummeted even more. Lithuania was lucky to have parliamentary elections in October 2008 in the midst of the crisis. The main winner in these elections was the Homeland Union–Lithuanian Christian Democrats. On November 28, its leader Andrius Kubilius became prime minister and the new government adopted a substantial programme and a budget for 2009 in the ensuing week.

Its approach was quite radical, as the crisis demanded. But as the economic decline proceeded, even more radical measures were adopted in May 2009. Without the government’s swift reaction, Lithuania could have defaulted.

Four-fifths of the fiscal adjustment consisted of expenditure cuts. As a consequence, most performance indexes bottomed out in the first quarter of 2009. Unemployment, usually the last crisis variable to peak out, did so in early 2010 at 17.8 percent.

The Lithuanian government managed to carry out this fiscal adjustment without calling for support from the International Monetary Fund (IMF), which played a major role in Latvia. The government was worried that the IMF would push for devaluation. To the surprise of most, Lithuania managed to maintain the confidence of the international credit market.

Thanks to its vigorous fiscal adjustment, Lithuania escaped devaluation yet stayed competitive and could hardly have expanded its exports faster than it did. The IMF expected “strong deflation,” but it never materialized. The expected long recession lasted only one year.

The Lithuanian government opted for internal devaluation. It utilized the crisis to raise the efficiency and competitiveness. Top public salaries were cut by more than 20 percent, but by less for those with lower salaries. The gross average wages declined by 12.4 percent from the pre-crisis peak to the bottom.

While the total tax burden increased marginally, the structure of the tax system changed considerably. Overall, taxes moved from labour to consumption. The current government continued the trend of reducing the flat personal income tax – from 33 percent in 2006 to 15 percent at present. After a temporary increase of the corporate tax rate to 20 percent in 2009, it is back to 15 percent. This tax structure offers people and entrepreneurship improved incentives for work.

Social benefit expenditures had risen excessively by 44 percent in real terms between 2006 and 2008. The government had no choice but to trim benefits, often in a progressive fashion to safeguard the most vulnerable. Eligibility requirements were tightened. The government also went ahead with pension reform. In June 2011 the parliament legislated a gradual increase of the retirement age to 65 for both men and women by 2026, to render the public pension system financially sustainable.

The government removed restrictions on flexible work arrangements and established a substantial job support programme with EU funds, pushing unemployment down.

Lithuania has enjoyed a good business environment for a long time, ranking as no. 27 on the World Bank index of ease of doing business for 2011, that is, about twice as high as Lithuania’s ranking by GDP per capita in the world (no. 51). During the crisis, the government has made it simpler to register property, to resolve insolvency, to pay taxes, to start a business and to enforce a contract. It has also improved protection of investors.

The government has launched a substantial higher education reform, tying state financing to students, so that institutions of higher education are competing to attract the best students and have obtained incentives both to economise on resources and to raise quality.

Finally, the Lithuanian government stepped up its use of EU funds, sharply raising its absorption of such grants from €1.2 billion in 2008 to €1.75 billion in 2009, that is, from 3.7 percent of GDP to 6.6 percent of GDP.

Thanks to its victory over the financial crisis, Lithuania is readying itself to adopt the euro in 2014. As a member of the eurozone, Lithuania would be entitled to ample ECB credit, so that the frightful liquidity squeeze will never be repeated.

One of the best kept secrets in Europe is how well the current Lithuanian government has managed the nation’s economy. The country’s international competitiveness had never been seriously undermined, but now it has improved significantly. The Lithuanian government has proven that internal devaluation was both possible and beneficial.

The writer is a senior fellow of the Peterson Institute for International Economics and co- author with Valdis Dombrovskis of the book “How Latvia Came out of the Financial Crisis”