Crisis and the Political Economy of Duality in Latvia Janis Berzins *

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1 Crisis and the Political Economy of Duality in Latvia Janis Berzins * Abstract Latvia is facing one of the deepest crisis in modern Economic History. By the external side, it is the result of ideological imposition of neoliberal policies, like Shock Therapy; by the internal side, it is the conjunction of the political and economic elite s incapacity to deal pragmatically with the transitioning process, permitting the horror of ethnic Latvian s to any political spectra than right to determine social and economic policies. Another important factor is the prevailing mentality of politicians and civil servants, a mix of Soviet rentseeking with a Neoliberalism-based notion that the State, thus politicians and civil-servants, is not responsible for what happen in the economic sphere, resulting in years of combined unsustainable development and deindustrialisation. After joining the European Union, this process was aggravated, as it favored the establishment of speculation with real estate and consumption of durable goods as Latvia s most significant sectors of the GDP. Their already expected downturn must not be taken as a solid indicator of the gravity of the current crisis, as it is structural and would happen with or without the international financial crisis. This paper discuss the international political economy of crisis in Latvia, dealing with the interaction of both external and internal sides as representation of the biggest failure of Neoliberal policies to promoting social and economic development. 1. Ignácio Rangel and Political Duality Ignácio Rangel ( ) was probably the most original thinker of the Brazilian economic development. Only Celso Furtado has a comparable contribution upon the analysis of the dynamics of development. Although his bachelor was in law, he was an autodidact in economics always researching the process of social and economic transformation of the concrete world, profoundly engaged with questions of national development. 1 His economic thought was formed at the nationalist school of the Superior Institute of Brazilian Studies (ISEB) and at the Economic Commission for Latin America and the Caribbean s (ECLAC) structuralist school. He was also profoundly influenced by Keynes, Schumpeter, and Marx, integrating these authors thought in a very personal way. As Rangel made his career at the Brazilian Development Bank (BNDE), his thought was independent from the academic politics and discipline. This explains why he was so original and creative, besides his own personal talent. Although he is unknown at the international level, at least one of his contributions has universal value: the principle of endogenous money. 2 Also, very characteristic of Rangel was his courage and venture to affirm and to analytically sustain his innovative approach. Rangel s idea of duality is based upon the notion of concurrent but simultaneous modes of production interacting through history. In his classic article A História da * Riga Stradins University, Department of Political Science. janis [at] janisberzins [dot] org. 1 By the time Rangel went to the university, there was not a course on Economics in Brazil. 2 Rangel s notion of endogenous money relies on the idea that there is a hidden tax represented by inflation affecting both households and government s budgets, called in Portuguese imposto inflacionário (literally translated as inflationary tax ). It results from the Central Bank printing money to compensate the effects of inflation on the governments budget. As the monetary base increases and the government s spending - in nominal terms - also increases, inflation also increases. Thus, accordingly to Rangel, the causality public deficit resulting in inflation is inverted: it is the public deficit that results from inflation and not the contrary. As in more recent times Central Banks are independent, the creation of endogenous money resulting in inflationary pressures is made by private banks and credit institutions.

2 2 Dualidade Brasileira (The History of the Brazilian Duality), Rangel analysis the specific contradiction that resulted in contemporary Brazil. It is a dialectic explanation, not only of the dynamics of economic development, but also of other spheres of social reality, that results from a historic-structural reality. The duality is a complex mode of production that combines elements of different fundamental modes of production. In other words, it deals with the specificity of Brazil being at the same time a capitalist and a pre-capitalist society. 3 Although the representation of the duality seems to be simple, it must not be considered a mechanical scheme. Rather, it synthesizes the evolution of the interaction between the internal and the core mode of socioeconomic production. This duality may be schematized as follows: Figure 1 Rangel s Duality The main pole represents the internal economy itself. Its internal side reflects the internal relations of production; its external side reflects the internal socioeconomicpolitical model in force. The secondary pole s internal side reflects the internal emerging relations of production; its external side represents the most advanced mode of production, reflecting the central countries' economic, social, and political structure. These relations are always more advanced than those observed internally, stressing the main pole s subordinate and peripheral character. This structure is always changing, as the development of the productive forces change the character of the economic model. Nevertheless, as usually occurs in peripheral and underdeveloped countries, this development is often late in comparison with the core. As a result, these countries experience a partial and subordinated process of development, forcing them to reproducing - instead of overcoming - the duality. The reproduction of the duality follows certain laws: 4 a) when the preconditions for changing from the current stage of development for a superior one are established - when new economic and social forces develop and start conflicting with the established socioeconomic model - only one pole changes. The other maintain its structure; b) the external and the internal pole change by turns; 3 Rangel, I. (1981). A História da Dualidade Brasileira. Revista de Economia Política, vol. 1, no. 4, pp Ibid., p. 12.

3 Main Pole 3 c) the change occurs from the external to the internal side. In other words, the socioeconomic model already present in the external side is adopted by the internal side; d) as a result, the external side of the changing pole also changes, adopting institutions characteristic to a more advanced socioeconomic model. A new dialectic union with the new internal side is established; e) this kind of duality is only present in peripheral countries. It results from the changes experienced by the systemic core toward which the periphery gravitates; The application of this process to the Brazilian economic history may be seen in the figure below: Secondary Pole Figure 2 Rangel s Duality Applied to Brazil 1st Duality ( ) 2nd Duality ( ) 3rd Duality ( ) 4th Duality (1973-????) Internal Side Slavery Feudalism Feudalism Semi-wage External Side Feudalism Mercantile Capitalism Major Partner Internal Side External Side Proslavery Farmers Mercantile Capitalism Industrial Capitalism Mercantile Bourgeoisie Mercantile Capitalism Industrial Capitalism Mercantile Capitalism Latifundiary Farmers Industrial Capitalism Financial Capitalism Rural Semi- Capitalism Industrial Bourgeoisie Industrial Capitalism Financial Capitalism Minor Partner Mercantile Latifundiary Industrial Financial Bourgeoisie Farmers Bourgeoisie Capitalists Source: Own adaptation based on Ibid. and Bresser-Pereira, L. C., & Rêgo, J. M. (1993). Um Mestre da Economia Brasileira: Ignácio Rangel. Revista de Economia Política, vol. 13, no. 2, pp Although the economic structure of the Brazilian duality is determined by four distinct socioeconomic models, its political structure results from the alliance of only two social classes. The structure of this implicit political alliance is determined by the duality s structure, and follows its changes. The main pole is governed by one class only, which is the political expression of the dominant socioeconomic model. Rangel calls it major partner. The secondary pole s external side is foreign. It influences internal affairs through one of the internal dominant classes. Nevertheless, its internal side represents an emerging internal dominant class called minor partner. It is dialectally united with the major partner, as their interests are different, forming a dual class. 5 When there are internal advances following Schumpeter s process of creative destruction, the differences between both classes turn to be contradictory and antagonistic. 5 Rangel, I. (1981). A História da Dualidade Brasileira. Revista de Economia Política, vol. 1, no. 4, pp

4 Main Pole 4 As the pre-conditions for the transformation of the social and economic relations of production are mature, the dual class experience a rupture. By one side, there is a progressive dissidence supporting the interests of the external side; by the other side, there is a retrograde and reactionary faction defending the status quo in force. After a political battle, there is the establishment of a new political pact. The most radical elements are excluded, and there is a new composition of the dual class. A new pole and a new regime are established Latvia and Duality As every underdeveloped and peripheral country, Latvia s economy, politics, and society are also dual. This duality is the result of the combination between Latvia s own historical process of development and the core socioeconomic and political model. However, the establishment of the duality should not be understood as an autonomous process guided by some kind of metaphysical demiurge, like the market. Rather, it results from direct human action shaped by concrete reality deformed by ideological and cultural constrains, determined both internally and externally. Figure 3 1st Duality ( ) 2nd Duality ( ) 3rd Duality (1993-????) Internal Side Agrarian Capitalism Russian Feudalism Industrial Feudalism External Side Mercantile Capitalism Industrial Feudalism Mercantile Capitalism Major Partner Mercantile Class Communist Party Oligarchs (former Communist Barons) Secondary Pole Internal Side Industrial Capitalism Industrial Feudalism Industrial Communist Barons Class Latvia s Dualities Industrial and Financial Capitalism External Side Industrial Capitalism Industrial Capitalism Neoliberal Capitalism Minor Partner Industrial and Financial Class Latvia has three historical dualities, instead of four as Brazil. The first began with Latvia s independence in 1918 and went until 1940, when Latvia was occupied by the Soviets for the first time. The second began in 1944, with Latvia s definitive occupation and annexation by the Soviet Union and went until 1991, year of the second independence. The third began in 1993, and is Latvia s current duality. The first duality represented an advance in relation to the previous social and economic structure, the Russian feudalism; the second a strong retrocession, as Soviet pseudo-communism was based on Russian feudalism; and the third the establishment of the development of underdevelopment. To make an analysis of all Latvia s dualities would be necessary to write an article only 6 Ibid..

5 5 analyzing them. Thus, on this paper only the third duality and Latvia s first serious structural crisis after independence are analyzed. The first thing to be noted regarding Latvia s dualities is that the first duality does not have a connection with the last one. This is consequence of the Soviet occupation which imposed more primitive modes of production. In agriculture, for example, both Kolkhozy and Sovkhozy were deeply feudal in their organization. First, although there was no formal prohibition for someone to leave the Kolkhoz or the Sovkhoz, the only real possibility to leave was to join the army. The rule was simple: people were allowed to work only in the place they were registered as permanent residents; however, to be able to register as permanent resident somewhere, it was necessary to be already working there. Thus, like serfs, Soviet workers did not have mobility. Second, the state appropriated all the production, paying a derisive price. Third, the peasants had 0.5 hectare and one cow to themselves, which with they were allowed to work during weekends and after their working day. 7 The comparison with the serfs weekly free day is quite obvious. They were allowed to sell what they produced freely, reproducing an underdeveloped form of mercantile capitalism. At the same time, although heavily subsided, the structure of Latvia s agrarian system during Karlis Ulmanis regime was essentially capitalist, making it more advanced in terms of historical development. The Soviet industrial sector did not result in a more advanced model of production than capitalism. Rather, it reproduced capitalist social relations, at the same time its dynamics were constrained by politicized central planning. In the first case, as Marx himself noted, capitalism s core social relation is to sell and to buy workforce to produce surplus value. Thus, if socialism is superior to capitalism as mode of production, other social relations must be established in place of the old ones that define capitalism. Under capitalism, people have to work a determined minimum number of hours to guarantee the generation of surplus value. The longer is the journey, if the wages are not changing, the bigger is the surplus value. Thus, if in a socialist society the objective is to end worker exploitation, this social relation must be changed. In other words, the social relations resulting in creation of surplus value must not be present. In the Soviet Union, the basic social relation of production continued to be selling and buying workforce to generate surplus value. Thus, instead of liberating the workers from labour, the Soviet Union subjugated them to the same social relations she claimed to free the workers from. In a socialist society, the logic would be to free the workers from labour, for example, permitting technological advances to result in increasingly reductions of the labour journey without reducing salaries. As a result, the rate of surplus value is also reduced until a limit where only what is socially necessary is produced, and salaries and the market mechanism is substituted by other forms of distribution of social wealth. The most relevant consequence is that any form of development resulting in greater productivity was undesirable. Without reducing working time, a higher level of productivity results in unemployment. This means that the Soviet Union was unable to surpass the capitalist paradigms to establish a more advanced mode of production. Instead, 7 Interview with Guntis Blūms, former head of the Kolkhoz Stari.

6 6 it established a system defined by Richard Ericson as industrial feudalism, 8 where there was a specific social network with its own elites who controlled the economy, including the black market, the Soviet barons. 9 As Latvia industrial sector was as developed as the core at that time, Latvia s productive, political, and social systems experienced a retrocession. This determined Latvia s second duality through the imposition of the Soviet Union main pole s internal and external side. Latvia s third duality is very specific, as it is the result of an ideologized version of the secondary pole s external side. Thus, Latvia s transition to neoliberalism after the independence is also dually determined. By one side, it reflects the ideological imposition of neoliberalism by the international community, mainly by the International Monetary Fund, the World Bank, and the European Union. By the other, neoliberalism was adapted to Latvia s internal structure by internal forces. As a result, there is the establishment of a specific neoliberalism resulting from Latvia s own understanding of liberalism and neoliberalism shaped by ethnic questions determined by the fear of Russians and Russia. Neoliberalism in Latvia s collective imaginary is the opposite of being occupied by Soviet Union and Russia, thus of loosening freedom. In the political system, this resulted in the establishment of Schumpeterian democracy; in the economic sphere, the result is deindustrialisation, the establishment of a Ponzi economy and, finally, the current structural crisis. 3. Neoliberalism and Latvia s Third Duality: the Political Side Since the end of the USSR, neoliberalism has been considered Latvia s new leviathan. However, although there is a liberal rhetoric in the society, in practice there s still a hiatus between discourse and reality. The formation of the liberal societies are the result of a long process of establishment of institutions, which give support to its existence, these institutions being not only juridical and administrative, but also individually cultural, sociological and political, relating to personal views of the meaning of a liberal society. Institutions change quickly only in historical terms. This means that 18 years is not enough to change all aspects of Latvia s social and institutional superstructure. While some are changing very fast, other persist in reproducing standards strange to liberal societies. This is not solely related to national but also to individual institutions, as for example personal convictions, which affect the notion of social responsibility. Thus, the first step to deal with the Latvian peculiar notion of liberalism is to understand how fast institutions have been able to change from the Soviet to a more liberal model and in what extent these changes relate more to some economic points than to political and social aspects. Although the idea that all ideologies ended in the 1990s has been widely spread by several scholars in the last years, this does not mean that ideologies have ended. Besides the idea of end of ideologies to be an ideology itself, it must be understood as the end of Soviet pseudo-socialist ideology and the victory of a specific type of liberalism based on economic assumptions, called neoliberalism. Political and social liberalism became 8 Ericson, R. E. (2000). The Post-Soviet Russian Economic System: an Industrial Feudalism. Bank of Finland, Institute for Economies in Transition, Working Paper no Brancato, E. (2009). Markets Versus Hierarchies: a Political Economy of Russia from the 10th Century to Northampton, MA: Edward Elgar.

7 7 subordinated to a specific kind of economic liberalism subordinated to a specific ideology and not in reason, which is used to establish, maintain and justify power relations. One of the most important ideologic aspects of neoliberalism is the notion that economic liberalism automatically means political and social liberalism, thus democracy, what history denies. Neoliberalism has much of the classic liberalism to be called neo; but as neo it is a falsification. The first point to be considered is that egoism substituted self-interest, with the introduction of social Darwinism as key factor as social regulator. The second is that the market or a market-like structure are seen as an ethic in itself, guiding all human action, and substituting all previously existing ethical beliefs. 10 In this aspect, it is much more than a process of liberalization resulting in a laissez-faire economy. It is a different form of social, political, and economic regulation, where society is highly regulated to reproducing an ideal situation of Pareto equilibrium under free market. Pinochet s Chile shows that economic liberalism is possible without political and social liberalism. Milton Friedman shaped Chile economic policies under a strong liberal base, at the same time people were being tortured and disappearing because of opposing the government. More recently, Jeffrey Sachs, the ideologue of shock therapy and thus of the basic model of Latvia s transition, stated that economic reforms are more important than democratization itself. That s not to say that Sachs thinks that democracy is not important. Rather, he rather believed that the establishment of economic liberalism would automatically result in the establishment of democracy and of those institutions supporting political and social liberalism. In this way, Latvia s history has also been shown that the causality of the idea that economic liberalism always presupposes political and social liberalism, thus is equal to democracy, is not true. At the same time that Latvia s economy has passed through a strong and rapid process of liberalization, turning to be one of the most liberal economies in the world, the institutions in Latvia are not facing a process of liberalization so fast. In other words, there s a gap between the level of economic liberalism and of political and social liberalism. The result is the lack of political and social institutional support through the idea of responsibility to the establishment of a true liberal society, resulting in a low level of effective democracy. The notion of liberalism in Latvia is a particular expression of the separation between economic, and political and social liberalism. Although this is the main feature of the variety of liberalism known as neoliberalism, in other transitioning countries the institutional framework that gives support to the establishment of political and social liberalism has developed differently than in Latvia, forcing the latter to occur together with the first. There are three factors explaining the gap between economic and political and social liberalism in Latvia. The first is the way the state was captured by the political elite; the second is the inner culture of civil servants; the third is people s mentality, where there is a gap between the level of political and social liberty they think they have and the one they effective have. The first and the second are interconnected, while the third is the result 10 Treanor, P. (2005). Neoliberalism: origins, theory, definition. Internet, available in users/paul.treanor/neoliberalism.html.

8 8 of the process of transformation of the soviet to a liberal mentality, which is time unpredictable. The political elite, with the involuntary and naive help of the media and most of the academic staff, distorted the concept of economic liberalism to something close to market anarchy, while social and political liberalism became associated with the idea that the state and the politicians are not responsible for what is going on politics, thus on the social and economic spheres. Thus, the Latvian notion of liberalism has been used by the authorities to shield themselves of any criticism through its rhetoric expression, the distorted concept of populism, to reproduce a Schumpeterian democracy in Latvia. Populism may be defined as an ideology which pits a virtuous and homogeneous people against a set of elites and dangerous others who are together depicted as depriving (or attempting to deprive) the sovereign people of their rights, values, prosperity, identity and voice. 11 However, in Latvia the term has experienced a process of banalization, being used to label anything that is not in accordance with the peculiar Latvian notion of liberalism. The idea is, as Latvia is a liberal society and the market its demiurge, all social problems must be solved by the market, while the State is just a spectator. As a result, social responsibility turned equal to populism in a negative sense. Thus, it became an estranged idea to politicians, authorities, civil servants and people in general. This distortion has been united with a deformation of Plato s idea of the philosopher-king and Lenin s conception that only a class of intellectuals and theoreticians could represent the real aspirations of the working class. Latvian politicians and civil servants think the same. Together, they think - very erroneously - they represent Plato s philosopher-king or Lenin s intellectuals, while their private interests are considered the essence of the interests of the entire society, in what turned to be a classic case of state capture. More, the term populism has been used to criticize something that is not understood, something that causes disagreement or something that is disliked. This lead to the notion that the State can t even perform the basic regulation to guarantee and secure the existence of a liberal society through administrative and juridical institutions, as it exists to promote the interests of specific social classes and not of the entire society, as the contrary is populism. The result is that private and public interest becomes irreconcilable and the latter became labeled as populism. This is the primary determinant of the process of alienation of the political project of Latvia s elite and the primary source of the distortion of the concept of populism to provide the justification of the establishment of Schumpeterian democracy in Latvia. The consequence is that voters are feeling distant from the politicians and the State. As Latvian politicians and civil servants understand the political process and the administration of the State as a way to achieve private goals, the rest of the population does not consider these groups and thus the State as legitimate representatives of their interests. The economic, social and political crisis Latvia is facing right now is the expression that the political project of the Latvian political elite has failed. Also, it is stressing the inadequacy of neoliberalism as ideology determining policies of development. 11 Albertazzi, D. McDonell, D. (2008). Twenty-first century populism: the spectre of Western European democracy. New York and London: Palgrave Macmillan, p.3.

9 9 Schumpeter s idea about democracy denies the neoliberal/neoclassical ideological conception that voters are enlightened, well informed and rational. Rather, democracy is that institutional arrangement for arriving at political decisions in which individuals acquire the power to decide by means of a competitive struggle for people s vote. 12 Although this understanding recognizes the significance of political competition in democracy, it denies that the process of competition for people s vote has any substantive value. It presupposes that the work of policy development is all done within groups of elites constituted as political parties, which prepare policy packages which are offered to voters at the election. Thus, the role of voters is reduced to choosing among policy packages presented by concurrent groups. As a result, voters themselves have absolutely no input: they merely exercise control over outputs, through their control over which team is installed in the government. 13 In other words, voters only can exercise some form of control when it is election time. This was very visible in the last elections in Latvia. The result of the last municipal and European Parliament elections have caused some perplexity to the Latvian intellectual elite: there were some people talking about political crisis, others even about democratic crisis. For sure there is a political crisis; also, it s true that there is a deep problem concerning democratic practice in Latvia, as Schumpeterian democracy in practice functions just to the elite of some political groups. By one side, a strong difference between the interests of voters and politicians has been one of the most significant characteristic of Latvia s political process, as the contrary would be considered populism; by other, this together with the poor level of voters turnout (52,85% in 2005 and 52,95% in 2009), what is already sufficient to configure a scenario of political crisis, at the same time democratic practice still developing slowly. However, the most important conclusion of the result of the elections, and of the fact that Latvia is experiencing one of the most extreme economic contraction in World s Economic History, is that the project of the Latvian political elite has failed. In other words, voters are punishing some parties, electing rival groups. The roots of the problem are dual: the Soviet cultural and sociologic heritage, together with the peculiar understanding of the notion of liberalism and populism by the politicians and civil servants, the media and the pundits, the intellectuals, and, in a certain extent, the Academy. Yet, the confusion is not solely about liberalism, but also about what may be called political liberalism and economic liberalism and the way both ideas relate to each other. The interaction between both variables, the Soviet heritage and the Latvian notion of liberalism, reaffirms the distance between people/voters and the political process, making the project of Latvia s political elite to be established as an alienated part of the social reality, what explains its failure as Schumpeterian democracy. The Soviet heritage s most important aspect is the horror of ethnic Latvians to any political spectra than right. 14 In this case, rather than an ideological character, the popularity of right wing politics in Latvia is the result of the association of left politics 12 Ibid., p Goodin, R. (2004). Input democracy In Engelstad, F. & Østerud, Ø. (Eds.), Power and democracy: critical interventions. Aldershot:Ashgate Publishing Limited. 14 It is not the intention here to discuss if this division is still valid or not.

10 10 with the Soviet Union. As a result, in the collective imaginary of ethnic Latvians any party which is not explicitly aligned with right wing politics is automatically considered to support the reestablishment of the Soviet Union and Latvia s occupation by Russians. In the best, a left party is automatically an ethnic Russian party. This results in a crisis of representation. As right wing policies are ideologically connected with neoliberalism as social and economic policies, all Latvian parties are offering, basically, the same policy packages based on neoliberal ideology. As they are all right wing, the voters have no choice; whatever party will be elected, the same policies will be applied. In conjunction with the fact they have no influence to the political process outside the electoral process, Latvian voters do not have incentives to go voting. The same is happening in Western Europe, 15 as a result of the neoliberal standardization of politics. Political liberalism turned to be equal to economic neoliberalism, while populism is any form of protest against neoliberal economics and Schumpeterian democracy. 4. Neoliberalism and Latvia s Third Duality: the Economic Side Andre Gunder Frank coined the term development of underdevelopment to describe a situation where an underdeveloped country integrated in the international economic system will be always a developing country. The process of development of underdevelopment begun in Latvia as result of the process of transition to capitalism, mainly with the application of a conjunction of monetarist/neoclassical policies known as shock therapy, with the inability of the local politicians to deal with neoliberal economic paradigms. More, it put too much weight on the financial system s role in promoting economic development. This is specially relevant, as since the end of both Gold Standard and Bretton Woods system, the financial system has split in two: one part continues to have contact with the real economy, but the other established itself as a separate and autonomous entity with no contact with the real economy. 16 This means the subordination of development, this of economic policies, to the financial market s interests. Figure 3 The Former and Actual Structure of Capitalism (Real Proportions, 2008) 15 See International Ideas (2005). Voter turnout in Western Europe since 1945: a regional report. Stockholm: International Ideas. 16 Berzins, J. (2010). Neoliberalism and the development of underdevelopment in Latvia: a Latvian disease?. Spectrum: Journal of Global Studies, vol. 1, no. 3 (forthcoming).

11 11 After joining the European Union, the complete openness of Latvia s financial and capital accounts changed the credit market s structure. Credit is the most powerful instrument to promote economic development, although the availability of credit is not a guarantee that the development will occur. In the period , there was a credit boom, as consequence of the strategy of the foreign banks operating in Latvia. In the last quarter of 2008, the loans issued to residents amounted Ls ,4 million, or 90,1% of the GDP. In comparison with the end of 2003, there was a significant change in the structure of the loans issued, because of the strategy of the banking sector and the demand of the public ,0 Chart 1 Bank credit growth, ,00% , , ,0 0 feb-09 jan-09 dec-08 nov-08 oct-08 sep-08 ago-08 jul-08 jun ,00% 30,00% 15,00% 0% -15,00% Mil. Lats % Source: Latvia s Financial and Capital Market Commission, own calculations.

12 12 While in 2003 the most privileged sectors were individual services (23,11%), wholesale (16,09%) financial intermediation (12,5%) and manufacture (11,73%), in the end of 2008 the situation had changed drastically. Since 2004, the banks started to lend relatively cheap money to finance operations in the real estate sector and consumption of durable goods. Besides, because of the process of increasing financial needs, the availability of credit for financial intermediation also rose. In this way, the money lent to non-banks in the last years turned to be mainly directed to finance operations with real estate actives (56,6%), consumption of durable goods (11,2%) and financial intermediation (7,2%), while all other sectors experienced a relative reduction. The result was a process of economic restructurization, making the process of development of underdevelopment to deepen. Chart 2 Loans Structure by national economy sector in and in % Agriculture, hunting and forestry Fishing Mining and quarrying Manufacturing Electricity, gas and water supply Construction Durable goods Hotels and restaurants Transport and storage Financial intermediation Real estate Other individual services Other 4,4 2,5 0,4 0,1 0,1 0,1 11,7 7,9 4,0 2,2 5,2 5,3 16,1 11,2 2,5 1,3 6,6 2,6 12,5 7,2 9,7 56,6 23,1 2,1 3,8 1, Source: Latvia s Financial and Capital Market Commission, own calculations. In 1995, manufacturing, agriculture and energy accounted for, respectively, 20,67%, 8,66% and 4,95% of the GDP. However, in 2008 the same sectors accounted for 10,56%, 3,03% and 2,82% of the GDP. The main point is that although the GDP was growing, the result of the structural changes was to deep the underdevelopment. First, because the demand for durable goods has a natural limit. As there was a huge repressed demand of these goods as people wanted to get rid of the old soviet durable goods, with the availability of credit the consumption of these goods experienced a boom. However, when

13 13 this demand is fulfilled, the sectors associated to it tend to experience a strong reduction in their level of economic activity. Second, as economic history shows, artificially inflated prices of real estate always go down, in other words, bubbles always deflate. Third, and most relevant, because the capacity of people to borrow is directly related to the amount of money they may dispose to pay back the credit, what limits the credit market. Chart 3 Structure of Latvia s GDP 1995 and 2008, % Agriculture Manufacturing Energy Construction Consumption of durable goods Hotels and restaurants Transport, storage and communications Financial intermediation Real estate Public administration Education Other 0,99 1,65 3,03 4,95 2,82 4,58 5,00 6,34 8,91 9,86 7,01 7,74 5,39 5,16 8,36 8,10 10,56 10,76 17,34 17,58 0 7,50 15,00 22,50 30, Source: Latvia s Central Statistic Bureau, own calculations. Also, the transport and storage sector depends of the production of goods, which by its time is dependent of their demand. With a crisis, both in the internal and in the external side, this sector tends to suffer a reduction in its performance. As Latvia s manufacturing sector had been shrinking, besides the inevitable decrease of the commerce of durable goods, the transport and storage sector has also experienced a slow down. In this way, nearly a half of the Latvian GDP has been remaining in an unsustainable basis, showing that a crisis would occur with or without the current financial crisis. Although the GDP was growing fast, in reality the structure of the Latvian economy was debasing and becoming increasingly dependent of four sectors that, by their own idiosyncrasy, are not sufficiently dynamic to push the economy in the medium and long terms. In other words, the failure of the internal model was a natural consequence of its own structure. Besides the process of economic restructurization, another problem was inflation. As result from the influx of foreign money by the banks, from 2003 to 2007, the monetary 8,66 9,99 14,52 20,67

14 14 basis of Latvia increased 181% 17. From May 2004 to June 2008, the increase was 163%. By the side of M1, the biggest growth was in overnight deposits, leading to the conclusion that the issuance of money by Bank of Latvia hasn t been the main cause of the increase of the monetary basis. Rather, this is the result of the strategies of the private banks operating in Latvia. If by one side they may naturally create money, by other the increase of their activities have been financed by external remittances of money. Usually inflation is seen as a bad indicator, it s also true that it may signalise economic growth. What developing countries must take in consideration, is that an annual rate of 13% of inflation is not so bad, if there is economic growth and, more important, development. Inflation is a problem when it s 13% a month. A yearly inflation of about 2-3% is the case of developing countries in deep recession or of developed countries approaching stagnation and starting to face problems as unemployment. Before achieving an inflation rate of 2-3%, a country first must develop. On contrary, such a low inflation rate is going to be under the expense of small economic growth/development. The restructurization of the economy and the inflationary process were the result of ineffective regulation of the market by the Financial and Capital Market Commission and the inability of the Bank of Latvia to deal firmly with the increases of the monetary base. The Financial and Capital Market Commission assumed a position of not intervening in the market, being rather an observer. It did not perform its basic function of regulate the financial system to guarantee its stability, controlling the explosion of the market credit and therefore protecting both banks and clients from overexposing to risk. The case of the Bank of Latvia is different. Its institutional discourse relies on the impossibility of performing monetary policy due to the impossible trinity, as Latvia s exchange rate is practically fixed against the euro and the capital and financial accounts of the Balance of Payments are opened. Also, by the fact that the currency of more than 85% of the credit lent in Latvia is in euros, meaning that the Bank of Latvia cannot use the interest rate as an instrument to control inflation. 18 Although this may be a true situation, this rhetoric has been used to shield the institution from criticism, through the discourse of impotence in face of the actions of the market. Much more important for the Bank of Latvia was to artificially maintain the exchange rate from going beyond the fluctuation band, and to maintain the long-term interest rate in accordance to the Maastricht criteria. This goals have been achieved administratively, without active interventions disciplining the market. Therefore, although aware of the growing inflation, it completely ignored the role of the monetary base as main determinant of inflation in Latvia. It also ignored that regulating the expansion of the monetary base, it could avoid the process of economic restructurization to be so drastic. A working paper of the Bank of Latvia even discussed the change of the expectations of the economic agents as determining inflation, but the authors did not go to the monetary aggregates, what would be logic to try to explain why the expectations are 17 Here considering M2. 18 About the impossibility of the Bank of Latvia to perform monetary policy, see Beņkovskis, K. (2008). Banku aizdevumu kanāls Latvijas monetārās politikas transmisijā. Latvijas Banka Pētījumi, vol. 1/2008,.

15 15 changing. 19 Although mostly of the sectors of the Latvian economy were developing based on unreal positive expectations, people have been feeling they were getting richer and richer and that this was occurring in a sustainable way. The result was a distortion of the apprehension of reality by the majority of the economic agents. Even in 2008, some international consulting companies were still defending the idea of Latvia becoming an international financial centre, when a superficial analysis of basic macroeconomic indicators was already clearly showing that the Latvian economy was starting to face a structural crisis. To put inflation down, as to avoid the economic structural changes as well, it would be necessary to impose some regulations. This is a delicate issue in Latvia, as the concepts of economic freedom and economic liberalism are understood by the Latvian authorities, politicians, and a significant part of the private economic agents as a synonym of complete anarchical freedom. Anything more than the regulations imposed from the outside, for example, the regulatory framework of the European Union, is considered or communism or populism. This cultural specificity helps to explain the lack of initiative of the regulators to perform their basic function of regulate efficiently. In addition, there is a lack of effective cooperation between the Bank of Latvia, the Financial and Capital Market Commission, and the central government, as they tend to act independently from each other. The Bank of Latvia was the unique institution several times alerting about the structural problems the Latvian economy was going to face, although did nothing to avoid them. The central government never took in consideration these alerts, often discrediting them, while the Financial and Capital Market Commission was ignoring the macroeconomic aspects of its chosen regulatory model. In this sense, the passiveness of the Financial and Capital Market Commission, together with the autistic attitude of the politicians, are important components of the formation of the structural crisis. By the side of the private banks, even with the signs that this process was unsustainable, as the structure of the loans appeared to be very sound mainly mortgage loans and commercial pawn, in the beginning of 2008 the banks were still considering secure to continue lending. 20 Also, there was a strong component of moral hazard. The answer of the head of the real estate division of one of the top three banks of Latvia to the question why they were inflating the real estate market with credit was that it was known that (...) it is unsustainable, but everyone s annual bonus depends on making more money. We know it will crash, but we are all making to much money now to stop it. 21 Although appetite for risk by large foreign banks was particularly strong given the modest exposure of their portfolios to the Latvian market and the very high returns on equity invested there, international experience shows that perceptions of loan quality are notoriously procylicalpositive during economic upswings, but deteriorating rapidly when conditions turn less favorable. 19 Beņkovskis, K., & Paula, D. (2007). Inflācija gaidas Latvijā: patērētāju apsekojuma rezultāti. Latvijas Banka Pētījumi, vol. 1/2007,. 20 Although not as profitable of other services, mortgage guarantee that the client will stay with the bank for a long period and that he/she will buy other products as, for example, insurance. 21 Cited in Sommers, J. (2008). Latvia living at the extremes: seeking equilibrium between central planning and financialization. Humanities and Social Sciences Latvia, vol. vol. 3, no. no. 56, pp

16 16 Chart 4 Structure of the Loans Classified Type in per cent 9,1% 3,4% 6,4% Mortgages Commercial pawn Guarantees Other kind of guarantees No guarantees Other Mortgages 71,8% 7,4% 1,9% Source: Latvia s Financial and Capital Market Commission, own calculations. The consequences of the end of the speculative cycle in the Real Estate market in Latvia were two. By the side of the banks, (a) the soundness of the loan portfolio experimented a reduction of its quality, in other words, the material guarantee of the issued loans is considerable less than the amount to receive, implicating in losses and (b) the assets of the banks suffered a reduction that may affect the profitability of the banks. As foreign-owned institutions dominate most of the banking system of Latvia, this means to export losses to the mothers, what is already suggested by the International Monetary Fund in the last Request for Standby Arrangement. By the side of the general population, the main problem has been the psychological impact affecting consumption and thus credit and the general level of savings. As buying a real estate property is seen as an investment and a form to save money, a decrease on the price of property makes people consider they ve lost part of their savings. This affects negatively their level of confidence in the national economy, resulting in a fall of the consumption level, in the expectations of the economic agents, thus in a lower level of economic activity and employment. This effect has been magnified in Latvia. As it was clear that the process of economic restructurization was deepening at least since 2006, some measures could be taken to avoid it. In this case, the Bank of Latvia could have at least taken one significant measure. Although its possibilities to perform a comprehensive monetary policy are limited, in this specific case one instrument was available: the compulsory reserves. As the monetary base was increasing mainly as consequence of the remittance of capital from foreign banks to their subsidiaries to be issued as credit, together with the endogenous creation of money by banks operating locally, a more strict increase of the compulsory reserves would be sufficient to dry the liquidity of M2. 22 Combined with stricter regulations for lending by the Financial and 22 The Bank of Latvia increased the compulsory reserves three times since 2005: in the beginning of 2005 from 4% to 6%; in december 2005 from 6% to 8%; and in 2006 through the inclusion of the financial liabilities due in more than two year, in order to limit the Scandinavian banks, which were able to attain longterm financing and were playing the major role in the sector. It s not clear why the bank of Latvia did not use all the potential of this instrument to control

17 17 Capital Market Commission and a more prudent tax policy by the Ministry of Finance, the process of economic restructurization wouldn t be so radical. 23 Latvia must be understood as an underdeveloped country integrating the European Union in a subordinated position. This means that Latvia s insertion in the international economic system results in paths of dependence being strengthened instead of lightened. Foreign trade s structure shows that Latvia exports mainly primary products or products of the paradigm of the Second Industrial Revolution. The imports are constituted by machinery and equipments to the fragile real sector of the economy, together with imports of mineral combustible and its derivates. Besides, Latvia also imports a considerable share of prepared foodstuff, showing that the agriculture is not capable to attend the internal demand and the agribusiness in the country is not sufficiently developed. The conclusion is that the Latvian economy is poorly developed and dependent of both technology and material products, assuming an underdeveloped and subordinated position in the international system. This is the essence of what may be called the Latvian disease, a modern version of the Dutch disease, as the latter is a concept dealing with economic paradigms surpassed by the establishment of the abstract-capitalism. Accordingly to the Routledge Dictionary of Economics, the Dutch Disease must be understood as: The harmful consequences for a national economy of discovering natural resources, especially the decline in traditional industries brought about by the rapid growth and prosperity of a new industry. New dominant industries can afford to pay wages far in excess of other industries, so the latter raise their wage levels to unaffordable levels causing unemployment. The successful new industry has high exports, creating a foreign exchange surplus and raising the country s exchange rate, with the consequence that other industries of the economy become internationally uncompetitive. This was noticeable in the Netherlands after the discovery of North Sea gas. There rising prosperity brought about higher levels of welfare benefits which persisted after the downturn in the economy, causing immense difficulties for the financing of public expenditure. 24 While the concept of Dutch disease deals with natural resources and the real sector, the concept of Latvian disease deals with the financial sphere and its relationship with the economy in its totality. It must be understood as the harmful consequences for a national economy of receiving huge amounts of financial capital. The result is the creation of a foreign exchange surplus, permitting or making the exchange rate to be overvalued. There is a dual process of economic transformation: deindustrialization and shrinkage in services sector by the lack of competitiveness resulting from the overvalued exchange rate; economic reorganization in favor of speculative and/or non-sustainable sectors, as for example consumption of durable goods. 4. Facing the Crisis: Underdevelopment as Destiny? If Latvia s current crisis is the direct result of neoliberal economic policies, it should be to expect that the authorities would try to find alternatives to the current model, 23 Until now, there are no taxes on capital gains, as very low taxes on real estate as well. Taking in consideration that other sectors are much more labour intensive, resulting in more taxes to be paid, there was a natural tendency to the development of the real estate sector. 24 Rutherford, D. (2002). Routledge dictionary of economics (2nd edition). London: Routledge.