February 03, 2009 (the date of publication in Russian)

Alexander Gaponenko


The crash of a postindustrial economy: a case study

Part 1:


For the period between 1989 and 2008, Latvia's population reduced by 14.5%, not considering 5% of Latvians who are permanently (often illegally) employed in other European countries. More significantly, the percentage of working population shrunk for the same period by 21.5%, despite the artificial increase of the supply of labor force by means of increase of pension age for both men and women. During the 20-year period, the amount of unemployment has never declined below 7%.

The qualitative level of labor force has not improved in the same period. School education was prolonged from 10 to 12 years, but higher education was simultaneously reduced from 5 to 3 years. The range of professional skills, taught in Latvian high schools, did not correspond to the requirements of economy. That was an additional reason for the flight of educated labor force.



The whole succession of Latvian governments has not displayed any interest in scientific research. Former Soviet research institutions lost their qualified cadres, but a new inflow of specialists did not and could not happen, as financial support of science has been miserable, not exceeding 0.25% of the budget expenses (in the EU, expenses for science amount to 3%, and in the United States 6% of the GDP). Between 1991 and 2008, the number of Latvians, employed in science, shrunk from 31,000 to 4,000. Not a single invention was registered in this period.

Latvian private companies, with the number of personnel exceeding 250 only in 252 cases (the average number comprising 6.6 persons), cannot afford support of science as well. EU expenses, earmarked for Latvia in the framework of structural funds, have dissolved in the bureaucratic machine of distribution.



In early 1990s, the governments of Latvia closed all the large-scale industrial enterprises, including such highly competitive scientific-productive associations as VEF (the once famous camera producer), RAF, and Alpha. Major agro-industrial enterprises were exterminated as well, their lands and technique being distributed among small private farms.

New capital investments in industry have been since insufficient. In 1989 (in Soviet time) capital investments accounted for 24% of the GDP, in 2007, the most successful year for Latvia, they contracted to 19% GDP from which 8% was the share of foreign investments. So, Latvian economy could generate national investments at the level of not more than 11% of GDP (i.e. less than a half of the level of investments in the late Soviet period). Investments were made only in the sectors with rapid return of capital but with a small or zero potential of productive output – particularly, in the infrastructure of logistics, retail trade, and hotel business.

In fact, Latvia has been deliberately shaped as an economy of services. Between 1991 and 2007, the share of productive enterprises in GDP reduced from 60 to 25%, while services expanded from 32 to 75%. Thus, the chosen model of national development did not guarantee even simple reproduction of scientific, technological and labor resources. Meanwhile, investment policy was concentrated on attraction of foreign capitals.

In 1990, Soviet Latvia's GDP comprised 6.771 billion lats in comparable 2000 prices. This level was overcome only a year after the country's entry in the European Union, due to massive foreign investments, donations and loans. By 2008, the amount of GDP rose to 8.717 billion. However, this figure was achieved by 50% for expense of the real estate market, construction, and commercial intermediation. Not surprisingly, difficulties of borrowing resulted in a 5% decline of GDP within months.



Facing exhaustion of domestic sources of growth, the existing economic model has increasingly absorbed financial resources from outside. After entry in the EU, the government, as well as businesses, banks, and households, have been increasingly using relatively cheap access to borrowing.

In early 2005, the credit indebtedness of financial and non-financial institutions and households totaled 3.877 billion lats (in then-current prices), or 52.4% of GDP. By late 2008, these figures rose to 14.577 billion lats or 110% of GDP, i.e. almost quadrupled in absolute terms and more than doubled as a share of GDP. Under these conditions, especially in the situation of crisis, return of debts becomes impossible. Overdue debts have already far exceed a 1-2% level which is supposed to be safe. Banks are confiscating property, lands and industrial objects from debtors, but these assets appear illiquid. For this and other reasons, incomes of private banks have collapsed to zero. Foreign, predominantly Scandinavian banks that had excessively pumped money into the Latvian economy, with no regard of its inability to return it back, have also encountered serious problems.

Simultaneously, Latvia's external debt was also sky-rocketing: from 25.4% of GDP at the beginning of 2005 to 57.6% of GDP in the third quarter of 2008.

Moreover, the 7.5 billion euros (5.3 billion lats) loan that Godmanis's government managed to wring out from international financial institutions will bring total foreign debt up to almost 100% of GDP! This means that not only Latvian business and Latvian households but now also the whole Latvian state is financially dependent and became a hostage of foreigners.

That is to say nothing of foreign investments which amounted to 2,515 billion lats at the end of the third quarter of 2008: though favorable to economic growth they also led to growing external dependency of the country in the situation of comparatively low investments made by native residents.

Thus, the persisting economic model deprived the country of the asset that its politicians ostensibly appreciated most of all – namely, state sovereignty. Not only foreign but also certain domestic policies are now imposed on Latvia by IMF, European Commission and Scandinavian banks.



Since the restoration of Latvia's independence, state bureaucracy has been the major subject of accumulation of private capitals. Lack of transparency, covered with massive propaganda, allows the bureaucrats to use public power for individual benefit. At first, the bureaucracy appropriated a lion share of business incomes in the process of privatization. In the following period, when this resource was exhausted, the bureaucracy imposed a severe toll on implementation of routine management tasks.

This toll is collected in two forms. Firstly, Latvian officials take bribes for providing privileges in achieving various benefits below market, and in distribution of state contracts above market. Secondly, rampant nepotism in administrative bodies makes them inefficient. In 1991, only 3% of Latvian population was employed in administration. By 2008, this figure inflated to 7.8%, while expenses for maintenance of the bureaucracy zoomed to 12.3% of the budget.

In the period of privatization, economic privileges were achieved by a narrow group of persons whose business is closely interwoven with interests of particular top officials. Meanwhile, most of Latvian small business felt itself discriminated. More and more resolutely, small business demanded transparency in state management and distribution of the budget. However, their demands were demonstratively neglected. The income tax remained flat; declaration of incomes provided exceptions for particular business figures, as well as top officials; no serious measures were undertaken to combat corruption in administration, courts, police, taxing bodies and customs offices. Generally, the bureaucracy has been interested in conservation of the economic model that was fatally disastrous for Latvia's statehood.

In the conditions of economic crisis, the bureaucracy carelessly shuffled off its burden on small businessmen, employees, jobless and pensioners. This conclusion can be made from the character of measures chosen by the government, particularly increase of direct and indirect taxes, financial support of privileged private banks and shadowy redistribution of EU loans. These loans are not supposed to be used for creating new jobs, for stimulation of real economy or support of the poor. Their only destination is compensation of the enormous budget deficit, generated by the excessive consumption of the bureaucracy and spending for obviously corruption-based ambitious projects.

Therefore, the real background of social unrest in Latvia is predetermined with years of state policy that has resulted in enormous social stratification, increasing contradictions between the oligarchy and the rest of the population that was only exacerbated by latest economic decisions.



The founding fathers of newly independent Latvia have laid one more time bomb under the state. During years of rule of rightist liberal governments, the bureaucracy conveniently protected itself by the slogan of "Russian danger" each time when small business associations, trade unions, MPs and journalists raised essential issues of economic strategy and transparency of governance. In fact, almost one half of ethnic Russians cannot influence political decisions in any way, as they are not granted Latvian citizenship. This discrimination, formally denounced by the EU but never used as a serious argument in relationship with the official Riga, has artificially created a layer of the society that is prohibited to ascend along the social ladder, and therefore concentrating in the undersupplied and neglected real economy. Persistence of the present model of state management is making this layer an explosive force.

On the contrary, in case the Latvian leadership ventures to introduce a strategic change of economic policy, the currently discriminated part of Russians will be of high demand, also on the political level. However, transition of this kind is obviously unfavorable for the Latvian political establishment, formed on the ethnocratic principle and adhering to the failed "economy of services".

The community of European investors and creditors which is today forced to impose external management on Latvia, is facing a rather delicate choice. On the one hand, they would prefer Latvians to be able to maintain its own economy by contributing to its real sector. However, this scenario is costly from a political viewpoint, as it suggests a serious dialogue both with the establishment and the numerous opposition. Moreover, it requires a change in economic thinking of the European bureaucracy as well.

Another option is much easier: to withdraw the assets of Scandinavian banks from the country, shifting the liabilities of business and households onto the Latvian state. This way of discarding losses is available without involvement of European institutions. But in this case, the state of Latvia will be bankrupt, with ensuing complications for Europe.

In case the European Union does not elaborate a new economic and political approach in dealing with the problem of Latvia, its resolution will require involvement of two other interested actors – the United States and Russia.

About the author:

Alexander Gaponenko, Dr. Sc. (Econ.), is the Director of the Institute for European Research, Riga, Latvia

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