Deficit and pension reform

It was a restless week for Keynes. The poor old economist must have been turning in his grave, his peaceful sleep disturbed by Latvian Prime Minister Andris Skele, who was pulling the economy in the opposite directions by trying to deal simultaneously with an economic crisis and social budget deficit. The latter was proposed to be done by taking money away from pensioners.

We shall leave out the arguments that dividing the working pensioners into two groups by income level may cause social tension, that the general public dislikes the measure, and even that the morality of taking money away from the poorest income group to patch up other parts of the budget is arguable. Such arguments can be dismissed by the statement that one sometimes has to take severe and unpopular measures to reach economic prosperity which would bring benefits to all. Instead we can look at the economic virtues (and vices) of this approach.

Considering the falling GDP, high unemployment, deflation in the manufacturing sector caused by demand deficiency, and the widening balance of payment deficit, crisis is probably the right word to describe the state of the Latvian economy. It is stepping into the period of economic slow-down, which carries a threat of recession. Judging by the way things are going, the threat is materializing.

Economic slow-downs do not have to turn into economic slumps. In the best case scenario it may mean a period of growth slower than the economy's potential, if the government and the central bank take the right actions. The task becomes more challenging when one's big neighbor is in economic crisis.

The government's purpose in such a case is usually to boost demand to keep the domestic producers happily producing and selling goods and services instead of laying people off and contributing to growing unemployment. The pension reform proposed by Skele does exactly the opposite, because reducing people's incomse rarely makes them spend more.

That the pension reform will reduce the income of a large portion of the Latvian population is beyond reasonable doubt. Finding employment in Latvia is hard for anyone over 35, and the difficulties of finding a job grow with age. It is naive to think that all of yesterday's prospective retirees, after their pensions have been moved half a year forward in time, will keep their old jobs or find new jobs for several months.

It is much more realistic to assume that they will become unemployed and collect the unemployment benefit instead of paying taxes to the state treasury, as the government hopes. Pensioners supplementing their income with low-wage or part-time jobs can also be expected to give up their employment when they have to choose between pensions and wages.

It doesn't take many calculations to see that many pensioners' incomes will go down as a result - and so will producers' revenues. Producers, who, as the prime minister noted, are already struggling because of insufficient demand.

It is hard to dispute the fact that the budget situation in Latvia needs improvement, especially in the light of the 1 percent of GDP limit set by the International Monetary Fund on budget deficits, and the honorable Latvian history of budget surpluses in 1998 and 1997. But on its own a budget deficit of 3.5 percent of GDP is not a sign of deep financial crisis.

In fact, it is a common phenomenon in economically developed countries: most of Europe had trouble meeting the Maastricht criterion of a 3 percent limit. And as far as the Latvian record of accumulated government debt is concerned, we score better than most of the countries we look up to. Our debt of 13 percent of GDP looks very healthy compared even to strict Maastricht criteria: European Union requires it not to exceed 60 percent.

A balanced budget is a noble aim. Nonetheless it shouldn't be an aim in itself, but a tool to keep the rest of the economy healthy. In the situation Latvia faces now: economic slowdown and less than desperate budget position - dealing with economic slowdown should be the top priority. Cutting the welfare spending, which is meant precisely to protect people's income from the effects of unfavorable changes in economic climate, to stay in the black in the period of economic problems is the same as trying to keep your umbrella dry in the rain.

Diana Kudayarova, a Riga native and current student at Harvard University, is a guest columnist for TBT.