Latvia uses police to quash talk of economic collapse

Last November, Dmitrijs Smirnovs, a young economics professor in this coastal university town, published an essay in a leading Latvian newspaper warning that the country was heading for a financial collapse to rival Iceland's.

Soon after, the secret police showed up at his home. They held Mr. Smirnovs for two days. The charge: spreading unrest and destabilizing Latvia's financial and banking system.

"I said we are bankrupt. I wrote that people should not have their money in banks, and they should not keep their money in Latvian lats," Smirnovs recalls, sitting in his cold office, the heat turned off, he says, to save money. "That was enough to have me detained. They are still investigating me."

Lawmakers here did not want to admit at first just how quickly Latvia's fortunes have changed. But a shrinking economy, rising unemployment, and a $7 billion loan from the International Monetary Fund have changed that. A new center-right government took the helm last week and hopes to steer this tiny Baltic nation of 2.3 million out of an economic emergency the European Union fears could soon destabilize the whole region.

At a summit in Brussels Thursday and Friday, the EU continued to debate whether to bail out cash-strapped Eastern Europe. Latvia, once a poster child for financial success, is now a cautionary tale of breakneck capitalism that has taken it to the brink of a meltdown.

Latvia's economy grew at a double-digit pace for years since it joined the EU in 2004. But it fell 10.5 percent year-on-year in the last quarter of 2008. The gross domestic product is expected to decrease another 12 percent this year. Unemployment could reach 15 percent. Housing prices, once a boon, are down 25 percent, according to Global Property Guide.

Lawmakers here are trying to minimize the kind of public panic seen last year in Iceland and, more recently, in Ireland, and have targeted those like Smirnovs whom they see as responsible for spreading it.

When Latvia pop star Valters Fridenbergs joked at a concert one night about bank runs, the secret police paid him a visit too.

"Devaluation [of the economy] is a very touchy subject here," says Pauls Raudseps, an editor at Latvia's most influential daily, Diena. "This society isn't used to open discussions about these things."

But public anger over the government's handling of the economic crisis has been steadily mounting. Late last year, the country's biggest national bank, Parex, was nationalized and the government reached out to the IMF – a gesture that carried with it deeply unpopular cuts in social spending, including salary reductions of 15 percent across many services, and hastened the resignation of Prime Minister Ivars Godmanis last month.

There has been unrest: A 10,000-strong rally in the capital, Riga, turned violent in January. Last month, farmers blocked the main road to the capital to protest agriculture policy.

In Riga, the trendy cafes, multistory shopping malls, and sleek sushi restaurants belie what the ordinary Latvians say about the declining state of things. Two years ago Mikhail Arutjunov moved to the capital from the coast, where he worked in the shipping industry. He drives buses and taxis, but is thinking of going back. "Life isn't so good here anymore," Mr. Arutjunov says. "Money was good back then, but now salaries are too low."

Latvia's problems are mirrored elsewhere in Eastern Europe. The region is foundering not because of toxic mortgages, but because of huge account debts following years during which governments borrowed too much in an attempt to improve institutions and infrastructure ahead of EU membership.

Then, governments cashed in after joining the EU. Foreign investment poured in, property values soared, housing markets boomed, and ordinary consumers found themselves with access to credit that was unthinkable during the dark days of communism.

"The government just went wild," says Mr. Raudseps. "They just went on a spending spree."

The Baltic countries borrowed heavily in foreign currencies, mostly in the euro, which has devalued significantly since the start of the financial crisis. And they kept their three currencies at a fixed exchange rate with the European single currency, eliminating the option of devaluing those currencies to help drive up exports.

"That was the one substantial flaw" in the fiscal policies of Latvia and the other Baltic countries, says Anders Aslund, a senior fellow at the Petersen Institute for International Economics. "During their boom times, they imported inflation, imported too much short-term capital, and it has caused overheating in their economy," he says.

Some of Latvia's leading economists, particularly those who came of age in the early days of capitalism, are saying the only solution for Latvia is to let it collapse like Iceland and start over again when the IMF loan runs out this fall. That may sound like risky advice, but Smirnovs says: "We need to change from wild capitalism to simple capitalism."

Raudseps says the Latvian people are ready for a new government to lead the country through the crisis, and are resigned to some cutbacks.

"When does it end? That is creating a lot of tension. People don't really know how they are going to deal with it," he says.