The lessons of Latvia The economic lessons of Latvia

The Latvian crash, more intense than that of the other Baltic states Lithuania and Estonia, was the hangover from a decade-long post-Soviet party in which everyone was a property speculator, while foreign banks and Russian oligarchs threw money at the country like drunken uncles.

Between 2008-10, the country saw the biggest drop in GDP in the EU, with output falling a cumulative 20% as the credit-fuelled property boom imploded, and a big bank, Parex, collapsed.

The thousands of well-educated Latvians working as cleaners or food processors throughout Scotland tells its own story of how the "Baltic tiger" went wrong. The lessons for other small, would-be independent northern European nations are complex and sometimes contradictory, but worth considering by those on both sides of the Scottish independence debate.

Latvia is the country that would direct the EU response to Scottish independence in the event of a Yes vote as it would have assumed the European presidency by then. Dombrovskis said his government was now "open for contacts, open for discussions" with Scottish representatives, while stressing Scottish independence was "an internal matter of the UK and Scotland to decide".

"Given there is a possibility that we would need to do something about this during the Latvian presidency, then I think it's also good to deepen our [legal] service's knowledge about the issue and about the potential things we will be dealing with," he says.

Scotland-Latvia discussions would be interesting. Dombrovskis does not share the SNP Government's reluctance to sign up to the euro, which he sees as a mandatory part of the EU package. He signed a formal application to join the eurozone this month, after proudly announcing early repayment of an IMF crisis loan.

Euro adoption is presented by Dombrovskis as a symbol of how Latvia's dire problems are being steadily put right. Although unemployment remains high at 12% and GDP is still short of its pre-crash peak (see chart), on the other hand Latvia's budget deficit this year is only 1.4% of GDP, with public debt a manageable 40% of GDP

After such a humiliating ejection from the north European "arc of prosperity, how did Latvia make itself competitive again?

Latvia took the radical step, previously taken in milder form in Sweden and Finland, of "internal devaluation", by slashing wages by up to 35%, and cutting already minimal welfare provision.

These steps were taken in defiance of international advice to instead decouple the currency, the lat, from its euro peg and devalue, as Greece and other European crash-victims were notoriously unable to do. And while Latvia's contraction more than quadrupled debt to about 45% of GDP, it was still less than half the debt ratio of Italy or Greece before the crisis.

This Latvian solution to a Latvian problem is one example of small-country agile autonomy that the Yes campaign sees as vital for economic growth. It was based on the conviction after "analysing the pros and cons" that "frontloading the adjustment.. cutting deep and cutting fast" was the key to recovery.

The apparent, as yet incomplete success of this "hard money" approach has become the stuff of economics textbooks though the lessons are still furiously debated.

Representing the centre-right Unity Party in a three-party coalition Dombrovskis has won grudging domestic, and effusive foreign, respect for pulling off a trick that few UK politicians would dare suggest – a fiscal adjustment of 17%, far greater than that imposed on Greece.

"If you delay this adjustment or postpone it and discuss the traditional austerity-against-growth debate, what unfortunately will happen is that you get deeper into recession." Dombrovskis explains.

Almost incredibly, Dombrovskis was re-elected and, at only 41, is now independent Latvia's longest-serving leader.

"We did the bulk of our adjustment programme during the crisis, especially in 2009" he told the Sunday Herald in his office in Riga last week.

"Once we restored financial stability we immediately returned to growth. Greece tried to postpone adjustment so they are not able to restore financial stability."

"Dombrovskis trained as a physicist," says Valerijs Kruglevskis, a former scientist whose experience of Soviet rule makes him respectful of executive competence. "He knows there are many other factors involved in the problem, but he isolates the ones that are most significant."

While Paul Krugman, the warrior-priest of Keynesian economics, continues to insist the Latvian cure was worse than the disease, the "austerians" cite it in support of not prolonging the agony. The European Commission projects Latvia's GDP will increase by 3.8% in 2013, compared to 5.3% growth in 2012, increasing by 4.1% in 2014, albeit from a low base.

Now that the currency question has been determined, the country's politics, albeit complicated by Russian influence, are no longer in crisis, allowing work on a new 2014-20 national development plan, considering Latvia's future competitiveness.

Meanwhile, the EU and IMF are talking up the country's success. Christine Lagarde, the IMF's boss, called its achievement a "tour de force". Her chief economist, Olivier Blanchard, admitted his scepticism about the euro peg had been proved wrong.

Anders Borg, the tax-cutting Swedish finance minister, has praised the country's "graduation" from crisis, adding that if Latvia could not satisfy the Maastricht requirements for euro membership then no other country could.

Latvia is still far from "converging" with the bigger EU countries. Its only significant natural resource is timber, its biggest export along with metals and chemicals – "nothing very sexy", according to Morten Hansen, head of economics at the Stockholm School of Economics in Riga.

"There is a lot of catching up to do," Hansen says. "Latvia's education system is badly in need of reform, complacently avoided during the boom years. There are too many doing social sciences, not enough doing hard science; this is a service economy, there's not enough manufacturing and IT."

On the plus side, Latvia has far less corruption than Italy and Greece. In addition, although innovation levels are among the lowest in Europe, the prime minister's fluency in five languages is not that unusual among younger Latvians who "understand the business mentality", according to Hansen. Starting a business is relatively easy.

"At least we don't have to discuss devaluation any more and can look ahead," Hansen continues.

"We are in the friendly straightjacket of the fiscal compact, we can think about reforms and future growth. It was a crazy time and now its calmer. From the eurozone's point of view it's better that Latvia is on the inside, as a hard-money ally of the Germans, the Finns and the Estonians."

Charles Cormack, of international trade firm CCG, who last year won a SCDI export award for almost single-handedly reviving the historic, pre-UK Scottish commercial presence in the Baltic, believes Latvia has much to teach his homeland.

"One of the advantages of being a small country is you can, if you have the courage, take tough decisions and implement them. [Countries like Latvia] have successfully reset their economies and are set as fair as anyone can be these days to resume growth."

"Unfortunately, the kind of political maturity needed to stomach very tough and brave decisions is lacking in countries with strong entitlement cultures like Scotland."

Cormack, once described as Scotland's most pro-European businessman, sees no logic in the Scottish Government's pro-EU but also pro-sterling position. "Having been tossed around on the waves of a crisis they [ought to be] going into the euro for the good reason that any further crisis would hit them anyway. Even if it wasn't already demanded of all new member states, an independent Scotland would be better to join anyway. If there were a sterling zone, we would be a prisoner of the pound with no input into fiscal policy."

Latvia lacks Scotland's mineral wealth, but it does have a God-given strategic location. Latvia stands between western and Nordic Europe on one hand, and the vast, fast-rising Russian sphere on the other.

This trading territory has been overrun by Swedes, Poles, Germans, Russians throughout history for good reason. Its "niche", according to Cormack, should be "the place where east and west do business".

Viesturs Sosars, a tech entrepreneur who has advised the Latvian Government, says the next stage is about channelling a formidable work ethic into improving productivity and growth, which is defined by Krugman as the supreme index of a country's health.

"The question is, now what?" says Sosars. "Bigger countries can live without vision, but smaller ones need to know exactly how they are going to earn their living.

"If you can find your niche, you are a king. We have been way too reactive. We need to dream big dreams about the future".

Of Latvia's white-knuckle ride, he makes the counter-intuitive point that small countries are better able to withstand shocks than bigger ones, "After all, it's much easier to clear up a mess in a small room". So Latvia's gamble paid off? "Yes," he says. "But don't try this at home."