The Political Economy of Latvia’s Economic Development: The Twin Roles of the Natural Resource Curse and Ethnic Fragmentation Vyacheslav Dombrovsky May 24, 2011

Plan of the talk Latvia 20 years ago and today The political economy of development Application #1: Accession to the EU Application #2: The natural resource curse Application #3: Ethnic fragmentation

Latvia 20 years ago : Latvia’s GDP fell by half 1992: inflation 958 % per annum : about one government per year on average

Latvia Today A market economy A parliamentary republic based on political competition Member of NATO Member of the European Union Member of the World Trade Organization

The Baltic Miracle

What’s really interesting: Latvia vs Estonia Very similar starting positions (except Finland?) Divergence in GDP growth that is already substantial and growing Estonia has more industry (28.7% of GDP), than Latvia (20.6%) Estonia’s Summary Innovation Index is above European average, Latvia’s is first from the bottom Estonia is less corrupt (26 th place in the world), than Latvia (59 th ), based on Transparency International Estonia is home to Kazaa, Skype, SMS parking, internet voting, etc. Estonia handled the crisis differently, and now has the euro

The questions and the theoretical framework What explains Latvia’s performance vs. ex-Soviet republics? Latvia vs. Estonia? These are the big questions of development, we need to invoke some theories. One is the institutional view: rule of law is what matters, but there is a commitment problem; societies create institutions as a cobwebs of checks and balances to ensure protection of property rights. Another is the theory of active, meddling state that must tackle a variety of country- specific market failures (e.g. Rodrik, 2006).

Application #1: Latvia vs fSU Latvia implemented the standard ‘Washington Consensus’ + full transposition of the European institutional matrix (aquis communaire) That doubtlessly hurt many domestic (special) interests Where did the ‘political will’ come from? My guess is that the ‘Russian card’ has been crucial (as in Georgia more recently?)

App #2: The Natural Resource Curse The rule of law is crucial to the economic development In nascent polities, however, economic power means political power, and vice versa – i.e. limited access orders (North, Wallis, Weingast, 2006) Substantial literature has established Natural resources tend to be negatively correlated with economic growth (e.g. Sala-i- Martin, 1997) The quality of institutions is decisive whether natural resources are a blessing or a curse (e.g. Cabrales and Hauk, 2011) Discovery of natural resources tend to make states less democratic (e.g. Tsui, 2011)

NATURAL RESOURCE OWNERSHIP POLITICAL POWER

NATURAL RESOURCE OWNERSHIP POLITICAL POWER EXCESS PROFITS Switzerland, etc.

NATURAL RESOURCE OWNERSHIP POLITICAL POWER EXCESS PROFITS FIRM 1 FIRM 2 … … FIRM N Enhancing returns Investments Switzerland, etc.

NATURAL RESOURCE OWNERSHIP POLITICAL POWER EXCESS PROFITS FIRM 1 FIRM 2 … … FIRM N RULE OF THE LAW Enhancing returns Investments Switzerland, etc.

NATURAL RESOURCE OWNERSHIP POLITICAL POWER EXCESS PROFITS FIRM 1 FIRM 2 … … FIRM N RULE OF THE LAW ECONOMIC GROWTH PRIVATE SECTOR DEVELOPMENT FOREIGN DIRECT INVESTMENT Enhancing returns Investments Switzerland, etc.

Latvia’s Natural Resource Curse…

Latvia’s Natural Resource Curse is… A combination of geographic position and incompatibility of railroad tracks between fSU and Europe – the port of Ventspils In 1990s, Mr. Lembergs (then mayor of Ventspils), with some enterprise directors, ‘privatized’ the port largely to themselves He then took control of some media (e.g. NRA) A political party (e.g. Union of Greens and Farmers) And sought to use his influence to gain ownership of other assets (e.g. Latvian Shipping Company)

A culture of ‘rent-seeking’?

Estonia seems to have no ‘oligarchs’ Somehow, there are no clearly identifiable ‘oligarchs’ in Estonia No clearly politically controlled media or political parties One theory is that the absence of oligarchs is due to the choice of privatization methods, i.e. selling to foreigners This may have contributed to better protection of property rights

App #2: Ethnic divisions Also seems to be a blessing for some countries (U.S.?), and a curse for others (e.g. Africa) Both Latvia and Estonia have large ethnic Russian-speaking minorities However, ethnic voting seems to be much stronger in Estonia, rather than in Latvia To date, a ‘Russian’ party has never been admitted to a ruling coalition in Latvia

Decision making in groups N1(N/2)+1 DictatorshipSimple majorityUnanimity MORE DEMOCRATIC MORE EFFICIENT

Example #1: 2002 elections Political party# of seats in the parliament New era party26 ‘Russian party’25 People’s party20 Greens and farmers12 First party10 Fatherland and freedom7

Example #1: 2002 elections Political party# of seats in the parliament New era party26 ‘Russian party’25 People’s party20 Greens and farmers12 First party10 Fatherland and freedom7 Number of possible (minimum size) majority coalitions without the ‘Russian’ party 4 # majority coalitions with ‘Russian’ party included9

Example #2: 2010 elections Political party# of seats in the parliament National unity party33 ‘Russian party’29 Greens and farmers22 For good Latvia8 Fatherland and freedom8

Example #2: 2010 elections Political party# of seats in the parliament National unity party33 ‘Russian party’29 Greens and farmers22 For good Latvia8 Fatherland and freedom8 Number of possible (minimum size) majority coalitions without the ‘Russian’ party 1 # majority coalitions with ‘Russian’ party included3

Ethnic fragmentation: implications One implication is that the decision rule, effectively, is somewhere between qualified majority and unanimity. Unanimous decision making in the parliament (liberum veto) likely crippled Poland’s development in 17 th - 18 th centuries. Ethnic fragmentation may make it difficult to create good governance, i.e. Rodrik’s ‘meddling’ state

Ethnic fragmentation: implications Another implication is that ethnic fragmentation may have helped oligarchs to exercise influence, thus, undermining the rule of law. For oligarchs, political influence implies substantial campaign finance investment to woo ‘impressionable’ voters. The return on investment depends on the chances to get into the ruling coalition. Ethnic fragmentation increased the chances of oligarchs’ pocket parties having the ‘golden share’.

THANK YOU!