Features of Living in Debt: Silini Government Advised to Cut Spending Rather Than Raise Taxes 0 8

The Latvian state debt has significantly increased over the past 20 years: from about 15% of gross domestic product (GDP) in 2004 to around 48% of GDP in 2025.

The growth of debt has been uneven. There were two periods of particularly sharp increases:

• during the global financial crisis (2008–2010), which severely impacted the Latvian economy,

• during the Covid-19 pandemic (2020–2021), when governments, including Latvia, significantly increased spending to support households and businesses.

Most economists consider the increase in debt during crises to be a normal phenomenon — the government has to borrow more as tax revenues decline and expenditures rise. The problem arises when, after a crisis, the debt does not begin to gradually decrease but remains at the same level or continues to grow.

Debt always has to be repaid. Interest payments are part of the government’s budget expenditures — just as mortgage payments are for households.

In recent years, interest payments in Latvia have significantly increased and are expected to reach about 443 million euros in 2024. To understand the scale, one can compare: in 2023, 364 million euros were spent on culture, 429 million euros on higher education, and 480 million euros on outpatient medical services.

The increase in interest expenses is explained by two reasons: the rise in state debt and higher interest rates in the eurozone compared to the previous decade. For a long time after the financial crisis, rates were very low due to the European Central Bank’s (ECB) stimulative monetary policy. This created the impression that debt "costs almost nothing." However, in the context of the ECB's fight against high inflation, the interest environment has changed, and debt servicing has become more expensive. Currently, inflation in the eurozone is at the target level (2%), meaning rates have stabilized and are unlikely to change significantly in the near future.

Risks for Borrowers

In addition to rising interest expenses, debt creates several interrelated risks.

• Sustainability risk. If investors begin to doubt the government's ability to manage its debt, they demand a higher risk premium, which means rising interest rates. A dangerous chain reaction may occur: higher risk premium – higher rates – larger interest payments – greater budget deficit – even faster debt growth.

Such dynamics can lead to the need for support from international financial institutions. This is not a theoretical scenario — several eurozone countries, such as Greece, experienced similar situations after 2010.

• Contraction of fiscal space. If debt is high, the government has fewer options to borrow additional funds during a crisis without causing market nervousness. And it is precisely in a crisis that borrowing is particularly important. Otherwise, the government may be forced to cut spending or raise taxes during a recession, deepening the downturn.

Therefore, fiscal discipline in "good times" serves as a kind of insurance against future shocks.

• Debt structure risk. If long-term interest rates rise faster than short-term rates, the government resorts more frequently to short-term borrowing. This leads to more frequent refinancing, making the debt more sensitive to rate fluctuations. Rising rates are reflected more quickly in budget expenditures.

When Borrowing is Beneficial

Debt itself is neither good nor bad. There are situations when borrowing is justified. The first is supporting the economy during a crisis. The second is financing one-off investment projects with high returns.

A study by the Bank of Latvia shows that over seven years, every euro invested in the state’s fixed capital attracts about two euros in private investment. The effect is stronger in countries with low corruption, high governance effectiveness, and strong rule of law. It is particularly noticeable in the areas of infrastructure and human capital.

Thus, borrowing is justified if it finances one-off investments with clear returns and if the government is capable of effectively implementing projects. Borrowing to finance ongoing expenses only increases debt risks.

How to Repay

Historically, state debt has been reduced in three ways:

• fiscal consolidation;

• accelerating economic growth;

• high inflation.

Inflation is under the competence of the European Central Bank, and its effect on debt is short-term. Moreover, rising prices are often offset by increases in wages and benefits, so relying on inflation as a long-term solution is unreasonable.

Faster growth also does not guarantee debt reduction, as rising revenues often increase pressure to raise expenditures.

Consequently, fiscal consolidation, however unpopular it may be, is practically inevitable for stabilizing debt. However, its effectiveness depends on the phase of the economic cycle: it is more effective during growth, while in a recession, it may deepen the downturn.

The choice of tools is also important. An analysis by the Bank of Latvia shows that cutting expenditures is more effective than raising taxes, as tax increases can significantly slow down economic activity. If tax increases are necessary, indirect taxes — such as excise duties or VAT — are relatively more effective.

In Summary

There is no universal level of debt at which the situation automatically becomes dangerous. The critical threshold depends on interest rates, growth prospects, fiscal discipline, trust in financial markets, and the structure of the debt.

Latvia's debt is currently not very high. However, it has increased to the point where interest payments are already noticeable in the budget, the dynamics of debt are sensitive to adverse scenarios, and the fiscal space for future crises is shrinking.

The question is whether today’s fiscal policy is being shaped in such a way that in a few years, painful, sudden, and harmful decisions for the economy will not have to be made.