Role Model of European Austerity Turns to Stimulus

As southern euro zone countries groan under the weight of austerity measures, the Baltic country Latvia has been so enthusiastic and seemingly successful in its application of austerity measures that even the International Monetary Fund (IMF) has warned Latvia to not go too far.

After suffering a 24 percent drop in gross domestic product (GDP) in 2009 after the financial crisis struck, Latvia has undertaken an aggressive drive to reduce its budget deficit, slashing public spending and raising taxes, undergoing the biggest fiscal adjustment in the European Union of 17 percent of GDP in three years.

The country has undergone such a dramatic economic turnaround as a result, going from recession to a forecasted growth rate of 3.7 percent in 2013. Though its fiscal discipline has made the small Baltic state a "cause celebre" for austerity, the IMF has warned that it should now focus on stimulus.

(Read More: Latvia Accepts Austerity, and Its Pain Eases)

Valdis Dombrovskis, Latvia's prime minister, has told CNBC the government now has room to increase expenditure and lower labor taxation.

Dombrovskis was accused of jeopardizing the country's economy when he introduced far-reaching austerity but he told CNBC on Wednesday that austerity and growth were not incompatible.

"Indeed, so far we have[implemented] the biggest fiscal adjustment among the EU's 27 nations… yet we are currently the fastest growing EU economy," he told CNBC in Vienna.

"Probably there is not so much of a contradiction between austerity and growth," he added, noting that the country had achieved modest budget deficit levels of an estimated 1. 2 percent of GDP in 2012.

An End to Latvia's Sacrifices?

In order to meet the conditions of a 7.5 billion euro ($9.9 billion) EU/IMF loan in 2008, Latvia enforced one of the harshest austerity budgets in Europe, with measures including tax increases and pay freezes or cuts - public sector wages were cut by 25 percent on average but up to 70 percent in some cases (for teachers, for example).

There has been massive increase in emigration from Latvia, a trend that increased markedly since austerity measures were introduced. Called a "demographic disaster" by one Latvian migration academic, emigration has increased by 13 percent in a decade, particularly among the younger, educated generation.

Politicians lost their jobs or had pay cuts of 35 percent too, yet despite the harsh measures, prime minister Dombrovkis was re-elected.

He told CNBC that 2013 should see a reversal of cuts.

"We have already agreed in this year's budget, salary raises of ten percent for quite a range of public sector employees," he said,listing a variety of public service employees set to have pay increases, or those that have already seen pay rises.

Far ahead of the 2015 deadline for its loan repayment, Latvia announced in December that it was paying back the IMF loan early, a move that means the IMF can no longer influence the country's budget.

(Read More: Europe's Leaders Must Rethink Austerity Strategy: Ex-IMF Chief)

The IMF warned that a number of measures, such as lowering the minimum wage, could damage an already fragile social welfare budget. Dombrovkis countered this by saying that economic growth would counteract unemployment - already at 10.7 percent.

Latvia's Lessons to Europe

The prime minister told CNBC that Latvia's reversal of fortunes had been due to a quick implementation of its fiscal adjustment, in contrast to Greece's pained and protest-marred progress in reducing its budget deficit. This, he said, had allowed Latvia to regain market credibility and financial stability.

He added that each country had its own particular difficulties but that 25 out of 27 EU states had signed up to the fiscal compact that ratified fiscal discipline and hence had effectively signed up to austerity.

"Austerity is part of the solution," he said, adding that the European Central Bank was also playing a part in terms of low interest rates but countries like Greece had to improve their financial credibility.

"For those countries that are having trouble with market access, there is no other way than to get their public finances in order."