Sunday, October 26, 2014
7

Austerity in Small Places

BRUSSELS – Interest in small countries’ economic policies is usually confined to a small number of specialists. But there are times when small countries’ experiences are interpreted around the world as proof that a certain policy approach works best.

Nowadays, Greece, the Baltic states, and Iceland are often invoked to argue for or against austerity. For example, the Nobel laureate economist Paul Krugman argues that the fact that Latvian GDP is still more than 10% below its pre-crisis peak shows that the “austerity-cum-wage depression” approach does not work, and that Iceland, which was not subject to externally imposed austerity and devalued its currency, seems to be much better off. Others, however, have noted that Estonia pursued strict austerity in the wake of the crisis, avoided a financial crisis, and is now growing again vigorously, whereas Greece, which delayed its fiscal adjustment for too long, experienced a deep crisis and remains mired in recession.

Both sides in these disputes usually omit to mention the key idiosyncratic characteristics and specific starting conditions that can make direct comparisons meaningless.

For starters, Latvia, like the other Baltic states, was running an enormous current-account deficit when the crisis started. This implies that the pre-crisis level of GDP simply was not sustainable, as it required capital inflows in excess of 20% of GDP to finance outsize consumption and construction booms. Thus, when the inflows stopped at the onset of the financial crisis, it became inevitable that GDP would contract by double-digit percentages. Seen in this light, it is not at all surprising that Latvia’s GDP is now still more than 10% below its pre-crisis peak; after all, no country can run a current-account deficit of 25% of GDP forever.

Any comparison of the Baltics with the Great Depression (or the United States today) is thus meaningless. The Baltics simply had to adjust to a sudden stop in external financing. That was not the problem of the US during the 1930’s; nor is it America’s problem today.

A better way to judge post-crisis performance is to look at the output gap – that is, actual GDP relative to potential GDP. According to a European Commission estimate, Latvian GDP was almost 14% above potential at the peak of the boom, then fell to 10% below potential when the boom went bust. The recovery, however, was equally rapid, with GDP now back to potential (albeit below the unsustainable peak of the boom).

Latvia’s government increased taxes during the bust to keep revenues roughly constant as a share of GDP, but a sizeable fiscal deficit emerged nonetheless as social-security expenditure, such as unemployment benefits, soared while demand and output collapsed. With a V-shaped recovery, however, this expenditure fell again, reducing the deficit rapidly. The recovery could only be partial, because the previous level of output was unsustainable, but it was enough to allow the government to balance its books again.

Thus, Latvia today enjoys a sustainable fiscal position, with output close to its potential and growing. Austerity might have worsened the slump temporarily, but it did deliver fiscal sustainability without permanent damage to the economy. By contrast, output in Greece, which was slow to adopt austerity, is still 12% below its estimated potential and continues to fall.

Does Iceland constitute a counter-example to Latvia? After all, its GDP fell much less, although it ran similarly large current-account deficits before the crisis – and ran much larger fiscal deficits for longer. In contrast to Latvia, Iceland let its currency, the krona, devalue massively. But, the devaluation was much less important than is widely assumed. While exports did indeed perform very well, Iceland’s main exports are natural resources (fish and aluminum), demand for which held up well during the post-2008 global crisis.

That sustained demand provided an important stabilizer for the domestic economy, which the Baltic states did not have. Indeed, Latvia was particularly hard hit by the slump in global trade in 2008-2009, given its dependence on exports. Iceland’s superior economic performance should thus not be attributed to the devaluation of the krona, but rather to global warming, which pushed the herring farther North, into Icelandic waters.

Nor is Iceland a poster child for the claim that avoiding austerity works. In small, open economies, higher deficits are unlikely to sustain domestic output, because most additional expenditure goes toward imports. So it is not surprising that, despite its large devaluation, Iceland continues to run a high current-account deficit, adding to its already-large foreign debt.

Moreover, Iceland’s public debt/GDP ratio now stands at 100%, compared to only 42% in Latvia. Part of the difference, of course, reflects different starting conditions and the cost of bank rescues. But there can be no doubt that, by keeping deficits under control, Latvia’s public finances are in much better shape today, with debt sustainability no longer a problem. By contrast, Iceland’s debt has become so large that it is likely to constrain future growth.

One must be careful when attempting to draw lessons from the experience of small countries that sometimes have very particular characteristics. The one conclusion that appears to hold generally is that shunning austerity does not allow one to avoid the problem of achieving both fiscal and external sustainability.

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  1. CommentedJamie Gordon

    I don't understand how you can say Latvia's GDP is close to full potential when its unemployment rate is 13.8%. I have just double-checked and the definition of potential GDP is the GDP when all factors of production are fully utilised.

    And note 13.8% is much higher than the rate back in 2007 which was 5.4%.

  2. CommentedOlga Butorina

    It's worth remembering that in 1991 Latvia (as other former Soveit Repudlics) got zero public debt as the former USSR debt was taken over by Russia.

  3. CommentedJose araujo

    Daniel Gross, Director russels-based Center for European Policy Studies doesn't know is basic national accounting identities....

    GDP=C+I+G+(X-M)

    So the called 20% of trade imbalance was already deducted on Latvian economy.

    Saying Latvia is back on potential output is just stupid, stupid because you can't consider the actual level of unemployment to be structural. Also extremely biased saying austerity didn't hurt Latvia economy, how the hell can he say that, is Mr. Gros, not only ignorant but blind?

  4. CommentedStamatis Kavvadias

    Meaningless "arguments".

    In the author's way of thinking, the impact of central bank maintained bank insolvency status and resulting domestic lending reluctance, is not an issue for Greece (as opposed to Iceland, or largest bank nationalization in Latvia). The role of banking is kept out of the discussion (like central banks keep it out of their models!).

    The problem becomes clear with the last statement of the article:
    "...shunning austerity does not allow one to avoid the problem of achieving both fiscal and external sustainability."

    Such (intentional?) simplification of the link between fiscal and external balance, is amazing and alarming for a Brussels policy maker and economist. Of course, *when increasing the pie is out of the question*, fiscal and external sustainability coincide. But then, one forgets that it is simply impossible for *all* countries in the world to have a trade surplus! As a result, the austerity guideline (that rules out increasing the pie until you have a balanced budget), requires that all EU countries make a large enough positive trade balance for a balanced budget, by "out-exporting" other countries! ...caged in a game of musical chairs.

    The race for very high returns on investment by the "markets" is respected, and no policy is set in this direction. That is the cost of eurozone and EU not going forward. It is also the cost of not fixing the banking system, keeping the creation of money in the hands of private banks and with minimal taxation of the *risk-free* interest seigniorage, but bailing them out at the cost of taxpayers.

    The rest are ..."arguments".

  5. CommentedJohn Brian Shannon

    Fine article, Daniel.

    I agree with your conclusions and with the conclusions of Professor Krugman.

    I would add however, that Canada is not a small country with a "one-off" economic debt/deficit success, such as Latvia or Iceland.

    In the late 1980's Canada's deficits and accumulated deficits had spiraled out of control.

    The Conservative government at the time, instituted a 7% Goods and Services Tax on practically everything sold in Canada.

    That government and the follow-on Liberal government cut government spending, used the GST windfall to simultaneously pay down debt and to directly stimulate the economy with job creation (major and minor national infrastructure projects) and it worked fantastically well.

    In 7 years, Canada went from "worse than Greece" and "an honourary member of the third-world" -- to the best performing OECD nation in many categories.

    Please read either the Globe and Mail account of this massively successful economic transformation.


    http://www.theglobeandmail.com/report-on-business/economy/the-lesson-from-canada-on-cutting-deficits/article2243702/print/

    http://www.theglobeandmail.com/commentary/how-to-tackle-us-debt-just-do-it/article4549984/

    I commented on this Canadian success story and posted it on my website:

    http://jbsnews.com/tag/the-lesson-from-canada-on-cutting-deficits/

    Best regards, JBS



      CommentedJohn Brian Shannon

      Also, see this hard-hitting piece by CNN Money written by Rob Norton back in 1995, on Canadian and Swedish economic efforts to gain control over deficits and debt.

      "The Baddest Budget Cutters"

      http://money.cnn.com/magazines/fortune/fortune_archive/1995/10/16/206853/index.htm

      While Canada and Sweden succeeded with their austerity programs, the U.S. was seen to be fighting a forest fire with a garden hose.

      Cheers, JBS

  6. CommentedFrank O'Callaghan

    Great misery is being caused to a great many. A small relative benefit is being generated for a tiny minority.

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