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.