by Anders Aslund, Peterson Institute for International Economics
Op-ed in Foreign Policy. Reposted with permission.
September 13, 2012
© Foreign Policy
Amid the carnage of the European financial crisis, the Baltic countries, by and large, are doing quite well. Estonia, Latvia, and Lithuania are booming. Last year, their growth rates reached 7.6 percent, 5.5 percent, and 5.9 percent, respectively. The turnaround, driven largely by manufacturing exports, has been one of the most remarkable and promising stories of the crisis. In 2008–09, all three countries were badly hit by a nearly complete liquidity freeze, which sank their economies by as much as 24 percent. Even so, only Latvia required an International Monetary Fund (IMF) and EU bailout, and all three returned to growth after only two years of recession. Today, all three Baltic countries have ample access to international financial markets, and their credit ratings have risen steadily since the summer of 2009.
The Balts' rebound stands in stark contrast to the fate of eight mainly southern EU countries—Hungary, Romania, Greece, Ireland, Portugal, Cyprus, Spain, and Slovenia—which either already have or probably will require stabilization programs with external financial support.
So what happened?
The simple explanation is that the Baltic countries have pursued the opposite policy of the southern Europeans. In 2009, the Baltic governments each carried out strict austerity, with a fiscal adjustment of about 9.5 percent of GDP, mainly though expenditure cuts and substantial structural reforms. The southern Europeans, by contrast, delivered substantial fiscal stimulus in 2009. Previously fiscally conservative Cyprus and Slovenia ran up budget deficits of 6 percent of GDP in 2009, but neither benefited from greater growth. Instead, they have been trapped with large budget deficits and are now being overwhelmed by their public debt, admittedly also because of banking crises.
One would think, given the divergent outcomes, that a serious economist would advocate for countries to follow the successful example of northern Europe rather than the failed strategies of the south. Nobel laureate and New York Times columnist Paul Krugman doesn't seem to see it that way. Throughout the crisis, Krugman has attempted to explain away or even mock the Baltic countries' success even as they have continued to inconveniently disprove his arguments.
On December 15, 2008, Krugman issued his first pronouncement on the Baltic crisis in a post titled, "Latvia is the New Argentina." He meant that Latvia would have to devalue its currency and perhaps default, as Argentina did in 2001. Neither happened. Latvia returned faster to fiscal health than anybody had anticipated. Krugman's claim that devaluation was necessary for Latvia's recovery (and presumably also Estonia and Lithuania's) turned out to be wrong.
Krugman's main argument has been that more fiscal stimulus is always needed as long as a significant output gap exists. But in Cyprus and Slovenia, very substantial fiscal stimulus generated minimal growth. Neither country would be suffering from its current financial conundrum had it not followed such a policy. Spain would probably be safe as well.
Krugman's disregard for the risk of sovereign default is perplexing. His main line of thinking seems to be that Europe has a growth problem, not a debt problem, and he appears to believe that a fiscal stimulus can always overcome the threat of the increased public debt burden. Even in the case of Greece, which had a gross public debt of 165 percent of GDP at the end of 2011, he failed to notice the danger but financial markets declared that the country's public debt was excessive. Slovenia's public debt of 50 percent of GDP, for instance, is more than the markets accept, as its bond yields have exceeded 7 percent.
It is difficult to understand how Krugman can ignore the structural reforms that are urgently needed in Europe. All the southern European countries have overregulated labor markets that have caused persistently high unemployment. In Spain, it is easier to get a divorce than to sack a worker —which explains in part why companies are very reluctant to hire new ones. But to Krugman, unemployment is merely a matter of lack of demand: "The urge to declare our unemployment problem ‘structural’—a supply-side problem of some kind, not solvable by the ‘simplistic Keynesian’ notion of just increasing demand—has been quite something to behold," he wrote on June 8.
Greece stands out as the main villain of the European crisis. Multiple Greek governments had grossly falsified their statistics and maintained an average budget deficit of 7 percent of GDP for the last two decades, refusing to fulfill their EU obligations. The George Papandreou government adopted a stabilization program in May 2010, with more IMF funding than any IMF program in history, but one year later it had expanded the already excessive public administration by a net of 5,000 civil servants. Papandreou raised already high taxes rather than cutting public expenditures.
Yet incredibly, Krugman calls Greece a victim, laying all blame for its predicament on the European Union, the European Monetary Union, and Germany. When he's not exclaiming "this isn't a Greek problem... it's a European problem," he's pointing the finger at "the arrogance of European officials, mostly from richer countries, who convinced themselves that they could make a single currency work without a single government."
More bizarrely, while he considers Greece innocent, Krugman has attacked the far smaller and poorer Baltic countries in perhaps a dozen blog posts. Krugman is not, presumably, some kind of bizarre anti-Baltic bigot. His problem is that they have pursued austerity and succeeded; they prove that Krugman's analysis of the European crisis is wrong. As it happens, Estonia actually adopted the euro in January 2011, and the Baltic economies appear to have entered a high-growth trajectory.
Krugman's sour grapes are on full display. He dismissed the success of Estonia, "the poster child for austerity defenders" as insignificant in a June 6 post that provoked the wrath of Estonia's President Toomas Hendrik Ilves on Twitter. Undeterred, on July 1, he wrote, "the best the defenders of orthodoxy can do is to point to a couple of small Baltic nations that have seen partial recoveries from Depression-level slumps, but are still far poorer than they were before the crisis." On one rare occasion, Krugman partially admitted a positive effect from austerity: "yes, it's actually worth noting that essentially nobody has managed to regain the confidence of the markets [through austerity], except for, you know, Latvia, which had almost no debt." Well, if you pursue austerity, you do escape debt.
The most generous explanation for Krugman's Baltic blind spot is that he thinks mostly about big states, and perhaps only about the United States. Small, open economies work quite differently. Tiny countries tend to adopt a foreign currency or peg their exchange rates, as the Baltic countries and Bulgaria have done. They cannot allow themselves large budget deficits, because the markets will not allow them as high levels of public debt as the likes of Japan or the United States. Their bond yields will rise at even moderate debt levels, as Slovenia, Cyprus, and Spain have discovered. Another way to look at it is that even when Krugman writes about European economic policy, he is actually only making arguments for what he believes the United States should do.
Citizens of the Baltic countries can be grateful that their leaders never listened to Krugman. He advocated devaluation when it proved unnecessary and probably would have been harmful. He has persistently argued for less austerity and more fiscal stimulus everywhere, blatantly disregarding the need for public debt to be sustainable. And the benefits of fiscal stimulus remain dubious, while the drawbacks—excessive budget deficits have forced several countries to accept international bailouts to escape default—are clear for all to see.
Krugman praises the fiscally irresponsible and scolds the virtuous, denigrating the Baltic achievements while trying to explain away miserable failures, such as Greece. Doesn't he see that his advice would only aggravate these crises, while the opposite policies resolve them? How can anybody be so wrong for so long without feeling at least a little bit ashamed?
Policy Brief 11-9: Lessons from the East European Financial Crisis, 2008-10 June 2011
Book: How Latvia Came through the Financial Crisis May 2011
Book: The Last Shall Be the First: The East European Financial Crisis October 2010
Paper: Proposals for Ukraine: 2010—Time For Reforms February 2010
Book: The Russia Balance Sheet April 2009
Book: How Ukraine Became a Market Economy and Democracy March 2009
Working Paper 06-5: The Eurasian Growth Paradox June 2006