Austerity in small places

Interest in small countries’ economic China Daily, Feb. 8

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 percent 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 currentaccount

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 percent

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 percent below its

pre-crisis peak; after all, no country can

run a current-account deficit of 25 percent

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 U.S. 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 percent

above potential at the peak of the

boom, then fell to 10 percent 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 sizable

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 percent

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 2008-9, 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-to-

GDP ratio now stands at 100 percent, compared

to only 42 percent 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.

Copyright: Project Syndicate, 20

*The author is director of the Center for European Policy Studies.

By Daniel Gros