Lessons learned in Baltic crisis

RIGA - The three Baltic States have done remarkably well in coming out of the global economic crisis, especially considering that they had the most overheated economies within the European Union just before the crash. They faced a nearly complete liquidity squeeze, which contributed to a total GDP fall of no less than 25 percent in Latvia and 17 percent in Estonia and Lithuania, writes Anders Aslund, senior fellow of the Peterson Institute for International Economics and author of the book ‘The Last Shall Be the First: The East European Financial Crisis,’ reports news agency LETA.

There were positive outcomes. These countries did not crumble. Social calm was maintained. Their democratic, parliamentary systems proved perfectly able to resolve the crises. Rather than devaluing, they pursued “internal devaluation,” a process which required the Baltic States to lower wages and increase worker productivity. Each carried out a fiscal adjustment of about one-tenth of GDP in 2009, mainly by slashing public expenditures and pursuing strategic reforms in public services. Latvia cut public wages by an average of 28 percent in one year. After two years, they have all returned to economic growth on the back of strong exports. Only Latvia required an international aid package, from mainly the IMF and the EU.

There are lessons to be learned from their experience.
First, a choir of international economists claimed that the Baltic currencies had to devalue, but none did. It is now clear that devaluation was neither necessary nor useful. They suffered from financial overheating because of excessive short-term capital inflows, while competitiveness was not all that poor. Their cure to overheating was to reduce capital inflows, which did not require devaluation. Moreover, the exchange rate parity forced the countries to undertake long-overdue structural reforms. The general lesson, says Aslund, is that depreciation is a much over-advertised cure in current macroeconomic discourse.

Second, the purported risk of a vicious, deflationary cycle was never real. For small and open economies such as the Baltics, prices are largely determined by the surrounding markets. Therefore the pass-through of inflation would be great, which means that devaluation would not have effectively enhanced the country’s competitiveness.

Third, the Baltic experience shows that both economically and politically it was better to cut public expenditures than to raise taxes. The most popular budget adjustments were salary and benefit cuts of senior civil servants and state enterprise managers as well as the reduction of public service positions.

Fourth, the countries have shown that their vibrant democracies were perfectly capable of cutting their public expenditures by about one-tenth of GDP in the first year of crisis. These large cuts facilitated structural reforms, and thus not only reduced the capacity but often improved the quality of public services.

The fifth lesson learned was from Latvia, which has gone through four government changes in the last three years, but it has not impeded - indeed it accelerated - the resolution of the financial crisis, which was delayed by a quarter from the anti-crisis program that had been adopted in December 2008. Many political scientists take for granted that political stability is good, but it is more important that a government is adequate than that it is stable; a pre-crisis government is rarely a suitable anti-crisis government. Latvia could quickly, through trial and error, form a responsive government.

The Baltic States show that advantages exist for sound macroeconomic policy when reforms of proportional elections lead to multi-party parliaments, coalition governments and leaders who can respond quickly in a time of crisis. The bottom line is that populism is not very popular in a serious crisis. The public understands the severity of the situation and wants a sensible and resolute government that can handle it as forcefully as necessary. Therefore, radical crisis resolution is likely to be a more successful political strategy in a time of economic trouble than populism, as shown by the victory of the Latvian government coalition in the parliamentary elections on Oct. 2, 2010, and of the center-right parties in Lithuania two years earlier.

The radical free-market government in Estonia sat safely throughout the crisis. Democracy has not impeded, but in fact has facilitated, crisis resolution. In this part of the world, free-market, center-right governments have never been stronger.
A final observation concerns the international macroeconomic discussion, which has been superficial and even harmful, indicating an intellectual and moral crisis. Whenever a crisis occurred, a choir of international economists claimed that it was “exactly” like some other recent one. Prominent economists led by The New York Times columnist Paul Krugman claimed that “Latvia is the new Argentina.” A fundamental problem is the inclination to accept a brief list of stylized facts, without bothering to take into account the most elementary facts, which distinguish one crisis from another.

Consequently, Estonia, Latvia and Lithuania can offer Greece and other crisis countries in the eurozone lessons of radical internal devaluation, because for the European and Monetary Union members of the EU, devaluation is not an option. Today, the Baltic crisis resolution exemplifies how it should be done: early, fast and surgically.