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