Interest in small countries’ economic policies is usuallyconfined to a small number of specialists. But there are times when smallcountries’ experiences are interpreted around the world as proof that a certainpolicy approach works best.
Nowadays, Greece, the Baltic states, and Iceland are often invoked to argue for or against austerity. Forexample, the Nobel laureate economist Paul Krugman argues that the fact thatLatvian 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, whichwas not subject to externally imposed austerity and devalued its currency,seems to be much better off. Others, however, have noted that Estonia pursuedstrict austerity in the wake of the crisis,avoided a financial crisis, and is now growing again vigorously, whereasGreece, which delayed its fiscal adjustment for too long, experienced a deepcrisis and remains mired in recession.
Both sides in these disputes usually omit to mention the key idiosyncratic characteristicsand specific starting conditions that can make direct comparisons meaningless.
For starters, Latvia, like the other Baltic states, wasrunning an enormous current-account deficit when the crisis started. Thisimplies that the pre-crisis level of GDP simply was not sustainable, as itrequired capital inflows in excess of 20% of GDP to finance outsize consumption and construction booms. Thus, whenthe inflows stopped at the onset of the financial crisis, it became inevitablethat GDP would contract by double-digit percentages. Seen in this light, it isnot at all surprising that Latvia’s GDP is now still more than 10% below itspre-crisis peak; after all, no country can run a current-account deficit of 25%of GDP forever.
Any comparison of the Baltics with the Great Depression (orthe United States today) is thus meaningless. The Baltics simply had to adjustto a sudden stop in external financing. That was not the problem of the USduring the 1930’s; nor is it America’s problem today.
A better way to judge post-crisis performance is to look atthe output gap – that is, actual GDP relative to potential GDP. Accordingto a European Commission estimate, Latvian GDP was almost 14% above potentialat the peak of the boom, then fell to 10% below potential when the boom wentbust. 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 keeprevenues roughly constant as a share of GDP, but a sizeable fiscal deficitemerged nonetheless as social-security expenditure, such as unemploymentbenefits, soared while demand and output collapsed. With a V-shaped recovery,however, this expenditure fell again, reducing the deficit rapidly. Therecovery could only be partial, because the previous level of output wasunsustainable, but it was enough to allow the government to balance its booksagain.
Thus, Latvia today enjoys a sustainable fiscal position,with output close to its potential and growing. Austerity might have worsenedthe slump temporarily, but it did deliver fiscal sustainability withoutpermanent damage to the economy. By contrast, output in Greece, which was slowto adopt austerity, is still 12% below its estimated potential and continues tofall.
Does Iceland constitute a counter-example to Latvia? Afterall, its GDP fell much less, although it ran similarly large current-accountdeficits before the crisis – and ran much larger fiscal deficits for longer. Incontrast to Latvia, Iceland let its currency, the krona, devalue massively.But, the devaluation was much less important than is widely assumed. Whileexports did indeed perform very well, Iceland’s main exports are naturalresources (fish and aluminum), demand for which held up well during thepost-2008 global crisis.
That sustained demand provided an important stabilizer forthe domestic economy, which the Baltic states did not have. Indeed, Latvia wasparticularly hard hit by the slump in global trade in 2008-2009, given itsdependence on exports. Iceland’s superior economic performance should thus notbe 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 childfor the claim that avoiding austerity works. In small, open economies, higherdeficits are unlikely to sustain domestic output, because most additionalexpenditure goes toward imports. So it is not surprising that, despite itslarge devaluation, Iceland continues to run a high current-account deficit,adding to its already-large foreign debt.
Moreover, Iceland’s public debt/GDP ratio now stands at100%, compared to only 42% in Latvia. Part of the difference, of course,reflects different starting conditions and the cost of bank rescues. But therecan be no doubt that, by keeping deficits under control, Latvia’s publicfinances 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 constrainfuture growth.
One must be careful when attempting to draw lessons fromthe experience of small countries that sometimes have very particularcharacteristics. The one conclusion that appears to hold generally is that shunning austerity does not allow one to avoid theproblem of achieving both fiscal and external sustainability.