Austerity in small places

Daniel Gros, Director of the Center for European Policy Studies, discusses how austerity affects small countries

Interest in small countries’ economic 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% 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 current-account 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% 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% below its pre-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 (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 US 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% above potential at the peak of the boom, then fell to 10% 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 sizeable 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% 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 2008-2009, 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/GDP ratio now stands at 100%, compared to only 42% 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.

The opinions expressed here are those of the author, not necessarily those of the World Economic Forum. Published in collaboration with Project Syndicate.

Author: Daniel Gros is Director of the Center for European Policy Studies

Image: A money counter counts Lats banknotes in Latvia REUTERS/Ints Kalnins