Lessons from the East European Financial Crisis

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Lessons from the East European Financial Crisis

• Anders Åslund
• Senior Fellow,
• Peterson Institute for International Economics,
  Washington, DC

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Theses

1. Sharp output falls Caused by liquidity freeze
2. Devaluation No salvation
3. Radical Crisis Resolution
4. Good politics
5. Early decent growth

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1. Causes of Crisis

• Massive overheating with large current account
  deficits
• Followed by sudden stops
• Which caused large falls in GDP, Latvia 25, Est
  20, Lith 18
• Led to large budget deficits
• Austerity did not cause output falls, but was a
  consequence

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GDP Growth 2007 2009(Percent)
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Crisis bred budget deficits 2009-11
(percent of GDP)
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2. Why Devalue?

• Paul Krugman Latvia is the new Argentina.
• Latvias competitiveness had fallen too sharply
• Internal devaluation was politically impossible
• Latvia needed stimulus

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Why Devalue? (2)

• Danger of deflationary cycle
• Latvia did not deserve help
• Latvia doesnt produce much to export
• Roubini devaluation seems unavoidable

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But Devaluation Was Risky

• Devaluation could have been uncontrollably large
  (Belarus)
• Led to wild inflation (Belarus)
• Less reform pressure (Ukraine)
• Bank system could have collapsed (Ukraine)
• Mass bankruptcies
• Real foreign debt would have doubled

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Conclusion on Devaluation

• No exchange rate regime could have salvaged the
  open Latvian economy
• Fixed exchange rate saved Latvia from collapse
  of bank system, mass bankruptcies and doubling of
  foreign debt
• It facilitated vital structural reforms
• Latvia ready for euro adoption 2014

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3. Crisis Resolution

• Early and comprehensive fiscal adjustment
• IMF EU program in Hungary, Latvia Romania

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Substantial Fiscal Adjustments

• Balts Public adjustment of 9 of GDP in 2009
• Latvia sacked 30 of public employees
• Closed half state agencies
• Reduced public salaries by 26 in one year

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Major Public Sector Reforms

• Public administration trimmed
• Education reforms more efficiency
• Health care reforms - same
• Alas pension reforms reversed to save the poor

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Maastricht Criteria More Respected in East

• Average public debt in 10 CEE 39 of GDP in 2010,
  but 85 of GDP in eurozone
• Only Hungary has exceeded the Maastricht debt
  ceiling, but 12 of 14 Western EMU members

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Sharp Improvement in Current Account 2007-2009
(Percent of GDP)
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Public debt remains limited, 2010
(percent of GDP)
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4. Good Politics

• Severe crises bred action
• Origin of crisis external
• Small countries more vulnerable
• Prior great economic success
• Credible culprits oligarchs
• Free market ideology
• New leaders
• Political instability
• Parliamentary support
• Expert policymakers

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4. Good Politics (2)

1. Comprehensive crisis program
2. Front-loaded measures
3. More expenditure cuts than tax increases
4. Social compact
5. Equity
6. International support sufficient finance
7. Domestic ownership
8. Early and decisive implementation
9. Good salesmanship and transparency
10. Policy review

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7 Conclusions

1. No country changed exchange rate policy Internal
   devaluation is possible and effective
2. Goal of euro accession is valuable Maastricht
   criteria more respected outside the eurozone
3. Substantial, early fiscal adjustments preferable

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7 Conclusions

1. Better to cut public expenditures than to raise
   taxes Drives public sector reforms
2. Strange myth that democracies cannot cut public
   expenditures
3. International rescue should be large and
   front-loaded
4. Growth has returned fast but is likely to stay
   lower than before

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Renewed growth, good but lower
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Total GDP Growth, 2000-2010
(percent change)
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European Convergence ProceedsGDP in PPP as of
EU Average
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