Lessons from the East European Financial Crisis

1. Lessons from the East European Financial Crisis Anders Åslund Senior Fellow, Peterson Institute for International Economics, Washington, DC

3. Theses Sharp output falls: Caused by liquidity freeze Devaluation: No salvation Radical Crisis Resolution Good politics Early & decent growth

4. 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

5. GDP Growth 2007 & 2009(Percent)

6. Crisis bred budget deficits 2009-11 (percent of GDP)

7. 2. Why Devalue? Paul Krugman: “Latvia is the new Argentina.” • Latvia’s competitiveness had fallen too sharply • Internal devaluation was politically impossible • Latvia needed stimulus

8. Why Devalue? (2) • Danger of deflationary cycle • Latvia did not deserve help • “Latvia doesn’t produce much to export” • Roubini: “devaluation seems unavoidable”

9. 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

10. 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

11. 3. Crisis Resolution • Early and comprehensive fiscal adjustment • IMF & EU program in Hungary, Latvia & Romania

12. 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

13. Major Public Sector Reforms Public administration trimmed Education reforms – more efficiency Health care reforms - same Alas pension reforms reversed to save the poor

14. 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

15. Sharp Improvement in Current Account 2007-2009 (Percent of GDP)

16. Public debt remains limited, 2010 (percent of GDP)

17. 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

18. 4. Good Politics (2) Comprehensive crisis program Front-loaded measures More expenditure cuts than tax increases Social compact Equity International support & sufficient finance Domestic ownership Early and decisive implementation Good salesmanship and transparency Policy review

19. 7 Conclusions No country changed exchange rate policy: Internal devaluation is possible and effective Goal of euro accession is valuable: Maastricht criteria more respected outside the eurozone Substantial, early fiscal adjustments preferable

20. 7 Conclusions Better to cut public expenditures than to raise taxes: Drives public sector reforms Strange myth that democracies cannot cut public expenditures International rescue should be large and front-loaded Growth has returned fast but is likely to stay lower than before

21. Renewed growth, good but lower

22. Total GDP Growth, 2000-2010 (percent change)

23. European Convergence ProceedsGDP in PPP as % of EU Average