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

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

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

GDP Growth 2007 & 2009 (Percent)

Crisis bred budget deficits (percent of GDP)

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

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

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

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

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

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

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

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

Sharp Improvement in Current Account (P ercent of GDP)

Public debt remains limited, 2010 (percent of GDP)

4. Good Politics 1.Severe crises bred action 2.Origin of crisis external 3.Small countries more vulnerable 4.Prior great economic success 5.Credible culprits: oligarchs 6.Free market ideology 7.New leaders 8.Political instability 9.Parliamentary support 10.Expert policymakers

4. Good Politics (2) 11. Comprehensive crisis program 12. Front-loaded measures 13. More expenditure cuts than tax increases 14. Social compact 15. Equity 16. International support & sufficient finance 17. Domestic ownership 18. Early and decisive implementation 19. Good salesmanship and transparency 20. Policy review

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

7 Conclusions 7 Conclusions 4.Better to cut public expenditures than to raise taxes: Drives public sector reforms 5.Strange myth that democracies cannot cut public expenditures 6.International rescue should be large and front-loaded 7.Growth has returned fast but is likely to stay lower than before

Renewed growth, good but lower

Total GDP Growth, (percent change)

European Convergence Proceeds GDP in PPP as % of EU Average