Can austerity bring growth?

Rainer Kattel and Ringa Raudla, guest bloggers

European crisis resolution seems to rest on one hope: austerity can bring growth. History and most of economic theory seems to suggest that this is not possible. The Baltics peg to differ. Or so it seems. During the 2008-2010 crisis the Baltic economies of Estonia, Latvia and Lithuania experienced peak-to-trough reductions in GDP as high as 20%, 25% and 17% respectively. Governments decided to stick to currency pegs and opt for austerity and internal devaluation by cutting government expenditure in 2009 around 8-9% and additional 3-4% (of GDP) in 2010. By 2011, all Baltic economies were growing again, real GDP growth, driven by rapid recovery in exports, topping European charts with 7.6% (Estonia), 5.5% (Latvia) and 5.9% (Lithuania). Based on our forthcoming paper, “The Baltic States and the Crisis of 2008-2010”, we discuss in what follows whether in fact the Baltic internal devaluation worked and, more importantly, whether it can be replicated anywhere else, Europe or elsewhere. All data comes from our paper, where the reader can also find detailed references.

Since regaining independence, the Baltic countries have stood out among the transition countries in the Central and Eastern Europe as radical pro-market reformers. In early 1990s, all three countries adopted a mix of policies advocated by the Washington consensus: currency boards with fixed pegs (acting as nominal anchors for securing stabilization), fiscal discipline, liberalization of prices and trade, and wide-ranging privatization. Indeed, in many ways they became neoliberal transition icons with thin governments, high penetration of internet and very open economies. After accession to the EU, all three economies witnessed an unprecedented boom; between 2004 and 2007, the Baltic countries stood out among the EU countries for their high growth rates: the average annual growth rates for this period were 10.3% in Latvia, 8.5% in Estonia and 8.2% in Lithuania. These remarkable growth rates were, however, accompanied by signs of overheating, like double-digit inflation, a housing boom, rapidly appreciating real exchange rates, accelerating wage growth (that exceeded productivity growth, especially in Latvia and Estonia, to a lesser extent in Lithuania), a fast accumulation of net foreign liabilities and soaring current account deficits. To a significant extent, the growth was fuelled by cheap credits (available through foreign-owned banks), which drove up domestic demand, and were channeled into real estate, construction, financial services and private consumption. All three economies were rapidly building up debt towards rest of the world. Thus, during the last boom year, 2007, the current account deficits exceeded 20% of GDP in Latvia and 15% in Estonia and Lithuania.

The crisis hit all Baltic countries quickly and painfully. The domestic bubbles burst in early 2008 (when the credit supply decelerated, as the banks started tightening credit conditions) and the downturn was further exacerbated by negative developments in the external economic environment after the Lehman Brothers’ bankruptcy. In 2009 the GDP fell by 14.3% in Estonia, 14.8% in Lithuania and 17.7% in Latvia. Following massive drops in both domestic demand and exports, unemployment figures soared, rising most rapidly in Latvia (from the lowest level of 5.3% to 20.5%, making it the largest increase in the EU), but closely followed by Estonia (from 4.1% to 19.8%) and Lithuania (from 4.5% to 18.3%). In all three countries, the unemployment rates were almost 4 times higher at the end of 2009 than they had been in 2007.

In response to the crisis, the Baltic countries all opted for internal devaluation (instead of external devaluation), which implied the downward adjustment of nominal wages throughout the economy and fiscal contraction (instead of counter-cyclical policy measures). The Baltic states’ governments were heavily objected to external devaluation of the domestic currencies for a number of reasons, ranging from practical to symbolic. Perhaps most importantly, nominal exchange rate adjustment would have precluded joining the eurozone as an exit strategy from the crisis. Furthermore, given that a large proportion of loans in these countries had been denominated in euros, external devaluation would have imposed large costs on significant parts of the population and reduced private sector net worth (and potentially led to a surge in loan defaults, with contagion effects to the rest of the economy). Importantly, none of the Baltic countries had had experience with alternative exchange rate regimes and hence no existing competencies to manage “non-automatic” systems, policy makers had indeed deeply internalize Washington Consensus policy prescriptions. Internal devaluation as an adjustment strategy was also supported by the European Union, who was afraid that devaluation of the Baltic currencies would cause havoc in the financial markets and, potentially, lead to spillovers to other Central and Eastern European countries, inducing capital flight from this region.

The choice of internal devaluation, in turn, implied the need for fiscal consolidation, which all three governments implemented in 2009 and 2010. All three countries relied also heavily on European Union structural support funding which exceeded in these years more than 4% of the GDP and still in 2012 EU’s funding makes up roughly 20% of government spending in Estonia.

The combination of the lack of public reserves and troubled domestic banks put Latvia in the most difficult situation of the three by the fall of 2008. Given the need to bail out the Parex Bank in the absence of fiscal reserves, the Latvian government had to ask for international support from the IMF, the EU and Nordic countries in November 2008. The package that was approved in December/January helped to avoid the spillover of the liquidity crisis to the other Baltic economies as well. In fact, Estonia was able to participate in this support action with 100 MEUR; this lent considerable political support both domestically and internationally to the Estonian government. Furthermore, the government reserves (around 9% of GDP) gave the Estonian government significantly more room in terms of building the case for fiscal retrenchment as international financial support with respective conditionalities was depicted as a loss of sovereignty: the politicians could argue that Estonia still needed to hold on to the accumulated reserves, in order to avoid a situation similar to Latvia’s, which in turn necessitated fiscal retrenchment, rather than spending the entire rainy-day fund. The lack of domestic banks also gave the Estonian government significantly more fiscal space as bailing out banks was ‘outsourced’ to the Swedish central bank. All Baltics thus averted banking crisis.

Estonia had a considerable advantage compared to the rest of the Baltics as it could unify all efforts behind one single goal: entrance into the euro zone. This option, and the added strain of election cycles, was not available anymore to Latvia and Lithuania, mainly because these countries did not fulfill the inflation criteria at the eve of the crisis, while the slowing growth was rapidly decreasing inflation in Estonia. More importantly, in Estonia’s case fulfilling deficit and debt criteria was rather realistic (Latvia had lost out on the deficit criteria with one single act: bailing out the Parex bank): it was feasible to fulfill all Maastricht criteria in 2009 and 2010 as the cuts started the earliest in Estonia and inflation was slowing because of the first signs of crisis. Lithuania had a much shorter window of opportunity for the eurozone entrance and it had negative experience from 2005 when Lithuania missed out on the eurozone entrance by 0.2% margin on the inflation criteria (calculation for which oddly includes also non-eurozone economies such as Sweden).

As Estonia’s next general elections were to be in 2011, and this gave the government also realistic hopes that with eurozone entrance it would be able to generate enough political capital domestically to survive the crisis. Thus, the initial conditions made it possible for Estonia to have a straightforward realistic goal how to deal with the crisis that the other two Baltic countries lacked.

With year 2009 the worst seems to have been over for the Baltics. The economies returned to growth and, in the second half of 2010 employment started picking up again. Exports followed a growth trend and current accounts turned into surplus. In the light of these developments, can we say that internal devaluation really worked?

In fact, a closer look shows that the current Baltic recovery has not resulted from the internal devaluation but rather from other factors not under the control of the Baltic governments. While many analysts hasten to call the internal devaluation successful, the downward adjustment of prices and wages in the Baltics was relatively modest – especially in the light of how overheated the economies had become by the end of the boom. None of the three countries actually experienced any significant deflation; in fact, in 2010 and 2011, inflation in all three countries resumed an upward trajectory. The reduction of real wages was from peak to trough about 15% in all countries. By the end of 2009, the real effective exchange rates had fallen by 3-5 percentage points from their boom-time peaks.

If not internal devaluations, then what is behind the Baltic recovery in 2011? There are two key factors: flexible labor markets and integration of export sectors into key European production networks. Flexible labor markets have had two consequences: first, persistently high unemployment, which did not lead to significantly higher social expenditure (automatic stabilizers are relatively unimportant as benefits are low and brief, and active labor market measures are financed largely by EU structural funds); second, while particularly in Lithuania emigration was high already before the crisis, the latter seems to have fastened emigration in all Baltic states (Lithuania’s and Latvia’s census in 2011 showed dramatic drop in population numbers; Estonia’s census data will come in later in 2012). As Baltic states are strongly ‘simple polities’, reflected, inter alia, in low levels of popular unrest and restrained civic dialogue, voice does not seem to be an option for many and thus exit becomes the preferred choice for a increasing number of people. However, both high unemployment and exit are forms of future costs in terms of future social issues and lack of workforce. Thus, while during the crisis the costs of external devaluation were argued to be higher than internal devaluation (or adjustment, as it is mostly referred to in Baltic debates), it remains to be seen whether this is really so given persistently high levels of unemployment and emigration.

Integration into European networks by few dozen leading exporters is another key factor explaining the Baltic recovery. This, however, has hardly anything to do with domestic conditions or policy actions, it is rather an increasingly important symptom of the Baltic blend of capitalism: enclave industries. It has been recognized for quite some time that one the key problems faced by Eastern European companies is the low embeddedness of foreign owned exporting companies, which is reflected in low level of linkages with domestic suppliers and partners, and with higher education and research institutions. For instance, one of the key electronics exporters from Estonia, Elcoteq, uses currently up to 200 suppliers, none of them are domestic. While Baltic exports have bounced back to the pre-crisis levels, the problem of linkages and feedbacks remains. In addition, the pre-crisis level of exports are by far not enough to make up for the lack of foreign financing that used to fuel Baltic growth in mid-2000s. In sum, while the crisis has hardened the Baltic neoliberal resolve, the responses to the crisis have not so far brought substantial changes to Baltic economic structure and consequently the underlying fragility remains unresolved. However, as the Baltic economies are very open and small, their recovery and future growth depends heavily also on European recovery. As the latter seems likely to be slow and sluggish for some years to come, it is also difficult to foresee that the Baltic economies will experience growth rates similar to mid-2000s any time soon.

In sum, almost all of the above-described factors make the Baltic cases unique and unreplicable in the EU context: first, most EU countries, especially in the troubled periphery, are already in the eurozone, so they cannot justify short-term austerity measures with eurozone entrance as an exit strategy from the crisis; second, very few EU countries have as weak civil societies as the Baltic countries and thus austerity breathes very visible unrest and instability; and third, few if any EU countries have such narrow and detached policy elites who have become accustomed to satisfy their European policy peers rather than domestic partners. Furthermore, there are a number of economic and structural factors that make the Baltics relatively unique. First, high levels of internationalization of the economy (both in exporting and financial sector); second, high dependence on larger neighboring economies (Scandinavia, Poland) in terms of trade and, in the case of Scandinavia, also of technology transfer. All these economies recovered quickly (Scandinavia) or did not experience almost any crisis at all (Poland). Thus, as Wolfgang Münchau argues, while the EU is more and more behaving as it was a small open economy where budget discipline is important for convincing the investors and markets, the experience of small open economies dealing best with such fiscal policies cannot be of almost any use to other troubled EU members.

Rainer Kattel is Professor and Director of the Department of Public Administration, and Ringa Raudla is a Senior Research Fellow, both at the Tallinn University of Technology, Estonia.