Lessons from the Lessons from the East European East European Financial CrisisFinancial Crisis

Anders ÅslundAnders ÅslundSenior Fellow, Senior Fellow,

Peterson Institute for International Economics, Peterson Institute for International Economics, Washington, DCWashington, DC

ThesesTheses1.1. Sharp output falls: Sharp output falls:

Caused by liquidity Caused by liquidity freezefreeze

2.2. Devaluation: No Devaluation: No salvationsalvation

3.3. Radical Crisis Radical Crisis ResolutionResolution

4.4. Good politicsGood politics5.5. Early & decent Early & decent

growthgrowth

1. Causes of Crisis1. Causes of CrisisMassive overheating with large Massive overheating with large

current account deficitscurrent account deficitsFollowed by “sudden stops”Followed by “sudden stops”Which caused large falls in GDP, Which caused large falls in GDP,

Latvia 25%, Est 20%, Lith 18% Latvia 25%, Est 20%, Lith 18% Led to large budget deficitsLed to large budget deficitsAusterity did not cause output falls, Austerity did not cause output falls,

but was a consequencebut was a consequence

GDP Growth 2007 & 2009GDP Growth 2007 & 2009(Percent)(Percent)

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

2. Why Devalue?2. Why Devalue?

Paul Krugman: “Latvia is the new Paul Krugman: “Latvia is the new Argentina.”Argentina.”• Latvia’s competitiveness had Latvia’s competitiveness had fallen too sharplyfallen too sharply• Internal devaluation was Internal devaluation was politically impossiblepolitically impossible• Latvia needed stimulusLatvia needed stimulus

Why Devalue? (2)Why Devalue? (2)

• Danger of deflationary cycleDanger of deflationary cycle• Latvia did not deserve helpLatvia did not deserve help• “ “Latvia doesn’t produce much Latvia doesn’t produce much to export”to export”• Roubini: “devaluation seems Roubini: “devaluation seems unavoidable”unavoidable”

But Devaluation Was RiskyBut Devaluation Was Risky• Devaluation could have been Devaluation could have been uncontrollably large (Belarus)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 Bank system could have collapsed (Ukraine)(Ukraine)• Mass bankruptciesMass bankruptcies• Real foreign debt would have doubled Real foreign debt would have doubled

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

3. Crisis Resolution3. Crisis Resolution•Early and Early and comprehensive fiscal comprehensive fiscal adjustmentadjustment

•IMF & EU program in IMF & EU program in Hungary, Latvia & Hungary, Latvia & RomaniaRomania

Substantial Fiscal AdjustmentsSubstantial Fiscal AdjustmentsBalts: Public adjustment of 9% of Balts: Public adjustment of 9% of

GDP in 2009GDP in 2009Latvia sacked 30% of public Latvia sacked 30% of public

employees employees Closed half state agenciesClosed half state agenciesReduced public salaries by 26% in Reduced public salaries by 26% in

one yearone year

Major Public Sector ReformsMajor Public Sector Reforms Public administration trimmedPublic administration trimmedEducation reforms – more Education reforms – more

efficiencyefficiencyHealth care reforms - sameHealth care reforms - sameAlas pension reforms reversed to Alas pension reforms reversed to

save the poorsave the poor

Maastricht Criteria More Maastricht Criteria More Respected in East Respected in East

Average public debt in 10 CEE Average public debt in 10 CEE 39% of GDP in 2010, but 85% of 39% of GDP in 2010, but 85% of GDP in eurozoneGDP in eurozone

Only Hungary has exceeded the Only Hungary has exceeded the Maastricht debt ceiling, but 12 of Maastricht debt ceiling, but 12 of 14 Western EMU members14 Western EMU members

Sharp Improvement in Current Account Sharp Improvement in Current Account 2007-2009 (P2007-2009 (Percent of GDP)ercent of GDP)

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

4. Good Politics4. Good Politics1.1. Severe crises bred actionSevere crises bred action2.2. Origin of crisis externalOrigin of crisis external3.3. Small countries more vulnerableSmall countries more vulnerable4.4. Prior great economic successPrior great economic success5.5. Credible culprits: oligarchsCredible culprits: oligarchs6.6. Free market ideologyFree market ideology7.7. New leadersNew leaders8.8. Political instabilityPolitical instability9.9. Parliamentary support Parliamentary support 10.10.Expert policymakersExpert policymakers

4. Good Politics (2)4. Good Politics (2)11.11. Comprehensive crisis programComprehensive crisis program12.12. Front-loaded measures Front-loaded measures 13.13. More expenditure cuts than tax More expenditure cuts than tax

increasesincreases14.14. Social compactSocial compact15.15. Equity Equity 16.16. International support & sufficient International support & sufficient

financefinance17.17. Domestic ownershipDomestic ownership18.18. Early and decisive implementationEarly and decisive implementation19.19. Good salesmanship and transparencyGood salesmanship and transparency20.20. Policy reviewPolicy review

7 Conclusions7 Conclusions1.1. No country changed exchange No country changed exchange

rate policy: Internal devaluation is rate policy: Internal devaluation is possible and effectivepossible and effective

2.2. Goal of euro accession is Goal of euro accession is valuable: Maastricht criteria more valuable: Maastricht criteria more respected outside the eurozonerespected outside the eurozone

3.3. Substantial, early fiscal Substantial, early fiscal adjustments preferableadjustments preferable

7 Conclusions7 Conclusions

Renewed growth, good but lowerRenewed growth, good but lower

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

European Convergence ProceedsEuropean Convergence ProceedsGDP in PPP as % of EU AverageGDP in PPP as % of EU Average