What Can the Baltic States Learn from the Economic Crisis and Recovery?

By Vytautas Kuokštisis, postdoctoral fellow at Vilnius University | 1 June 2015

To quote this document: Vytautas Kuokštisis, postdoctoral fellow at Vilnius University, “What Can the Baltic States Learn from the Economic Crisis and Recovery?”, Nouvelle Europe [en ligne], Monday 1 June 2015, http://www.nouvelle-europe.eu/node/1907, displayed on 27 April 2017

The Baltic countries were one of the worst hit countries during the Great Recession. Despite numerous predictions about the likely failure of their anti-crisis policy – internal devaluation – the Baltic States have managed to preserve currency pegs, restore fiscal sustainability and return to economic growth. Nevertheless, this fast adjustment should not be taken for granted in the future. The crisis experience speaks to the importance of fiscal policy, trust in government, and safeguarding against excessive indebtedness.

Crisis in the Baltics: a deep contraction and a fast recovery

During the Great Recession, the Baltic States went through a very sharp economic contraction, with their real GDP falling by double digits in 2009. At the time, many foreign analysts, economists and financial market participants were of the opinion that the Baltic States were going to end up like Argentina back in the early 2000s [i]. They pointed to huge macroeconomic vulnerabilities that the Baltic trio had amassed as reflected in massive pre-crisis current account deficits. The prevailing wisdom was that the Baltic countries would find it extremely hard (if not impossible) to implement their chosen anti-crisis policy, namely internal devaluation, which entailed rapid fiscal consolidation and preservation of the fixed exchange rate pegs.

While the economic pain was indeed severe, the Baltic countries managed to defy those expectations and saw growth return fairly quickly. They have lately been amongst the fastest growing countries in the EU (see Figure 1 which also includes selected other small European countries that also faced a severe crisis). While unemployment shot up dramatically during the downturn, it has been gradually falling since 2011, especially in Estonia (see Figure 2). They also managed to restore fiscal sustainability and escaped a currency crisis (in the form of abandoning the peg). As a result, some have even pointed to them as successful models for other countries (notably the Southern Eurozone members). With several years of hindsight, what lessons could be drawn from the experience pertaining to the crisis and the subsequent recovery? What actions should be undertaken by Baltic policy-makers to avoid facing similar challenges in the future?

Figure 1. Real GDP developments in the Baltic States and several other selected small European countries. 2010=100. Source: Eurostat.

Figure 2. Unemployment rate in the Baltic countries, in percentage. Source: Eurostat.

The importance of fiscal discipline and the role of trust

The first lesson for the Baltic countries is to stick to fiscal discipline. More specifically, this is a lesson for Latvians and Lithuanians. And they could do much worse than simply look at the Estonian example. As can be seen in Figure 2, prior to the crisis, Estonians had fiscal surpluses and built up a reserve which they drew upon in time of distress. In contrast, Lithuanians and Latvians were forced to borrow at a time when borrowing was extremely costly (Lithuania turned to the bond market) or came with many strings attached (Latvia applied for international financial assistance).

Figure 3. General government deficits/surpluses in the Baltic States, in percentage of GDP. Source: Eurostat.

What is particularly interesting about the divergence between Estonia on the one hand and Latvia and Lithuania on the other, however, is the fact that the difference in budgetary performance during the crisis cannot be attributed solely to the pre-crisis reserve. An important additional factor was that tax revenue in Estonia fell significantly less than it did in Latvia and Lithuania during the crisis, resulting in a rapid jump in the fiscal deficit in the latter two in 2009-2010 (Figure 2). Furthermore, this difference cannot be explained merely by tax policy or economic structure changes, but could instead be related to the different developments in shadow economy[ii]. In turn, this difference in shadow economy can be explained by different levels of trust in political institutions[iii]. Latvians and Lithuanians mistrusted political institutions, which resulted in lower willingness to pay taxes and to support the provision of public goods[iv]. Thus, the implication is to work on the relationship between the state and society in Latvia and Lithuania. If not, the danger is that a vicious cycle might develop where low trust results in bad performance, which in turn fuels dissatisfaction and lower readiness to pay taxes.

The dangers of excessive debt

While the fiscal dimension is undoubtedly important, one must also remember that, despite Estonia’s prudence, it did not escape the full brunt of the crisis. In fact, its real peak-to-trough GDP loss (17.3 percent) surpassed Lithuania’s (14.8 percent). This is explained by the fact that what mattered most to the accumulation of pre-crisis vulnerabilities was private sector borrowing fuelled by huge capital inflows. This argument is also corroborated by the experience of the Southern Eurozone countries where (with the clear exception of Greece) it is hard to name fiscal irresponsibility as the major culprit of the pre-crisis imbalances[v]. Thus, the policy implication is that one should put much more emphasis on the prevention of the formation of imbalances in the form of credit and asset price bubbles, real exchange overvaluation, and big current account deficits resulting in the growth of external debt.

One promising area lies in the macro-prudential regulation field where authorities could play a more active role in safeguarding against the build-up of such imbalances[vi]. Before the crisis, there was more skepticism about the desirability of the government’s intervention to prevent excessive indebtedness and credit bubbles. The prevailing consensus seems to be changing, however, as authorities have been called upon to intervene more actively in this area. It should be noted that excessive capital inflows leading to bubbles and macroeconomic imbalances are particularly dangerous for countries with fixed exchange rates (as well as countries in the eurozone). First, the currency peg might encourage the development of imbalances in the first place by establishing macroeconomic stability leading to positive expectations which can turn into excessive optimism. Second, the fixed exchange rate policy does not allow for currency devaluation and monetary stimulus in times of crisis, which means that a potentially important policy tool is unavailable. Instead, they need to rely on so-called internal devaluation where falling prices and wages add to higher competitiveness.

Why were the Baltic countries able to implement internal devaluation?

It is generally assumed that such a policy takes a long time to restore competitiveness due to nominal wage rigidity (it is hard to cut wages) which leads to a longer period of unemployment and all the associated political and social costs. Instead, a currency devaluation is expected to immediately make exports competitive. Thus, while it is true that many foreign analysts were wrong in casting overly pessimistic predictions on the Baltic strategy, they were not off the mark based on theoretical and historical experience. As a matter of fact, history shows that the kinds of trouble which the Baltic countries had found themselves in are indeed very difficult to overcome without abandoning the currency peg. Several factors enabled the Baltic countries to become an exception to this general trend. First, Baltic economies are very flexible (which means that wages can be cut relatively quickly). On the political side, one of the factors giving rise to this flexibility was the weakness of trade unions. Furthermore, due to the general structural and ideational weakness of the political Left, the Baltic countries have adhered to a very liberal economic regime. Besides, the Baltic countries had a very strong domestic consensus for the need to avoid currency devaluation at all costs. Interestingly, on all of these dimensions the contemporary Baltic political-economic regimes bear a striking resemblance to the Classical Gold Standard Regime of the late 19th – early 20th century[vii].

Last but not least, one should also mention that – rather unexpectedly – the Baltic adjustment (increase in competitiveness) was based more on a productivity jump rather than wage reduction[viii]. Of course, it is much more desirable to restore competitiveness via productivity growth rather than via wage reductions. First, it is much easier politically and socially. Second, wage cuts tend to contribute to deflation and lower aggregate demand. The former in turn adds to the real debt burden, while the latter further contributes to the growth of unemployment. The more productivity increases, the less wages need to fall. The problem is, however, that generally productivity growth is expected to only increase in the medium to long-run. Nevertheless, Baltic businesses were able to increase efficiency and reorient themselves towards exports.

Conclusion

The most important conclusion for Baltic countries could be formulated in this way: do not take the relatively successful episode of adjustment for granted. The adjustment was the result of a fairly unique set of economic, political and social conditions. If those conditions disappear or weaken with time, the Baltic countries will have an even harder time in dealing with the sort of challenges that they faced during the Great Recession. After all, one should remember that the Classical Gold Standard System stopped working successfully after the First World War as a result of changes in its economic, political and social preconditions[ix]. Therefore, it is important to invest serious thought into how to prevent the accumulation of such imbalances in the first place, especially since all three Baltic countries have now joined the Eurozone and completely relinquished the option of monetary independence.


[i]See, for instance, Roubini on the comparison between Latvia and Argentina: Nouriel Roubini, Latvia’s currency crisis is a rerun of Argentina’s, June 10, 2009, FT.com http://www.ft.com/intl/cms/s/0/95df08fe-55f3-11de-ab7e-00144feabdc0.html

[ii]Vytautas Kuokštis, „Cooperating Estonians and „exiting“ Lithuanians: trust in times of crisis“, Post-Soviet Affairs, published online,2015, 1-19.

[iii]Ibid.

[iv] It has been demonstrated in the literature that trust in government has a positive influence on ‘tax morale’ – i.e. intrinsic motivation to comply with the tax laws. See, for instance, Benno Torgler, “Tax Morale, Rule-Governed Behaviour and Trust”, Constitutional Political Economy, 14(2), 2013: 119-140.

[v]Alison Johnston, Bob Hancké, and Suman Pant, “Comparative Institutional Advantage in the European Sovereign Debt Crisis”, Comparative Political Studies, published online, 2014: 1-30.

[vi]As was put by the Economist, macroprudential regulations are “targeted rules to reduce instability across the financial system”: The Economist, “What macroprudential regulation is, and why it matters”, August 4, 2014, http://www.economist.com/blogs/economist-explains/2014/08/economist-explains-1

[vii]Vytautas Kuokštis, “Searching for Historical Analogies in Political Economy: The Baltic States and the Gold Standard Regime”, forthcoming in Journal of Baltic Studies, draft text version available at: https://vu-lt.academia.edu/VytautasKuokstis

[viii] As noted by Blanchard et al. in Latvia‘s case: Olivier Blanchard, Mark Griffiths, and Bertrand Gruss, “Boom, Bust, Recovery: Forensics of the Latvia Crisis”, Brooking Papers on Economic Activity, Fall 2013: 325-388.

[ix] Barry Eichengreen, Globalizing Capital: A History of the International Monetary System. Princeton, N.J.: Princeton University Press, 1996.

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