The Eurozone continues to go from bad to worse. Greece may be on its way out. Spain wants a bank bail-out. Italy may be next up for a plunge in investor confidence. Even Germany risks fiscal disaster as it burdens its debt rating with seemingly endless bail-outs of its profligate neighbors.
As “old” Europe sinks, “new” Europe threatens to capsize. Investor confidence in Eastern Europe is down, along with bank lending and foreign direct investment. The European Bank for Reconstruction and Development is warning about credit risks. There is talk of “contagion” if the Eurozone cracks.
Never mind the political problems afflicting several of the former Soviet republics. The economic situation is enough to challenge the region’s stability.
Buried amongst this depressing cascade of impending catastrophe is some good news. The Baltic States have demonstrated the art of economic reform.
They were perhaps the most successful of the former Soviet republics—all three were early entrants to both the European Union and NATO. However, for a time their fate suggested the greater the success, the bigger the fall. All suffered along with the world economy. But they rebounded while demonstrating that there is an alternative to trying to solve a debt crisis by piling up more debt.
Lithuania has the largest economy of the three Baltic States. It suffered significantly from the financial crisis, with a substantial GDP drop in 2008 and 2009. Its economic slowdown was less severe than its neighbors and its rebound was quicker, with economic growth of 1.4 percent in 2010.
Although public debt rose, it remained low as a share of GDP compared to the rest of Europe. Moreover, the IMF lauded Vilnius for reducing its fiscal deficit, “reflecting mainly expenditure restraint.” For instance, the government cut wages and social benefits, causing total spending to fall even with higher debt service payments. IMF adviser Christoph Rosenberg suggested that Lithuania’s “delayed (and smaller) boom may now make it easier to regain competitiveness.”
Estonia found itself with a shrinking economy in the late 2000s. Per capita GDP fell by a fifth from 2007 to 2010. Rather than borrow money to lavish on a “stimulus” program, the government emphasized fiscal responsibility. Spending was restrained, debts did not balloon. The government imposed a modest increase in the Value-Added Tax but not in the (flat) income tax, which has a greater incentive effect on work and productivity.
Last year Estonia’s per capita GDP jumped 17.3 percent. Economists forecast that Estonia’s economy will be back at its 2008 level this year, continuing a dramatic recovery despite the chaos elsewhere in Europe. In fact, the government intends to lower the income tax rate in 2015, which should further boost growth.
Latvia has had a similar experience. It enjoyed an average economic growth rate of ten percent a year from 2005 to 2007, but suffered a crash in 2008 when economic output dropped ten percent. The decline continued the following year. Olivier Blanchard, the IMF’s chief economist, said he feared “disaster” when Riga insisted on maintaining its currency peg in preparation for adopting the Euro.
However, Latvia played to its strengths. It had low public debt and cut public sector wages when the crunch hit. Its labor market exhibited more flexibility than that elsewhere in Europe. And, noted Blanchard, “There was support for fiscal consolidation, and the acceptance of pain.” Latvia’s economy now is one of the fastest growing in the EU. Indeed, its first quarter growth of 6.9 percent over the previous year was the fastest in Europe.
Latvia enjoyed not just economic success but relative social peace. Economist Dani Rodrik observed: “To an outsider what is the most striking aspect of the Latvian experience is the relative absence of political conflict and social strife during what must have been a catastrophic economic crisis.”
The Baltic States offer obvious lessons for the rest of Europe and especially their supposedly more mature neighbors. Don’t run up big debts. It’s a lot easier to manage when things go bad.
Don’t engage in an orgy of “stimulus” spending. That will run up big debts without generating long-term growth. Don’t engage in political war to sustain the unsustainable. When budgets eventually are cut, as they will have to be, the political pain will be greater.
Make tough decisions early. “The Baltic experience shows that speed is of the essence when it comes to fiscal consolidation,” argued Jorg Asmussen, an Executive Board member of the European Central Bank.
Finally, stick with a commitment to fiscal responsibility. Otherwise any progress will be temporary at best. Explained Latvian Prime Minister Faldis Dombrovskis: “Restoration of financial stability is a precondition for economic growth, because once you restore financial stability, banks start lending, people stop worrying, businesses stop worrying, capital is not fleeing the country, probably capital is starting to flow into the country again.” Growth will be the natural result.
If only the other EU nations can learn the Baltic lesson before it is too late.