The Last Shall Be the First: The East European Financial Crisis, Anders Åslund Senior Fellow Peterson Institute for International Economics, Washington, DC

Queries  Causes of crisis?  To devalue or not?  Outcome?  Political economy?  Outlook?

Causes of the Crisis  Loose Monetary policy of the US Fed and ECB  Excessive capital inflows (carry trade)  Excessive credit expansion  Real estate bubble  Rising inflation  Current account deficit  Currency mismatches But decent public finances and little leverage

Percent Change Credit Expansion,

Inflation in 2008 (average consumer prices, percent change)

Current Account Deficit, 2007, 2009, (Percent of GDP) Source: World Economic Outlook, IMF, (accessed on March 24, 2011) *2010 figures based on IMF estimates

Foreign Debt, end 2009 (percent of GDP)

Currency Mismatches: Share of Foreign Currency Loans, 2007 (percent of total loans)

Big GDP Fall in Baltics in 2009 (percent annual growth)

Issues  Overheating followed by “sudden stop”  Large falls in GDP: Latvia 25%  Caused big budget deficits  Large current account deficits Needed: Liquidity, budget cuts & competitiveness

To Devalue or Not? No! No country changed exchange rate policy:  Slovenia & Slovakia: euro  Poland, Czech, Hungary & Romania – floating  Baltics & Bulgaria - fixed

Holding the Peg  Bank system survived & govt did not have to recapitalize it  Bankruptcies avoided  Great integration renders devaluation ineffective

Internal Devaluation: A crisis is a terrible thing to waste  Major fiscal adjustment 10% in 2009 in Baltic countries  Reduced public salaries & staff  Closed state agencies  Closed schools & hospitals Lean & efficient public sector

Alternative: Devaluation  Advantage: Earlier recovery through exports  Disadvantages: Bank system collapse Bank system collapse Oligarchs/big exporters would have gained wealth and power Oligarchs/big exporters would have gained wealth and power Less reforms Less reforms

Conclusion  Ultimate problem: Loose monetary policy of US Fed and ECB  No exchange rate regime could salvage these open and attractive economies  No country changed exchange rate regime as no evident advantage

Poor Macroeconomics Poor Macroeconomics Paul Krugman: “Latvia is the new Argentina.” ! Devaluation was neither necessary nor inevitable in the Baltics...

Outcome (1)  Unit labor costs fell sharply  Flat income tax and low corporate taxes survived  Current account turned around to big surplus in 2009  No deflationary cycle  Return to growth sooner than expected

Outcome (2)  Minimal bank collapses  All foreign-owned banks survived

Inflation and Gross Wages: up and down,

Crisis bred budget deficits (percent of GDP)

Public debt remains limited (percent of GDP)

Apart from in Hungary & Poland, end 2010 (percent of GDP)

Political Economy  People have demanded realistic, radical crisis resolution  Minimal social unrest  Cuts of 10% of GDP (Baltics) politically easier than 2% of GDP  Strange myth that democracies cannot cut public expenditures:

Political Economy 2  Radical, early adjustment preferable  Better to cut expenditures than raise taxes  Equity is important

Political Economy 3  8 of 10 countries have changed government during the crisis  9 of 10 countries have center- right governments – center right stronger than ever  Multi-party coalitions most effective in crisis

International Assistance 1.International liquidity crucial: missing first because ECB was passive 2.Large early international assistance vital 3.New cooperation IMF-EU worked well 4.EU grants important: 4-7% of GDP

Outlook  Main concerns: reversed pension reforms and rising inflation  Trimmed public sectors: Expenditure cuts rather than higher taxes  Eastern Europe has gained efficiency and self-confidence: European convergence continues The Last Shall Be the First

(percent change) Inflation: Threat again

Total GDP Growth, (percent change)

European Convergence GDP in PPP as % of EU Average