the last shall be the first: the east european financial crisis, 2008-10 anders Åslund senior...

The Last Shall Be the First: The Last Shall Be the First: The East European The East European

Financial Crisis, 2008-10Financial Crisis, 2008-10

Anders ÅslundAnders ÅslundSenior FellowSenior Fellow

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

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

Causes of the CrisisCauses of the Crisis Loose Monetary policy of the US Fed and ECBLoose Monetary policy of the US Fed and ECB Excessive capital inflows (carry trade)Excessive capital inflows (carry trade) Excessive credit expansionExcessive credit expansion Real estate bubbleReal estate bubble Rising inflationRising inflation Current account deficitCurrent account deficit Currency mismatchesCurrency mismatches

But decent public finances and little leverageBut decent public finances and little leverage

Percent ChangePercent Change

Credit Expansion, 2000-2009 Credit Expansion, 2000-2009

Inflation in 2008Inflation in 2008(average consumer prices, percent change)(average consumer prices, percent change)

Current Account Deficit, 2007, 2009, Current Account Deficit, 2007, 2009, (Percent of GDP)(Percent of GDP)

Source: World Economic Outlook , IMF, (accessed on March 24, 2011)

*2010 figures based on IMF estimates

Foreign Debt, end 2009Foreign Debt, end 2009

(percent of GDP)(percent of GDP)

Currency Mismatches: Currency Mismatches: Share of Foreign Currency Loans, 2007Share of Foreign Currency Loans, 2007

(percent of total loans)(percent of total loans)

Big GDP Fall in Baltics in 2009Big GDP Fall in Baltics in 2009

(percent annual growth)(percent annual growth)

IssuesIssuesOverheating followed by “sudden Overheating followed by “sudden

stop” stop” Large falls in GDP: Latvia 25%Large falls in GDP: Latvia 25%Caused big budget deficitsCaused big budget deficitsLarge current account deficitsLarge current account deficits

Needed: Liquidity, budget cuts &Needed: Liquidity, budget cuts &

competitivenesscompetitiveness

To Devalue or Not? No!To Devalue or Not? No!

No country changed exchange No country changed exchange rate policy:rate policy:

Slovenia & Slovakia: euroSlovenia & Slovakia: euroPoland, Czech, Hungary & Poland, Czech, Hungary &

Romania – floatingRomania – floatingBaltics & Bulgaria - fixedBaltics & Bulgaria - fixed

Holding the PegHolding the PegBank system survived & govt Bank system survived & govt

did not have to recapitalize itdid not have to recapitalize itBankruptcies avoidedBankruptcies avoidedGreat integration renders Great integration renders

devaluation ineffectivedevaluation ineffective

Internal Devaluation: A crisis Internal Devaluation: A crisis is a terrible thing to wasteis a terrible thing to waste

Major fiscal adjustment 10% in Major fiscal adjustment 10% in 2009 in Baltic countries2009 in Baltic countries

Reduced public salaries & staffReduced public salaries & staffClosed state agenciesClosed state agenciesClosed schools & hospitalsClosed schools & hospitals

Lean & efficient public sectorLean & efficient public sector

Alternative: DevaluationAlternative: Devaluation

Advantage: Earlier recovery Advantage: Earlier recovery through exportsthrough exports

Disadvantages:Disadvantages: Bank system collapseBank system collapse Oligarchs/big exporters would have Oligarchs/big exporters would have

gained wealth and power gained wealth and power Less reformsLess reforms

ConclusionConclusionUltimate problem: Loose monetary Ultimate problem: Loose monetary

policy of US Fed and ECBpolicy of US Fed and ECBNo exchange rate regime could No exchange rate regime could

salvage these open and attractive salvage these open and attractive economieseconomies

No country changed exchange rate No country changed exchange rate regime as no evident advantageregime as no evident advantage

Poor MacroeconomicsPoor MacroeconomicsPaul Krugman: “Latvia is the new Paul Krugman: “Latvia is the new

Argentina.” !Argentina.” !

Devaluation was neither necessary Devaluation was neither necessary nor inevitable in the Baltics...nor inevitable in the Baltics...

Outcome (1)Outcome (1)Unit labor costs fell sharplyUnit labor costs fell sharplyFlat income tax and low corporate Flat income tax and low corporate

taxes survivedtaxes survivedCurrent account turned around to big Current account turned around to big

surplus in 2009surplus in 2009No deflationary cycleNo deflationary cycleReturn to growth sooner than Return to growth sooner than

expectedexpected

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

Inflation and Gross Wages:Inflation and Gross Wages: up and down, 2004-2010 up and down, 2004-2010

Crisis bred budget deficits 2009-11Crisis bred budget deficits 2009-11

(percent of GDP)(percent of GDP)

Public debt remains limitedPublic debt remains limited

(percent of GDP)(percent of GDP)

Apart from in Hungary & Poland, Apart from in Hungary & Poland, end 2010end 2010

(percent of GDP)(percent of GDP)

Political EconomyPolitical EconomyPeople have demanded realistic, People have demanded realistic,

radical crisis resolutionradical crisis resolutionMinimal social unrestMinimal social unrestCuts of 10% of GDP (Baltics) Cuts of 10% of GDP (Baltics)

politically easier than 2% of GDPpolitically easier than 2% of GDPStrange myth that democracies Strange myth that democracies

cannot cut public expenditures:cannot cut public expenditures:

Political Economy 2Political Economy 2Radical, early adjustment Radical, early adjustment

preferablepreferableBetter to cut expenditures Better to cut expenditures

than raise taxes than raise taxes Equity is importantEquity is important

Political Economy 3Political Economy 38 of 10 countries have changed 8 of 10 countries have changed

government during the crisisgovernment during the crisis9 of 10 countries have center-9 of 10 countries have center-

right governments – center right right governments – center right stronger than everstronger than ever

Multi-party coalitions most Multi-party coalitions most effective in crisiseffective in crisis

International AssistanceInternational Assistance

1.1. International liquidity crucial: missing International liquidity crucial: missing first because ECB was passivefirst because ECB was passive

2.2. Large early international assistance Large early international assistance vitalvital

3.3. New cooperation IMF-EU worked New cooperation IMF-EU worked wellwell

4.4. EU grants important: 4-7% of GDPEU grants important: 4-7% of GDP

OutlookOutlookMain concerns: reversed pension Main concerns: reversed pension

reforms and rising inflationreforms and rising inflationTrimmed public sectors: Expenditure Trimmed public sectors: Expenditure

cuts rather than higher taxescuts rather than higher taxesEastern Europe has gained efficiency Eastern Europe has gained efficiency

and self-confidence: European and self-confidence: European convergence continuesconvergence continues

The Last Shall Be the FirstThe Last Shall Be the First

(percent change)(percent change)

Inflation: Threat againInflation: Threat again

Total GDP Growth, 2000-2010Total GDP Growth, 2000-2010

(percent change)(percent change)

European ConvergenceEuropean ConvergenceGDP in PPP as % of EU AverageGDP in PPP as % of EU Average