Public finance systems for coping with the crises: lessons from the three Baltic states.

Author:Groenendijk, Nico

    Mid 2007 the world entered into a financial crisis which led to the most severe economic downturn since the end of WWII. The crisis began in the United States as a result of the sub-prime mortgage-backed securities crisis and spread out to a more general financial crisis which then hit the real economy and ended with (global) recession. Additionally, in the Eurozone a sovereign debt crisis emerged.

    Even though in 2010 financial market conditions improved and economic growth resumed in most countries--these improvements having resulted largely from the massive support measures taken by governments and central banks in Europe and North America, with a significant impact on fiscal deficits and public debt levels--the economies of most EU member states declined again as from 2012. Early 2014 economic recovery regained ground (European Commission, 2014a) but slowed down again and came to a halt at the end of 2014 (European Commission, 2014d). Economic recovery in Europe seems to be a matter of fits and starts.

    This article focuses on how the three Baltic States (Estonia, Latvia and Lithuania) handled the crises. The case selection of these three countries is based mainly on similarities in general background variables as size, GDP per capita and time of EU membership (2004). Comparing the three countries is interesting because even though the starting point before the crisis was more or less the same for all three Baltic countries, the situation during the crises and the measures taken were different. Still, what the three countries have in common is that--in comparison to other EU countries--they had very high growth rates before the crisis, were hit very hard in 2008-2010, but then recovered relatively quickly. Throughout the crisis Estonia was able to keep its public debt level one of the lowest in the EU and qualified easily for euro membership (which started in January 2011). The two southern Baltic States were in a more difficult situation and saw their deficits and debts rise significantly from 2008 onwards. The Latvian government responded to EU and IMF pressure by taking on debt; early 2009 it accepted a 7.5 billion euro EU-IMF loan package. Just as Latvia, but without support, Lithuania has been able to reduce deficits and to keep the public debt level acceptable. Latvia has adopted the euro in January 2014; Lithuania is scheduled to join the Eurozone on January 1, 2015. Currently, the three Baltic States are among the few EU Member States for which no in-depth-review (IDR) is considered to be needed within the framework of the Macroeconomic Imbalance Procedure (MIP) (European Commission, 2013).

    The Baltic experience with the crisis has drawn considerable academic attention. Various authors have tried to make sense of what happened in the run-up to the crisis and of how recovery took place in the Baltic countries (Brixiova, Vartia & Worgotter, 2010; Deroose et al., 2010; Kuokstis & Vilpisauskas, 2010; Purfield & Rosenberg, 2010; Lindner, 2011; Masso & Krillo, 2011; Weisbrot and Ray, 2011; Aslund, 2012a and 2012b; Mezo & Bagi, 2012; Kallaste & Woolfson, 2013; Kattel & Raudla, 2013). Often, the speed and determination with which the Baltic countries carried out austerity measures is put forward as an example for other E(M)U member states, such as Spain and Greece (see for instance Aslund, 2012a and 2012b). Likewise, the case of the Baltic States is often highlighted as evidence of effective expansionary fiscal consolidation and/or successful internal and/or fiscal devaluation. This paper critically assesses these various claims. The aim of the paper is twofold. First, to critically assess the validity of the use of the model of "internal devaluation" (i.e. cutting wages and public expenditures while retaining fixed exchange rates) to describe what went on in the Baltics. It is argued that in the case of the Baltic countries more complex economic and political mechanisms were at play. Secondly, it aims at looking at the lessons that can be drawn from the Baltic experience, especially for other countries in the Eurozone that--still--suffer from the crises. Here it is argued that lessons can surely be learned from how the Baltic countries handled the crisis, but they are not as simple as often thought and they are to a large extent context-specific. Moreover, rather than merely emphasizing the success the Baltic countries had in recovery, attention should also be paid to the question why these countries were hit the hardest in the first place.

    The paper is structured as follows. In section 2 a brief overview is given of the debate on fiscal consolidation and the implications for the analysis in this paper are put forward. In section 3 we present some (macro-economic) facts and figures which shed light on the magnitude of the impacts of the crises on the Estonian, Latvian and Lithuanian economies, compared to the EU-28 at large, covering a fairly long period (2004-2013), using data from Eurostat. Section 4 discusses the policy mix chosen by the three countries. Section 5 deals with fiscal consolidation and specific austerity measures, based on in-depth analysis of earlier research and policy documents. Section 6 looks specifically at the importance of fiscal equalization measures within the EU (through the EU Structural Funds and specific support measures). Section 7 discusses and concludes.


    Long before the crises hit, a significant body of literature developed that deals with the question whether fiscal retrenchment has expansionary or recessionary effects. The debate was triggered by the idea of expansionary fiscal contractions as witnessed by Giavazzi & Pagano (1990, 1996) for Ireland, Denmark and--later--Sweden. Subsequently, the counterintuitive notion that fiscal contractions could have expansionary (i.e. non-Keynesian) effects was empirically tested in a number of studies and largely corroborated (Alesina & Perotti, 1995, 1997; McDermott & Wescott, 1996; Perotti 1996, 1998; Alesina & Ardagna, 1998; Hemming, Kell & Mahfouz, 2002). In addition to the notion of expansionary contractions, two more ideas were put forward in the same literature (and again largely corroborated empirically, see however Heylen & Everaert, 2000 and Kumar, Leigh & Plekhanov, 2007, for different empirical findings). First, it was emphasized that expenditure-based consolidations are more likely to be effective, i.e. the composition of consolidation measures matters. Secondly, it was argued that fiscal austerity could be beneficial rather than harmful from an electoral viewpoint (Alesina, Perotti & Tavares, 1998). Taken together this all means that fiscal adjustments can be relatively painless, both in an economic and in a political sense ("gain without pain").

    Gradually this message found its way into the policy domain and became the conventional wisdom in IMF and EU circles (see Dellepiane-Avellaneda, 2014, for a reconstruction). In the policy arena a comprehensive literature on successful consolidations emerged and was readily available before the crises hit. Despite criticism on the basic idea of austerity without pain (Krugman, 1995, for example) and on the neglect of equity issues and their electoral implications (Mulas-Granados, 2004, 2006), and notwithstanding a short period of "emergency Keynesianism" (as Hall, 2013, called it; see also Ortiz & Cummins, 2013) when the crisis hit in 2008, followed by (media and internet) debate on fiscal stimulus-versus-fiscal austerity, the need for fiscal consolidation was never truly questioned in policy circles (see Buti & Carnot, 2013, for a recent defense of the European Commission's position).

    If we put the political debate aside for a bit, we can argue that two different but connected factors play a part when discussing fiscal consolidation within the context of economic crises: credibility and competitiveness. In the earlier literature the need for fiscal consolidation and the mechanisms by which austerity would work its way into the economy are mainly framed from the perspective of credibility (of government vis-a-vis investors, entrepreneurs, consumers and citizens) within single economies, whereas more recently (see for instance EEAG, 2013, 2014; Sinn, 2014) the issue of fiscal consolidation is framed as a means to tackle imbalances in competitiveness between core and peripheral countries in the EU.

    From the credibility perspective fiscal consolidation should aim at falling real interest rates and increased confidence of economic actors, as this will result in crowding-in effects on private investment and in increased consumption (outweighing the negative and multiplied effects on aggregate demand of fiscal consolidation as such, in line with the idea of expansionary fiscal contractions). Three main characteristics of such "smart" fiscal consolidation can be put forward (see among others Alesina & Giavazzi, 2012; Kolev & Matthes, 2013; EEAG, 2014):

    * Spending cuts are to be preferred to tax increases;

    * Spending cuts should be accompanied by structural reforms (labor market reforms, pension and health system reforms, public sector reforms);

    * Fiscal adjustment can be gradual, but countries with large credibility problems should front-load fiscal consolidation.

    From the perspective of competitiveness, re-alignment of prices is the key issue. For those countries that cannot engage in (formal) external devaluation (because of EMU membership or hard pegs), and that cannot engage in autonomous changes of import duties or export subsidies (due to being subject to a common EU trade policy) internal and fiscal devaluation may be alternatives, both aiming at reducing production costs, particularly labor unit costs. As governments generally do not have direct influence on overall prices, internal devaluation is done through substantial cuts in public sector wages which are assumed to propagate to the private sector and eventually...

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