A Baltic Future for Greece?

As I have noted previously, Latvia has experienced the worst two-year economic downturn on record, losing more than 25% of GDP. It is projected to shrink further during the first half of this year, before beginning a slow recovery, in which the International Monetary Fund (IMF) projects that it will not reach even its 2006 level of output by 2015 - nine years later.

With 22% unemployment, a sharp increase in emigration, and cuts to education funding that will cause long-term damage, the social costs of this trajectory are also high.

By keeping its currency pegged to the euro, the government gives up the opportunity to allow a depreciation that would stimulate growth by improving the trade balance. But even more importantly, maintaining the peg means that Latvia cannot use expansionary monetary policy, or expansionary fiscal policy, to get out of recession. (The United States has used both: in addition to its fiscal stimulus, and cutting interest rates to near zero, it has created more than 1.5 trillion dollars since the recession began).

Some who believe that doing the opposite of what rich countries do - ie pro-cyclical policies - can work point to neighbouring Estonia as a success story. Estonia has kept its currency pegged to the euro, and like Latvia is trying to accomplish an "internal devaluation". In other words, with a deep enough recession and sufficient unemployment, wages and prices can be pushed down. In theory this would allow the economy to become competitive again, even while keeping the (nominal) exchange rate fixed.

But the cost to Estonia has been almost as high as in Latvia. The economy has shrunk by nearly 20%. Unemployment has shot up from about 2% to 15.5%. And recovery is expected to be painfully slow: the IMF projects that the economy will grow by just 0.8% this year. Amazingly, by 2015 Estonia is projected to still be less well off than it was in 2007. This is an enormous cost in terms of lost actual and potential output, as well as the social costs associated with high long-term unemployment that will accompany this slow recovery. And despite the economic collapse and a sharp drop in wages, Estonia's real effective exchange rate was the same at the end of last year as it was at the beginning of 2008 - in other words, no "internal devaluation" had occurred.

Yet Estonia is being held up as a positive example, even used to attack economists who have criticised pro-cyclical policies in Latvia. The reason is that Estonia has not had the swelling deficit and debt problems that Latvia has had in the downturn. Its public debt of 7% of GDP is a small fraction of the EU average of 79%, and its budget deficit for 2009 was just 1.7% of GDP. It is therefore on its way to join the eurozone, perhaps adopting the euro at the beginning of next year.

How did Estonia manage to avoid a large increase in its debt during this severe downturn? First, the government had accumulated assets during the expansion, amounting to some 12% of GDP; and it was also running a budget surplus when the recession hit. And it has received quite a bit in grants from the European Union: in 2010, the IMF projects an enormous 8.3% of GDP in grants, with 6.7% of GDP the prior year.

Greece, unfortunately, is not being offered any grants from the European Union or the IMF. Their plan for Greece is all about pain and punishment. And with a public debt of 115% of GDP and a budget deficit of 13.6%, Greece will be forced to make spending cuts that will not only have drastic social consequences but will almost certainly plunge the country deeper into recession.

This is a train going in the wrong direction, and once you go down this track there is no telling where the end will be. Greece - like Latvia and Estonia - will be at the mercy of external events to rescue its economy. A rapid, robust rebound in the European Union - which nobody is projecting - could lift these countries out of their slump with a huge boost in demand for their exports, and capital inflows as in the bubble years. Or not: Western European banks still have hundreds of billions of bad loans to Central and Eastern Europe from the bubble years. Some big shoes could still drop that would depress regional growth even below the slow recovery that is projected for the eurozone. And Germany, which has been dependent on exports for all of its growth from 2002-2007, could continue to soak up the regional trade benefits of a eurozone and/or world recovery.

No matter how you slice it, these 19th-century-brutal pro-cyclical policies don't make sense. They are also grossly unfair, placing the burden of adjustment most squarely on poor and working people. I would not wish Estonia's "success" on any population, simply because they avoided a debt run-up and are on track to join the euro. They may find, like Greece - as well as Spain, Ireland, Portugal, and Italy - that the costs of adopting a currency that is overvalued for a country's level of productivity are potentially quite high over the long run, even after these economies eventually recover.

The European Union and the IMF have the money and the ability to engineer a recovery based on counter-cyclical policies in Greece as well as the Baltic states. If it involves a debt restructuring - or even a haircut for the bondholders - so be it. No government should accept policies that tell them they must bleed their economy for an indeterminate time before it can recover.