The euro area continues to struggle with its crisis. In the eastern part of the European Union, however, an illustrative contrast has arisen that tells us a lot about how to act and not to act in a financial crisis. The contrast between successful Estonia and Latvia on the one hand, and struggling Hungary and Romania on the other could hardly be greater or more instructive.
The two European countries that were hit first and worst by the crisis, Estonia and Latvia, have already climbed out of their hole. Incredibly, these two countries experienced a total fall in GDP from peak to trough of 20 percent and 24 percent, respectively, in 2008–10. Latvia required an International Monetary Fund (IMF) program but completed it in 2011. Today, they are out of the financial crisis. Estonia even adopted the euro in 2011. Both countries enjoy sound economic growth—Estonia grew by 7.6 percent and Latvia by 5.5 percent in in 2011, and they continue to grow impressively. Both countries saw their governments easily re-elected in parliamentary elections in 2011.
Hungary and Romania experienced much smaller declines in output, only 7 percent and 9 percent, respectively. Yet, they had humdrum growth of 1.6 percent and 2.5 percent, respectively, in 2011. And GDP is definitely falling in Hungary in 2012 and close to stagnant in Romania. Both countries adopted IMF programs at the height of the global financial crisis in 2008 and 2009, respectively, and they still need them. The governments of Hungary and Romania in the initial crisis phase were ousted, as were their successors. Not only have these governments failed, but their failures have undermined these countries’ commitment to democracy, which has aroused many protests from the European Union.
Why has crisis resolution been more successful in Estonia-Latvia than in Hungary-Romania? I would suggest three important explanations.
The first reason is that Estonia and Latvia have done much better economically for a long time. From 1995 until 2011, that is, Estonia grew by 125 percent and Latvia by 123 percent (figure 1). Both nations felt reassured that they knew how to expand an economy and saw the global financial crisis as a temporary phenomenon. The underlying cause of this expansion was very substantial and radical market economic reforms. By contrast, in this period, Hungary’s GDP increased by only 48 percent and Romania’s by 51 percent. These nations were demoralized and presumed that their governments did not really know what they were doing. And right they were.
The second explanation is crisis resolution. Estonia and Latvia carried out massive and early fiscal adjustments of 9.5 percent of GDP in 2009. These two countries carried out most of the necessary cure in the first year of crisis. Their radical fiscal reforms also drove structural reforms. Both Hungary and Romania carried out substantial fiscal adjustment, but not quite enough. Figure 2 shows the budget balance from 2006 to 2011, and it does not reveal who failed and who succeeded. Hungary’s shortcoming was that the fiscal adjustment was not accompanied by structural reforms to promote growth, and the rather illusory budget surplus in 2011 was caused by the nationalization of private pension funds. Romania’s case is sad. The country carried out a considerable fiscal tightening, but it was insufficient, especially in view of the new south European crisis in 2010. Moreover, it did far more tightening in the second year of austerity than in the first one.
The difference between success and failure is strikingly small, but it is hugely important for economic performance. The conclusion is that it is better to overshoot and tighten the budget—even if more than necessary—than to risk failure. If Spain and Cyprus had not pursued a fiscal stimulus in early 2009, they would hardly be in such dire straits today. The margin required for fiscal safety has turned out to be much greater than was understood in the boom times, when many opinion makers were unduly concerned with the risk of double-dip recession. Instead they should have focused on the risk of default, as Carmen Reinhart and Kenneth Rogoff emphasize.
Finally, the difference between sufficient and insufficient fiscal adjustment and structural reforms becomes evident in the resulting growth rates. Clearly, Estonia and Latvia have entered far higher growth trajectories than Hungary and Romania (figure 3), and nothing succeeds like success both economically and politically. The conclusion is that our policy focus in the crisis resolution should no longer be so extremely short term, as is characteristic of most Western debate, but long term. Growth or decline in the next year is far less important than growth in the next decade or two also for re-election of a government.
Eventually, economic crisis resolution is important also for the strength of democracy because if a democratic polity fails to deliver responsible economic policy, people’s belief in democracy may be undermined—as we see most clearly in Hungary.