The Crisis Has Been Wasted

April 12, 2011 11:00 AM

Despite the budget deal to keep the government running for the rest of the fiscal year, the United States remains at a profound impasse over its long-term public finances, with fiscal deficits lingering around 10 percent of the gross domestic product. Early in the financial crisis, presidential chief of staff Rahm Emanuel made the much-quoted statement: "A crisis is a terrible thing to waste." President Obama then used the crisis as leverage to enact a major stimulus program and an overhaul of the nation's health care and banking regulation systems. But since none of the fundamental problems with the American government's finances have been resolved, the crisis has been wasted.

All developed economies were hit by the crisis of 2008-9, but they reacted very differently. Some pursued major fiscal adjustment, most spectacularly the three small Baltic countries — Estonia, Latvia and Lithuania — while the United States indulged in fiscal expansion. The experiences of the Baltics suggest what went wrong in the United States.

The crisis was far more severe in the Baltics than in the United States. In total, GDP fell by 25 percent in Latvia, 19 percent in Estonia, and 17 percent in Lithuania, but only by 4 percent in the United States. The Baltic countries had no choice but to tighten their belts. Undoubtedly, the massive American monetary and fiscal stimulus limited the recession, but the cure might turn out to be worse than the disease if the US fiscal deficit becomes increasingly unsustainable.

All the three Baltic governments carried out vigorous fiscal tightening of about 10 percent of GDP in 2009, with a total of 16 percent of GDP in Latvia. Such big budget cuts can usually only be undertaken in the midst of a serious crisis. Since the United States did not exploit the opportunity during the Great Recession, it might not be able to do so until it faces a new, greater crisis.

Carmen Reinhart and Kenneth Rogoff have shown that public debt usually almost doubles after a severe financial crisis. The United States seems set to achieve that, with public debt on track to reaching the level of nearly 100 percent of US GDP in coming years if policy changes are not enacted. It now seems that the country could not afford its great stimulus, which put the United States on the wrong track. By contrast, Latvia has the highest public debt in the Baltics at 42 percent of GDP.

A severe financial crisis often changes political thinking. What had previously been politically impossible becomes not only possible but necessary. Abandoning old demands and vested interests, Baltic politicians competed with each other in suggesting expenditure cuts for the sake of social justice and public efficiency, as public outrage turned against privileges. During the Great Depression, the United States went from polarization to consensus, but not during the Great Recession. Polarization on views of public expenditures and taxation remains extreme.

A fast fiscal adjustment has to rely primarily on expenditure cuts which amounted to three-quarters of the belt-tightening in 2009 in the Baltic countries, as state revenues cannot possibly rise that fast. Deep cuts in state expenses compel governments to reform the public sector. Few reforms are more popular than a reduction in the size, power, and resources of public administration, since governments are inefficient almost everywhere. Latvia cut the nominal salaries of civil servants by 26 percent in 2009, and their number was slashed by 30 percent. It also reformed health care and education, while Lithuania reformed higher education.

Good explanations to the public pay off, and so does burden sharing and support to the poorest, while hypocrisy is duly punished. While the Balts have slashed public expenditures, they have maintained a sense of social justice. The prime minister of Latvia, Valdis Dombrovskis, cut his own salary by 35 percent, and his austere office contains no decorations. Taxes on capital gains, real estate, and excise taxes on expensive cars were hiked, while pensions have been maintained, and unemployment benefits extended. The leaders must lead and make real personal sacrifices to be credible.

Soon after the crisis, the vested interests of the public sector regrouped, and deep cuts are no longer possible either here or in the Baltics, which means that most of later fiscal tightening is likely to result in tax hikes. But then the Balts have done their job, while the US government has not even started.        

Also in Europe at large, the parties that have called for fiscal responsibility are mostly on the center right, and with the financial crisis the center right has grown stronger than ever. Center-right governments rule no fewer than 23 out of the 27 European Union countries, and the Portuguese government, one of the few remaining socialist governments, has just fallen. On the left, the communists have been wiped out, and the social democrats have never been weaker since World War I.

Much is written about the hard anti-immigration right, but so far such sentiment has tended either to mellow to gain influence or to stay marginal. Nor is it true that the crisis has led to a swing from the embrace of the market to the state. Indeed,  public expenditures and public ownership have expanded because of the crisis. In reaction to this undesired development, Europeans have turned away from the statist left to the responsible liberal right.

The financial crisis in the European Union has led to winning and losing strategies, giving encouragement to the efficacy of democracy. But for the United States, where politicians fear a backlash resulting from a tightening of fiscal policy, the examples of Europe are highly instructive. The common presumption that voters punish governments that pursue severe austerity programs or oversee large contractions of output has turned out not to be true.

The Portuguese government was recently ousted by the parliament when it tried to pass an austerity program. Similarly, the Irish government was punished by the voters. Is an austerity program a poisoned chalice? No. The problem of the Portuguese and Irish governments was that they acted too late and hesitantly. They came back too many times with new austerity programs, each of which was too weak, revealing a lack of competence and courage.

Voters have instead shown a strong preference for competent crisis management and fiscal responsibility. In spite of the massive economic contraction in Latvia and Estonia under the watch of the current governments, both governments have recently been reelected. Also Sweden, Finland and Denmark pursued responsible fiscal policies, and their governments sit secure. In the Czech Republic and Slovakia the center-right won elections by promising stricter fiscal policy. The current socialist Greek government has carried out heroic fiscal adjustment and remains popular. In effect, Europe has started a competition in fiscal virtue, which is cheered on by increasingly vigilant bond markets.

In Europe, populism has not been popular in this profound crisis, as voters have demanded that their leaders pursue fiscal adjustment, and many European countries have not wasted the crisis.

Anders Åslund is a senior fellow of the Peterson Institute for International Economics and author of the book "The Last Shall Be the First: The East European Financial Crisis".