The “May the road rise with you” theory of fiscal correction

Germany’s Man at the ECB, Jörg Asmussen, popped up in Riga yesterday at a conference  on the theme of the lessons of the Baltic adjustment over the last 5 years for other European countries. His message: it was better to take a huge hit to GDP up front:

First, it disproved the frequently made claim that an internal devaluation strategy cannot work. From 2008, Latvia was faced with the deepest recession in the world. The cumulative output decline was 24%; unemployment peaked at 20%. Compared with this economic collapse, even some of the euro area peripheral countries were faring relatively better. Keeping the euro peg was considered by many as a “mission impossible”. External devaluation was presented as the only way forward. But Latvia did not choose the easy “quick fix”. It embarked on a courageous fiscal consolidation path and structural reforms. Two years later, the speed of the economic rebound is as extraordinary as the depth of the recession. Against all the odds, Latvia recorded a real GDP growth rate of 5.5% in 2011.

Now it’s stating the obvious that 5.5 percent growth only gets you part of the way back from a 24 percent output decline. And the IMF is projecting just 2 percent growth for Latvia in 2012. Does Asmussen have a point that the dynamics of growth are much better when the initial downturn is larger?

Undertaking the necessary austerity measures at an early stage had a triple beneficial effect. First, it allowed the Baltics to benefit from positive confidence effects. Second, it allowed Latvia to return to the financial markets well ahead of schedule. Third, it allowed growth to bounce back after exceptionally severe output contractions. In 2011 the Baltic countries were the three best performers in the EU in terms of GDP growth. At a time when all euro area policy-makers urgently seek ways to relaunch growth, this is a remarkable achievement. The concept of “expansionary contraction” has been used and criticised in the ongoing debate about growth and austerity. The Baltic experience provides an indication that this need not be an oxymoron: even if fiscal consolidation weighs on the growth prospects in the short term, it has sizeable positive effects in the medium to long term.

The FT’s Martin Wolf highlighted a related issue the other day when noting the prevailing assumption that the UK’s output losses due to the financial crash are permanent, which is a much more severe assumption than for a war or natural disaster, where recovery to the previous level of GDP (and therefore more rapid growth in the recovery phase) is the more common assumption.

There is some logic to the argument that whatever the effects of austerity, drawn-out austerity is worse. For example, Ireland is now entering its 5th year of discussions about what to cut. It can manage this because foreign investment has held up, but it’s not exactly the most encouraging environment for domestic spending. Would it have been better to have a quasi-disaster in GDP terms 5 years ago, so that the only way was up?

It’s perhaps useful to be a bit more systematic than Mr Asmussen was in his speech and expand the frame of reference from beyond the Baltics to Ireland and Iceland, i.e. other small economies facing severe adjustment problems. Here’s an IMF data query with the relevant variables for all 5 countries. If Ireland shows the costs of protracted adjustment, then Iceland is the case of front-loaded adjustment, but crucially, spread over the exchange rate and banking system foreign creditors as well as in public spending — two margins not available to Eurozone members (or aspiring Eurozone members).

Let’s go back to Martin Wolf’s question about why exactly a financial crash might be worse than a natural disaster. One reason may be that in an actual natural disaster, the country would have been free to claim force majeure and expect some concessions from the outside. With no similar consensus about what had gone wrong in 2008, countries were left to their own devices. As disturbing as it sounds, it may be that those who chose to mimic a natural diaster in their response were better off.

11 thoughts on “The “May the road rise with you” theory of fiscal correction

  1. Pingback: FT Alphaville » Further reading

  2. I’m not sure from a physics of economics standpoint that there is really any difference, but from a not having to listen to whiny conservatives standpoint natural disasters are way better. They don’t blame natural disasters on the leeches. On the other hand, conservatives probably think natural disasters cause liberals to be all whiny about climate change.

  3. “Two years later, the speed of the economic rebound is as extraordinary as the depth of the recession. Against all the odds, Latvia recorded a real GDP growth rate of 5.5% in 2011.”

    He forgot to mention one thing.

    Births in Latvia have dropped about 20% since 2008.

    Deaths now exceed births there by over 1.5 to 1.

    A triumph of austerity! Business is booming!

    Unless you will need a labor force in 20 years. Or customers.

  4. Hey wanderer, did the young women move out or did fertility fall?


    It seems that about 30k people, or 1.3% of the population, emigrated to the UK alone in 2009-2010. If you assume these are mostly workers, that would be 2-3% of the workforce. Now add the numbers for other neighboring, wealthy countries, and compare with the drop in unemployment rate.


  6. Natural disaster or economic depression, I’d suggest short but sharp beats prolonged if less deep for simple reasons of human nature and stamina. People are far more willing to share with the less fortunate after a disaster but as time goes by ‘compassion fatigue’ sets it. Confidence and faith in the future is eroded over time and reserves, both material and psychological, are depleted.

    In the present situation the palliative measures taken by central banks may have delayed the final reckoning but not prevented its ultimate arrival and thus, for the reasons above, made the final reckoning more traumatic.

  7. Is there any economic benefit to Estonia in having maintained its Euro currency peg that can be supported by evidence, rather than merely asserted as Mr Asmussen does?

  8. “Is there any economic benefit to Estonia in having maintained its Euro currency peg that can be supported by evidence, rather than merely asserted as Mr Asmussen does?”

    Most people will point to the relatively fast growth of the Estonian (or Latvian) economy in 2011. But this is not a very good argument as it is difficult to know what would have happened if they would have broken the peg. But we can look at other countries who went through similar crises (bubble, unsustainable current account deficit) like the East Asian crisis in the second half of the nineties. These countries recovered much more fast than Estonia (or Latvia) after their currencies depreciated very sharply.

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