Why the Baltic Recovery is Not a Success Story for Austerity: Lessons for the US

While EU members along the shores of the Mediterranean struggle with a seemingly endless slump, others who dip their toes in the Baltic are making a strong comeback. As the following chart shows, real GDP growth in the Baltic 3—Estonia, Latvia, and Lithuania—has recently run well above the euro area average. Meanwhile, the Med 4—Greece, Italy, Spain and Portugal—continue their downward trajectories. Official forecasts call for their economies to bottom out in 2014, but predictions have been wrong before.

Some readers might object that this chart is misleading, since, to facilitate comparison, it shows output in all of the economies on a scale with 2004 equal to 100. Isn't it simply the case that the Baltic countries are much poorer, and it is easier to grow from a low base? Besides, what is there to brag about when real GDP in the Baltic 3 hasn't even gotten back to its pre-crisis peak?

Fair enough. Let's change the scale, then, to show each country's per capita GDP relative to the EU average, rather than relative to its own 2004 value. The next chart does that. It confirms that the Baltic 3 were the poorest members of the EU when they joined in 2004. Since that time, though, they have made great progress while the Med 4 have lost ground. It appears likely that Estonia and Lithuania will pass Greece and Portugal in per capita GDP as early as the end of this year, with Latvia not far behind. Note also that in terms of living standards, all three Baltic countries were already above their pre-crisis peaks by the end of last year. Not so bad, after all.

A third chart, showing unemployment rates, is even more impressive. Joblessness in the Baltic 3 has fallen for three years running. In all three, it is now below the EU average. Meanwhile, unemployment in Greece, Spain, Portugal and Italy is headed nowhere but up—for the sixth year in a row.

What is going on, then? Proponents of a policy of austerity—of budget cuts in the middle of a slump—sometimes point to the Baltic economies as a success story. I think that is highly misleading. Here is why.

Why austerity is always a sign of policy failure, never success

The reason we cannot point to the Baltics as a success story for austerity is that there is no such thing. By its nature, the very need for austerity is a sign that there has already been a policy failure.

Rational fiscal policy, as I have written many times before, should always be countercyclical, or at least cyclically neutral. The proper measure of the cyclical orientation of a country's fiscal policy is the path over time of its primary structural budget balance (PSB)—its surplus or deficit adjusted both for the state of the business cycle and for interest payments. As a country falls into recession, countercyclical policy requires discretionary tax cuts or spending increases that move the PSB toward deficit. As it recovers and nears full employment, the PSB should move back toward a small surplus. During a boom, when the economy is temporarily above its long-run potential level of GDP, the PSB should show a more substantial surplus.

Some countries, Chile for one, more modestly aim for a cyclically neutral policy. That requires the PSB to remain constant, usually in a slight surplus, throughout the business cycle. If it does so, the current budget balance will move into deficit during a recession and surplus during a boom, in response to automatic stabilizers like unemployment benefits and income taxes. A cyclically neutral policy may not be theoretically optimal, but it can be a good choice for a country that trusts policy rules more than the unrestrained discretion of its politicians.

What never makes sense is a policy that is deliberately procyclical. A procyclical policy is one that makes the business cycle more severe by moving the PSB toward deficit during a boom, with tax cuts and new spending, and then moves it toward surplus during a slump with tax increases and spending cuts.

That is the sense in which austerity is always a sign of policy failure. The need for austerity during a slump is simply the payback for recklessly running procyclical deficits during a preceding boom. Some people have described austerity as the hangover on the morning after the party, but I think it is more apt to think of it as a trip to the vomitorium after one too many pieces of cheesecake.

Unfortunately, fiscal policy was, to one degree or another, procyclical in each of the Baltic 3 and Med 4 countries during the years leading up to the financial crisis. Even Spain and Estonia, which managed a few years of annual budget surpluses at the height of their booms, were really running procyclical primary structural deficits when we strip away the effects of temporarily elevated tax