The REBLL Alliance and the Debt Star: Adventures in the Science Fiction of Austerity

A July 9, 2012, cartoon in The Economist shows two men on a beach. One is a blond, beaming, Baltic man flexing his biceps. Crouched next to him, under a sign that says “South,” is a swarthy, mean-looking man holding a beggar’s cup. It’s not a ridiculous picture of how policy elites in Europe and elsewhere saw the morality tale playing out between the Baltic countries and Southern Europe in the summer of 2012: guts versus surrender, work versus sloth, real austerity versus fake austerity. Beginning in 2008 Estonia, Latvia, and Lithuania voluntarily embraced an extraordinarily deep fiscal adjustment, keeping their currencies pegged to the euro while internal prices and wages collapsed. Romania and Bulgaria joined them in this exercise in 2009. By 2011, they had all returned to growth levels higher than the rest of Europe, especially Southern Europe (see figure 6.1). Maybe austerity did work after all? Again, if a picture paints a thousand words, this one takes your breath away.
Starved for good news on the austerity front, the troika of the IMF, ECB, and EC responded to the Latvian government’s call to join them in a celebration of the success of Baltic States.151 After the party in Riga, an ECB board member read straight from the expansionary austerity script:

"Undertaking the necessary austerity measures at an early stage … allowed the Baltics to benefit from positive confidence effects … allowed Latvia to return to the financial markets well ahead of schedule … allowed growth to bounce back after exceptionally severe output contractions. … The concept of “expansionary contraction” has been used and criticized 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.152"

Praise came from other prominent sources. For IMF director general Christine Lagarde, Latvia was an “inspiration” for Southern Europe.153 Olivier Blanchard, IMF chief economist and austerity skeptic, noted that the Latvians “can take pain.”154 Even Hillary Clinton praised Latvia, saying that austerity will ensure a “stable, prosperous future.”155 But, the Latvians were not alone. The Romanians and the Bulgarians received praise from the austerity camp later that summer, thus joining the Baltic States’ austerity alliance.156

Despite these states constituting an astonishing example of massive fiscal retrenchment and demonstrating a robust bounce back in growth, the REBLLs do not in fact provide much evidence for the expansionary austerity thesis. To see why, we need to understand that the economies the REBLLs built for themselves after communism were accidents waiting to happen. This is why they had to be so austere in the first place—the accident happened and it cost them a fortune. It’s an accident we have already seen in this book: yet another banking crisis that ended up on states’ balance sheets. No one does this sort of thing for fun—not even Balto-libertarians. We need to understand why the REBLLs were compelled to undertake such extreme measures before we can understand why their experiences prove neither the expansionary austerity thesis nor provide much in the way of portable and practical lessons for the rest of the world.

The REBLL Growth Model

By the eve of the 2008 crisis, the REBLLs had developed a unique growth model based on massive foreign investment, even more massive foreign borrowing, and economic institutions that could only be described as open to money coming in and people going out. The problem with this growth model was that it was extremely vulnerable to external shocks due to its high degree of dependence on transnational capital flows, its tendency to develop large current account deficits, and its chronically weak export performance.
They ended up this way because the post-communist period of the 1990s was one of extensive deindustrialization in the REBLLs. This prompted the migration of between 10 percent and 30 percent of the most active part of their labor force to Western Europe. These losses compounded an already weak capacity to develop infrastructure, which in turn led to the concentration of investment in real estate and finance rather than manufacturing. As a consequence, exports were never a strong foreign currency earner, which meant a shortage of foreign exchange to cover imports.157 This led to increasing dependence on foreign capital inflows and remittances from all that expatriate labor to provide for the financing of these large deficits. Yet despite such problems these economies grew rapidly because by the 2000s there was plenty of credit at the local bank to finance consumption. There was just one problem—the local banks were not local—and neither was their financing.

Encouraged by the prospect of EU membership for the REBLLs, which made these countries appear to be undervalued assets that would appreciate simply by adopting the euro, Austrian, French, German, Swedish, and even Greek banks went on a shopping spree to buy Eastern European banks in the early 2000s. REBLL banking sectors became between 80 percent and nearly 100 percent foreign owned in short order.158 These banks made little contribution to industrial investment, in part because there wasn’t much industry in some of those states in which one could invest, so they provided instead plenty of consumer credit to cash-strapped REBLL citizens and real estate speculators. Given the spread between the home banks’ funding costs and the rates they could loan at locally, this was a good deal for all concerned. This also encouraged local actors to load up on foreign currency loans, thereby building time bombs into their balance sheets set to explode the minute exchange rates moved against them.159

This transnational credit pump created a phenomenal construction bubble that made the Spanish and Irish property experiences look tame by comparison. Spain and Ireland managed a paltry 6 and 8 percent annual growth in construction expenditures, respectively, in the 2000s. Romania was the laggard with 11 percent yearly increases. Bulgaria busted the curve with a near 20-percent-a-year increase.160 Therefore, while REBLL states busily cut their debt even before the crisis, their citizens and firms increased it exponentially in the form of nonproductive assets, on the back of weak exports and current account deficits, using foreign sourced cheap credit. All that was needed to make this whole system explode was a detonator—and the foreign banks provided that too.

Yet Another Banking Crisis

The 2008 crisis hit the REBLLs as a combination of a current account crisis—exports slumped as financing for imports dried up and deficits, already large, exploded—and the bursting of real estate bubbles once the foreign banks that owned their financial sectors tried to cover their losses in the credit crunch. As we discussed back in chapter 2, when a bank makes a loss in one part of its portfolio, it looks to liquidate assets elsewhere in the portfolio to cover those losses.161 The REBLLs were the very definition of “elsewhere in the portfolio.” Worried about the solvency of their home-base operations in the aftermath of the Lehman crisis, the parent banks of these REBLL banks let it be known to the REBLL governments that they were considering pulling out of their countries to supply much-needed liquidity to their core (home) operations.162 Given the extremely open and market-friendly economic institutions of the REBLLs, these states had no way to keep capital at home. As such, they rather suddenly discovered that the Western banks didn’t just own their banks—they owned their money supplies too. Fear set in, the money started to flow out, demand abroad constricted, their construction bubbles popped, and the REBLL economies collapsed (table 6.1).

At this point, the EU and the IMF intervened and orchestrated a massive bailout of the Central and Eastern European financial systems—in other words, of the Western banks’ wholly owned foreign subsidiaries—just at the point when current accounts in these states were exploding. In Vienna in 2009, and long before any Greek or Irish bailout, an agreement was signed between the Western banks, the troika (EU-IMF-EC), and Romania, Hungary, and Latvia that committed Western European banks to keeping their funds in their Eastern European banks if these governments committed to austerity to stabilize local banks’ balance sheets.162 The Vienna agreement prevented the liquidity crunch from spreading to the rest of the REBLLs, so long as the same balance-sheet guarantee (austerity) was applied elsewhere—and it was. Once again, it was all about saving the banks, and the bill for doing so, in the form of austerity, high interest rates, unemployment, and the rest, was dumped once again on the public-sector balance sheet of the states concerned. As early as 2009, then, while the United States and Western Europe were rediscovering Keynes, the REBLLs were enforcing local austerity packages to save core EU country banks. If you think that you have heard this story already, it’s because you have. It’s an earlier form of what is going on in the Eurozone with the periphery states’ sovereign debt and the core banks’ exposures.

Given this bust and deflationary bailout, the size of consolidation following the collapse was massive: 17 percent of GDP in Latvia, 13 percent in Lithuania, and 9 percent in Estonia, with half of it enforced in the first year, and most of it, per Alesina’s recommendations, on the expenditure side.163 Double-digit public-sector wage cuts became the norm across the REBLLs despite the IMF’s then managing director Dominique Strauss Kahn protesting that, at least in the case of Romania, the government should have taxed the wealthy instead.164 Expenditure cuts of such magnitude wreaked havoc in health, education, and social protection.165 Taxes were increased, but only on regressive value added taxes (VAT) and labor taxes. Massive tax evasion predictably followed, which simply worsened the overall fiscal situation.

Let’s stop for a moment and take this in. A set of patently unsustainable and unstable economies financed by foreign credit bubbles blew up, quite predictably, the minute there was a shock to these economies. These countries are now supposed to be the role models for the rest of the world to follow? Spain is in bad shape, certainly, but is it really supposed to hollow out its economy entirely and live off more foreign borrowed money? Is Italy supposed to abandon its competitive export sector and sell off its banks? That would be what “following the example of the REBLLs” actually means. In fact, these so-called “models” are little more than the worst features of Ireland, Spain, and Greece combined, with no compensatory airbags, a sideline in divide-and-rule ethnic politics, and a libertarian instruction sheet. The REBLLs may have bounced back, but why would anyone want to copy policies that led to such an unstable and inequitable growth model in the first place? What lessons, then, are we to take from the REBLL alliance if becoming more like them is surely not one of them?