Anders Aslund: why Ilves is right and Paul Krugman is not

12.06.2012, 11:57

According to Anders Aslund, economist at the Peterson Institute in Washington, Nobel-prize winner Paul Krugman lashed out on Estonia because he has a personal issue with the Baltic states.

Aslund writes in Postimees that Krugman may have been stinged because he has been forced to admit that his predictions that no Baltic country will recover economically before they devalued their currency were false.

It has now turned out that Krugman was wrong, but he is not ready to admit it, writes Aslund.

In 2007 Krugman claimed that Latvia was the new Argentina. He said that Baltic countries had no option but to devalue their currencies.

This is the reason why he is now claiming that Estonia has should not be an example of those who believe in austerity measures.

Aslund writes that, contrary to Krugman’s recommendations, Estonia did not devalue. Instead, it opted for so-called internal devaluation that included huge cuts in public spending and implemented structural reforms.

Many claim that Estonia was a special case, but Latvia and Lithuania who took a similar path and followed similar policies achieved similarly impressive turnaround.

All three Baltic governments did what they were expected to do and the Baltic nations approved it, as shown by general elections in Estonia and Latvia where current coalitions were re-elected.

Krugman’s mistakes
Krugman’s mistakes were that he looked only at one graph and did not think about underlying connections.

He took a very short period and chose not to include the earlier period of rapid economic growth.

He claim that Argentina showed how valuable a devaluation can be is proof that he ignored of the important developments that took place before the crisis.

While Argentine economy grew 15 percent between 1992 and 2003, Latvia’s economy expanded an amazing 51 percent between 2000 and 2011.

Secondly, Krugman ignores the real cause of Baltic crises, believing that it was their cost-cutting that caused their crises, while actually it was the lack of international capital supply.

When Lehman Brothers went bankrupt in September 15, world financial markets went into a turmoil and the three Baltic countries lost much of the available international capital.

This caused their GDP to plummet and was the key cause for the economic crisis.
As there was also lack of liquidity along with the dramatic decline in GDP, the countries had no other option but to cut spending.

In short, austerity was the result of the GDP decline, and not vice versa.
Thirdly, Baltic countries had actually no other choice at the end of 2008. They were facing a massive budget deficit and they could not finance. They had to restore confidence in their currency, and time was running out.

Without their own fiscal space or independence monetary policy, the Baltic countries did not have the luxury of stimulating their economies, as Spain and Cyprus.

Fourth, Estonian crisis solution was both political and economic success story. The Estonian government took advantage of the public opinion that the time of crisis calls for rapid and dramatic action.

When a country is in crisis, you need to act decisively. The government drew up a crisis program and implemented it rapidly. So it was also a public relations success.

Fifth, Krugman has always claimed that the Baltic states need to devalue to increase their exports. In fact, exports have been skyrocketing above all expectations without devaluation.