The Sun Is Rising in the East

August 11, 2010 5:00 PM

What hand wringing there has been recently on both sides of the Atlantic as the major European economies pursue austerity in their budgets and social programs! But is it not overdone? Europeans and Americans need only look east—to the European Union's new eastern members—to see that austerity can deliver growth and improve the efficiency of the European economic and social systems.

Latvia, Lithuania, Estonia, Hungary, Romania, and Bulgaria were hit by profound financial crisis in late 2008, but their cure has proven effective. Almost all East European economies are growing and their public sectors have become leaner and more efficient.

It is true that the northern European Union has reformed much more than the south, but many analysts overlook an important factor: The sun rises in the east. Finland, Sweden, and Germany have benefited from outsourcing to their eastern EU neighbors in the Baltics and Central Europe, while gaining efficiency from competition from cheap, skilled labor over there. Southern Europe has been less favored because of its greater distance from Eastern Europe. The roadmap for ailing economies is thus ready.

The first East European lesson is that a country in crisis should not wait to undertake the necessary cuts in public expenditures, because any delay will postpone the restoration of confidence. Estonia, Latvia, and Lithuania each cut their public expenditures by 8 to 10 percent of GDP in 2009.

Ironically, it is often more difficult for countries to cut a couple of percent of GDP than to cut 10 percent because when the crisis is real and drastic steps are necessary, the threat of social unrest fades away. Moreover, large cuts cannot be even, they have to be selective and strategic.

The crisis made it possible to undertake long-needed reforms of the postcommunist public sector. All have closed superfluous state agencies and reduced public-sector employment and pay, by up to 30 percent. Latvia closed 24 out of its 49 hospitals, greatly improving the efficiency of medical care, because communism offered many hospital beds but little medical treatment. Lithuania carried out a voucher reform of higher education, which raised both quality and efficiency.

Yet the East Europeans have not given up on their old achievements. Seven of the ten new eastern EU members have low flat personal income taxes, and Poland and Hungary are seriously contemplating adopting such taxes. No country has raised personal income taxes in the crisis. Corporate profit taxes have also stayed very low. Instead tax loopholes have been eliminated and the worst hit countries have raised excise taxes and value-added taxes, taxing consumption rather than income or capital. The far-reaching deregulation of labor and product markets is not questioned.

These radical reforms are carried out in the name of economic necessity and pragmatism, but they are not ideologically neutral. A reformed social market economy is arising that is more liberal and efficient than the old statist model, providing better service. It reflects the reformed Scandinavian model with more choice and therefore greater efficiency.

These ideological changes have not been lost on East European voters. Nine out of the ten new eastern EU members are ruled by center-right governments (with Slovenia being the only exception). In June 2009, center-right parties won majorities in all these countries in the European Parliament elections. The moderate free-market center-right has never been stronger in Europe. It is commonplace to complain about lack of European leadership, but this is merely a West European problem. Eastern Europe has many proven leaders.

A year ago, the conventional wisdom was that Estonia, Latvia, Lithuania, and Bulgaria, which have pegged their currencies to the euro, would be forced to devalue. But none of them has. Nor will they. Estonia has already been approved to adopt the euro next year. By sticking to their fixed exchange rates, these governments forced through the long-needed reforms of the public sector, for which their electorates are thanking them, and the public majority for their adoption of the euro remains massive.

The European economic convergence is proceeding because the east is reforming faster than the inert center.

In the American debate, it is commonplace to blame the current slow recovery on insufficient aggregate demand, and to suggest that Europeans need to do more to stimulate their economies. But the European perspective is quite different. The crucial flaws in Europe are poor competitiveness because of excessive regulations, public expenditures, and rigid labor markets, which are structural rather than macroeconomic shortcomings. Therefore, no fiscal stimulation can resolve them, while austerity breeds vital structural reforms.

The lesson for Greece, Spain, Portugal, and Italy is clear. They need lower public expenditures and need to deregulate labor markets and improve efficiency in their public sectors, which no fiscal stimulus will breed. They should look to the east.

Senior Fellow Anders Åslund is the author of The Last Shall Be the First: The East European Financial Crisis (2010).

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Anders Åslund Former Research Staff

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