Europe remains divided, but its division no longer runs between East and West—it is now between North and South. Northern Europe thrives economically, while most of Southern Europe is in financial crisis.
The advantages of the northern fiscal approach are crystal clear. Latvia and Greece offer the most obvious contrast. Both countries have lost almost a quarter of their output, but Latvia suffered only two years of output decline, while Greece has so far recorded six years of contraction. And unlike Greece, Latvia has now resolved all its financial problems.
Any observer would presume that the International Monetary Fund (IMF) would praise the North and urge the South to follow its example. Incredibly, the IMF does the opposite. It urges the North to loosen its sound fiscal policies and the South to take more time to reduce its excessive budget deficits. Thus, the IMF encourages the South to suffer longer. The explanation seems to be poor economic theory, a revival of old-style Keynesianism that caused stagflation with low growth and high unemployment in the 1970s.
When the global financial crisis hit in the fall of 2008, the three Baltic countries—Latvia, Estonia, and Lithuania—instantly put their house in order. They front-loaded fiscal tightening, carrying out a fiscal adjustment of about 9 percent of GDP in 2009. Each of them cut public expenditures by about 6 percent and hiked tax revenues by about 3 percent of GDP. In doing so, the Baltic countries enjoyed seven notable advantages. And most of the lessons they learned would be useful to other European countries as well.
First of all, when a severe crisis hits, it is politically easy to do what is necessary. As Rahm Emanuel so rightly stated: "A crisis is a terrible thing to waste." In crisis, people think of the interests of the nation rather than the interests of their particular group. The Baltic countries saw minimal protests precisely because they resolved their crisis almost instantly, while the tardy South European governments have experienced massive and prolonged popular unrest.
Second, the design of a reform program becomes much better if it is developed right away, as vested interests lie low when a crisis hits. Good program design is much more a matter of politics than analysis, because we largely know what reforms are needed. Europe's big problems are low growth and high unemployment, and both require structural reforms such as deregulation of labor and product markets.
Third, financial sustainability is a fundamental issue. At the end of 2011, public debt in the euro area averaged no less than 98 percent of GDP, while the EU Maastricht ceiling is 60 percent of GDP. One-third, or nine, of the 27 EU countries have required or still require financial stabilization programs. European fiscal policy should therefore focus on containing public debt.
Fourth, international rescue funding is often limited. Latvia faced such a barrier in 2009, while the IMF and the European Union have poured excessive funds in Greece, leaving it with an unsustainable debt burden. As a result, Greece has gone through a default.
Fifth, an early fiscal improvement restores confidence both at home and abroad. Financial flows return to the country, firms invest again and interest rates decline. Latvia had accomplished that by July 2009, while Greece has yet to succeed in doing so.
Sixth, a large front-loaded fiscal adjustment inevitably contains more expenditure cuts than tax increases, simply because tax revenues cannot be boosted fast. This is advantageous in European countries, which all have excessive public expenditures. The Baltic fiscal adjustments consisted of two-thirds of expenditure cuts and only one-third of tax hikes, while the less successful southern programs relied much more heavily on tax increases, which in turn have stalled economic growth.
Finally, a quick return to economic growth is vital for economic, financial, and political reasons. The three Baltic countries restored growth after only two years of decline, and all three recorded growth rates of around 5 percent in 2011 and 2012. They are now clearly on the highest growth trajectory in Europe, a result of allowing fiscal adjustments to drive vital structural reforms. Southern Europe, by contrast, is set to record many consecutive years of economic decline. No wonder that the Greek people protest so vehemently.
It is now clear that the IMF advice to Southern European countries could hardly have been more flawed. In 2008–09, it urged them to carry out fiscal stimulus. Cyprus, Slovenia and Spain did so, ending up in severe financial crises. Now, the IMF is publicly telling the crisis countries not to cut their budget deficits too fast, which means that the IMF effectively contributes to prolonging and aggravating their crisis.
So what does all this mean for the United States? In fact, because the US situation is so different, it does not mean very much. Admittedly, the US public debt is significant at 107 percent of GDP (not deducting the social security trust fund), but the US government also enjoys an exorbitant privilege of cheap international financing because it holds the dominant global reserve currency. Therefore, it runs minimal risk of default. Moreover, the United States does not have the European problems of overregulated labor and product markets, and thus few Americans understand the nature of these issues in Europe. The US public expenditures remain far below the average European level, so the need to cut them is not as obvious.
Since the United States faces a rather different economic situation, much of the American commentary on the European financial crisis is misplaced. Few American economists know much about the European economies—Paul Krugman is a prime example with his persistent condemnation of the successful Baltic countries. If you know so little, the Hippocratic Oath should be applied: Do no harm!