Madis Müller: New models in Northern Europe?
Speech by Mr Madis Müller, Deputy Governor of the Bank of Estonia (Eesti Pank), at a
symposium organised by the Konrad-Adenauer-Stiftung, Berlin, 28 November 2012.
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Ladies and gentlemen,
Thank you for this excellent opportunity to discuss together with colleagues from Latvia and
Lithuania the experience of the three Baltic countries during the financial crisis. While the
situation of each country is undoubtedly different, we can still consider if there are any
lessons one could learn from the Baltic cases.
In my opening comments, I would like to address specifically the question of what is the best
pace for economic adjustments once a country has been hit by a crisis. We hear today many
suggestions that austerity requirements have gone too far and that we should allow more
time for implementing difficult reforms.
First, let me start by saying that in more open economies, the crisis was felt almost instantly.
In small and open countries such as the Baltic countries, there was no domestic demand to
substitute for the lost export income. The economic reality had changed very suddenly.
The EU countries could be divided into two groups. The countries that had a higher export
dependence had to react fast to the changed economic environment. This applies especially
to smaller countries, including the Baltic States, although Germany's economy is also heavily
reliant on exports. Those small countries in particular had to accept the new economic reality
of lower demand, higher unemployment and forced fiscal consolidation due to a fall in tax
income or borrowing difficulties.
The other group consists of bigger or more closed economies that were relying on domestic
demand. They were able to smooth the initial impact of the crisis with more extensive
government support measures. There was also the expectation that the crisis would be
temporary. With the benefit of hindsight we know that we were not facing a temporary bump
on the road, but a more fundamental need for adjustment. The initial smoothing of the shock
may have been even more costly as it resulted in a higher level of public debt.
Secondly, the required policy adjustment involves a dimension which we now consider
critical: the speed of reacting and the decisiveness of policy actions. The Baltic countries
have learned it firsthand through their experience, which of course is the hard way.
There are few economists today that would fundamentally question the need for fiscal
consolidation and structural reforms in Europe, as the crisis has clearly turned out not to be
temporary. However, we all know it is politically difficult to cut government spending and
implement reforms fast. The natural tendency for most politicians is to favour gradual
adjustment. "Gradualists" say that in case of fast changes the risk of possible policy mistakes
is higher, leading to losses in physical and human capital. Opponents of that view, including
myself, certainly acknowledge those risks. But we feel that the costs of delayed action may
sometimes outweigh its benefits, as postponing the inevitable and failing to accept the
changed reality will lead to additional unnecessary costs. One should not want to keep alive
old structures that clearly cannot be sustainable in the changed world for longer than
necessary. This is a waste of limited resources and reduces long-term productivity. There is
a saying that "a crisis should not be wasted" - negative shocks to an economy should lead to
productivity gains.
Our experience shows that quick decision-making and decisive policy actions can shorten
the period of uncertainty that also weighs on economic activity. People and entrepreneurs in
countries with delayed reforms overreact, leading to a higher level of risk aversion than
necessary. Overshooting in risk aversion results in lost jobs and postponed investments.
Estonia, for example, lost almost 20% of its GDP during the crisis. By now we have regained
the pre-crisis level, contrary to many countries that preferred to delay the necessary reforms.
Some of them still face years of decreasing economic output.
In summary, I would like to stress that prolonged fiscal consolidation and structural reforms
can lead to unnecessary costs to the society. Some countries have chosen to delay the pain
and take only gradual steps with their structural reforms, but this has in fact resulted in a
reduction of the overall economic activity to the extent that might be no less than the
shortterm cost of a quicker adjustment. The difference is that they are still not done and cannot
hope for a rebound that might otherwise be there.