Amid the carnage of the European financial crisis, the Baltic countries, by and large, are doing quite well. Estonia, Latvia, and Lithuania are booming. Last year, their growth rates reached 7.6 percent, 5.5 percent, and 5.9 percent, respectively. The turnaround, driven largely by manufacturing exports, has been one of the most remarkable and promising stories of the crisis. In 2008-2009, all three countries were badly hit by a nearly complete liquidity freeze, which sank their economies by as much as 24 percent. Even so, only Latvia required an IMF and EU bailout, and all three returned to growth after only two years of recession. Today, all three Baltic countries have ample access to international financial markets, and their credit ratings have risen steadily since the summer of 2009.
The Balts' rebound stands in stark contrast to the fate of eight mainly southern EU countries -- Hungary, Romania, Greece, Ireland, Portugal, Cyprus, Spain, and Slovenia -- which either already have or probably will require stabilization programs with external financial support.
So what happened?
The simple explanation is that the Baltic countries have pursued the opposite policy of the southern Europeans. In 2009, the Baltic governments each carried out strict austerity, with a fiscal adjustment of about 9.5 percent of GDP, mainly though expenditure cuts and substantial structural reforms. The southern Europeans, by contrast, delivered substantial fiscal stimulus in 2009. Previously fiscally conservative Cyprus and Slovenia ran up budget deficits of 6 percent of GDP in 2009, but neither benefited from greater growth. Instead, they have been trapped with large budget deficits and are now being overwhelmed by their public debt, admittedly also because of banking crises.
One would think, given the divergent outcomes, that a serious economist would advocate for countries to follow the successful example of northern Europe rather than the failed strategies of the south. Nobel laureate and New York Times columnist Paul Krugman doesn't seem to see it that way. Throughout the crisis, Krugman has attempted to explain away or even mock the Baltic countries' success even as they have continued to inconveniently disprove his arguments.
On Dec. 15, 2008, Krugman issued his first pronouncement on the Baltic crisis in a post titled, "Latvia is the New Argentina." He meant that Latvia would have to devalue its currency and perhaps default, as Argentina did in 2001. Neither happened. Latvia returned faster to fiscal health than anybody had anticipated. Krugman's claim that devaluation was necessary for Latvia's recovery (and presumably also Estonia and Lithuania's) turned out to be wrong.
Krugman's main line of argument has been that more fiscal stimulus is always needed as long as a significant output gap exists. But in Cyprus and Slovenia, very substantial fiscal stimulus generated minimal growth. Neither country would be suffering from its current financial conundrum had it not followed such a policy. Spain would probably be safe as well.
Krugman's disregard for the risk of sovereign default is perplexing. His main line of thinking seems to be that Europe has a growth problem, not a debt problem, and he appears to believe that a fiscal stimulus can always overcome the threat of the increased public debt burden. Even in the case of Greece, which had a gross public debt of 165 percent of GDP at the end of 2011, he failed to notice the danger but financial markets declared that the country's public debt was excessive. Slovenia's public debt of 50 percent of GDP, for instance, is more than the markets accept, as its bond yields have exceeded 7 percent.
It is difficult to understand how Krugman can ignore the structural reforms that are urgently needed in Europe. All the southern European countries have overregulated labor markets that have caused persistently high unemployment. In Spain, it is easier to get a divorce than to sack a worker -- which explains in part why companies are very reluctant to hire new ones. But to Krugman, unemployment is merely a matter of lack of demand: "The urge to declare our unemployment problem "structural" -- a supply-side problem of some kind, not solvable by the "simplistic Keynesian" notion of just increasing demand -- has been quite something to behold," he wrote on June 8.