Paul Krugman's Baltic Problem

Why is the Nobel Prize-winning economist mocking the countries that have escaped the eurocrisis?

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.

Greece stands out as the main villain of the European crisis. Multiple Greek governments had grossly falsified their statistics and maintained an average budget deficit of 7 percent of GDP for the last two decades, refusing to fulfill their EU obligations. The George Papandreou government adopted a stabilization program in May 2010, with more IMF funding than any IMF program in history but one year later it had expanded the already excessive public administration by a net of 5,000 civil servants. Papandreou raised already high taxes rather than cutting public expenditures.

Yet incredibly, Krugman calls Greece a victim, laying all blame for its predicament on the EU, the European Monetary Union, and Germany. When he's not exclaiming "this isn't a Greek problem... it's a European problem," he's pointing the finger at "the arrogance of European officials, mostly from richer countries, who convinced themselves that they could make a single currency work without a single government."

More bizarrely, while he considers Greece innocent, Krugman has attacked the far smaller and poorer Baltic countries in perhaps a dozen blog posts. Krugman is not, presumably, some kind of bizarre anti-Baltic bigot. His problem is that they have pursued austerity and succeeded; they prove that Krugman's analysis of the European crisis is wrong. As it happens, Estonia actually adopted the euro in January 2011, and the Baltic economies appear to have entered a high-growth trajectory.

Krugman's sour grapes are on full display. He dismissed the success of Estonia, "the poster child for austerity defenders" as insignificant in a June 6 post that provoked the wrath of Estonia's President Toomas Hendrik Ilves on Twitter. Undeterred, on July 1, he wrote,  "the best the defenders of orthodoxy can do is to point to a couple of small Baltic nations that have seen partial recoveries from Depression-level slumps, but are still far poorer than they were before the crisis." On one rare occasion, Krugman partially admitted a positive effect from austerity: "yes, it's actually worth noting that essentially nobody has managed to regain the confidence of the markets [through austerity], except for, you know, Latvia, which had almost no debt." Well, if you pursue austerity, you do escape debt.

The most generous explanation for Krugman's Baltic blind spot is that he thinks mostly about big states, and perhaps only about the United States. Small, open economies work quite differently. Tiny countries tend to adopt a foreign currency or peg their exchange rates, as the Baltic countries and Bulgaria have done. They cannot allow themselves large budget deficits, because the markets will not allow them as high levels of public debt as the likes of Japan or the United States. Their bond yields will rise at even moderate debt levels, as Slovenia, Cyprus and Spain have discovered. Another way to look at it is that even when Krugman writes about European economic policy, he is actually only making arguments for what he believes the United States should do.

Citizens of the Baltic countries can be grateful that their leaders never listened to Krugman. He advocated devaluation when it proved unnecessary and probably would have been harmful. He has persistently argued for less austerity and more fiscal stimulus everywhere, blatantly disregarding the need for public debt to be sustainable. And the benefits of fiscal stimulus remain dubious, while the drawbacks -- excessive budget deficits have forced several countries to accept international bailouts to escape default -- are clear for all to see.

Krugman praises the fiscally irresponsible and scolds the virtuous, denigrating the Baltic achievements while trying to explain away miserable failures, such as Greece. Doesn't he see that his advice would only aggravate these crises, while the opposite policies resolve them? How can anybody be so wrong for so long without feeling at least a little bit ashamed?



Libya's Downward Spiral

The country has been going to hell in a handbasket for months now. We just weren't paying attention.

The tragic death this week of four U.S. officials, including the U.S. Ambassador to Libya, Chris Stevens, is a major turning point for Libya's transition to lasting stability.

As details emerge, it appears increasingly probable that al Qaeda-linked groups were behind the violence, likely acting in reprisal for the death of Abu Yaya al-Libi, Al Qaeda's second in command, who was killed by a drone strike in Pakistan earlier this year. Just prior to the Benghazi assault, on the 11th anniversary of the 9/11 terrorist attacks, al Qaeda leader Ayman al-Zawahiri released an Internet video in which, according to CNN, he said that al-Libi's  "blood is calling, urging and inciting you to fight and kill the crusaders."

Even if the deaths were not linked to al Qaeda or its dangerous North African affiliates, the event is still a major threat to Libya's chances of successful transition to stability, and could be a watershed of the worst kind. The nightmare scenario that Libya could go the way of Iraq in 2004 is still not likely, but no longer seems implausible.

The Libyan government's public statements indicate they fully recognize the gravity of these attacks. The immediate response, if any, must be adroitly measured and await a clear picture of the facts.

In a way, this tragedy is an opportunity for Libya's new government. More than any other event since the fall of Tripoli, the attacks should force the country's leaders to take a much more active approach to ensuring safety and security and pushing ahead with other state-building measures. If these attacks do not galvanize momentum for progress, they could undermine it entirely. Instability in Libya could, in turn, undermine progress elsewhere in a region where transitions are still fragile after the Arab uprisings.

For their part, the United States, its allies, and partners that helped free Libya from Qaddafi's rule have a responsibility to do their utmost -- providing intelligence, technical advice, and, where necessary, military support -- to ensure the situation does not spiral out of control, squandering the investment that was made in toppling Muammar al-Qaddafi last year.

One question many are asking the wake of Tuesday's events: Were the United States and its allies naïve about the dangers in post-intervention Libya? The attacks come on the heels of a gradual deterioration of the country's security in recent months.

Last year's uprising began in Benghazi, Libya's second largest city, where Tuesday's attacks occurred. Qaddafi claimed the revolt was the work of terrorists, long native to Eastern Libya, and warned that if it were not crushed, the country could become the Somalia of the Mediterranean -- a string of radical "Islamic emirates" just across the water from southern Europe.

This was a gross exaggeration -- the vast majority of the revolutionaries had no ties whatsoever to al Qaeda or other terrorist groups, and when Qaddafi moved to raze Benghazi with tanks and aircraft, the Arab League and United Nations condemned him.  The United States, its NATO allies, and Gulf partners quickly intervened with massive airpower and a small number of special forces on the ground. The conflict dragged on, but in August, Tripoli fell, and in October, Qaddafi was captured and killed. After four decades of repression under Libya's self-proclaimed "Brother-Leader," Libyans emerged free to build their own future.

But how much building has really been done?

In contrast with nearly all other post-Cold War military interventions, NATO and its partners chose not to deploy post-conflict stabilization forces when the war was over.  The security situation seemed calm -- indeed much calmer than many had anticipated it would be. The putative Libyan authorities were adamantly against any such deployment, fearing their already limited legitimacy would be further weakened by the presence of foreign troops on Libyan soil. They needed full credit for their victory, they argued. Few outside powers were interested in putting "boots on the ground" anyway, since most Western leaders had promised that Libya would be very different from Iraq and Afghanistan.

Libya's new leaders were right to be concerned about their legitimacy: They evinced little control over Libya's territory and security, which, for all intents and purposes, was still in the hands of hundreds of armed revolutionary militias that had sprung up across the country during the revolution.

Initial efforts to disarm, demobilize, and reintegrate these militias into a centralized Libyan army under the authority of Libya's leadership were quickly abandoned when it appeared that doing so might spark violence and undermine Libya's tenuous stability. Subsequent efforts to do so by international actors met with further resistance and even suspicion from Libyan authorities. Libyan hackles were raised by an initial effort by the British and others trying to help assess Libya's security-sector needs, further slowing reform and disarmament efforts. Meanwhile a hodgepodge of small-scale, apparently grassroots local disarmament initiatives went forward in an uncoordinated fashion.

Luckily, the situation remained relatively calm. Over the course of the next several months, the delicate peace was punctuated by occasional clashes between the militias. Some of the fighting was between pro-regime holdouts and representatives of the new Libya. Other violence, however, was more parochial in nature, with militias battling over turf,in Tripoli and other cities.

Most of this violence, however, did not affect Libya's citizens or significantly hamper progress on other fronts. In July, Libya held successful elections, and moderate secular parties took a plurality of seats in the new Libyan congress. Most outside observers hailed these elections as a major success and evidence that Libya's future was brighter than many had once predicted. 

At the same time, however, troubling signs that the security situation was falling apart began to appear. Whereas most of the violence in the first half of the year involved small-scale turf wars between militias and struggles over access to smuggling routes in Libya's distant southern reaches, a new kind of violence had begun to emerge over the summer.

This violence has come in three forms:

First, attacks against Libyan government officials and buildings, both in Benghazi and in Tripoli. Car bombings and small-armed assaults on government buildings indicated a different kind of threat than militia turf wars.

Second, more aggressive actions by radical Islamist militias, who recently destroyed a number of Sufi shrines charging that Sufi practices are un-Islamic. Although it condemned these attacks, the Libyan government put its inability to stop them on full display, weakening its authority.

Third, attacks against diplomats, including an attack against a U.S. diplomatic vehicle in Tripoli and an attack on the British ambassador's car in Benghazi. Until this week, these attacks looked like isolated incidents. Now they appear in a different light.

So who is responsible? While the reaction to the online release of an incendiary film viewed as offensive to the Prophet clearly set the stage for Tuesday's attacks in Libya and Egypt, the attacks in Benghazi, which involved small arms and rocket-propelled grenades, were clearly more than just a mob that got out of control and accidentally burned down the U.S. consulate.

The first impulse of the Libyan government has been to point the finger at holdover Qaddafi-regime sympathizers. That Libya's new government should blame Qaddafi is understandable given how long they suffered under him and the fact that their authority comes from first defying and then ousting him.

But while these claims are plausible, the evidence for them is thin. They seem aimed more at keeping the spirit of the revolution alive in hope of distracting from the slow progress in other areas and the government's own lack of authority.

More likely, groups in eastern Libya that have had ties to al Qaeda are involved.  Concerns about groups such as the Libyan Islamic Fighting Group (LIFG), which played an important role in Libya's liberation, are long-standing. Knowledge of such groups initially made several U.S. officials wary of intervention. Even if the LIFG appears now to support the new Libyan state, such concerns have not gone away. The eastern town of Derna is well known as a hotbed of radicalism and source of recruits for the insurgencies in Iraq and Afghanistan. This summer, the Libyan authorities, reportedly arrested 20 suspected AQIM members on Libyan soil.

Until now, Libya had enjoyed a relatively calm environment for its transition. To avoid a nightmare scenario, the Libyan government and broader public must use these attacks to galvanize momentum for progress on key fronts -- above all militia disarmament -- building necessary security institutions and establishing a just but effective control of its own territory. Most militias are benign. But as long as they persist, the fractured nature of Libya's security will create opportunities for calamities like this one.

Progress on these fronts, difficult already, will be even harder now because the attacks complicate Libya's relations with the United States and other Western powers. Most U.S. diplomats are being evacuated, and the embassy will likely go on lockdown. The security measures, coupled with the reduction in bandwidth, will seriously hamper the ability of U.S. officials to meet with their Libyan counterparts and access Libyan society at large. Many Western NGOs in Libya are grappling with whether to curtail their efforts, which would further slow progress toward transition.

Meanwhile, the deteriorating security could introduce a new dynamic. The less able the Libyan state is to provide security for Libyan citizens, the more those citizens will turn to other forms of protection -- and the more the legitimacy of the new state and its officials will falter. In these conditions, the appeal of extremist elements could easily grow.

No matter what happens in Libya, history will recall that NATO's intervention saved lives in Benghazi and opened new prospects for Libya's future. But the post-conflict order has been in limbo ever since Qaddafi was killed last October.

Libya is neither Iraq nor Afghanistan, let alone Somalia. It has much going for it that these post-conflict cases did not, including relatively unified citizens, wealth, a neighborhood comparatively conducive to stability, and a clear victory over the former regime.

But Libya's future remains unwritten. NATO's intervention handed the country over to the Libyan people. Now they need to govern it, lest that opportunity slip from their hands.