Nowadays, Greece, the Baltic states, and Iceland are often invoked to argue for or against austerity. For example, the Nobel laureate economist Paul Krugman argues that the fact that Latvian GDP is still more than 10% below its pre-crisis peak shows that the “austerity-cum-wage depression” approach does not work, and that Iceland, which was not subject to externally imposed austerity and devalued its currency, seems to be much better off. Others, however, have noted that Estonia pursued strict austerity in the wake of the crisis, avoided a financial crisis, and is now growing again vigorously, whereas Greece, which delayed its fiscal adjustment for too long, experienced a deep crisis and remains mired in recession.
Does Iceland constitute a counter-example to Latvia? After all, its GDP fell much less, although it ran similarly large current-account deficits before the crisis – and ran much larger fiscal deficits for longer. In contrast to Latvia, Iceland let its currency, the krona, devalue massively. But, the devaluation was much less important than is widely assumed. While exports did indeed perform very well, Iceland’s main exports are natural resources (fish and aluminum), demand for which held up well during the post-2008 global crisis.
That sustained demand provided an important stabilizer for the domestic economy, which the Baltic states did not have. Indeed, Latvia was particularly hard hit by the slump in global trade in 2008-2009, given its dependence on exports. Iceland’s superior economic performance should thus not be attributed to the devaluation of the krona, but rather to global warming, which pushed the herring farther North, into Icelandic waters.
Moreover, Iceland’s public debt/GDP ratio now stands at 100%, compared to only 42% in Latvia. Part of the difference, of course, reflects different starting conditions and the cost of bank rescues. But there can be no doubt that, by keeping deficits under control, Latvia’s public finances are in much better shape today, with debt sustainability no longer a problem. By contrast, Iceland’s debt has become so large that it is likely to constrain future growth.
Vir: Daniel Gros, Project Syndicate