The hard way

By R.A. | WASHINGTON

THERE'S been a new skirmish in the occasional war of words over the Baltic experience in the crisis. The usual pattern in these little battles is, someone says that internal devaluation can work around the euro-zone periphery because look at the success of the Baltics, someone else (often Paul Krugman) responds that the Baltics had a terrible crisis with output falling by far more than across the rich world and unemployment soaring, and then Baltic defenders call those people names. This all seems a little silly as the basic story of the Baltic experience and its lessons for the rest of Europe strikes me as fairly clear.

First, it is totally reasonable for Baltic leaders to be proud of the discipline they've shown and of their commitment to reform and long-run growth. And it is totally fair for Baltic residents to resent the fact that the euro-area periphery appears to be unwilling to suffer the sacrifices they suffered to get through a difficult economic period. I get the bitterness. They feel as if they've done things the "right way", that is has worked for them, and that others are now telling them that their experience was somehow a grand mistake and that others should be excused from having to follow a similar path.

At the same time, the macroeconomic facts are not in dispute. Baltic economies are growing once again. But it took a very deep downturn to get them there, including an extraordinary collapse in domestic demand and extraordinarily high unemployment. Despite recent growth, output in the Baltics remains well below pre-crisis levels—below even the trend level suggested by the pre-bubble years before 2005. It is neither an insult to the Baltics or a falsehood to point out that their experience has in fact been remarkably painful.

Third, and this is the important part, it seems quite clear that the Baltic experience is not generalisable to the euro-area periphery (so agrees Charlemagne and Olivier Blanchard, chief economist at the IMF).

The Baltic route back to growth ran through what we call internal devaluation. In the boom years before the crisis rapid growth and huge capital inflows pushed up wages, leaving workers uncompetitive after the crash. Normally, a country could address this issue by allowing its currency to depreciate; as capital flows back out of the country during the crash, the currency weakens, restoring the competitiveness of workers and enabling the country to return to growth on the back of external demand. But the Baltics were unwilling to sacrifice their pegs to the euro, such is their commitment to joining the euro area. Depreciation was therefore not an option. And so to restore competitiveness actual wage rates needed to fall. Typically, big declines in wage rates only occur in the midst of mass unemployment, which is precisely what the Baltics got.

Can internal devaluation work? Sure, under the following conditions:

1. The economy in question is willing to suffer.
2. The economy is small and open.
3. The economy has flexible labour markets, especially in wage contracts.
4. The economy has a relatively small debt stock.
5. The economy's major trading partners have relatively healthy economies.

The Baltics satisfied most of these conditions. Ireland satisfies them to a somewhat smaller extent and has had some success revaluing. The rest of the periphery looks nothing like the above conditions. Even if the south had the most flexible labour markets in the world it is unlikely that they could pull off internal devaluations. Why?

Because, as much larger economies, domestic demand is a more important component of output, and a much larger increase in trade is necessary to restore growth. Because they are heavily indebted, and so internal devaluation makes debt burdens harder to service, raising the prospect of defaults or crises. And because most of their major trading partners are in recession, often because they're also trying to devalue.

So sure, the Baltics can feel proud of their accomplishments. They suffered a lot, perhaps all for naught if the broader euro area continues to stumble. But it is fair to describe their experience as a fairly meagre success given its costs, and their model of recovery simply cannot save the euro area.