The Boom-Bust in the EU New Member States: The Role of Fiscal Policy

Thursday, January 21

Presenter
Bas Bakker, Senior Regional Resident Representative for Central and Eastern Europe, International Monetary Fund


Figure 1

Summary
Booms never last, and the reversal is usually sharper than expected—the need to build up buffers in good times to prepare for the bad times that inevitably follow is therefore a clear, if too often unheeded lesson of past crises. This was one of the key lessons when Mr. Bas Bakker, IMF Senior Regional Resident Representative for Central and Eastern Europe, spoke on  January 21, 2016 at the JVI on “The Boom-Bust in EU New Member States: The Role of Fiscal Policy.” The lecture was open to the public and also formed part of the IMF course on Macroeconomic Management and Fiscal Policy. Mr. Norbert Funke, JVI Director, gave welcoming remarks and Mr. Martin Schindler, JVI Deputy Director, moderated the session.

Mr. Bakker explained that from 2003 to 2008 emerging Europe experienced a dramatic boom in both credit and domestic demand, fueled by unprecedented capital inflows from Western European banks. Though the credit boom contributed to the region’s rapid economic growth and facilitated income convergence with Western Europe, it also led to overheating and rapidly rising current account deficits. For instance, during 2002-07, Bulgaria, Estonia, and Latvia averaged deficits of more than 10 percent.

By 2008, in many countries growth had become unsustainable, and was vulnerable to  sudden declines in capital inflows—as happened in September 2008 after the Lehman Brothers collapse. The sudden stop, and then reversal, of flows from parent banks into emerging Europe ended the boom in domestic demand and triggered a deep recession, especially in the countries where credit and domestic demand had been highest pre-crisis. Mr. Bakker pointed out that the IMF had moved promptly to provide balance-of-payments support to crisis-hit countries. The crisis was deep, but n the second half of 2009 risk aversion dropped, and  in 2010, the region started to grow again.

As for the role of fiscal policy in the financial crisis, Mr. Bakker emphasized that in CESEE (except for Hungary) the crisis originated in the private sector-led boom and abrupt bust. However, procyclical fiscal policies exacerbated the imbalances. During the good years, expenditure, grew too rapidly (boosted by a surge in tax revenues), fueling overheating (Figure 1). When the crisis hit, tax revenues collapsed while the need to provide support to the financial sector further added to the fiscal pressures. Confronted by very high risk premia, most countries were forced to adjust by tightening fiscal policy in the midst of the crisis.

Mr. Bakker noted that this adjustment did help lower the cost of funding and insulate the region from spillovers from the euro area sovereign debt crisis. However, although countries recovered to above pre-crisis growth, the experience has left the new EU members with higher public debt than before the crisis (Figure 2), which will require continued fiscal consolidation. Unfortunately, in Romania, Croatia, and Slovenia, among other countries, some “adjustment fatigue” seems to have already set in.

Figure 2

Mr. Bakker concluded by reiterating the basic lesson that economic imbalances tend to accumulate during good times, and when times worsen the reversal that follows is always more abrupt than anticipated. Therefore, countries where domestic demand is booming need to build up very large fiscal surpluses so that automatic stabilizers can operate when the bust comes.

The presentation ended with questions and answers from the floor, which focused on issues related to vulnerabilities, crises, and the policy-mix in the CEECs. To pick just one question, participants wondered whether capital flow management measures would have been a good option during the boom-bust. Mr. Bakker noted that while EU membership restricts the ability to impose capital flow restrictions, a number of countries in the region made active use of prudential measures during the boom phase. Given that macro-policies (in particular, fiscal policy) were procyclical, such measures did little to stem the surge in capital flows. However, at the height of the crisis, the European Bank Coordination “Vienna” Initiative helped prevent a systemic banking crisis in the region and ensured that credit kept flowing to the real economies.

Irina Bunda, Economist, JVI

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