Bridge over Venta in Kuldiga, Latvia.

Eastern Europe seems poised for recovery according to the IMF (International Monetary Fund). Exports are rebounding and domestic demand is showing signs of stabilizing. The Fund predicts the region will grow by 3.3% in 2010. Meanwhile, Anders Åslund, a Senior Fellow at the Washington DC think-tank, the Peterson  Institute for International Economics, who is a former professor at the Stockholm School of Economics and the founding director of the Stockholm Institute of East European Economics, says Europeans and Americans need only look East - - to the European Union’s new eastern members - - to see that austerity can deliver growth and improve the efficiency of  European economic and social systems.

Prof. Åslund,who is author of the forthcoming book, The Last Shall Be the First: The East European Financial Crisis, says that Latvia, Lithuania, Estonia, Hungary, Romania, and Bulgaria were hit by profound financial crisis in late 2008, but their cure has proven effective. Almost all East European economies are growing and their public sectors have become leaner and more efficient.

He says it is true that the northern European Union has reformed much more than the south, but many analysts overlook an important factor: The sun rises in the east. Finland, Sweden, and Germany have benefited from outsourcing to their eastern EU neighbours in the Baltics and Central Europe, while gaining efficiency from competition from cheap, skilled labour over there. Southern Europe has been less favoured because of its greater distance from Eastern Europe. The roadmap for ailing economies is thus ready.

The first East European lesson is that a country in crisis should not wait to undertake the necessary cuts in public expenditures, because any delay will postpone the restoration of confidence. Estonia, Latvia, and Lithuania each cut their public expenditures by 8 to 10 % of GDP in 2009. The economist says ironically, it is often more difficult for countries to cut a couple of % of GDP than to cut 10 % because when the crisis is real and drastic steps are necessary, the threat of social unrest fades away. Moreover, large cuts cannot be even, they have to be selective and strategic.

Åslund says the crisis made it possible to undertake long-needed reforms of the post-communist public sector. All have closed superfluous state agencies and reduced public-sector employment and pay, by up to 30 %. Latvia closed 24 out of its 49 hospitals, greatly improving the efficiency of medical care, because communism offered many hospital beds but little medical treatment. Lithuania carried out a voucher reform of higher education, which raised both quality and efficiency.

Yet the East Europeans have not given up on their old achievements. Seven of the ten new eastern EU members have low flat personal income taxes, and Poland and Hungary are seriously contemplating adopting such taxes. No country has raised personal income taxes in the crisis. Corporate profit taxes have also stayed very low. Instead tax loopholes have been eliminated and the worst hit countries have raised excise taxes and value-added taxes, taxing consumption rather than income or capital. The far-reaching deregulation of labour and product markets is not questioned.

Prof. Åslundsays these radical reforms are carried out in the name of economic necessity and pragmatism, but they are not ideologically neutral. A reformed social market economy is arising that is more liberal and efficient than the old statist model, providing better service. It reflects the reformed Scandinavian model with more choice and therefore greater efficiency.

These ideological changes have not been lost on East European voters. Nine out of the ten new eastern EU members are ruled by center-right governments (with Slovenia being the only exception). In June 2009, center-right parties won majorities in all these countries in the European Parliament elections. The moderate free-market center-right has never been stronger in Europe. It is commonplace to complain about lack of European leadership, but this is merely a West European problem. Eastern Europe has many proven leaders.

The economist says that a year ago, the conventional wisdom was that Estonia, Latvia, Lithuania, and Bulgaria, countries which had pegged their currencies to the euro would be forced to devalue. But none of them has. Nor will they. Estonia has already been approved to adopt the euro next year. By sticking to their fixed exchange rates, these governments forced through the long-needed reforms of the public sector, for which their electorates are thanking them, and the public majority for their adoption of the euro remains massive.

The European economic convergence is proceeding because the east is reforming faster than the inert centre.

Åslund says in the American debate, it is commonplace to blame the current slow recovery on insufficient aggregate demand, and to suggest that Europeans need to do more to stimulate their economies. But the European perspective is quite different. The crucial flaws in Europe are poor competitiveness because of excessive regulations, public expenditures, and rigid labour markets, which are structural rather than macroeconomic shortcomings. Therefore, no fiscal stimulation can resolve them, while austerity breeds vital structural reforms.

The lesson for Greece, Spain, Portugal, and Italy is clear. The economist could have added Ireland to the list. These countries need lower public expenditures and need to deregulate labour markets and improve efficiency in their public sectors, which no fiscal stimulus will breed. They should look to the east.

IMF

Bas B. Bakker and Anne-Marie Gulde  of the IMF's  European Department say that  emerging Europe cannot return to business as usual. Future growth - - especially in countries that had built up large imbalances during the boom years of the mid-2000s - - must rely more on capital flows into the tradable sectors and less on flows into the non-tradable sectors. In these countries, exports are recovering but domestic demand will likely stay weak as consumers continue to rein in spending to pay off debt.

Eastern Europe was hit hard by the global crisis. The region grew very rapidly in the decade and half that preceded the world economic downturn but, in 2009, GDP declined by 6%.

The economists say that a economic theory predicts that capital should flow from richer to poorer countries. That is what happened in eastern Europe. Capital flows to the region had always been high, but from 2003 onwards, they accelerated even further. Western European banks began to invest vigorously in eastern Europe’s growing markets - - and in the ensuing competition, credit conditions loosened and growth became unbalanced. Capital inflows went largely to sectors such as real estate, construction, and banking that did not produce tradable goods - - boosting domestic demand but not supply. That led to a surge in imports, unprecedented current account deficits, and overheating economies.

In late 2008, the capital inflows came to a sudden stop. The decline in capital inflows caused a sharp drop in domestic demand. Domestic demand contracted most in countries that previously had the biggest increases in domestic demand, the large current account deficits, and the highest raise in the credit-to-GDP ratio. In countries without large imbalances, domestic demand held up better.

New export markets

Bakker and Gulde say that private sectors in countries that experienced the boom must develop new markets for exports of manufactured goods and services, which will require restructuring of their economies. That is no mean task, but it is achievable. Restructuring will be helped by market signals that will change as profits in the nontradables sector shrink and investments seek more promising venues.

But the process may be difficult. Even in the tradables sector, new projects may have to fight for much scarcer financing. Inflows will remain reduced as western banks struggle to rebuild their balance sheets and risk-adjusted returns in emerging Europe seem less attractive.

The economists say that public policies can play a role as well in steering eastern Europe toward a more sustainable growth path. More balanced macroeconomic policies and wage restraint can help prevent the overheating that pulls resources from the tradables to the nontradables sector. Fiscal policy in particular could play a much more active role—saving money when revenues are growing instead of increasing spending and boosting public wages. This may mean that during boom times small fiscal surpluses are not sufficient - - that large surpluses are needed.

Policymakers may prefer to spend in boom times, but the payoff of saving is that a large fiscal buffer will reduce the need to cut expenditure sharply during a recession - - as several countries had to do during this crisis.

The IMF says preventing overheating is important, because manufacturing competitiveness in many emerging European economies deteriorated during the boom. For example, according to EU data, Latvia’s unit labor costs in manufacturing rose 90% relative to its trading partners between 2003 and 2008. Some other countries - - notably Bulgaria, Estonia, and Romania - - also experienced a sharp appreciation of their real exchange rate.

Tighter fiscal policy

The IMF says tighter fiscal policy will help moderate wage growth. Over time, wages will catch up with those in western Europe. But if the catch-up goes hand in hand with productivity increases in manufacturing, it need not impede competitiveness nor discourage investors.

But emerging Europe should not compete on low wages alone - -  and will find it difficult to do so. Other emerging markets have even lower wages now and, as workers emigrate to western Europe, wages will rise in emerging Europe. Instead, the region should aim to produce increasingly sophisticated products. Structural reforms, including those that bolster the business climate, could help, as would improving education and, in some nations, fighting corruption.

Foreign capital inflows can also play an important role, if they are aimed at enhancing supply, especially in the external trade–oriented sector. Such investment would support growth, transfer technology, and help contribute to an improvement of labor force skills.

Bakker and Gulde conclude that some countries in the region are already following this model. In the Czech and Slovak Republics, growth during the boom was much more balanced, credit growth more restrained, and current account deficits small - - and exports played an important role. Although this strategy produced growth more muted than in some of their neighbors before the crisis, their recessions were much less deep. As a result, over a longer horizon, these two countries have grown faster than countries that had a domestic demand boom.