Twice the pride, double the fall

Transcription

1 ALEXANDER PFANNKUCHE UNIVERSITY OF APPLIED SCIENCES BREMEN Twice the pride, double the fall - The Baltic States facing the aftermath of Financial Instability - Abstract This paper investigates the recent economic outcomes of the Global Financial Crisis (GFC) in the Baltic states. It shows that the structure of the financial system is crucial to understand the huge impacts of GFC on economic development. In this context, the Financial Instability Hypothesis from Hyman Minsky is recommended to understand the fragility of the financial system as a threshold for debt inflation processes leading to fatal recessions. The vulnerabilities of the small, open Baltic economies to external global shocks were boosted through a policy of short-term production strategy and a high dependency on FDI combined with indebtedness of household and enterprise sector via foreign dominated banking sector. This situation led to scheme of Ponzi finance in the Baltic states and explains why the crisis spread so early and so disastrous through the economies of the Baltic states. I. Introduction The Global Financial Crisis (GFC) had a huge impact on the economic development of the countries in Central and Eastern Europe (CEE). Economic upswings were stopped, economic stagnation occurred, or recessions accelerated in all countries. The crisis, however, did not spread simultaneously through Europe, and the negative outcomes for national economies varied significantly. Some countries have almost overcome the situation and are returning to a path of growth in Other countries are still caught in recessions with high economic and social costs, including unemployment, current account deficits, and budget deficits. The

2 2 ALEXANDER PFANNKUCHE heterogeneity of the economic impacts of the crisis in CEE countries lead to the question of whether there are inherent factors which help to mitigate or, alternatively, to boost the negative economic effects of the GFC. In this context, the Baltic countries make an excellent case study regarding the vulnerabilities of small open economies within the Global Financial System. This paper identifies the transmission channels and multipliers that were responsible for the economic progress in recent years. The financial system should be seen as the core cause of the crisis. For the theoretical background, this paper uses a Minsky-Approach of the unstable economy to reveal the role of international finance in the Baltic states during the recent crisis. The paper is organized as follows: Section II provides a short survey of the recent economic situation in the Baltic states, with its main focus on the years of crisis. Section III uses a Post-Keynesian approach of Minsky s Financial Instability Hypothesis, which is applied to the Baltic Financial System in the fourth Section. II. Recent Economic Situation During , the emerging East European countries suffered the largest output declines of all regions in the world. Among these countries, the Baltic economies fared the worst. Figure 1: Real GDP growth rates, , in percent. Note: 2010 are estimates. 15,0 10,0 5,0 0,0-5,0-10,0-15,0-20, Estonia 10,0 7,2-3,6-14,1 0,8 Latvia 12,2 10,0-4,6-18,0-4,0 Lithuania 7,8 9,8 2,8-15,0-1,6 Source: IMF, World Economic Outlook Database, April 2010

3 Twice the pride, double the fall 3 As can be seen in Figure 1, output decline in 2009 has double-digit values. Even in 2010, a contracting GDP in most countries is estimated, ranging from -1.6 to -4.0 percent. Only the Estonian Economy seem to realize a small positive growth this year. Starting in 2007, the Baltic countries benefited from high, nearly double-digit growth rates. The crisis occurred early in the Baltics, starting in the third quarter of 2008, after the collapse of Lehman-Brothers. The economic decline has continued until the present. From the third quarter of 2008 to the third quarter of 2009, output in Estonia fell approximately 16 percent, in Latvia approximately 19 percent, and in Lithuania approximately 14 percent. 1 These huge output declines led to high unemployment in these countries. Figure 2 shows the rise in joblessness. Starting from different levels in first quarter of 2008, unemployment rates in these countries jumped to double-digit values. The situation in Latvia is most dramatic, with unemployment rates temporally above 20 Percent. Figure 2: Quarterly Unemployment rates 2008/1-2010/2 in % /1 2008/2 2008/3 2008/4 2009/1 2009/2 2009/3 2009/4 2010/1 2010/2 Estonia 2,5 2,5 2,8 3,9 7,1 9,8 10,9 15,5 17,8 18,6 Latvia 6,5 6,3 7,2 9,9 13,9 16,7 18,4 19,7 20,4 19,4 Lithuania 4,9 4,5 5,9 7,9 11,9 13,6 13,8 15,6 18,1 18,3 Source: Central Statistical Bureau of Latvia / Department of Statistics to the Government of the Republic of Lithuania / Statistical Office of Estonia (2010), own calculations. On the other hand, the Baltic States seem to have no inflationary problems in the subsequent years. Instead, they have deflationary processes. Besides the distortion in the real sphere, the sharp cut in consumer spending dropped the inflation rate below zero. Table 1 shows the annual percentage change of consumer prices from

4 4 ALEXANDER PFANNKUCHE 2007 to The IMF forecasters have estimated deflation will continue until at least Even if the economic recovery is much faster than expected, the risk of another period of accelerating inflation is minor. Table 1: Annual percentage changes of consumer prices Estonia 6,6 10,4-0,1 0,8 1,1 1,3 Latvia 10,1 15,3 3,3-3,7-2,5 0,0 Lithuania 5,8 11,1 4,2-1,2-1,1 0,1 Source: IMF, World Economic Outlook Database, April 2010 For these reasons, the problem of inflation must not be considered within the recent situation. To sum up, the major macroeconomic indicators leave no room for interpretation: The Baltic countries were trapped in a deep economic recession. The question of how to overcome this situation in order to reduce unemployment and to return to a path of growth as fast as possible is highly related to the questions of how and why the negative economic effects of the GFC hit the Baltic states so hard. For this reason, we will try to answer this question with an approach that assesses the core of a modern monetary economy. III. Financial Instability Hypothesis In this Section we will build up a theory of financial fragility for further investigation in the rest of this paper. As mentioned in the introduction, we recommend a theory that considers the special characteristics of the object of investigation and that also has the ability to explain the economic circumstances of the recent crisis. Hyman Minsky s thoughts regarding a fundamental interpretation of Keynes General Theory were banned a long time in the academic community. Economic researchers have rediscovered this approach, although a few people always advised against the risks of uncontrolled capital markets. 2 1 Source: Central Statistical Bureau of Latvia / Department of Statistics to the Government of the Republic of Lithuania / Statistical Office of Estonia 2010, own calculations. 2 For an excellent interpretation of Minskys thoughts in conjunction with the GFC see: J. Bibow, Keynes on Monetary Policy, Finance and Uncertainty Liquidity preference theory and the global financial crisis,

5 Twice the pride, double the fall 5 The main statements of Minskys theory and its interpretations have to be seen in contrast to the economic mainstream known as the New macroeconomic Consensus, which is highly affected by the classical theory. First, the economy is not a self-stabilizing system at all times, it depends on the financing regime. Second, the classical dichotomy of monetary and real sectors is ineligible. The role of money should not only be reduced to price affection. Monetary policy has had an impact on the real sphere. Third, the classical saving first hypothesis is flawed. Finance (and therefore money) is crucial for investment, not saving. 3 These statements trace back to Keynes general theory and the fundamental interpretations of it given by Minsky in Why is the economy not a self stabilizing system? The answer is quite simple: within economic business there is uncertainty about the future. Economic units act without knowledge of future events; they can only compose expectations. In times of boom and crisis, these expectations misjudge the real state of affairs. Therefore, business cycles are an inherent factor of the economic system. This point was already stressed by Keynes 5. Going further, however, situations sometimes occur which seem to have the potential to spin out of control. 6 The above-mentioned contradictions to mainstream economics can be seen as the underlying processes leading to instability and the so-called Minsky Moment. The crucial point is the structure of finance by the time an economy is on the edge of crisis. In general, three debt relations can be identified for economic units: hedge, speculative, and Ponzi finance. Within the hedge finance, all contractual liabilities of a firm, for example, can be covered by the cash flow. Speculative finance units are those that cannot cover all commitments on operating activities. Therefore, borrowing or selling assets is needed. In a Ponzi situation, the assets owned by the unit were smaller than the liabilities. 7 Routledge, New York For older debates see: J. Kregel, Yes It Did Happen Again A Minsky Crisis Happened in Asia, The Levy Economics Institute of Bard College 1998, Working Paper, No H. P. Minsky, The Financial Instability Hypothesis The Levy Economics Institute of Bard College 1992, Working Paper, No. 74. pp H.P. Minsky, John Maynard Keynes- Finanzierungsprozesse, Investitionen und Instabilität des Kapitalismus, Metrolpolis-Verlag, Marburg For an illustration of the business cycle see: J.M. Keynes, Allgemeine Theorie der Beschäftigung, des Zinses und des Geldes, Duncker & Humblot, Berlin 2006, pp H. P. Minsky, The Financial Instability Hypothesis The Levy Economics Institute of Bard College 1992, Working Paper, No. 74. p H. P. Minsky, The Financial Instability Hypothesis The Levy Economics Institute of Bard College 1992, Working Paper, No. 74. p. 6.

6 6 ALEXANDER PFANNKUCHE Bringing the above arguments together, the financial regime in an economy is responsible for instability. The economy may well be characterized as a stable system if hedge finance dominates. The greater the weight of speculative and Ponzi finance, however, the more unstable the economy is. Furthermore, the economy becomes a deviation amplifying system. The Minsky Moment describes the point at which an economy changes from speculative to Ponzi finance. A high inflationary process is a potential starting point if monetary policy tries to reduce inflation by monetary constraints. The high addiction to foreign financing like FDI can be another cause for reaching a Minsky Moment. If capital inflows decrease abruptly, then a sizeable body of finance commitments can go Ponzi and a process of asset elimination begins. In the next section, we will investigate the structure of the economic crisis in terms of the Financial Instability Hypothesis. IV. Financial Fragility and Macroeconomic Outcomes The past section argued that the economic system will fall into an unstable condition if the financing structure is highly speculative. Regarding the impact of the GFC, one can assume that the Baltic states were hit so hard because of the characteristics of the financial system. To verify this assumption, we will present the state of finance prior to and at the beginning of the GFC. Two major theoretical issues should be investigated: the role of FDI for finance and the condition of the banking sector. Because finance can be seen as the cockpit of the economy as Bibow notes. 8 The structure of the finance system is crucial to the explanation of the economic outcomes of recent years. First, we will discuss the role of FDI in the financial system of the Baltic States. After regaining independence 1991, the Baltic states followed the suggestions of international policy advisors for the transition process. The main goals of (economic) transition set out by the IMF, the World Bank, and the EBRD focused mainly on stability. To achieve this goal, a macroeconomic framework that stressed price stability, balanced budgets, low taxes, and an open trade regime was 8 J. Bibow, Keynes on Monetary Policy, Finance and Uncertainty Liquidity preference theory and the global financial crisis, Routledge, New York 2009.

7 Twice the pride, double the fall 7 recommended. 9 The Baltic states quickly recovered from the economic crash after the introduction of the so-called shock therapy 10 via FDI inflows. 11 Table 2: FDI stocks in Baltic counties FDI inward stock (mill. $) FDI inward stocks as % of GDP Estonia Latvia Lithuania Source: UNCTAD, World Investment Report 2010, Country facts sheets: Estonia, Latvia, Lithuania As can be seen in table 2, the high growth of FDI inflows accelerated within the last decade. In 2009, the FDI inward stock of the Baltic states was about five to six times higher than in Compared to GDP, the stock of foreign capital has a share of 85.1 percent in Estonia (with 34.7 % of GDP outward stocks), 44.8 percent in Latvia (with 3.8 % outward stock), and 37.4 percent in Lithuania (with 6.2 % outward stock) in These data attest a relatively high percentage share of foreign finance in GDP. This should not indicate a significant problem. Other CEEcountries, like Poland, had high shares of FDI as well and were not hit so hard by the crisis. The more interesting question is the role of FDI for investment. Figure 3 shows that during the year before the crisis occurred (2007), the share of FDI of gross fixed capital formation was about 40 percent in Estonia, 23 percent in Latvia and 18 percent in Lithuania. These relatively high shares of foreign finance in the investment sector, especially in Estonia, may well explain the hard contractions in gross fixed capital formation (GFCF) in In all three countries, the estimated real growth losses in this component of GDP were higher than in any other component. In Estonia, the GFCF fell approximately 12 percent, in Latvia approximately 13 percent, and in Lithuania approximately 7 percent. 12 The early and hard decreasing of GFCF indicates the FDI dependency as a threshold for the GFC in the Baltic states. 9 For transition strategies in this context see: World Bank, Development Report 1996 From Plan to Market, Oxford University Press, Oxford 1996, pp For the architecure of the shock theraphy see: D. Lipton, J. Sachs, Creating a Market Economy in Eastern Europe: The Case of Poland Brookings Paper on Economic Activity 1990, Vol. 1, pp See: M. Tilts / R. Kattel / D. Tamm, Catching up, forging ahead or falling behind? Central and Eastern European development in Innovation 2008, Vol. 21, pp

8 8 ALEXANDER PFANNKUCHE Figure 3: FDI inward flows as a percentage of gross fixed capital formation, Estonia 32 36, ,3 Latvia 17,9 23,8 12,7 1,3 Lithuania 16,8 18,2 15,4 5,5 Source: UNCTAD, World Investment Report 2010, Country facts sheets: Estonia, Latvia, Lithuania This issue alone, however, did not explain the ongoing economic events as a whole. Besides the vulnerabilities of the investment sector via FDI, the role of the gatekeepers of finance, as Schumpeter 13 noticed, also played an important role: the banks. The transition of the banking sector form a socialist system to a marketorientated structure was achieved by early privatization. Already in 1989, under Soviet power, the first commercial bank was formed, Tartu Commercial Bank. Ironically, it was to be the first to file for bankruptcy in the banking-crisis of This crisis was basically caused by bad debt position from former state-owned enterprises. Thereafter, most of the national commercial banks went bankrupt or were in a lamentable condition. At the time, the governments in the Baltic states permitted foreign investors to engage in the banking sector. 14 At present, the banking sector in Estonia is under near complete foreign ownership, as can be seen in table 3. Besides the high concentration of foreign bank ownership, the extent of the financial system played a key role in terms of the vulnerabilities to the GFC. The total assets of the financial system compared to GDP were relatively high in Latvia (154 % of GDP), Estonia (141 % of GDP), and quite small in Lithuania (80 % of GDP). 12 For data see: European Bank for Reconstruction and Development, Transition Report 2009, p J. Schumpeter, The Theory of Economic Development, Harvard University Press, Boston For an Investigation of the banking reform process in an early stage see: S. Lainela & P. Sutela, The Baltic Economies in Transition Bank of Finland 1994, Working Paper, No. 91, pp

9 Twice the pride, double the fall 9 Table 3: Financial System of the Baltic Countries in 2008 Total assets of financial system (per cent of GDP) Share of nonbanks Share of foreignowned banks (per cent of banking system assets) Share of banks Estonia Latvia Lithuania Source: EBRD, Transition Report 2009, p. 13. It is an interesting point that in those countries in which the financial system is relatively large, the impact of the GFC was felt earlier and harder, such as in Lithuania, where the financial system is much smaller compared to GDP than in Latvia. To give an interim conclusion, the combination of FDI dependency and a foreign dominated banking system with high assets concentration elevated the vulnerability of getting hit by external financial shocks. This combination is true for Estonia and Latvia, but less so for Lithuania. Nevertheless, in all countries the crisis spread its way via the financial system in a devastating way through two different channels: (i) The precipitate credit crunch to investment (ii) The crash in consumption caused by debt inflation in private consumer credits. These two evolutions were direct causes of a short-term profit-orientated financial system and were accompanied by a third evolution: the decreasing volume in world trade, especially in Eastern Europe. The contradiction in international trade is, of course, hard to offset for small open economies like those of the Baltic countries. Although the Baltics were net importers before the crisis, declining sales in export markets put a lot of pressure on Baltic enterprises. Each of these three abovementioned macroeconomic problems had the potential to cause recessionary tendencies. The Baltic states were hit by all. In the case of Estonia and Latvia, it even happened simultaneously. In Lithuania, the negative outcomes of the crisis were felt first in the investment sector. Table 4 shows the relevancy of the macroeconomic components in GDP.

10 10 ALEXANDER PFANNKUCHE Table 4: Macroeconomic components by expenditure approach in percentage of GDP Estonia Private C GFCF Public C Exports Imports Latvia Private C GFCF Public C Exports Imports Lithuania Private C GFCF Public C Exports Imports Source: Central Statistical Bureau of Latvia / Department of Statistics to the Government of the Republic of Lithuania / Statistical Office of Estonia (2010), own calculations. The GDP shares of the main aggregated economic components illustrate the characteristics of the Baltic economies. The high degree of openness in combination with a relatively large amount of investment (GFCF) characterizes the Baltic states as very open economies with a concentration on the investment sector. It is not surprising that the decrease in GFCF as mentioned before had a great impact on negative overall GDP growth in the first year of crisis. Besides the disinvestment, the problem regarding with consumption is serious, too. The demand-driven boom since the Entry into the European Union was financed by strong income growth but also by household debt. This is also true for investment. By the end of 2008, the debt ratio was 118 percent in Estonia, 124 percent in Latvia and 68 percent in Lithuania. 15 The above-mentioned evolutions of private and business debt can be attributed to an unregulated basically foreign-conducted financial system. The attraction of FDI and the high degree of openness in the economic structure have also increased the vulnerability to external shocks from world markets. There is, however, even more to it than that. Within the last years of high growth, the Baltic states lost competiveness in the world markets. One reason was 15 DIW Berlin, Weekly Report No. 34/2009, p. 233.

11 Twice the pride, double the fall 11 the high real wage growth from 2003 to Another and rather important factor was the imbedded structure of Baltic exporters in international value chains. This strategy, which focuses on short-term production, reduces the ability for specialization and high value-added production in future years. In this context, Kattel states that the recent low value-added structure in industry is not going to strengthen industrial forward and backward linkages and therefore a diversification of production. 16 The latest Global Competiveness Report emphasizes this argument that sees the Baltic countries loosing ground in international competiveness. 17 In the next section, the problematic situation of the Baltic states will be summarized and policy option for the future years be made. Summary The investigation of the impacts of the GFC in the Baltic states revealed that the distortions in the economic system were mainly determined by the financial system or, at least, worsened by it. The financial system of the Baltic states is highly susceptible to external shock, as the GFC showed. The level of indebtedness of private households and enterprises led to precarious debt inflation. Within the theoretical background of the Financial Instability Hypothesis, the financial system of the Baltic states became Ponzi schemes. This is especially the case for Latvia and Estonia. A strategy for sustainable growth has to consider more instruments than attracting FDI and demand-led growth via borrowing, especially if the financial system is mainly foreign owned. What strategies, however, were to be recommended and reasonable? To avoid currency crises and periodic exchange rate fluctuations, the Baltic states pegged their currencies to the Euro and will at least make the adoption in a few years (as Estonia will join in January 2011). Therefore, monetary police is not an objection right now or in the future. So the field seems to be open for fiscal policy, but the fiscal restrictions of the Stability and Growth Pact which have to be maintained for Euro adoption are leaving no room for fiscal stimulus. In fact, the governments of the Baltic states are building up huge deficits. The Latvian government even had to accept official help from the IMF to avert national bankruptcy. 16 R. Kattel, The Rise and Fall of the Baltic States, UNDP, Human Development in Europe and the CIS, Issue Number 13/2009, p. 2.

12 12 ALEXANDER PFANNKUCHE For these reasons, large macroeconomic policies are not feasible for the next few years. Instead, a new growth strategy is needed that focuses more on long-term capacity building and production diversification. Admittedly, this goal cannot be achieved within the economic recovery of the next few years, but it should be considered anyway. p K. Schwab et al., The Global Competiveness Report , World Economic Forum, Geneva 2009,

13 Twice the pride, double the fall 13 Reference Bibow, J. (2009), Keynes on Monetary Policy, Finance and Uncertainty Liquidity preference theory and the global financial crisis, Routledge, New York Central Statistical Bureau of Latvia, Department of Statistics to the Government of the Republic of Lithuania, European Bank for Reconstruction and Development (2009), Transition Report IMF (2010), World Economic Outlook Database, April Keynes, J.M. (1936), Allgemeine Theorie der Beschäftigung, des Zinses und des Geldes, Duncker & Humblot, 10. Auflage, Berlin Kregel, J. (1998), Yes It Did Happen Again A Minsky Crisis Happened in Asia, The Levy Economics Institute of Bard College, Working Paper No Lainela, S. / Sutela, P. (1994), The Baltic Economies in Transition, Bank of Finland, Working Paper No. 91. Lipton, D. / Sachs, J. (1990), Creating a Market Economy in Eastern Europe: The Case of Poland, Brookings Paper on Economic Activity, Vol. 1. Minsky, H.P. (1990), John Maynard Keynes- Finanzierungsprozesse, Investitionen und Instabilität des Kapitalismus, Metrolpolis-Verlag, Marburg. Minsky, H.P. (1992), The Financial Instability Hypothesis, The Levy Economics Institute of Bard College, Working Paper No. 74. Schumpeter, J. (1934), The Theory of Economic Development, Harvard University Press, Boston. Schwab, K. et al. (2009), The Global Competiveness Report , World Economic Forum, Geneva. Statistical Office of Estonia, Tilts, M. / Kattel, R. / Tamm, D. (2008), Catching up, forging ahead or falling behind? Central and Eastern European development in , Innovation, Vol. 21. UNCTAD, World Investment Report World Bank (1996), Development Report 1996 From Plan to Market, Oxford University Press, Oxford.