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Global macro & geopolitics from a small economy perspective

Crisis lessons from small states

David Skilling
8 June 2012

There is much debate on how advanced economies should respond to the substantial economic and fiscal challenges they face. Austerity or stimulus? Additional quantitative easing? Exit the Eurozone to obtain a lower exchange rate? But is this debate focused on the right issues? The post-crisis experience of small advanced economies suggests that another set of priorities might be more appropriate. Small states have performed relatively strongly over the past few decades, effectively responding to globalisation, but were acutely exposed to the effects of the global crisis. So how have small countries, defined here as developed countries with populations of less than 10 million, chosen to respond to the crisis? Based on more detailed work in progress, this week’s Observer examines the experiences of three groups of small countries in an attempt to derive some general insights.

Responding to the crisis
The first group is the highly open city-states such as Singapore and Hong Kong, who were hit hard by the crisis but bounced back rapidly. For example, Singapore’s GDP shrank by 10% in 2009 (at one stage exports were down by about 50% y.o.y.) and then grew by almost 15% in 2010. These economies are now back at more stable growth rates. Singapore and Hong Kong benefit from being situated in a high-growth part of the world, but they were also well-prepared to respond. These economies are used to external shocks – recent examples include SARS and the Asian financial crisis – and so there was a degree of economic and psychological preparedness; the accumulated reserves in Singapore, for example, positioned the government to respond with time-limited stimulus measures. But beyond these short-term measures, the policy approach remained focused on competitiveness.

The second group of small economies were those that were not hit as severely by the crisis, such as the Nordic economies (ex Iceland), Switzerland, and New Zealand, because they had lower export exposures than the city-states and had manageable levels of private or public debt. Although many of these economies entered recession, the combination of flexible, prudent policy settings before the crisis together with a coherent, determined response to the effects of the crisis helped them to stabilise unemployment and public debt (albeit at higher levels than pre-crisis). They didn’t recover as quickly as Singapore and Hong Kong, partly because their primary export exposures were to lower growth regions, but there is a generally positive trajectory.

In terms of the policy response, these countries took steps to maintain fiscal control and improve competitiveness, based on a sense of shared purpose. In New Zealand, for example, there is broad political consensus on the importance of a conservative fiscal approach (the crisis had led to a sharp fiscal deterioration after 15 years of fiscal surpluses). And more generally, the crisis experience was a reminder of the fragility of the fiscal positions of even well-managed small countries (and the risks of exposure to market sentiment). Although there was measured fiscal stimulus, fiscal control remained a priority. For some of these economies, this consolidation and adjustment process occurred in the context of stable or appreciating exchange rates – either because they were in relatively good shape (Switzerland, New Zealand) or because of various policy commitments. These economies still face many challenges in a sluggish, volatile global economy, but have responded effectively and have stabilised the situation.

The third group is the small economies that experienced deep recession, because the crisis interacted with existing economic or policy weakness; for example, Ireland, Iceland, and the Baltic states like Latvia and Estonia. Both Ireland and Iceland experienced major asset bubbles: Iceland had become a giant hedge fund with banking assets of 10x GDP, and Ireland’s banks had substantial bad loans – which the government chose to nationalise, turning a financial crisis into a fiscal crisis (gross debt/GDP doubled to just over 100% of GDP between 2008 and 2010). Real GDP in both countries collapsed by about 7% in 2009, and IMF support was required. The Baltic states, which had been over-heating prior to the global crisis, experienced even larger economic contractions with GDP down by around 15% in Latvia and Estonia in 2009.

This group of small states responded in a similar manner, focusing on fiscal consolidation and structural adjustment (and in general, without significant assistance from exchange rates). Ireland has committed to a 3% deficit target, to be achieved through major spending cuts, is taking steps to strengthen its economy, and remain committed to European integration. The situation is stabilising, and growth and investment is returning. Iceland acted to restructure its financial sector (including writing off substantial amount of debt) and improve its fiscal position. Iceland has now had two years of growth with reducing unemployment (assisted by a substantially lower exchange rate). Similarly in the Baltics, and in several of the small central European economies, the emphasis was on major fiscal consolidation, structural reform and wage restraint, but no exchange rate adjustment – and these economies are now growing strongly. These responses were supported by political institutions that allowed for shared sacrifice.

Broader implications
What should we take from this experience? Although the exact policy approach varies, and countries like Ireland are at an early stage of the path to recovery, the broad consistency of response and outcomes is instructive for larger countries. Small states have emphasised thoughtful fiscal consolidation and structural reform to strengthen competitiveness. Macro levers like loose fiscal and monetary policy and a lower exchange rate have been relatively unimportant compared to internal adjustment. This suggests that the growth debate needs to move beyond stimulus and lower exchange rates (if exchange rates were not important for small countries, they are unlikely to be systematically important for larger countries). Small countries have tended to emphasise structural measures in their response to the crisis, with demand measures playing a secondary role. Although context matters, and there is not a perfect mapping of the small country experience onto larger countries, this experience suggests a rebalanced policy approach should be seriously considered by other countries.

And the small state experience clearly demonstrates the importance of politics in developing an effective, sustained response. The adjustment process requires the allocation of painful losses. Perhaps this is easier in small country political systems. But this is important for larger countries as well; if the policy response is forced to work around a third-best political system, it is unlikely to generate good outcomes (for example, the over-reliance on central banks because the legislatures cannot make progress). But the good news is that there are examples of countries that have responded, made hard choices, and are on the path to recovery.