Academic journal article Current Politics and Economics of Russia, Eastern and Central Europe

The Impact of Fiscal Consolidation in the European Development Countries

Academic journal article Current Politics and Economics of Russia, Eastern and Central Europe

The Impact of Fiscal Consolidation in the European Development Countries

Article excerpt

1. PRE-CRISIS

Generally, the group of the CEE countries and of the Baltic States had a number of common economic features when the crisis began, these premises favoring the occurrence of negative externalities due to the overlap of the contagion effect (largely determined by the globalization of the financial markets, the high percentage of foreign banks in the domestic banking systems and the high intensity of the trade flows with the regions that have been strongly affected by the initial stages of the crisis) with the occurrence of the internal imbalances which are specific to each country. Thus, the cumulative causality effect generated by this overlapping increased the damages suffered by the CEE countries and Baltic States, resulting in a certain type of reverse symmetry in the evolution of these countries. After such economic growths of 5-8% in the pre-crisis years, economic declines of the same magnitude occurred, thus stimulating cyclicality, macroeconomic volatility and the negative consequences related to these phenomena (details in Figure 1).

One of the causes of the high amplitude in the boom and bust evolutions is the bad economic policies in good times. We bring up here pro-cyclical budget fiscal policies that resulted in a low sustainability of the public finances - characterized, among other things, by the high structural budget deficits (details in Figure 2), the poor management in the state companies, imbalances in the social budgets, occurrence of twin deficit problems (budget and current account), lack of financial reserves in Treasury (consolidated buffers to prevent the occurrence of the liquidity crisis) as well as the lack of strong mechanisms for automatic stabilization of the economy. Hence, the result is the high dependence on the foreign capital inflows both in the public and private sector for many of the analyzed countries.

The area of the Central and Eastern European countries and Baltic States encountered the problem of high twin deficits, budget deficits and current account deficits during the period 2005-2008 (Figure 3). The lack of sustainability of financing the high current account deficits was noticed at the moment of the reversal of the foreign capital flows that financed most of the gross liquidity needs of the countries in that group.

In the first year of the financial crisis, Romania and the Baltic States recorded current account deficits well above the sustainability limit, the financing of these deficits being made from loans and from capital flows characterized by high volatility only. Figure 4 illustrates a strong decrease of the foreign direct investment flows from the real economy (measured as a percentage of GDP) in 2009 compared to 2008, the latter being the year when the effects of the financial crisis started to be strongly felt in the real economy in the group of the analyzed countries.

Macroeconomic Imbalances Procedure (early warning instrument/alert mechanism implemented post crisis), the matrix according to which the potential risks the European Union countries are exposed to are examined, indicated certain macro and micro-economic vulnerabilities in the group of the selected countries starting from 2006-2007. Thus, besides the accumulation of high current account deficits, the Central and Eastern European countries/Baltic States had unsustainable Net International Investment Positions, spectacular increases of the nominal ULC as well as strong flows of credits towards the private sector and obvious signs of a bubble in the realestate sector. Thinking and implementing of such an analysis and monitoring mechanism during the pre-crisis period would have probably reduced the negative effects generated by the financial and economic crisis started in 2007- 2008 in the real economy. The analysis of the indicators in the Figure 5 clearly shows some of the future weaknesses of the diagnosed economies, so that an early preventive action would have allowed the minimization of amplitude of the vicious relations between the financial crisis/saving of the banking system - the sovereign debt crisis - the crisis generated by macroeconomic imbalances. …

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