Emerging Europe—Lessons from the Boom-Bust Cycle

By Ajai Chopra

Almost unnoticed, amid the difficulties in western Europe, the other half of the continent has begun to recover from the deepest slump in its post-transition period. The emerging economies in central and eastern Europe will grow by 3¾ percent this year and next—a relief after the 6 percent decline in 2009.

Why was the crisis so severe—and how do we avoid a repeat? We consider just that question in our fall 2010 Regional Economic Outlook: Europe. While the crisis was triggered by external shocks, it is clear that domestic imbalances and policies also played a key role.

After Lehman Brothers defaulted in September 2008, global trade collapsed, capital inflows into the region plummeted, credit growth suddenly stopped, and domestic demand plunged.

But pre-crisis domestic imbalances and policies made a difference in how these shocks affected each country’s economy. Some countries saw declines in gross domestic product (GDP) similar to those in the Great Depression (Estonia, Latvia, Lithuania, Ukraine), while others avoided declines altogether (Albania, Poland).

Origins of the crisis

The seeds of the crisis were sown, in large part, in the five years before the crisis. Between 2003 and 2008, much of the region experienced a boom in bank credit, asset prices, and domestic demand. This boom was fueled and financed by large capital inflows.

With low interest rates in advanced countries, banks in western Europe expanded aggressively into emerging Europe—where returns were higher. And, while the influx of capital boosted growth, it also led to rising imbalances and vulnerabilities.

  • Current account deficits increased to unprecedented levels in some countries, and inflation accelerated.
  • Substantial vulnerabilities emerged in bank and household balance sheets, particularly because much of the borrowing was in foreign currency.

The boom years had left much of the region addicted to foreign-financed credit growth, making it very vulnerable to a disruption in capital inflows.

High-cost experience

The first lesson of the crisis is one that is unfortunately not new. Boom-bust credit cycles can be very costly, so it is essential to prevent credit booms from getting out of hand.

Indeed, countries that experienced the fastest credit growth during the boom years saw the deepest recessions. And it now appears that average GDP growth over the full business cycle in this group was no higher, and in some cases was lower, than in countries with more modest credit growth.

How to restrain credit booms

Controlling credit growth is not easy. Prudential measures alone rarely do the trick, particularly in small countries easily overwhelmed by foreign capital inflows. Fixed exchange rates often impose further constraints. Indeed, it is striking that the strongest credit growth during the boom years took place in countries with fixed exchange rate regimes. This is partly because countries with fixed exchange rates don’t have the full range of monetary policy tools to restrain credit booms once they set in.

Fixed exchange rates are not the cause of credit booms—there were also some countries with fixed exchange rate regimes that did not have a credit boom. But fixed exchange rates do make it harder to stop credit booms, particularly in the presence of large capital inflows.

 Closer cooperation with supervisors in western Europe can help prudential measures become more effective. Credit booms driven by capital flows from western European parent banks are hard to stop, especially when faced with supervisors only from the (often smaller) recipient country.

Building up fiscal buffers

The second major lesson is the need for more prudent fiscal policy. This is a policy of saving money when revenues are growing instead of increasing spending and boosting public wages. Prior to the crisis, fiscal positions in emerging Europe looked good—better than in other emerging market regions. But those good-looking headline numbers masked a deterioration of the underlying fiscal position. Public expenditure was surging, financed by a temporary revenue boom. This not only further contributed to overheating; it also set the stage for large fiscal deficits. So when revenue plummeted in 2009 and fiscal deficits increased sharply, many countries had no choice but to cut spending precisely when this was most painful.

When revenue takes off during the next boom, it should be used to build up fiscal buffers rather than boost expenditure. Politically, this may be very challenging—when revenues abound there is strong pressure to increase expenditure or cut taxes—but this will help dampen the boom and create fiscal space that can be used to soften the impact of the next recession.

In search of balanced growth

Going forward, growth in the region should become more balanced, and less dependent on domestic demand and capital inflows. Much of the shift will come about through private sector actions. Now that profits in the nontradable sector (finance, real estate, construction) have shrunk, investments will seek more promising venues. More balanced macroeconomic policies and wage restraint can also help maintain balanced growth by preventing the overheating that pulls resources from the tradable to the nontradable sector.

Above all, it will be important—when the next boom comes—to be wary of claims that “this time will be different.” Such narratives often have some plausibility and attractiveness in the heat of the moment. But a careful analysis of the drivers of growth, current account deficits, asset price developments, and credit growth should always be used as a “reality check.”

12 Responses

  1. I still cant believe that the IMF didn’t force the Irish government to benchmark their social welfare to the rest of Europe. The current system is a joke and way too generous. It is clear to me that the direction of the IMF is being “adjusted” by a European leadership intent on bailing out their own failed € project.

  2. Dear Mr Chopra,

    I read in the media this morning that the IMF has stipulated that accountancy/consultancy firms that have worked for the banks over the past 3 years are to be banned from doing bank-related work for the Government. Whilst I rarely believe everything I read in the papers, if this is correct, then


    The IMF is definitely on the right track. I say this as a Chartered Accountant.

  3. Dear Mr. Chopra
    Welcome to Ireland.
    it has been one of the worst weeks of my working life, with my “so called” government annouancing their 4 year “so-called plan” to rescue the country from economic doom. It is safe to say that if further action from outside Ireland is not taken we are economically doomed for decades to come,
    simply because of the measures the Government are FAILING to take. I am referring of course to my government’s refusal to tackle public sector pay in their 4 year plan (well they and there friends after all are extremely well paid public sector people).
    We are all been asked to pony up for the payment in order to save the country, but the single biggest payment out of annual budget is public sector pay.
    Seeing as the Gov nor the opposition have not the courage to tackle this monster head on, I, as a low-middle income earner are asking you to step in. Rip up the croke park public sector agreement and demand a 30% paycut against all public servants currently earning in excess of EUR 100,000, also an end to the expenses that they get (some of which are mulitples of the average industrial wage), ministerial cars, government jets–all have to go.

    Why should people on EUR 15,000 to 40,000 a year have to pony up, when the politicans and top public servants earning 100,000 upwards get off without paying a penny, it just is not fair?

  4. Dear Mr Chopra,

    Welcome to Ireland. This commentator called just about everything that has happened macro economically in Ireland accurately. Please consider his suggestions about a possible solution as our children should not foot the bill for these bondholders failed, risky investments.

  5. Dear Mr. Chopra,

    Welcome to Ireland.

    We Irish don’t tend to riot like the Argentinians or the Greeks (us Mediterraneans of the North are more peaceful), but I’m sure you’ve noticed we’re still deeply unhappy about this bailout, and the circumstances that have caused it.

    Our government may have failed to communicate to you that many Irish people regard the bank bondholders as solely responsible for their bad investment in Irish banks. Based on a poll we conducted today, 88.24% of people want us to “burn the bondholders” – let them eat their bad investment, via massive haircuts or a debt to equity conversion. 7.84% want this complex problem left to experts (like you), and only 3.92% want to pay the bondholders.

    See more on the poll here: .

    This poll probably got more votes than the entire government will in the next election. So we thought we’d pass on the results to aid your decision making.

    Also, we should discuss sharing links to get more hits on your blog.

    Kind regards,


  6. Ajai and team welcome to Ireland,
    Please, please save us from our rapacious Civil Service Unions and restore sanity fairness and justice to pay and conditions for all those paid from the public purse, especially those paid over €50,000. Not only does such manifest incompetance not deserve to be paid 30%-100% more than other European countries, it clearly do not deserve to be paid even 80% of that level! We, the international traded goods and services workers of Ireland, are being held hostage by a cosy cartel of insiders! Only you and your team can help us now!
    Mark Dargan

  7. I bumped into you briefly on Saturday afternoon outside government buildings here in Dublin and wished you ‘good luck’. I hope you’re also getting good information of what goes on behind the scenes here. The crisis here in Ireland has been amplified by years of corruption between our government and their close friendships with construction companies and banks. You should get a good summary of what’s been going on here in books like Ship of Fools by Fintan O Toole, an Irish Times journalist, and The Bankers by Shane Ross a local economist. For example, our (so-called!) ex-financial regulator Pat Neary was paid 650,000 euros plus full pension in a golden handshake after ignoring any real attempt at regulation and an ex-director of the Central Bank Ken O’Reilly-Hyland was on the Fianna Fail fundraising committee and was involved in the Ansbascher financial scandals. I feel as a hard working taxpayer in the Health Service that the elite of this country has gotten away with so much. I am concerned that it will be the ordinary people of Ireland, now saddled with all this debt, paying very high mortgages on low salaries. Please, in your efforts to sort out this mess, can you seek justice and show compassion to those who find it hardest to bear the burden of the corruption of the cartel that has run this country into the ground? Once again, I wish you the best of luck.

    • You expressed what I wanted to say a lot better than I did!
      Having observed the more informed foreign media coverage over recent years, I would be surprised if the IMF team is not fairly well briefed on the corruption and incompetence of the establishment here.
      Fianna Fail failed to comprehend that the garbage propaganda that they put out for internal consumption has not had any relevance in the wider world since the days of the arch-corrupter, Haughey.

  8. Dear Mr Chopra,

    Welcome to Ireland.
    You have a difficult job to do, but from even a limited perusal of your blog, I am confident you will do that well.

    Whilst the immediate problem is economic, the endemic long-term disease is, as with Greece, a deep-seated corruption of the political, business and professional establishment….and I am a professional.

    Whilst your brief is non-political, I implore you to take whatever steps you can to bring fundamental change.

    In a democracy, it is said that a country gets the Government it deserves. So true, but this populace is crying out for proper leadership and have no confidence that they will get it from anywhere within.

    As a nation, we have to take some very unpleasant medicine. It will reluctantly do it ….as long as those who caused this mess are brought to book and dramatic cuts initiated in Government itself. If not, this country will convulse.

  9. Mr. Chopra,

    Congratulations on the article. A commendably concise, if partial analysis.

    Given your obvious intellect, I expect that your diagnosis and proposed reforms for Ireland will also respond to, and incorporate a thorough refutation of, arguments of the sort expressed in this 1994 video:


  10. We must also take into account the different levels of integration in different sectors of the European economy. This allowed multiple different levels of inflation to occur across the entire EU, causing internal dislocation in every Member State as well as asymmetrical changes in competitiveness. While agriculture, goods, retail, fisheries and low end services are all highly integrated, the high end services sectors are not (yet). It is very instructive to examine the rates of inflation of nationally protected sectors vis-a-vis the european sectors. This has created a two-speed economy in every MS, not just in Emerging Europe.

    In the MS I know best (Ireland), services inflation was running at 12% at the height of the boom, while manufacturing was running at 3%. The costs of doing business with your European peers becomes unsustainable in such a situation.

  11. Dear Mr Chopra,

    Here in Ireland, we’re concerned that the public is being held accountable for gambling losses in the financial sector – especially in Anglo Irish Bank. Recklessness and lack of regulation have led to our sorry state. Oh, and outright theft too. Are you going to pass the market losses on to the people of Ireland? I look forward to your reply.

    I hope that you enjoy your stay in Dublin,

    Justin Casey

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