Taking Away the Punch Bowl: Lessons from the Booms and Busts in Emerging Europe

By Bas B. Bakker and Christoph Klingen

With all eyes on the euro area, it is easy to forget that only a few years ago the emerging economies of Europe, from the Baltic to the Black Sea, went through a deep economic and financial crisis. This crisis is the topic of a new book that we will introduce to the public this week in Bucharest, London, and Vienna.

One lesson is that your best chance to prevent deep crises is forcefully addressing booms before they get out of hand. Another is that even crises that look abysmal can be contained and overcome— policies to adjust the economy and international financial support do work.

In the half decade leading up to the crisis, easy global financial conditions, confidence in a rapid catch-up with western living standards, and initially underdeveloped financial sectors spawned a tremendous domestic demand boom in the region. Western banking groups bankrolled the bonanza, providing their eastern subsidiaries with the funds to extend the loans that fueled the domestic boom.

Economic growth was impressive, but underneath there was much to worry about.  Current account deficits were as high as 15-25 percent of GDP in the Baltic countries and Bulgaria; private sector credit surged, much of it denominated in foreign currency; housing prices boomed; and non tradable sectors, such as construction, became bloated. Governments also contributed to the problem, using buoyant taxes to fund rapid spending growth. While headline fiscal balances looked good, the underlying health of public finances deteriorated rapidly.

The crisis in emerging Europe was an accident waiting to happen. Time was up when Lehman Brothers defaulted in September 2008. As banking groups in Western Europe came under pressure, new funding for the subsidiaries in emerging Europe stopped. This pulled the rug out from under credit and domestic demand booms—just when the collapse of global trade pummeled the region’s exports.

The economy went into a tailspin, housing prices collapsed, and unemployment surged. The region’s economy contracted by 6 percent in 2009, but that is an average: some countries experienced recessions comparable to the Great Depression in the United States, though some with less extreme precrisis booms, more policy space, and better crisis management escaped more lightly.

But it could have been worse had governments not moved quickly to stabilize their financial systems and get their public finances back under control. The international community committed €100 billion of financing under IMF-supported programs to stave off  regional financial meltdown. Western banks contributed by refraining from recalling previously provided financing in an effort coordinated under the Vienna Initiative.

One lesson the episode drives home is that countries are better off if they deal with domestic demand booms before they get out of hand.

  • Policies to fight bad economic times should not only be preserved for bad times. Taking away the punch bowl in good times helps mitigate the build-up of imbalances and creates buffers to fall back on when fortunes turn. Fiscal policy should keep a lid on expenditure growth in boom periods, even if the government’s fiscal balance is in surplus and higher spending seems easily affordable.
  • Keeping credit growth in check is critical. It requires more effective cooperation with bank supervisors in Western Europe, where emerging Europe’s banks are headquartered, and a tougher line on foreign-currency lending.
  • Some countries in the region, such as Poland, implemented policies in this vein; it was rewarded with avoiding a recession in 2009 and achieving healthy growth in the subsequent years.

Another lesson is that determined adjustment after a crisis works. Many countries in emerging Europe implemented highly demanding adjustment policies, including reducing government debt and deficits, bank restructuring, labor cost reductions, and other measures to restore competitiveness. It is paying off. Currency and systemic banking crises were largely avoided. Growth in the region has bounced back—4½ percent in 2010-11—unemployment has started to come down; the repair of public finances and financial systems is well underway; and external flow imbalances have disappeared. Most encouraging is the renewed focus on exports. Estonia’s sales abroad, for example, now account for 100 percent of GDP, up from 70 percent of GDP in 2007.

Emerging Europe is not out of the woods yet. External debt is still high, fiscal repair has further to go, and the banks need to resolve a large stock of non-performing loans. Moreover, the crisis in the euro area poses new challenges considering its tight linkages with emerging Europe.

But the experience of emerging Europe should give hope to other countries that face tough adjustment challenges—including in the euro area. Risk premiums for sovereigns in emerging Europe are now often lower than those in Western Europe. Who could have imagined that in 2009? That year, emerging Europe was the sick man of Europe, but no longer.

9 Responses

  1. The two veterans have had a nice educative debate about the regulators and their primary function of regulating. I have, however, failed to understand how the WT towers came down by ‘controlled demolition’. Proper controls and safeguards should not cause demolition. If Angus uses this demolition as a metaphor for banking crisis, does he mean that banking institutions be left loose without control? Adequate capital adequacy ratios do keep the banking institutions afloat.

    • Javed Mir wrote: “Proper controls and safeguards should not cause demolition.”

      I interpret the documentary video as telling us that 1,500 professional architects and engineers cannot understand how the WT Towers can have come down without a controlled demolition. The planes were not enough. At the same time, who can open his/her mind to a controlled demolition? The very idea is threatening to conceive for it opens the possibility that security at the towers was lax in some way, and also to an endless array of conspiracy theories. Hence the call, and IMO need, for follow-up investigation.

      Javed Mir also wrote: “If Angus uses this demolition as a metaphor for banking crisis, does he mean that banking institutions be left loose without control? Adequate capital adequacy ratios do keep the banking institutions afloat.”

      I do NOT intend that the metaphor be used to propose that banking institutions be left loose without control. The metaphor only relates to people’s reluctance to consider facts that open the range of what requires thinking about after a catastrophe (such both the WT Towers coming down and the credit collapse that occurred through the 2007-8 period were) into possibilities that threaten some people’s psychological security, That reluctance is shared, don’t you feel?, by both the US Congress (whose official investigator of the WT atrocity was NIST), and by the Basel Committee on Banking Supervision for neither of these authorities — on whose competence we are all in some degree dependent — has shown the least interest in facing up to all the facts which experts like Per and the 1500 architects and engineers have informed us must be considered.

      The latter part of the WT documentary video whose link I shared in my first post to this topic, below, discusses such reluctance as being widespread among humans unwilling to consider possibilities that are psychologically threatening. You, other readers, the US Congress, the BCBS, and I, all of us are human in this aspect of our psychological patterns.

      In this bleak situation I have drawn attention to the work of the Bank of England’s Executive Director for Financial Stability, Andy Haldane, because his papers (available for download from the Bank) show interest in, and develop insight into, the credit collapse by going fearlessly into as wide a range of factors as I or anyone I have talked to can imagine.

    • And I definitely do not want to connect the 9/11 crime with bank regulations, because, no matter the good intentions of these 1,500 professional architects and engineers, the fact is that, out there, there are those interested in using 9/11 conspiracy theories to advance their own malignant and evil causes.

      But, let us suppose that an investigation (perhaps something no longer or never possible) would have indicated that one probable cause for the twin towers crumbling, after the terrorist act, was an engineering miscalculation or the fact that such a terrorist act had not even been envisioned.

      In that case, we would then be confronting a discussion very much relevant to bank regulations, namely, should we have to construct all buildings to resist that type of terrorist act?… or would doing so cost so much that it could paralyze construction and perhaps also bring much other real suffering?

      • Per Kurowski:

        Your blog points out that risk-weighting formulae for bank reserve calculations is rationally absurd, even if it sounds simply logical to the outsider and, to the insider, may sound only a ‘natural part of the right to rule’ of the insider. Your blog also points out that risk-weighted formulae must inevitably lead to a skewing of the flow of capital toward big institutions (and big bonuses), which always are the trigger for serious system-wide catastrophes, and away from small institutions, which never cause system catastrophes and which often are the source of innovations that respond most directly to real needs. And I understand that your blog is now even receiving acknowledgment of its main point from the Financial Times.

        Thus, risk-weighting is not only a part of the continuing risk we all face of another credit crunch (something that countries outside the main centres of financial concentration continually face in dire permanence), but also a contributor to the world-wide phenomenon of the rich (who are the customers for banks wealth-management services that are inaccessible to others) getting richer and kidding themselves that ‘they are doing it all by themselves’!

        The IMF has published excellent studies explaining how widespread gross income inequality has become; how too much income inequality iinevitability turns into growth-retarding circumstances (to say nothing of exacerbating the social unrest now rising dangerously around the world); and also how success in reversing and restraining this economic and social disease can be, and has occasionally been, accomplished.

        So doesn’t all this imply that IMF professionals in banking regulation now have an attractive moment of opportunity, even an obligation, to join in calling upon the BCBS to change its addiction to risk-weighting formulae?

      • Yes Angus, for instance Martin Wolf has acknowledged my argument that major crises never occur where perceived risks are high, and only where the risks were erroneously considered almost inexistent.

        But, unfortunately, I have not been able to convince anyone in the FT yet, at least from what I have seen in print, about something much more important, namely that these regulatory credit-weights distort the markets immensely, in favor of what is officially perceived as not risky, like AAAs and infallible sovereigns, the haves, and against what is officially perceived as “risky”, the have not or have less, like small businesses and entrepreneurs. In other words, that they are sort of castrating our economies–those which thrived and became what they are over the centuries, as a result of risk-taking. “God make us daring!”

        That said, I am still hopeful I will one day be able to get through to them and you can follow my adventures and arguments in trying to so (already more than 700 letters on this issue) on:


        With respect to the IMF, all my comments to them, and which have not yet been replied to, are on this blog.

  2. I hear you, Per. What you are saying is that the dysfunctionality of risk-weighted reserve requirements did not arise as a consequence of any evil intent by the Basel Committee for Banking Supervision. It is much more likely that this dysfunctionality — which you have for many years, including in this forum, pointed out exists in that framework of logic — arose out of the tendency of any non-transparent organization to want impose its viewpoint on the part of the outside world given focused in its ‘particular mandate’ — in this case, international banking.

    Likewise the 1,500 professional architects and engineers contributing to the video linked from my post are not pointing their fingers at any specific organization for having planned and executed what seems likely was a controlled demolition. No, they have, to their credit, carefully avoided getting into any such conspiracy theory. Rather, what they have done is observed, after contributing a huge amount of hard evidence, that the towers coming down cannot be explained solely by the planes crashing into them, and additionally pointed out that evidence exists of explosions very likely caused by a controlled demolition by parties unknown and that this evidence was not looked into by the official investigators — something the official investigators themselves have since admitted.

    Thus what the 1500 architects and engineers did in presenting that documentary could be a model for what IMF professionals in banking regulation are well-placed to emulate. IMF banking regulation professionals could demand, on the evidence of your posts and blogs and these ones right here in this iMFDirect blog, that the BCBS consider again what appears to you and me and many others as the mistaken direction they have taken.

    In this context, it is worth drawing attention to something that Paul Ekman, professor emeritus of psychology at UCSF and author of 14 books after a lifetime of field research into the nature of emotion, wrote in “Emotions Revealed”, which was published in 2003 by Henry Holt. Ekman refers in that book to the concept of “a refractory state, during which time our thinking cannot incorporate information that does not fit, maintain, or justify the emotion we are feeling. This refractory state may be of more benefit than harm if it is brief, lasting for only a second or two. In that short window it focuses our attention on the problem at hand, using the most relevant knowledge that can guide our initial actions, as well as preparations for further action. But difficulties can arise or inappropriate emotional behaviour may occur when the refractory period lasts much longer …”

    Therefore it is not irrelevant to point out that the mistake of regulating via a risk-weighted framework for calculating required reserves was initiated in the hurried wake of the crisis before last, which occurred before Ekman’s book was published, because that makes clear that the mistake by the BCBS cannot be ascribed to any evil intent.

  3. Your narrative of the crisis sort of misses the mark. Nothing perceived as “risky” has caused a boom, and all booms that get out of hand are based on the finally erroneous perception that it was something “not risky”.

    In that respect, what has happened is that the pillar of current bank regulation, that of capital requirements based on perceived risk, is fundamentally wrong, and produces very serious distortions. Bank regulations need to be corrected urgently for this.


    • What you say is true, Per: nothing perceived as risky has ever caused a boom, and all booms that end in a big enough bust to matter began with erroneous perceptions as to low risk.

      The banking community, with the exception of the Bank of England’s Andy Haldane, do not seem to be listening. Is the IMF listening? That’s not clear to me.

      The official report, done by NIST on behalf of the U.S Congress on the 9/11 bombings ignored data relating to the possibility that the WT towers came down by controlled demolition. But a documentary video contributed by 1,500 professional architects and engineers strongly urges that this possibility now be the subject of another official investigation:


      This video is hard to ignore even if one wants to do so. Toward the end, professionals from the psychological community explain why all of us resist hearing things that would upset us to the point where we risk having to change the crucial presumptions upon which we base our worldviews.

      Let’s hope that the IMF will not be intimidated by the world-wide banking community into continuing to sit by while the nonsense of a risk-weighted framework for bank reserves continues to be perpetrated around the world.

    • Angus, I understand that you are referring to the difficulties of accepting something which forces us to change some basic paradigm we believe in, but I must nonetheless object to you putting something as evil as the possibility of some planned 9-11 events which you refer to, and which by the way I do not believe in one iota, in the same context of lousy bank regulations.

      We have these bad regulations not because regulators were bad or much less had bad intentions, but because they were allowed to carry on an incestuous discussion, in a small mutual admiration club, without any adult supervision. The regulators unwittingly got sidetracked into believing in a false paradigm, something which they now find too embarrassing to admit… something which by the way is also human.

      That said, current capital requirements based on perceived risk, have such a destructive impact on our economy that it can allow us, figuratively, to talk about regulatory terrorism.

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