Don't Blame Greenspan

John Tamny

The housing bubble was driven by a weak dollar, not low rates.

When economic problems reveal themselves, a great deal of finger-pointing inevitably ensues. For quite some time now economists and commentators have sought to place blame for the housing crisis, and quite a lot of it has been heaped on former Federal Reserve Chairman Alan Greenspan. But when it comes to housing, both Greenspan's critics and Greenspan are wrong about what really happened.

The general consensus among Greenspan's critics (including the Wall Street Journal's editorial page, along with Nobel Laureate Gary Becker), is that his 2003 decision to keep the Fed funds rate at 1% for a year led to the rush into housing. Intuitively this makes sense, but if true there would presumably exist a great deal of empirical or anecdotal evidence supporting the notion that housing does best when nominal rates of interest are low. The problem here is that very little evidence supports the claims made by Greenspan's detractors.

Indeed if true, housing would have been an awful asset class in the early part of the 1970s. But despite 450 basis points worth of increases in the Fed funds rate from 1971 to 1973, housing emerged as the top asset class during President Nixon's second term, according to Rice University historian Allen Matusow. Moving to Jimmy Carter's presidency, the Fed funds rate rose over 800 basis points, but according to George Gilder's 1981 book, Wealth and Poverty, during the Carter years "America's middle class was doing better in the housing market than all of the shrewdest investors in the financial and capital markets of the world."

And to show that this seemingly contrarian rate phenomenon is not unique to the U.S., we can look to England in the early 1970s, along with Germany in the aftermath of World War I. The bank rate in England rose from 5% to 9% in 1972, but in a 1978 retrospective on the early '70s English property boom in the Bank of England Quarterly Bulletin, it was written that "There was no other general area of economic activity, which seemed to offer as good a prospective rate of return to an entrepreneur as property development."

Regarding post-WWI Germany, despite rising rates of interest in the war's aftermath, economist Benjamin Anderson recounted in Economics and the Public Welfare that "the wise thing to do was to go heavily into debt, purchase any kind of real values--real estate, commodities, foreign exchange--hold them for a time, then sell a small part of the purchases and pay off the debt."

On an empirical level, my H.C. Wainwright Economics colleague David Ranson has found even more evidence that calls into question the claims made by Alan Greenspan's critics. Indeed, while intuition would once again suggest that housing does best when rates are falling, what he's found is that nominal U.S. home prices since 1976 have increased the most when Treasury bill rates have risen over 200 basis points, and they've declined the most when those same rates have fallen more than 200 basis points.

Where it gets interesting is that in defending himself, Greenspan basically confirms the arguments made by his critics, all the while selling down the river one of his intellectual mentors, Joseph Schumpeter. According to Greenspan's March 11 Wall Street Journal op-ed, an "excess of savings propelled global long-term interest rates progressively lower between early 2000 and 2005." The decline, according to him, led to a "global housing price bubble."

The first problem there is that the notion of an "excess of savings" is a logical impossibility. As Schumpeter observed in Capitalism, Socialism and Democracy, "It is not conceivable that wants some day may be so completely satisfied as to become frozen." More to the point, it's an economic reality that human wants are limitless, and as such, there always exist opportunities for entrepreneurs to fulfill those same wants through the accession of capital.

But it's in the area of rates that Greenspan truly missed the chance to prove his critics wrong. Indeed, despite intuition suggesting otherwise, there's no historical correlation between low nominal rates of interest and housing vitality either in the U.S., or around the world. If there was, housing would have slumped stateside in the 1970s, and it would have boomed in the 1990s in Japan, to use but two examples.

There is, however, a strong correlation between weak currencies and nominal housing strength. Ludwig von Mises referred to this phenomenon as a "flight to the real," while his sometime intellectual nemesis John Maynard Keynes was more to the point in observing that when currencies are weak, the "practice of borrowing from banks is extended beyond what is normal."

In that case, and with the U.S. Treasury serving as the dollar's mouthpiece, Treasury secretaries John Connally and W. Michael Blumenthal (under presidents Nixon and Carter respectively) used the value of the Japanese yen as a way to communicate to the markets their desire for a weaker dollar in the '70s. This decade, Treasury secretaries Paul O'Neill, John Snow and Henry Paulson (and now apparently Tim Geithner) jawboned China on oversight of the yuan as a way of communicating their own desire for a weaker greenback.

Housing is a great place to be when currencies are in decline, and just as they did in the high interest rate '70s, Americans rushed to housing to hedge the dollar's decline.

And when we bring the rest of the world into the equation, foreign currencies this decade were only strong insofar as the dollar was very weak. Measured in gold, there was a worldwide run on paper currencies that led people around the world into the safe harbor that housing represents. Basically, worldwide monetary authorities mimicked U.S. monetary mistakes, and there was a rush to housing. As Gilder observed, housing is an inflation shelter in which individuals can actually live.

Back to the present, it's fashionable to blame low rates of interest fostered by the Greenspan Fed as the cause of the housing boom, but the real reason had to do with weak currencies, which historically have revealed themselves when rates of interest are in fact high. Greenspan had the chance to make this point but failed to. Still, just because Greenspan proved unequal to his critics doesn't mean his policies were at fault.

In short, there was a housing boom this decade thanks to weak-dollar policies favored by the U.S. Treasury, which Greenspan did not control. His interest-rate policies did not cause the housing boom, no matter the evidence-free efforts used by his critics to prove otherwise.

John Tamny is editor of RealClearMarkets, a senior economist with H.C. Wainwright Economics and a senior economic advisor to Toreador Research and Trading. He writes a weekly column for Forbes.

Don't Come Up Short, G-20

MARCO ANNUNZIATA

From today's Wall Street Journal Europe.

There is a serious risk that tomorrow's G-20 summit in London will do little more than provide a prominent stage for anticapitalist anger and acrimonious bickering among governments. This would be especially regrettable now that international cooperation is more essential than ever and when widespread public anger and witch hunts are already hindering efforts to stabilize the financial sector and rekindle growth.

Corbis

Decisive and coordinated policy action now could leverage the tentative, moderate improvement in macroeconomic data and sentiment that we have seen in recent weeks into a sustained improvement in financial and economic conditions. That timing alone makes this summit especially important.

After the sudden and dramatic plunge in economic activity of the past six months, even the most pessimistic forecasts now envision a deceleration in the pace of contraction, which could constitute the first sign of bottoming out. Glimmers of hope have begun to appear: U.S. private consumption expenditures seem to have stabilized in the past couple of months; surveys of purchasing managers in Europe show signs of finding a floor; and China's fiscal stimulus is gaining traction. Investors, tired of contemplating a never-ending scenario of doom and gloom, are now looking to anticipate the recovery.

Yet fear still retains the upper hand. Credit markets have so far refused to share the nascent optimism of equity markets. A lack of confidence in the financial sector persists, and delays in the impact of policy actions are feeding skepticism about their effectiveness. The looming rise in corporate defaults and unemployment will provide a formidable headwind against optimism.

This is a crisis born of a collapse in confidence, triggered by a lack of information and transparency in the financial sector and by the initial fumbling policy reaction. Restoring confidence remains essential, and isolated interviews and TV appearances by policy makers will not suffice. We need a change of pace in global leadership commensurate with the unprecedented depth and complexity of the crisis -- now.

Unfortunately, the leaked G-20 draft communiqué is not reassuring. So far, the only concrete result likely to emerge from the summit is the already mooted doubling of the International Monetary Fund's resources to $500 billion. This is an important step forward that would provide the IMF with the firepower it needs to promptly contain further crises in emerging and developed markets. It may also act as a prelude to a rebalancing of voting powers within international financial institutions.

Yet this G-20 summit must aim higher. First, the distracting dispute over the primacy of financial regulation versus further fiscal stimulus should be swept aside; we clearly need both. Policy makers should accelerate their existing efforts to overhaul financial regulation. The bulk of the benefits will be reaped in the future, but do not underestimate the immediate, positive impact such an action would have on investor sentiment -- provided we get more effective and focused regulation rather than a shopping list of longstanding designated targets.

Priority should be given to harmonizing regulatory standards internationally and establishing a stronger and continuous flow of information among national regulators and supervisors. By contrast, the emphasis on regulation of hedge funds seems misplaced, given that they have been mostly collateral damage in a crisis that originated in the highly regulated banking sector.

Second, G-20 leaders should reach a broad agreement on how to share the burden of further fiscal stimulus and commit to a coordinated exit strategy from the massive fiscal and monetary expansion under way. This will require a drastic change from the latest cacophony of cross-accusations. Lately, the U.S. has reiterated its call for Europe and Asia to spend more, while Angela Merkel has restated Germany's determination to stick to an export-oriented strategy and China has flaunted the seemingly quicker response of its economy and called into question the U.S. dollar's role as the primary reserve currency. At the same time, Europe's emphasis on the need for a timely reduction in public expenditures and a rise in euro-zone interest rates once a recovery begins has clashed with U.S. Treasury Secretary Timothy Geithner's warning not to put the foot on the brake too soon.

This public exchange of criticism must end. An open debate on the use of vast amounts of public money is absolutely essential. But watching the U.S. accuse Europe of not doing enough to trigger a recovery, and Europe counter that the U.S. is sowing the seeds of the next crisis, can only undermine investor sentiment further.

Europe will need additional fiscal stimulus, and the fact that the IMF forecasts a deeper recession and less dynamic recovery in Europe than in the U.S. should engender a greater degree of humility on the Continent. According to UniCredit estimates, automatic stabilizers -- which refer to the decline in tax revenue and the increase in social-welfare payments that naturally occur as growth slows and unemployment rises -- account for more than two-thirds of the projected fiscal boost over 2009-2010 in Germany, and nearly the entire amount in Italy. This of course reflects the stronger welfare system in Europe, but automatic stabilizers are not fully equivalent to fiscal stimulus. A worker losing his job does not see his purchasing power boosted because he no longer has to pay income taxes.

The IMF estimates that the average fiscal stimulus for advanced G-20 economies will be 1.5% of GDP in 2008-2009. The virulence of the crisis suggests that these countries will likely need additional stimulus this year and next. G-20 leaders should pledge to coordinate these spending programs in a way that does not re-create global macroeconomic imbalances. G-20 leaders must also credibly pledge that fiscal stimulus measures will not become protectionism in disguise.

At the same time, the importance of a credible commitment to restoring fiscal sustainability is obvious. Bond markets already show signs of unease at the quantum leap in fiscal deficits, and the looming problem of aging populations in many countries will soon bring more pressure. Establishing such a credible commitment won't be easy: Part of the euro zone's woes stem from the fact that the Stability and Growth Pact has been largely ignored, with most countries running a pro-cyclical fiscal policy during the boom instead of reducing public spending and debt. G-20 countries should explicitly commit to a fiscal consolidation path, mostly via a sustained reduction in public spending, once global growth returns to potential.

Credibility needs to be established early on. The G-20 should use this summit to prove with concrete and coordinated commitments that global leadership is finally coming of age.

Mr. Annunziata is chief economist for UniCredit Group.

Mexico and the United States

Don't keep on trucking

Mexico retaliates against American congressmen who want closed borders

IN JANUARY Mexico’s president, Felipe Calderón, became the only foreign leader to meet Barack Obama between his election and his inauguration. Their long lunch was a success. Mr Obama said afterwards that he would be “ready on day one to build a stronger relationship with Mexico.” According to one Mexican official present at the talks, the visitors felt reassured that Mr Obama would resist protectionist pressures and that the criticisms of the North American Free-Trade Agreement (NAFTA) he had expressed during the campaign could be dealt with in a trilateral review, involving all three North American countries, that would seek to improve the agreement rather than unpick it.

Just two months later, the honeymoon has soured somewhat. Mr Calderón has taken to lambasting American officials for allowing the illegal drug trade between the two countries to flourish, and to criticising the American media’s coverage of Mexico’s drug-related violence. Now a provision inserted into the Omnibus Appropriations Bill signed into law by Mr Obama has scrapped a pilot programme that allowed a small number of Mexican trucking companies to carry cargoes north of the border—as NAFTA requires.

Mexico’s response was swift. On March 18th it imposed tariffs of up to 45% on 90 American agricultural and industrial imports, ranging from strawberries and wine to cordless telephones. The list was carefully chosen to avoid pushing up prices of staples in Mexico while hitting goods that are important exports for a range of American states. That way, it could have maximum political effect north of the border.

Since NAFTA was signed in 1992, trade between Mexico and the United States has boomed. But the issue of road transport has turned into a political battle. Around two-thirds of cross-border trade goes by road. Transport companies from each country were supposed to be able to operate freely in the others by 2000. The Teamsters union, whose members include American truck drivers, has fought a long and largely successful rearguard action against this provision. It argues that Mexican trucks are unsafe and polluting and their drivers insufficiently trained.

An American court rejected these arguments. So did a NAFTA dispute-settlement panel, which ruled in 2001 that the United States was violating the agreement and gave Mexico the right to impose retaliatory tariffs. Mexico chose not to do so, to give the United States a chance to honour its commitment. The Bush administration tried, but was thwarted when Congress approved a measure setting 22 new safety standards for Mexican trucks.

To try to break this stalemate in 2007 the Bush administration set up the pilot programme, under which trucks from 100 transport firms in each country were allowed to cross the border. Opponents in Congress slipped a provision delaying this into an unrelated bill. This was hailed by James P. Hoffa (son of Jimmy), the Teamsters’ president, as a victory in “the battle to keep our borders closed”. But the pilot scheme eventually went ahead.

The Teamsters’ safety argument looks spurious. Mexican transport firms have invested in new trucks and trained their drivers to meet the safety requirements under the pilot scheme. A study commissioned by America’s Department of Transportation, which tracked Mexican trucks operating north of the border in the first year of the programme, found that these trucks clocked up far fewer safety violations than their American counterparts.

The Teamsters’ victory means that most Mexican goods going north will continue to have to be unloaded at the border, reloaded for the short hop across it, then loaded again onto an American truck. This amounts to what Mexicans call a “trucking tax”. And since the short-haul lorries tend to be older gas-guzzlers, it is environmentally unfriendly, points out Barbara Kotschwar, a trade specialist at Georgetown University in Washington, DC. No such restrictions apply to Canadian lorries.

Mexico had the right to impose bigger tariff rises. Its government hopes the dispute can still be settled. The American administration said it would try to come up with a new scheme to meet the “legitimate” concerns of Congress. That will be a job for Ron Kirk, confirmed this week by the Senate as United States Trade Representative. But Mr Obama’s early capitulation to a transparently protectionist lobby sets a worrying precedent. On March 25th Hillary Clinton, the secretary of state, will visit Mexico, dispatched by Mr Obama originally to discuss security issues. Her task will now also be to reassure America’s second-biggest trade partner that her country honours its commitments. Perhaps Mexican officials should invite her to make the return journey by truck.

Don't Bail Out Eastern Europe

by Bogdan C. Enache

There's a new subprime crisis in the news. Unlike the US original, however, which has sparked the worldwide recession, this one doesn't involve only falling home prices but also falling economies. The countries of Central and Eastern Europe, after years of high growth fueled by investment from Western Europe, are now heading towards a recession. The banks that provided much of the credit in the booming period, already hit by liquidity pressures due to events in the US and their home countries, are now faced with the prospect of big losses on the loans made in the Eastern half of the continent.

With the downturn in the US and the developed economies of Western Europe also came the end of the boom in the emergent Eastern European economies. The freezing of money markets in the United States and Western Europe in the summer of 2007, followed by a sharp increase in credit risk subsequent to the Lehman Brothers bankruptcy, drove investors into a liquidity scramble. In Eastern Europe, these events translated into capital repatriations, lower foreign investment and higher risk premiums. The slowdown in the developed economies and, finally, the onset of the recession in the second part of last year brought a fall in Eastern European exports, which further exacerbated the downfall. The region's currencies plummeted.

In Eastern Europe, banks were privatized during the 1990s and early 2000s. The preferred method of privatization was the sale — either by direct negotiations with the government in place or through a public auction — of a majority stake in a local state-owned bank to a big foreign banking group, deemed capable of restructuring it and making it profitable. Consequently, nowadays most banks in the region — and especially in those countries that are now members of the European Union — are owned by big Western Europe groups, such as Raiffeisen Zentralbank or Erste Bank of Austria, Swedbank of Sweden, Société Générale of France, Unicredit of Italy, KBC of Belgium, Bayern Landesbank of Germany and others. The Eastern European subsidiaries of all of these banks, often among the largest in their home countries, form a significant share of their assets. And because of this huge exposure, the growing crisis in Eastern Europe is now proving critical to their financial health. Furthermore, a fall of any one of these banks due to losses on their operations in Eastern Europe will add a new threat to the stability of the European financial system.

Thus, it turns out that Eastern Europe has now become the subprime borrower of Western Europe. As was the case with the US mortgage borrowers, both the public and private sector in Eastern European countries are highly leveraged while falling currencies and declining output mean lower income in the immediate future. Because of the deepening recession in the United States and Western Europe, the Eastern European countries are moving quickly into negative growth rates as well. And with them comes the increased risk of default on debts.

The banks now realize the gravity of the situation. Nine of the most exposed Western Banks in the region, led by the Raiffeisen group of Austria, have already called on the European Commission and the European Central Bank (ECB) to come to the rescue of Eastern European economies in order to avoid, later on, the repercussions that the loan defaults in the region will have on the financial health of economies in the west of the continent. The most exposed countries to a fallout in Eastern Europe are Austria, France, Italy, Belgium, Germany, and Sweden. Austria alone made loans of $297 billion to Eastern Europe, according to Josef Pröll, the Finance Minister in Vienna. This is the equivalent of 70% of the country's GDP.

However, Switzerland, a nonmember of the European Union, is also among the big creditors of Eastern Europe. The low interest on Swiss francs made it the main currency for mortgage credit in the region. Lending in Swiss francs reached around 50% of the total in some countries such as Hungary or Poland. According to a Morgan Stanely report based on the Bank of International Settlements' data on international lending, total foreign borrowing in Eastern Europe has reached $1.6 trillion as of September 2008, of which $1.5 billion have been provided by Western European creditors.[1] Between 2005 and 2008 alone, the volume of foreign credit absorbed by the region grew three times. All this credit brought huge profits to the Western banks present in the region and was, to a large extent, responsible for the average growth rates of around 6% real GDP that Eastern Europe experienced during the last 7–8 years. Housing, cars, and other consumer durables were booming. At the same time, the lending standards became lax. In Romania, for instance, banks advertised that having an ID card was all you needed to get a loan. This worked well as long as growth was strong. But now Eastern Europe's economies are sinking, unemployment is rising, and the debt accumulated in these past years might not be repaid.

Loan Portfolios of Western European Banks' CEE Subsidiaries, H1 2008 (in millions of euros)

Sources: Company data, Merill Lynch estimates

Compiled by IMF Central Europe and the Baltics Office, November 7, 2008

The prospect of a debt default is real. The local currencies are falling rapidly against the euro, the dollar, and the Swiss franc, making it harder for individuals, companies and governments to repay their debt denominated in Western currencies. The Baltic countries are the most indebted in the region. Estonia's foreign debt represents 131% of its GDP, for Latvia it is 116% and for Lithuania is 72%. Together, Eastern European countries have to repay $400 billion worth of debt this year alone.

Moreover, the growing contraction in output is pushing up the already high deficits in government spending at a time when borrowing costs and risk premiums have increased considerably. Given the capital exodus underway and the significant current account deficits, the Eastern European currencies will continue to lose value against the euro and the dollar even if the Hungarian forint, the Polish zloty, or the Romanian leu have already reached historical lows. Although the central banks in some countries, like Russia, Poland, the Czech Republic, or Romania, have significant foreign-exchange reserve and have used them to shore up some of the fall in their currencies, the macroeconomic imbalances are generally so great that the current crisis in Eastern Europe has the potential of surpassing the Asian currency crisis of the mid-1990s.

Under these circumstances, the banks are not the only ones that are calling on the wealthier European Union (EU) countries, the ECB, IMF, and the World Bank to bail out Eastern Europe. In the fall of last year, the IMF approved a $16.4 billion loan to Ukraine, whose currency, the hryvna, has lost half its value in the last six months, triggering a run on exchange houses. But the government is unable to reduce its deficit, and inflation is well over 20% per year. Hungary, the country with the biggest government debt, also received a $12.5 billion IMF loan, ten times it's normal quota, as well as an $8.1 billion loan from a special EU borrowing facility and a $1.3 billion credit from the World Bank.

In mid October, at the height of the credit freeze, the ECB also came to the rescue of Budapest and provided 5 billion euros in a swap arrangement with the Hungarian central bank to ease liquidity in the money market. This event marked a significant extension of ECB's role. It was the first time the bank, which oversees monetary policy for the 16-nation Eurozone, lent to a country outside the European Monetary Union. The ECB subsequently extended swap arrangements to the Polish central bank and, despite its reluctance, it will probably do so with other central banks in the Eastern part of the EU. In December last year, the IMF, together with the EU, the World Bank and Sweden, also loaned $10.5 billion to Latvia. On the other hand, Georgia got a ¾-billion-dollar credit line to prop up its currency, followed by Belarus, which received $2.5 billion in January of this year. Finally, Serbia is in the process of acquiring a $2 billion loan. But the other two Baltic states, Estonia and Lithuania, are next in line for IMF, World Bank, and EU help, followed by Bulgaria and Romania. Since the start of the Eastern Europe crisis in the fall of last year, the IMF has lent $40 billion. Counting the loans granted to Iceland and Pakistan, the figure has reached $50 billion.

The leaders of the richest EU countries, who gathered in Berlin before the second G20 summit since the world economic crisis began, now say they want to increase the IMF lending capacity from its current level of $250 billion to $500 billion. Japan has already pledged another $100 billion, but the big Western European countries might not be able to raise additional money, even as they discuss the possibility of issuing a new euro bond designed to reduce the risk premiums borne by the governments with lower sovereign credit ratings.

The United States is already in a mountain of debt, while China and Middle Eastern countries — which have the reserves needed — refuse to supplement IMF funding without receiving in exchange more voting power in the international body, a concession that the big European countries, whose voting rights will therefore be diluted, don't want to make.

Concentration of Emerging Europe's Exposure to Western Europe, H1 2008

Source: Bank for International Settlements, Quarterly Review, June 2008

Note: Country names are abbreviated according to the ISO standard codes.

Emerging Europe exposure to western European banks is defined as a share of the reporting banks in each western European country in the total outstanding claims on a given emerging European country (both bank and nonbank sectors). For example, about 42 percent of Croatia's exposures to western European reporting banks is owed to Austrian banks, 38 percent to Italian banks, 13 percent to French banks, etc. For the Baltic countries, 85 percent or more of exposures to the reporting banks is owed to Swedish banks.

At the same time, within the EU, the southern countries (Spain, Italy, Portugal, Greece) and Ireland, confronted with severe turmoil in their banking system due to falling mortgage assets and rapidly contracting economies, want the ECB and the EU to channel their resources primarily into bailing out their banks. The politics of who is bailing out whom will become ever more complex as the economic crisis in Europe and the rest of the world deepens.

The current crisis in Eastern Europe, just like the one in America or the western part of the old continent, is a painful process, but a concerted international bailout of the irresponsible banks and governments of the region is not the solution. It was precisely such expectations, coupled with years of loose monetary policy in the United States and Europe, that created a chain of moral hazard which led to the current economic crisis.

The gradual lowering of interest rates by the Fed, the ECB, the Bank of England, and other independent European central banks, such as Riksbank and the Swiss National Bank, in the aftermath of the dotcom bubble and the 9/11 events, provided the incentive for Western European banks to overleverage their assets and then, through their subsidiaries, to begin extending poorly underwritten loans into a virgin Eastern Europe.

The Eastern European central bankers also joined in the effort of their Western counterparts in stimulating global demand, but their cuts were smaller and their interest rates remained comparatively higher. Consequently, some of the cheap money in the West was carry traded by sophisticated financiers in the East, making the local currencies, like the Romanian leu for instance, look strong. When the financial crisis unfolded in the United States and Western Europe in the summer of 2007, the reverse carry trade kicked in as investors drew on their money in Eastern Europe to cover their liquidity shortages. Then the funding lines of the parent banks (who now had problems of their own) to their local subsidiaries were cut back. The boom was now coming to an end in Eastern Europe as well. As interest rates went up, the housings and residential markets in Poland, Bulgaria, Romania, the Baltics, and Russia came to a halt and began to decline. The local banks were left with a pool of loans of uncertain value.

In many cases, high levels of government debt were a big part of the problem. Even though the region's economies experienced high growth rates in the previous years, in many countries the public debt grew. Hungary is the most prominent example among the Eastern European countries that are members of the EU, but relatively high government deficits were also the case in Romania. Among the non-EU members, Ukraine stands out as the country ravished by government spending excesses.

The main floating Eastern European currencies: Czech koruna, Romanian leu, Russian ruble, Hungarian forint, and the Polish zloty

Source: Danske Bank

However, the economic slowdown will increase budget deficits even in those countries where fiscal policy was relatively well balanced. In the case of Russia, which, unlike almost every other Eastern European country, has a current account surplus, the sharp fall in oil prices in the second part of last year considerably reduced revenues. This coincided with a significant deterioration of the business environment following the short war with Georgia, its small southern neighbor. The government's hostile policies led investors to pull their money out of the country, provoking a spectacular fall of the Moscow stock market and a plunge of the ruble.

There is tremendous pressure in Europe not to allow the bankruptcy of any banks that expect massive write-downs on their Eastern European operations; and, in the case of Bulgaria and the Baltic countries, the pegs to the euro formally exclude the devaluation of the currency. But a joint EU, IMF, and World Bank bailout for the region will amount to a continuation of the risk-subsidizing policy and market-discipline erosion that gave birth to the current turmoil in the first place.

The banks that gambled on ill-conceived loans would be rewarded for their inefficiency and kept alive through wealth redistribution from those businesses and individuals who were comparatively more prudent. The net effect of such policies is to encourage moral hazard in the future, which, in turn, will induce a higher unpredictability in the financial system.

However, Eastern Europe is not a homogeneous or even clearly definable entity.[2] The situation differs from one country to another. In same cases, particularly in non-EU ex-Soviet countries, such as Ukraine or — beyond strictly geographical Europe — Kazakhstan, governments might default on their foreign debt. Elsewhere some form of debt restructuring will be pursued, while in some places a combination of currency devaluation and refinancing would solve the problem.

The reality is that there is no costless solution out of the current mess. But using the ECB, the IMF, or the World Bank to absorb the losses of insolvent banks in the guise of smoothing temporary imbalances in the balance-of-payment system is the worst solution one can think of. In time, most of the external imbalances will work themselves out. Already, the economic slowdown is shrinking the region's current account deficits.

The rapid growth in prosperity that took place in most Eastern European countries during the last eight years has fueled high hopes of catching up with Western living standards. Not surprisingly, the economic downturn is sparking anxiety and, in some countries, even civil unrest. Although the situation will get worse before it gets better, the fear of an economic collapse that would transport the region back to the conditions experienced shortly after the fall of the communist central-planning system are exaggerated.

This doesn't mean, however, that there is no reason to worry. The policy choices enacted in the face of the current crisis will shape the potential for prosperity in the future. A full-blown bailout of the banks responsible for making bad loans will only further an economic system of private profits and socialized losses. Such a system is as incompatible with the free-market economy that many Eastern Europeans thought they were adopting after 1989 as is the old Marxist-Leninist socialism.