Should Greece follow Iceland or the Baltics?

8th June 2012

Iceland depreciated the krona by more than 50% against the euro between mid-2007 and mid-2009. The Baltics, by contrast, adopted extreme austerity policies to defend euro exchange rate pegs, with Estonia joining the single currency in 2011.

A comparison for each country of the level of GDP in the fourth quarter of 2011 with its pre-recession peak provides surprisingly modest support for the devaluationist view. Iceland's GDP shortfall was still 7.9% versus 7.6% for Lithuania and 9.2% for Estonia. Latvian GDP, however, was 15.9% lower.

This comparison, moreover, flatters Iceland because the prior economic boom was less extreme than in the Baltics, implying a smaller excess to unwind during the bust. An alternative benchmark is the level of GDP in the first quarter of 2005, when booms were arguably at an early stage. Iceland has grown 9.2% since then versus 13.2% in Estonia, 16.8% in Lithuania and 9.6% even in Latvia – see chart.

Greece may lack the political and social cohesion to undertake Baltic-style austerity and "internal" devaluation, implying that euro exit is inevitable.

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The real Euro 2012: the economic championship of Europe

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