Lately, much ado has been made about the impact, efficiency, and quality of the decisions and policy recommendations made by economists. Last April, the LA times ran a piece in which Harvard economist Greg Mankiw had his students walk out on him during lecture. The walk out was followed by an open letter, which expressed student dismay with the narrow bias in his economic lecturing. Around the same time, the New York Times ran an op-ed in which, several leading economists – including Nassim Taleb and Robert Skidelsky – outlined their beliefs on how the teaching in the economic profession had to change. In both cases, the concern was of the economics profession being in a state of reality-disconnected crisis – and depending too heavily on assumptions, biases, and too narrow focus.
Such views however, are not monolithic. Despite concerns raised about the economic profession over questionable financial practices, which went virtually unchallenged prior to the emergence of the crisis, a silver lining has emerged. We have already seen a few instances in which the right policies at the right time can rescue entire economies. The story of the Vienna Initiative and the rescue of Eastern Europe is such a story.
In 2008, the world financial crisis first came to the shores of Europe. While financial and economic volatility in the Eurozone was initially kept at bay, trouble immediately began brewing along the European periphery. In Iceland, the entire country was in default by October of 2008. What was specifically at issue was that the country’s commercial banks had outgrown the Central Bank of Iceland’s capability to provide the traditional Lender of Last Resort guarantee. When the banks came under attack in the market, there was no buffer for them.
Soon European leaders and financial-market experts realized that a large-scale uncoordinated economic withdrawal from the Eurzone’s periphery in Central and Eastern Europe could potentially have disastrous consequences for Europe. Erik Berglöf, Chief Economist at the European Bank for Reconstruction and Development made repeated warnings about the regional systemic risks associated with uncoordinated national responses in October 2008. At the same time, six parent banks who were heavily involved in Central and Eastern Europe wrote a letter to EC President Manuel Barosso and G20 Chief Christine Lagarde in which worries of the effects of a credit crunch were expressed and a plea for measures supporting both liquidity and the real economy was issued.
The economic boom in the CEE region which had existed until that time had been underwritten largely by the local subsidiaries of venture capital, real estate and project finance arms of Western Banks. Austrian banks such as Volksbank, Erste Bank, and Raiffeisenbank had particularly large exposures to the CEE economies. Time magazine reported that, in total, Austrian banks’ exposure to the CEE region was equivalent to 80% of Austria’s GDP in 2008. Moreover, there was certainly reason for concern. In Poland, 70% of all mortgages were in foreign currency, while in Hungary the same was true for 67% of all consumer debt.
In January 2009, public, private, and international stakeholders met at the Austrian finance ministry to discuss the problem. Present at the meeting alongside delegations from 17 European parent banks with large exposures in Eastern Europe, were delegations from the CEE region’s central banks and finance ministries, as well as a critical mass of International Financial Institutions including the IMF, World Bank, EBRD, IFC, and EIB.
What emerged by late February and early March 2009 was an agreement on the distribution of burden sharing, as well as an agreement to maintain exposure in the region. The banks in turn, would be re-capitalized by international financial institutions (IFIs). The Joint IFI Action Plan was launched on February 27th, and it initially pledged €24.5 billion over a two-year period. The funds were meant to bolster the region’s systemic banks and stimulate lending to the real economy. In 2010, the amounts expanded slightly, as the initiative was extended to a handful of non-EU countries in Eastern Europe and the Balkans.
Fundamentally, the Vienna Initiative was a win-win situation for all parties involved. While it was evident that haircuts had to be taken, the orderly manner in which the process was handled, in addition to in institutional structural support that emerged, helped to ensure that the damage was limited. In short, haircuts were had, but beheadings they were not. This is the effect that having well-designed policies put in place by a body of professional and well-motivated economists can foster.
The Vienna initiative was so effective in restoring confidence and avoiding severe economic contraction and austerity in Central and Eastern Europe that by 2010, the ECFIN Country Focus Report for Poland was titled “The Polish Banking System: hit by the crisis or merely a cool breeze?”, while in 2011, Slovak economists were openly commenting that the crisis had been seen in the news, but not felt on the ground.
In its final report on the Vienna Initiative, the EBRD reported that the unprecedented level of cooperation made a key contribution to restoring market confidence in the Central and Eastern European banking system when it was at particularly low point. This illustrated the important counter-cyclical role played by the IFIs during the financial crisis. At the helm, were a large, well coordinate group of like-minded economic experts, who were all driven to take the crisis very seriously indeed.
Photo Credit: Luca Sartoni