Financial and economic crisis in Eastern Europe

Abstract

Most Eastern European policymakers acted as if they had been completely taken by surprise when the global financial crisis hit them in late 2008. This paper argues that the partially enormous imbalances, particularly in the Baltic economies, were, however, visible far and beyond. The foreign savings-led strategy that relied on foreign direct investments, cross-border lending, and exports created an almost decade-long carry trade of easy credit in Eastern Europe in the 2000s that, first, transformed the domestic financial sector into largely foreign-owned universal banks with weak linkages toward the domestic productive sector and, second, burdened Eastern European consumers and producers with both interest and currency risks. The paper further argues that Eastern European economies are experiencing decreasing returns from integration into European production networks as they still seriously lag behind European core economies and East Asian catching-up countries both in productivity and knowledge intensity. In essence, the credit and consumption boom helped to gloss over deeper structural problems during the 2000s. Thus, during the next few years, Eastern European economies will continue to rely on European fiscal transfers but need to considerably step up their efforts in industrial and innovation policies in order to pave the road out of the current crisis.