Paul Krugman Isn’t Always Right

Don’t Trade on the Opinions Even of Geniuses

Aug 01, 2025

I’m a fan of Paul Krugman’s Substack and, like everyone else, marvel at how he manages to produce a substantive post every day. And, freed of the Times’— or as my late friend Brom called it, The Jack & Jill of 43^rd Street — stodgy house style, Krugman now lets his snark flag fly. Indeed, he writes with such authority that it’s hard to believe he could ever be wrong. But he can. His most famous bad call, which he owns up to, was in 1998 when he wrote: “By 2005 or so, it will become clear that the Internet’s impact on the economy has been no greater than the fax machine’s.” Oops.

I’m not a Nobel economist — in fact I’ve only taken one course in macroeconomics, in college (I got a B+) — but I’ve seen reality, not theory, play out in numerous emerging markets over 30 years. One region I know well, having invested there since 1994 both in public and private equity, is the Baltic States. This gave me the courage (chutzpah?) in 2011 to publish an article taking Krugman and Nouriel Roubini to task for the wrong advice they had tried to push on the Baltics during the Global Financial Crisis. Fortunately, the countries ignored these views, followed the IMF and their own good sense, and went on to be the success stories they are today.

When I wrote the article in 2011, the Baltic States had endured two years of austerity and had already returned to growth. Growth was to continue, albeit not in a straight line, and GDP per capita in Estonia, Lithuania, and Latvia is now €29,000, €27,000, and €22,000, almost double the 2008 levels. This reflects roughly a 30% discount to the EU average vs. over 50% in 2008, meaning that, statistically, living standards have converged toward Western Europe’s. This is visible on the ground. If you visit Estonia’s capital, Tallinn, which I recommend doing, you might think you were in Finland, and beautiful Riga and Vilnius have also become popular tourist destinations.

While it’s true that many people left to work in Western Europe during the 2010s, this stopped in recent years. Estonia and Lithuania now have net migration, which makes sense given their relatively low unemployment and rising wages. Estonia’s vibrant tech sector has produced several unicorns. Importantly, the three countries are stable democracies, what we at Firebird call “post-political” in that elections no longer dramatically alter a country’s path. This week, the Lithuanian PM resigned in a corruption scandal, and it barely registered in the capital markets.

By 2013, it was clear to anyone engaged there that the Baltic austerity plans were working, though unemployment remained high in the context of a European recession. Still, unwilling to admit he’d ever been wrong, Krugman was hanging in with a blog post, “Baltic Brouhaha,” in which he wrote:

People praising the Baltics tend to brush off the observation of still-high unemployment and output still well below pre-crisis peaks by claiming that the high output and employment of 2006-7 were a bubble and we shouldn’t expect them to come back. I don’t think they realize just how problematic an argument this is.
First of all, the idea that real GDP and employment can be hugely inflated above sustainable levels by a bubble is questionable. We know that economies can operate far below capacity; operating far above capacity is a tougher proposition to defend. In fact, it’s normal to assess trends in capacity by “peak to peak” interpolation, assuming that the peaks are much more similar than the troughs, that “overfull” employment, while it can happen, can’t be all that large.

First, he wrongly says that output in 2013 was “well below” pre-crisis peaks; in fact, they were back at peak levels and on much sounder footings than during the pre-crisis real estate/consumption bubble. Second, was he really claiming that economies cannot overheat very much? I wish I were an economist so I could demolish his argument in that language — if you are one, please do so in the comments — but I only have actual experience to refer to, and they for real do.

As I wrote in 2011, “[T]he claims of Paul Krugman and others that the current [unemployment] problem is the result of the austerity program seems akin to me saying that my hangover this morning is the result of my waking up.”

A Counterfactual

Would Estonia, Lithuania, and Latvia enjoy the calm prosperity they do today if they had followed Krugman’s advice? It’s almost certain they would’ve had banking crises, which usually cause losses of confidence from which it takes years to recover. Would a populist have seized the opportunity to come to power and push the countries away from the reform path? Even if that setback hadn’t come to pass, they couldn’t have joined the Euro when they did in the 2010s, if ever. No serious observer denies that Euro membership has been a great benefit to the Balts.

Why bring all this up now in my investing-oriented Substack? Because Krugman has suddenly become so big that investors may be acting on what are, in the end, opinions from him and other commentators — as I did in April, when I sold stocks near the bottom after getting freaked out. And I never market time.

So, in the knowledge that when you come at the king you best not miss, I’m extracting below my 2011 article explaining how Estonia, Lithuania, and Latvia got into economic trouble and how Dr. Krugman’s devaluation medicine would’ve made the patients even sicker. I think I’ve actually made my point already and you can stop reading here; if you do go on, you’ll at least learn some interesting post-Soviet history.

In early 2009, the strong consensus among economists studying the crises in the Baltic States of Estonia, Lithuania and Latvia, was that they could not possibly restore stability and growth without first devaluing their currencies. Paul Krugman, the loudest exponent of this view, even coined a phrase when he called Latvia “the new Argentina.” Nouriel Roubini, another prominent bear, expected not only that the Baltics would have to devalue but that they would be the first dominoes that knocked other Eastern European countries like Bulgaria off their currency pegs — then again, he also assured me personally, at a nightclub in early 2009, that the four top U.S. banks would be nationalized by June: nobody’s perfect.

Now, just two-and-a-half years later, all three Baltic States have swung to current account surpluses and GDP growth above 4% and accelerating, their unemployment rates are falling rapidly, and fixed capital investment is again growing. While major headwinds remain, they are clearly on their way. And all three countries got here without devaluing – in fact Estonia joined the Euro in 2010. [Latvia joined in 2014, Lithuania in 2015.]

How did they pull this off?

Blowing Up a Bubble

For those who are unfamiliar with these small (ca. 7 million population combined), beautiful countries, they are situated on the Baltic Sea across from Finland, and were Soviet republics for 50 years before achieving independence in 1991. The Estonian language is similar to Finnish, the two countries are close trading partners, and indeed a popular Finnish holiday is to cruise to Tallinn for a weekend of beer drinking and discount shopping.

Lithuania, the largest by population, has a significant agricultural sector, with ties to Germany that date back to the Lithuanians’ wars against and treaty with the Teutonic Order in the 13^th century. Latvia, having spent much of the last 400 years under Russian control, has the closest relationship with Russia, and most Latvians are bilingual; this attracts many Russian tourists to the charming capital city, Riga, and the seacoast.

All three countries are parliamentary democracies that have followed generally liberal social and economic policies, especially Estonia, which has a flat income tax and no capital gains taxes, and ranks roughly equal to France on Transparency International’s Corruption Perceptions Index. Latvia is rated the most corrupt of the three, but even so it ranks about equal to Turkey. In fact it was the openness of the post-independence Baltic economies that resulted in their stunning growth, but also planted the seeds of their eventual crisis, as we shall see.

To understand the depth of the hole the Baltics had gotten into, and thus the enormity of their task digging out, we must first examine the roots of the crisis. (I should note that the three were not in exactly the same positions, as the problems in Lithuania, for example, were less severe, but as they were generally in the same boat, we will consider them as one unit.) After the 1998 Russian devaluation, the Baltics reoriented their economies away from Russia (which had previously taken 80% of their exports) and toward Europe, in particular the Nordic countries. Once the Baltics were on track to join EU, their largest banks became obvious targets for the Scandinavians, and between 2000-05 SEB and Swedbank acquired dominant shares in the banking systems, with others like Nordea and Danske also entering.

Delighted by the high growth and profits in their Baltic subsidiaries, the parents funneled more money to the region. This enabled a consumer-lending boom, in Euros — 90% of Estonian mortgages were in the common currency — and, given competition for market share, at increasingly low interest rates. Considering the Baltic States’ 2005 entry into ERM2 and expected Euro adoption, none of this seemed overly risky. Domestically owned Latvian and Lithuanian banks were also able to join the lending party by funding with non-resident foreign deposits and on the wholesale market. Unsurprisingly, this led to a housing boom, with prices doubling between 2005 and mid-2007.

GDP and wage growth soared, as did inflation; inflation was also stoked by absorption of EU funds and adoption of EU rules on raising tariffs in regulated industries. Investment was now being directed to the non-tradeable sectors, mainly construction, as we saw the strange phenomenon of British and German citizens, having bought into the New Europe boom story, acquiring vacation homes on the Latvian coast or on the Bulgarian Black Sea. (I recall seeing ads for Bulgarian coastal property in the London Times and wondering how the optimistic buyers would feel the accommodations in, say, Varna compared to those in Brighton.) As the boom peaked, Baltic current account deficits reached 15-20%. By mid-2007 the seriousness of the bubble was evident, leading Swedbank and SEB in early 2008 to start slowing their credit growth in the region.

As a result, equities and real estate were already weakening when the global crisis began. The Baltics’ troubles were exacerbated as European export markets dried up at the same time SEB and Swed were cutting funding to the domestic economy. Nor could the governments replace lost private demand with public spending, as Russia and China did, because their politically and economically liberal policies of the preceding years meant that wealth had been accrued not centrally but in private hands; and now tax revenues were going to plummet, while capital markets would be closed. Latvia, with faith in its banking systems damaged, and bank runs underway, would have to enter an IMF program, which would impose fiscal austerity. The rest of the crack-up story is too sad to recount, especially for someone who lived through it with significant exposure both in the portfolio markets, via the Firebird funds, and in private equity, via our co-managed Amber funds, that are among the largest in the Baltics. Suffice it to say that a 70% peak-to-trough decline in the Estonian stock index left it and me deeply depressed.

The crisis laid bare the Baltics’ structural weaknesses, which had worsened during the early years of EU membership. As summarized in a September 2010 IMF Working Paper, these were 1) loss of competitiveness owing to real exchange rate appreciation, 2) public expenditures that were out of line with the post-crisis tax base, 3) high private sector debt (ex-Lithuania, which had no real estate bubble), 4) bad loans in the banking sector, and 5) structural unemployment. Since these issues were typical of post-bubble emerging economies, it was generally assumed, as noted above, that the region would take the typical currency devaluation route as the core of macroeconomic adjustment. However, Latvia’s and later Estonia’s government resisted this course, and in doing so were lambasted by commentators such as Paul Krugman, who argued that they were maintaining the currency pegs in order to protect the assets of the fat cats while imposing all the burdens on the working class. In one blog post, Dr. Krugman referred sarcastically to “oh-so-virtuous Baltics” in an unfavorable comparison to the (presumably more empathetic) Icelanders.1

Setting aside the fat cat straw man, let us explore the true reasons that Latvia and Estonia chose to maintain their pegs, and preserve their chances to join the Euro. First, because the vast majority of bank loans — including, as noted above, 90% of Estonian mortgages — were Euro-denominated, devaluation would have made it much harder to service debt; the explosion of bad loans would in turn have damaged fragile confidence in the banking sector. Estonia, like Russia, had experienced a banking crisis in 1998 and had seen the challenge of recovery, once money had gone back into the mattresses; this is one reason why both countries made it their top priority in 2008-09 to protect systemic banks. Of course, this was also the EU’s priority, as it was concerned about direct damage to the Nordic banks as well as contagion to other countries with currency pegs, which would in turn damage Western European banks’ major investments in the East. Maintenance of the pegs was a condition of EU and IMF aid.

Second, devaluation would not necessarily have done much to help the domestic-oriented Baltic economies, where even exported goods have very high import content. Moreover, as the Baltic States have positioned themselves as entrepots between Russia and the West, and regional banking centers, widespread bank failures would have had long-term negative effects on this role. Fixed exchange rates had been the anchor of macroeconomic stability for nearly twenty years, just as the source of political stability had been the national project to join first NATO and the EU, and then the Euro.

The people of the Baltic States had consistently shown their willingness to pay almost any price to achieve these goals, forged from the determination never again to come under Russian domination. For myself, the moment I was sure Estonia would never devalue came in early 2009, when President Toomas Ilves emerged from a meeting with business leaders about the crisis and said that they had all agreed the best solution was early adoption of the Euro. The absence of any populist rhetoric indicated that Ilves felt certain of the popular support for this course, whatever the short-term pain.

Finally, like the old joke about why dogs lick their private parts, the Baltics chose to maintain their currency pegs because they could. They were small, flexible, open economies with support from the EU and IMF, illiquid currencies that were near-impossible to short, and little to no sovereign debt outstanding — thus ideal candidates for so-called “internal devaluation.”

Austerity

Internal devaluation in the Baltics was a mix of policies that, again as summarized in the IMF report, included several main elements. The first was an unprecedented fiscal adjustment to bring deficits within the Maastricht criteria, as well as containing domestic demand growth to support a correction of the real exchange rate. The huge fiscal adjustments (11% of GDP in Latvia in one year) were almost exclusively via spending cuts and not higher taxes, based both on the acknowledgement that pre-crisis spending levels were now unsustainable, and the countries’ preference for low tax rates.

Nominal wages were cut, both in the public and private sectors, by 20-30% across the board. As economist Anders Aslund and others have noted, these severe cuts also forced structural reforms, as the governments had not only to reduce the capacity, but also improve the quality of public services. Numerous social programs were created, or enhanced, to reduce the impact of the employment cuts. Also, priority was given to banking sector liquidity, including by securing commitments from the parent Nordic banks. The high integration between the Baltics and their neighbors was critical in the banks’ willingness to stay the course and protect their existing investments.

The results of internal devaluation were grim in the short run, as GDP in 2009 shrank by 13.9%, 18%, and 14.7% in Estonia, Latvia, and Lithuania, initially causing their debt-to-GDP ratios to surge and unemployment to rise to the high teens. Nevertheless, aside from a few protests in Latvia, public support for the austerity programs remained solid. While the Latvian government changed four times in the next three years, this was due more to dissatisfaction about specific implementation of austerity than any fundamental disagreement with the program itself. In this regard, Aslund has pointed out that as long as there is popular consensus about the underlying goals of such a program, there is no reason to panic over political changes. The people will keep replacing the leaders until they find a combination that can get the job done fairly and efficiently. Political turmoil is more worrisome in a country like Greece, which seems to lack any clear national agenda driving popular agreement about the direction of policy. It may not be clear to the average Greek worker what he or she stands to gain, personally.

In the Baltic States, the relatively quick acceptance of austerity stemmed, as noted above, from the desire to fully integrate with Europe and in doing so to end Russian domination permanently, and maybe also from deep-seated pessimism, which had caused most of the working population to remain skeptical even when the boom was in high gear. Unlike, say, Americans, who believe that general wealth is our natural state, austerity for former Soviet peoples represents a return to reality, and their main concern is that all suffer equally. Hence the public widely supported the drastic cuts to public workers, who were perceived to have unfairly cushy jobs.

As anticipated, the Baltics have been assisted during the crisis by the relative flexibility of the workforces. This is not unusual in the former Soviet Union, where even during good times many people have had at least one “unofficial” source of income, i.e., doing import/export from the trunk of their cars.2 Eastern Europeans also tend to have family support networks, which supplemented the enhanced state social programs.

Now, recovery in the Baltics is fully underway, with GDP growth of 4-4.5% this year. The pace of recovery was accelerated by the turnaround in Western Europe and pick up in exports, which had a quick and dramatic impact on the current accounts – as the Baltic leaders had anticipated and hoped would happen. Lithuania in particular has benefitted from strong agricultural prices. A major setback in Europe would of course hit the Baltics hard, especially because domestic demand has been slow to revive. Individuals are rebuilding personal balance sheets while struggling with existing debts, and persistent unemployment also is a drag.

However, the improving strength of the banks means that consumer loans are at least available. New car sales in Estonia through May 2011 were 78% above 2010. In the corporate sector, we have found credit conditions for our Amber portfolio companies to be far better now than last year, and new banks are entering to take market share from the still cautious Swedish incumbents. Fixed capital investment is expected to bounce back in 2011-12, also facilitated by the more confident financial sector. It is hard to believe that any of this would be happening had Estonia gone the devaluation route, which would almost certainly have caused a widespread banking crisis.

As for sticky Baltic unemployment rates, the claims of Paul Krugman and others that the current problem is the result of the austerity program seems akin to me saying that my hangover this morning is the result of my waking up. The fact is that the countries have structural weaknesses, and these were exacerbated by three years of mis-investment into real estate and other booming sectors. Also, the return of thousands of workers who had been doing construction in Ireland has swelled the ranks of jobseekers, most of whom lack the skills needed for the jobs that are available. This too is a long-term problem, not the result of recent austerity policies, which requires attention in the Baltics, as it does in many other emerging economies.

After some fears that Estonia’s Euro accession might be deferred, given the ongoing turmoil, it went ahead as scheduled in 2010. It would have been demoralizing to defer them when they met all the criteria, and after having taken the tough medicine of the EU and IMF programs. By keeping its promise, the EU re-incentivized Lithuania and Latvia, as well as the next wave of Balkan aspirants, to stay on track. While Krugman and others may view Euro membership as a “So what?” issue, they are missing the specifics of the Baltic economies.

A common currency eliminates inefficiencies and costs stemming from FX transactions, an important issue given the high degree of trade interdependence with Euro members — e.g., Estonia with Finland. In addition, the Baltics are all eager to attract foreign direct investment to help, among other things, develop their manufacturing bases — with the idea that lower labor costs could make them to Western Europe what Mexico is to the U.S. FDI should be easier to attract if the foreign investors do not have to worry about currency risks. Finally, Estonians are gaining both financial and psychic benefits from the ability to borrow in their own currency, and from the knowledge that Europe will be fully committed to assist if the country runs into trouble again.

The Falling Knife

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