In the worst case, falls on the stock exchange that correct overvaluations can lead to financial instability, if share prices have been driven by pledged shares and if the market participants are in some cases unable to pay back their loans. This can result in panic sales, exaggerated falls in prices and credit institutes facing difficulties as a result of exposure to households and institutions that have become insolvent. This result risks leading to large fluctuations in the real economy. Critics of the Federal Reserve in the USA claim that when Alan Greenspan coined the phrase "irrational exuberance" in 1996, it was clear that prices on the stock exchange had risen too much and that this development should have been counteracted. Nothing was done and the rise in share prices continued until March 2000. Since then the stock exchanges have fallen, Nasdaq by 70 per cent, and the fall on the stock exchange risks pulling the USA down into a recession that could have been avoided. However, comes the objection; is it really possible to realise when a stock exchange has risen too much? The answer is that prices on the stock exchange must have some relation to the underlying development of productivity in trade and industry, to company profits and to the market's pricing of risks. Of course, it is not possible to determine precisely when the stock market has risen too much or when it is undervalued. However, it should not be too difficult to detect obvious deviations.
Those small countries in particular had to accept the new economic reality of lower demand, higher unemployment and forced fiscal consolidation due to a fall in tax income or borrowing difficulties. The other group consists of bigger or more closed economies that were relying on domestic demand. They were able to smooth the initial impact of the crisis with more extensive government support measures. There was also the expectation that the crisis would be temporary. With the benefit of hindsight we know that we were not facing a temporary bump on the road, but a more fundamental need for adjustment. The initial smoothing of the shock may have been even more costly as it resulted in a higher level of public debt. Secondly, the required policy adjustment involves a dimension which we now consider critical: the speed of reacting and the decisiveness of policy actions. The Baltic countries have learned it firsthand through their experience, which of course is the hard way. There are few economists today that would fundamentally question the need for fiscal consolidation and structural reforms in Europe, as the crisis has clearly turned out not to be temporary. However, we all know it is politically difficult to cut government spending and implement reforms fast. The natural tendency for most politicians is to favour gradual adjustment. “Gradualists” say that in case of fast changes the risk of possible policy mistakes is higher, leading to losses in physical and human capital. Opponents of that view, including myself, certainly acknowledge those risks.