Estonian Economics

National Review, September 27, 2012 (October 15, 2012 issue) 

Raekoja Plats, Tallinn, August 2012 © Andrew Stuttaford

Tallinn, Estonia – Sitting shirt-sleeved and without, sadly, his trademark bow tie, in his official residence here in the Estonian capital, this Baltic nation’s Swedish-born, New Jersey–raised president, Toomas Hendrik Ilves, looks pained. He’s chewing antacid pills (I’d guess), but it’s the name that I just mentioned that is the problem, not indigestion: “Krugman.”

He sighs.

“I know this has been done to death,” I admit.

Ilves does not disagree.

Estonia has a tragic history of being a battleground for other people’s wars. Thankfully, the latest conflict into which the country has found itself unwillingly drawn — the debate over how the West can emerge from its post-Lehman malaise — has involved nothing more than a “snide” (to borrow Ilves’s adjective) bit of blogging by Paul Krugman for theNew York Times. And even that, the president concedes, ultimately turned out to be “good publicity” for a tale of economic recovery.

In 2008, Estonia’s boom, fueled to overheating by (primarily Scandinavian) banks attracted by the country’s post-Soviet revival, turned, like so many others, into bust. GDP fell by 3.7 percent in 2008 and by 14.3 percent in 2009, taking tax revenues with it: The budget went into a deficit of 2.7 percent in 2008, shocking in a country that aims to run a structural surplus. Unemployment soared to 16.9 percent in 2010, from 4.7 percent in 2007. Housing prices crashed 40 to 50 percent from their peak.

In response, the country’s governing coalition of conservatives and classical liberals cut spending and raised taxes (Estonia’s flat-rate income tax was, however, left untouched at 21 percent) in a squeeze equivalent to over 9 percent of GDP. But it was what happened next that must have really bothered Krugman: After pain came gain. GDP jumped 7.6 percent in 2011, and should grow by 2 to 3 percent this year and next. Unemployment has dropped to 10.2 percent and seems set to fall farther.

That did not fit comfortably with the sometimes-cartoonish Keynesianism that the professor has been pushing since the era of hope, change, and stimulus. So he took to his blog, cropped a graph, and took aim at “the poster child for austerity defenders” — not a role that the Estonians had sought for themselves. There had, wrote Krugman, been a “depression-level slump” (true enough) “followed by a significant but still incomplete recovery. . . . This is what passes for economic triumph?”

Well, no, but that is not what the Estonians, a modest bunch, are claiming. No one I talked to described times as easy, but progress is progress. What’s more, if you push the graph back a touch earlier than 2007, which Krugman used as his starting date, the broader picture is revealed to be rather prettier than the Nobel laureate let on. Yes, it was true that GDP had yet to return to 2007 levels, but it still stood slightly higher than in 2006, no plague year. President of one of Europe’s tech-savviest countries, an irritated Ilves turned to Twitter to rough up the “smug, overbearing & patronizing” Krugman.

Let’s take a step back: Estonia is not Greece. Government is transparent and thrifty. Taxes are paid. Private borrowing ballooned during the bubble years, but that of the public sector did not. At the end of 2008, the state’s debt stood at a sober 4.5 percent of GDP, a figure that might have tempted some governments to try to splurge their way out of recession. In rejecting that route, Estonia did the right thing. It depends on its external trade: Exports amounted to 79 percent of GDP in 2010 (compared, for example, with Greece’s 22 percent). With the European economy in savage, sudden free fall, efforts to pump up domestic demand would have achieved little.

Instead the government concentrated on maintaining the fiscal discipline that is one of the country’s most valuable assets and waited for better times, helped in the meantime by the fact that its banking system (dominated by the subsidiaries of large, well-capitalized Swedish banks) kept liquidity flowing. The wait was not too prolonged. Benefiting from policies often very different from those pursued by the tightwads of Tallinn, many of Estonia’s trading partners pulled out of their post-Lehman dive rather more rapidly than might otherwise have been expected, dragging the Estonian economy up in their wake as exports picked up again. The budget is (broadly) back in balance, and the ratio of central-government debt to GDP stood at 6 percent at the end of 2011, a time, ahem, when the U.S. number was over 100 percent. Estonia’s finances remained intact.

And so, largely, did the population. Demography is a sensitive topic in the three Baltic states, small nations with (in the case of Latvia and Estonia) ethnic balances severely distorted by the influx of Russians who arrived in the Soviet years. The slump has triggered a large wave of emigration. Estonia has been spared the worst of this, not least because of the presence of Finland (Finnish and Estonian are closely related languages) just across the Baltic Sea. Why emigrate if you can commute? There’s probably something else at play, too. All three countries have come a long way since their escape from Moscow in 1991, but Estonia has gone the farthest: Perhaps its citizens were more willing to believe that hanging on would be worth their while.

Estonia’s is an impressive story, but it is a distinctive one, with specifics — including a history of budgetary prudence, the presence of those Swedish banks, a heavy export orientation, assistance from the EU’s structural funds, and a windfall from the sale of emissions quotas — that mean that advocates of an Estonian solution to the euro-zone crisis should proceed with care. Crushing the economic activity on which tax revenues depend is increasing the burden of government debt in many of the PIIGS. In that sense, Krugman was right. Estonia is not a poster child for “austerity defenders.”

But it is a poster child for Estonia: Its frugal, free-market, low-tax, and transparent democracy is indeed something to emulate. An Estonian-style tightening could never have ended Greece’s slump, but if the Hellenic Republic had earlier taken a path that was more Baltic than Balkan, it would not be in the mess that it now is. Coulda, shoulda, drachma.

The sting in this tale is that the euro’s distress may mean that Estonia will not be allowed to follow its own example much longer. This will not be the first time that the trickster currency has caused trouble in Tallinn. It was the prospect of Estonia’s adoption of the euro that triggered that last, fatal surge in Scandinavian lending. On the other hand, it has also represented an additional incentive (and some political cover) for the maintenance of that budgetary discipline without which — ironically, in the light of the shambles elsewhere — the country would not have been eligible for membership in the currency union.

Switching to the euro was seen by most of the Estonian elite as final confirmation that the country had left its Soviet past behind. Even though the Estonian kroon had been pegged to the Deutsche mark, and then to the euro, since its rebirth, many ordinary Estonians were not so convinced that it should be swapped for the single currency, but the terms of the country’s accession into the EU in 2004 rendered their discontent moot. Calls for a referendum were ignored, and Estonia moved over to Brussels’s funny money on January 1, 2011.

If the alternative approach, retention and then devaluation of its own currency (frequently a useful tool in an economic crunch), was considered, it was not considered for long. Exports are vital to Estonia, but it adds comparatively little value to them. Devaluation would therefore have had little impact on their cost to international customers. What it would have done, however, is risk importing yet more inflation into Estonia’s small, open economy. Above all, devaluation would have, as Ilves explains, “wiped out” the middle class. Typically, the mortgages — often on properties that had since collapsed in value — that Estonians had taken out from those generous Scandinavians were denominated in euros. To repay them in depreciated krooni would have been a Sisyphean nightmare. Another alternative, redenominating those loans in local currency, was never a serious option: The liquidity that the Swedes provided throughout the crisis would have dried up overnight.

That was then. The problem now is that Estonia arrived in the euro zone at a very bad time. The safe haven has turned out to be anything but. And it could prove an expensive place to stay. Estonia dutifully helped underwrite the European Financial Stability Facility, the currency union’s temporary bailout fund, and just a few weeks ago ratified its commitment to the fund’s permanent successor, the European Stability Mechanism. If things go badly, that could leave this small country on an unnervingly large hook.

This has not played very well with the electorate. To date, the country’s voters, many of whom remember the infinitely harder Soviet period, have supported the hair shirt. The government was reelected with an increased majority last year. But bailing out feckless, richer folk in Europe’s south (for example, Estonian average earnings are only about one-third higher than the Greek minimum wage) has been a tougher sell. Most Estonians opposed participation in the EFSF and ESM. By contrast, the political class remains willing to trudge through euro-Calvary, although there are some signs that this resolve may begin to crumble if the bailouts grow bigger (and thus potentially more costly to Estonia) and more widespread. And it would be the insult, not just the cost. Should still-poor Estonia really be asked to stump up for Spain? Or Italy?

Ilves points out that, “to put it crassly,” Estonia has profited nicely from its membership in the EU (not least from the financial support that Brussels channels to the union’s less prosperous members), and it has — so far. But there’s an obvious danger that Santa could turn Fagin.

And the euro’s woes menace more than Estonia’s coffers. It now seems clear that attempts to fix the single currency will revolve around trying to integrate the euro zone into a deeper political and budgetary union. Such a union, were it to be formed, would be launched with promises of financial discipline, transparency, and democratic accountability, none of which, given such a construction’s artificial, ill-fitting, and unnatural character (not to speak of the EU’s own lamentable track record in these respects), are even remotely credible. And what then would happen to Estonia, trapped within a Frankenstein union that could be held together only by methods — budgetary and otherwise — that would be the antithesis of everything that independent Estonia has come to stand for?

Neither Ilves nor any other of the political figures to whom I have spoken in Tallinn appear to believe that this is what lies ahead, but, even amid the confidence that is the product of past success and satisfaction at Estonia’s hard-won arrival in “Europe,” it is impossible to miss some hints of uncertainty over what comes next.

That uncertainty needs to be replaced by alarm.