Home > Uncategorized > A voice from the Baltics. Rainer Kattel and Ringa Raudla on the question if the Baltics are an example – or not.

A voice from the Baltics. Rainer Kattel and Ringa Raudla on the question if the Baltics are an example – or not.

RAINER KATTEL is a professor and director of the Department of Public Administration at the Tallinn University of Technology (TTU), Estonia. RINGA RAUDLA is a senior research fellow at TTU. They’ve written a study on the essence and consequences of post-2008 economic policy in the Baltics (Estonia, Latvia, Lithuania). Some days ago we posted a graph from this study, showing EU trasfers to these countries. Here are some parts of a Levy Institute policy brief, based upon the aforementioned study.

from Rainer Kattel and Ringa Raudla

“The commonly cited example of the successful application of “internal” devaluation as a strategy for economic recovery is that of the Baltic economies. In this Policy Note, we discuss whether the Baltic austerity plan worked, how it was designed to work, and, most important, whether it can be replicated anywhere else. We argue that the recent Baltic recovery has unique features that do not relate to domestic austerity policies, nor are they replicable elsewhere”

The problem with this recovery story is that, as with so many other things in the past 20 years, the Baltics “outsourced” their recovery, and they did it very well. Namely, behind the Baltic recovery are two phenomena: the massive (and partially ahead of schedule) use of European Union (EU) fiscal funds (e.g., 20 percent of Estonia’s 2012 budget is made up of EU transfers), and extreme integration of the export sector with Scandinavian producers. These sources of growth are unlikely to be sustainable. The problem with EU funds is that they run out by 2015, and nobody knows if and in what amounts they might continue. The problem with the export sector is that it tends to be an enclave: for instance, Elcoteq Tallinn, until February 2012 a subsidiary of the now-bankrupt Finnish-owned mobile components manufacturer Elcoteq SE and for the past decade a key exporter in Estonia, uses around 200 suppliers in its manufacturing production—none of them based in Estonia.

After accession to the EU, all three economies witnessed an unprecedented boom; between 2004 and 2007, the Baltics stood out among EU member-states for their high growth rates, which averaged 10.3 percent in Latvia, 8.5 percent in Estonia, and 8.2 percent in Lithuania. However, this remarkable growth was accompanied by signs of overheating, like double- digit inflation, a housing boom, sharply appreciating real exchange rates, accelerating wage growth (which exceeded productivity growth, especially in Latvia and Estonia), rapid accumulation of net foreign liabilities, and soaring current account deficits. To a significant extent, the growth was fueled by cheap credit (available through foreign-owned banks; Baltic banking sectors are overwhelmingly Swedish owned), which drove up domestic demand and were channeled into real estate, construction, financial services, and private consumption. All three economies were rapidly building up debt with the rest of the world… Even without the global financial crisis, the Baltics were Ponzi schemes in spe.

In response to the crisis, the Baltics opted for internal, as opposed to external, devaluation of the domestic currency, which implied the downward adjustment of nominal wages and fiscal contraction (instead of countercyclical policy measures). The Baltic state governments heavily objected to external devaluation for a number of reasons, ranging from the practical to the symbolic. Perhaps most important, nominal exchange rate adjustment would have precluded their joining the eurozone as a crisis exit strategy. Furthermore, given that a large proportion of the loans in these countries had been denominated in euros, external devaluation would have imposed heavy costs on large segments of the population and reduced private sector net worth (and potentially led to a surge in loan defaults, with knock-on effects for the rest of the economy). Significantly, none of the Baltic countries had had experience with alternative exchange rate regimes and hence lacked competencies in managing “nonautomatic” systems; policymakers had indeed deeply internalized Washington Consensus policy prescriptions… The choice of internal devaluation, in turn, implied the need for fiscal consolidation, which all three governments
implemented in 2009 and 2010. They also relied heavily on EU structural support funding, which exceeded 4 percent of GDP
in these years. Under EU structural support regulations, countries can access funds earmarked for later use; all of the Baltic
economies took advantage of this opportunity.

The lack of domestic banks also gave the Estonian government significantly more fiscal space, since bank bailouts were “outsourced” to
the Swedish central bank. (The latter, in fact, took out a loan from the European Central Bank in the amount of three billion euros).

By the close of 2009, the worst seemed to be over for the Baltics. Their economies returned to growth, and in the second half of 2010 employment started picking up again. Exports followed a growth trend, and their current accounts turned toward surplus. In light of these developments, can we say that austerity and internal devaluation really worked? In fact, a closer look shows that the current Baltic  recovery did not result from internal devaluation … the downward adjustment of prices and wages in the Baltics was relatively modest, especially considering how overheated these economies had become by the end of the boom…

If not internal devaluations, then what was behind the Baltic recovery in 2011? There are three key factors: massive use of European funds, flexible labor markets, and the integration of export sectors into key European production networks. Flexible labor markets have had two consequences: persistently high unemployment, which did not lead to significantly higher social expenditure (automatic stabilizers are relatively unimportant as benefits are low and brief, and active labor market measures are financed largely by EU structural funds); and higher emigration. While emigration was already high in the mid-2000s, particularly in Lithuania, the crisis seems to have hastened emigration in all of the Baltic states… Since the Baltic states are “simple polities,” reflected, inter alia, in low levels of popular unrest and restrained civic dialogue, having a voice in government does not seem to be an option for many; thus, emigration becomes the preferred choice for an increasing number of people. However, both high unemployment and emigration have future costs in terms of social stratification and a smaller workforce. Thus, while during the crisis the costs of external devaluation were argued to be higher than internal devaluation (or “adjustment,” as it is mostly referred to in Baltic debates), it remains to be seen whether this is really so, given the persistently high levels of unemployment and emigration.

Integration into European networks by a few dozen leading exporters is another key factor in explaining the Baltic recovery. However, this has hardly anything to do with domestic conditions or policy actions. It is, rather, an increasingly important symptom of the Baltic brand of capitalism: enclave industries. One of the key problems faced by Eastern European companies is the low embeddedness of foreign-owned exporting firms, which is reflected in the low level of linkages with domestic suppliers and partners, and with higher education and research institutions. While Baltic exports have bounced back to precrisis levels, the problem of linkages remains… In sum, while the crisis has hardened the Baltic neoliberal resolve, the responses to the crisis have not so far brought substantial changes to Baltic economic structures; consequently, the underlying fragility remains unresolved.

However, since the Baltic economies are very open and small, their recovery and future growth also heavily depend on a broader European recovery. As the latter seems likely to be slow and sluggish for some years to come, it is difficult to foresee that the Baltics will experience growth rates similar to those in the mid-2000s anytime soon. In sum, almost all of the above factors make the Baltic cases unique and irreproducible in the EU context. First, most EU countries, especially in the troubled periphery, are already in the eurozone, so they cannot justify short-term austerity measures and eurozone entry as a crisis exit strategy; second, very few EU countries have civil societies as weak as those in the Baltic countries, and thus austerity breeds visible unrest and instability; and third, few if any EU countries have such narrow and detached policy elites—elites that have become accustomed to satisfying their European policy peers rather than their domestic partners.

Yet, even if the EU periphery could somehow manage to replicate the aforementioned political conditions—by weakening civil society, retrenching the welfare state, and relaxing labor regulations—they still would not have similar economic factors. There are a number of economic and structural factors that make the Baltics relatively unique, including high levels of economic globalization (both in exporting and in the financial sector) and strong dependence on larger neighboring economies— Scandinavia and Poland—in terms of trade and (in the case of Scandinavia) technology transfer. Both of these economies either recovered quickly (Scandinavia) or did not experience any crisis at all (Poland). Thus, as Wolfgang Münchau argues, while the EU is behaving more and more as if it were a small open economy where budget discipline was important for convincing investors and markets, the experience of the small open economies that have dealt best with such fiscal policies is of very little use to other troubled EU members.

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  1. June 11, 2012 at 2:43 am

    On Saturday, June 9, Peter Schiff (Austrian-libertarian type) touted Estonia as the road to recovery because unlike the rest of the EU that is practicing austerity by raising taxes and fees to close budget gaps (he failed to mention how much they are slashing government spending) Estonia cut government without raising taxes.

    The true story of Estonia (and I guess the other Baltics) will be an important counter-weight to the “story” that the Austrian school likes to tell — It is true Schiff identified the bubble but he also argues that the Keynesian policies (weak Keynesian policies) of Obama and Bernanke are going to set the US up for a big fall when interest rates skyrocket.

    Let’s make sure he is forced to eat his words in a couple of years when that doesn’t happen.

    • Merijn Knibbe
      June 11, 2012 at 7:19 am

      Well, if you’re right Peter did not do his homework. Taxes (% of GDP) in Estonia increased from around 31% around 2005 to 36% in 2009 and 34% in 2010. That’s an increase.

      In Latvia and Lithuania taxes in 2005 were about 29% of GDP and, in Latvia, declined to 27% in 2009 and 28% in 2010. In Lithuania the increased slightly to 30% in 2009 to decrease again to 27% in 2010.

      Schiff might have stated that (which is true) the government deficit of Estonia (about zero) is smaller than the Latvian and Lithuanian deficits (large in 2009 and 2010, smaller in 2011, but as indicated in all countries there was a 4% of GDP EU transfer in 2008, 2009, 2010 (which, in an accounting sense, to the extent that this was possible by ‘pre-spending’ already promised grants should be added to the government deficit).

      Anyway – the facts above suggest that the deficit difference between Estonia and the other two countries was at least to an extent caused by increasing taxes, not by decreasing them.

      It took me only minutes (minutes!) to check this. Schiff (and many old school economists with him) have clearly not yet adapted to the internet age. Economics is on its way to become an empirical science.

      Click to access KS-DU-12-001-EN.PDF

      Click to access KS-SF-12-002-EN.PDF

  2. henry1941
    June 11, 2012 at 12:01 pm

    I visited Estonian in 2006 and Latvia in 2010. There seems to be a lot of poverty alongside a substantial group of people who are doing very nicely. There appears to be a thriving small scale agriculture and food retailing sector, mostly a cash economy. That would mean, first, that statistics are not to be trusted, and second, that the government’s ability to collect tax through taxes such as income tax and VAT is restricted.

    There also appears to be an antiquated industrial sector, such as the 1950s-style coal transhipment dock at Riga, with double-handling by crane which could be eliminated by investment in tipping wagons.

    I also noticed a lot of vacant but valuable city centre land, especially in Riga.

    The three Baltic countries are remote from the most populated areas of Europe and presumably have high energy costs because of the cold winters. There also seem to be language issues, with Estonians being fluent in English whereas Latvians seem to be more orientated towards Russian.

    A useful reform, as always, would be for the governments to give up on taxes like Income Tax and VAT and go for a proper land value tax as their main source of revenue.

    http://www.landvaluetax.org

  3. jo
    June 12, 2012 at 2:03 pm

    Banchard has a blog which makes a somewhat similar argument for Latvia.
    http://blog-imfdirect.imf.org/2012/06/11/lessons-from-latvia/:

    So, the lessons are not easily exportable.

    Btw. how come that Technological University of Turku has such interesting people as Kattel, Drechsler, Reinert or Carlota Perez. And – for those in the know – how much influence do they have on actual Estonian policy?

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