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Latvian and Estonian Austerity Models by Martins Vargulis "Success Stories" Differ: Latvian and Estonian Austerity Models

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Latvian and Estonian Austerity Models by Martins Vargulis "Success Stories" Differ: Latvian and Estonian Austerity Models by Martins Vargulis "Success Stories" Differ: Latvian and Estonian Austerity Models Author: Mārtiņš Vargulis, Master's degree student of Riga Stradins University, Faculty of European Studies The report in this publication does not represent official position of the Friedrich-Ebert-Stiftung on any of the issues reflected in the text. The author is responsible for the content and information in the report. Electronic version available www.fes-baltic.lv and www.liia.lv October 2012 A working paper “Success Stories” Differ: Latvian and Estonian Austerity Models Introduction perspective of foreign investors the The Baltic States experienced a troubled Estonian approach has also been evaluated transition period from the communist as successful and quite attractive for 2 planned economy to an open market liberal investing in the country. Although economy through the 1990s, and success- economic indicators from both countries fully acceded to the common market of the over the last two years have significantly European Union (EU) in May 2004. The improved, the approach used by the Latvian aftermath of EU accession has demonstra- government in many ways differs from ted economic developments worthy of Estonian policies. both criticism and acclaim. The trajectory of Therefore, among other questions raised in economic developments have taken the this article, there is an analysis of Latvian and countries from being called the ‘Baltic Estonian economic development up to the Economic Tigers’ to becoming fastest falling global financial crisis in 2008, a look at the economies in the world, and then again to countries’ experiences, an analysis of the being the fastest growing economies in the economic challenges during the recession, EU, within little more than seven years. an overview of adopted policies and Nevertheless, there are some obvious solutions, as well as an exploration of differences – in addition to the similarities – opportunities for further development, in the policies that were implemented by which from the perspective of some well both the Latvian and Estonian govern- known economists – like, for instance, Paul ments. These differences determined the Krugman – has been questionable.3 unequal readiness of the countries to overcame challenges that were presented by the global financial crisis. Estonia and its policies of avoiding economic recession Estonia and Latvia are presently perceived by various representatives of international Estonian economic indicators like GDP, the institutions and economists as success unemployment rate, wages, and others stories, thanks to their specific approach to from the period after Estonia joined the EU until the eve of the crisis in late-2008 overcoming the economic crisis. For obviously improved. Estonia was a very instance, IMF Managing Director Christine dynamic economy, with a GDP growth rate Lagarde recently announced that the of 8.2% per year on average from 2004 to Latvian government's economic policy is a 2007. The unemployment rate decreased "success story", and that it "could serve as an continuously throughout this period to inspiration for European leaders grappling 1 reach 4.7% in 2007, its lowest level since the with the euro crisis”. Moreover, from the transition to a market economy in Estonia4. 1 Mark Wesbort, IMF Chief Praises Latvian "Success Story" -- A Scary Speech for the Eurozone, http://www.huffingtonpost.com/mark-weisbrot/imf-chief-praises-latvia_b_1587723.html, 13.06.2012,12:40 pm. 2 Edition.cnn.com, March 29, 2012, Estonia’s success: Liberal regulation, strong work ethic, http://edition.cnn.com/2012/03/29/business/marketplace-europe-estonia-quest/index.html 3 Investors.com, Baltic Tiger Takes A Bite Out of Paul Krugman, http://news.investors.com/ibdeditorials/ 060812-614335-estonia-teaches-paul-krugman-a-lesson.htm#ixzz27wjDs3E5, 08.06.2012. 4 Levasseur, S. Labour market adjustments in Estonia during the global crisis. – OFCE, December 2011. - p.2. - http://www.ofce.sciences-po.fr/pdf/dtravail/WP2011-25.pdf 3 However, as was found during the crisis, econmic pillar that not only contributed to these indicators weren’t based on a stable the economic growth of the pre-crisis framework. An economic breakthrough period, but could also protect Estonia from similar to that of Latvian was built on the deeper recession during the crisis by basis of widespread credit for households improving the balance of payments. The and very high wages, which were the main fourth aspect of the Estonia’s economic contributing factors to GDP from 2004 till development was related to it’s export 2007. Estonia’s very rapid economic growth growth, which was based on financial flows and large investment volumes were rather than on real production. One of the supported by both an increase of loans major stumbling blocks for the Estonian issued by the banking sector and the active economy in the pre-crisis period was low operation of foreign investors in reinvesting competitiveness. For instance, in 2007, the 5 profits earned in Estonia. At the same time, manufacturing sector contributed only 9% many factors that supported the country's to GDP growth, while construction, development have had a fairly short impact wholesale & retail trade, financial and there was reason to doubt their intermediation, and real estate contributed sustainability. This raises the question of a total of 63%7. Last but not least, the why Estonia stepped into economic Estonian economy was positively recession and what guaranteed Estonia's stimulated by the benefits of EU successful way of overcoming the crisis. membership: various funds, the elimination The economic development of Estonia from of trade restrictions, a bigger trade market, 2004 to 2007 could be described by the five attractiveness for investors, foreign tourists, main pillars upon which the Estonian etc. economy was built: increase of the demand, Except FDI, and to some extent the benefits increase of the government sector, active from the EU, all other aspects that FDI, export growth, and the impact of contributed to the development of Estonia’s accession to the EU. The strength/weakness economy were artificially created without a or sustainability/unbalance of these pillars stable base and resulted in other economic set the future direction of the country’s problems. For instance, after joining the EU economic policy. First of all, accession to the there were widespread legitimate concerns EU in 2004 decreased the level of risk among entrepreneurs about the migration premium, which obviously stimulated the of skilled workers to other EU countries. To process whereby Estonia received an influx retain highly skilled employees, most of cheap money. Finland and other companies significantly increased wages. Scandinavian countries were eager to offer From 2004 – 2007, the average salary was cut-rate mortgages and build new homes. increased by 64%. This high growth of The result was a real estate bubble, wages exceeded the increase of labor artificially stimulated economic growth, and 6 competitiveness and productivity. For malinvestment. example, in 2006 the Estonian GDP per Secondly, the increase of demand in the capita amounted to only 22% of the relevant government sector contributed to the indicators of the five wealthiest European extremely high speed of growth in the state Union states (42% if considering the level of 8 budget, which was funded through the prices). The low level of productivity taxation of domestic demand as a result of affected the competitiveness of Estonian the loan boom. FDI in Estonia was an companies in the region, whose price of goods and services increased. 5 Urmas Varblane, The Estonian Economy Current Status of Competitiveness and Future Outlooks, Eesti Arengufond, Tallinn, 2008, http://www.arengufond.ee/upload/Editor/English/ty_raport_eng.pdf, p.13. 6 The WealthCycles Staff, Estonian Austerity Models Healthy Economic Correction, July 27, 2012, http://wealthcycles.com/blog/2012/07/27/estonian-austerity-models-healthy-economic-correction 7 Levasseur, S. Labour market adjustments in Estonia during the global crisis. – OFCE, December 2011. - p.2. - http://www.ofce.sciences-po.fr/pdf/dtravail/WP2011-25.pdf 8 Urmas Varblane, The Estonian Economy Current Status of Competitiveness and Future Outlooks, Eesti Arengufond, Tallinn, 2008, http://www.arengufond.ee/upload/Editor/English/ty_raport_eng.pdf, p.11. 4 When the bubble burst in 2008, in order to provided an opportunity for companies to continue the successful development that report their taxes online to minimize time Estonia had implemented after its accession consumption and procedures. The main to the EU the Estonian government was goal was to provide an easy, understand- forced to choose between two main options able, and competitive business field. And – austerity versus a devaluation of the obviously the Estonian government has national currency; a hard decision that has succeeded in this. At the worst point of the been made by many countries during the crisis, in 2009, Estonia was ranked 22nd out of crisis. Instead of devaluation the Estonian 183 countries on the World Bank’s Ease of government chose austerity and developed Doing Business Index13. It held the highest policies. Rather than attempting to reflate position of all three Baltic States. its economic bubble via a flood of new, un- In 2010 Estonia became the 17th member of backed kroon and massive spending the eurozone – the first ex-Soviet state to packages, the Estonia’s government slashed adopt the EU single currency. The greatest spending sharply. It froze pensions, cut advantage that countries hope to obtain as government salaries by 10% (and ministers’ a member of the eurozone is an increase in salaries by 20%), and raised the value-added 9 FDI. Compared to the pre-crisis period of tax by 2%. The Estonian government stuck early 2008, foreign direct investments had with its 10 year plan to join the eurozone, increased by 15% by mid-2011. According which pegged the kroon first to the German to the data, the export of Estonian goods mark, then to the euro.
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