by Andreas Hoffmann*
The new member states of the EU were hit hard by the current crisis. Especially the former Baltic tigers (Estonia, Latvia, Lithuania) have seen a tremendous decline in GDP. While our economies face difficulties to cope with a decline of about five percent of the GDP, they lost 10 to 15 percent. In my opinion, Estonia is the most interesting of the three as it chose a distinct way to deal with the crisis.
Like many economies, Estonia saw an artificial boom driven by cheap credit rates until the latest crisis. From 2003 to 2007 growth rates reached up to 12 percent. At the same time wages grew rapidly. Huge current account deficits reflected the increase in wages, influx of capital and the credit boom. However, unlike most other economies and even though it lost by two digits, Estonia managed to keep the budget relatively balanced in the current crisis. Estonia was even able to contribute to the IMF-program for its formerly “growth mate” Latvia. What is the reason behind it?
With a tradition of a fixed exchange rate to first Germany and now the euro area, Estonia has been waiting to enter the euro area as soon as possible. Even though the boom brought about real convergence as the GDP per capital caught-up with the former EU-15, nominal convergence was out of sight. The credit boom fuelled inflation, not only in real estate prices but also in consumer prices. Nominal and real convergence did not go hand in hand. This caused a problem in not fulfilling the Maastricht inflation criterion, necessary to introduce the euro.
Thus the Estonian government reacted in a way to the current crisis that should bring tears of joy into the eyes of any free market economist: First, they did everything to hinder a devaluation of the Estonian kroon, as a relatively stable exchange rate to the euro is a prerequisite for euro introduction. Secondly, they did not overspend. Instead they cut wages heavily with the fall in per capita GDP – even in the public sector. And third, unlike most economies, Estonia did not sacrifice economic freedom for crisis management. Instead, officials wait for the crisis to heal the market. At the same time lower spending is assumed to bring inflation down. The crisis is seen as a chance to (readjust and) fulfill the Maastricht inflation criterion, which was impossible during the boom period.
Thus, as Estonia allowed for an adjustment process, malinvestment from the previous boom should be dismantled soon. This should bring about lucrative future investment possibilities in an economy with solid macroeconomic fundamentals, a high degree of economic freedom and prospects to enter the euro zone. At the moment interest rates are much higher there than in the euro area and a credible fixed exchange rate assures against depreciation. These facts should attract new investors. Therefore it is likely that we soon see the return of at least one Baltic tiger.
*Andreas Hoffmann is visiting the Department of Economics, New York University from the Institute for Economic Policy, University of Leipzig during the current academic year. He is a Bradley Fellow and a Fellow of the Friedrich Naumann Foundation. Some of his work can be found here.