Articles on Estonia

(November 2, 2012) Long-term political agreements over ad hoc policy
by Robert Müürsepp

A recent Mises Daily article by Frank Shostak at covers the road Estonia has taken since the economic bubble burst a few years back. The core statement in the piece is how a non-inflationary monetary policy and the lack of government bailouts can cure the economy from the structural illnesses that grow out of an inflationary boom. As the author points out, this is precisely the reason why Estonia has fared so well compared to the rest of the Europe.

But while he argues that the success came thanks to the decisions made by the current government I make the case for a different approach. Instead, I claim that Estonia is a good example of why a democratic system must be guided by firm economic principles rather than be suitable for ad hoc policies.

Shostak writes that Estonian GDP and labor market have improved significantly since the crash and that we are strongly outperforming the general trend in the EU. There is no denying that Estonian economy, being lead by international trade has recovered well over the last two years. And although there is still a bit to go before reaching the peak levels of 2007 the consensus among local analysts is that the underlying structure of the economy is far healthier now.

As for the unemployment, the recovery has been as strong. Even though Shostak’s data underestimates the current levels, the trend is represented accurately. It is also noteworthy that even during the height of the preceding boom the unemployment fell barely below 5%. In this light the 10,2% today seems a fairly good number in comparison to western countries that are used to even lower natural levels.

Source: Statistics Estonia

Now, for the tricky part. Despite Shostak being right about the fall in money supply and government spending during the crisis, he unfortunately misses on the reasons for that and therefore also comes to wrong conclusions in regard to the actions of the government.

Rather than persisting with the cleansing process, the government and the central bank have chosen to reverse the stance, thereby arresting the process of healing the economy.

This is always the danger when basing your analysis simply on data without deeper knowledge of the specifics in a given system.

The secret of the Estonian success lies actually in the political traditions started 20 years ago, right after the Soviet Union fell apart. Ever since becoming independent all ruling coalitions have adopted the principle of a balanced budget. So, in essence the government has not been able to spend more than its incomes. As a result a fall in the GDP and therefore in tax revenue necessitates less spending while a growing economy enables more spending. Occasionally there has been even talk of adding this principle to the constitution.

Another reason that has held public spending in check has been the long-term policy of  integration with European Union which during the crisis brought us on the brink of joining the Euro area and therefore required the fulfillment of the Maastricht criteria of low public deficit.

Source: Statistics Estonia

The Estonian Central Bank has similarly had its hands tied. The reason being that the local currency was set up on the basis of a currency board. This was achieved by pegging the Estonian Kroon to the German Mark (later switched for the Euro), the entire money supply had to be backed by foreign currency or gold. In addition, the ability to change this monetary setup was given solely to the parliament, while the central bank was also forbidden to give out loans to central and local governments. As a consequence the ability of the central bank to manipulate the money supply became very limited. The only available tool left was the reserve ratio of commercial banks, which before the acceptance into the Euro area was at 15%. Afterwards it was gradually dropped to the ECB levels.

Knowing all this we can understand how the contraction in the spending of the Estonian government was caused by the traditions of fiscal policy while the changes in the monetary base were brought about by banks buying local currency in exchange for foreign ones. Both processes are also represented in Shostak’s graphs. While the boom driven by loose monetary policy abroad helped to fuel one in Estonia as well, the following recession has helped to clean up the economy as the government has lacked the ability to go down the road of bailouts and stimuluses. Principles set in place two decades ago also provided the government with good excuses against public pressure favoring intervention.

But Estonia presents us with another related interesting insight. The limitations set upon the public sector create a situation where its welfare is directly dependent on how the private sector is doing. This helps to hold back the growth of government beyond sustainable levels. Perhaps we could even argue that it creates some incentives for politicians and bureaucrats to actually work in favor of the taxpayers. For example the main focus of the Estonian government during the crisis was to promote entrepreneurship and reform legislation accordingly.

(July 25, 2012) We Live in a Ban Economy
by Paul Vahur

Mikk Salu’s recent article about the consequences of regulations was most welcome because as ordinary consumers we might not notice these negative consequences.

Although entrepreneurs encounter absurd and restricting regulations on a daily basis, consumers rarely hear about those because complaining is bad for business. Entrepreneurs are only successful if they make lives of the consumers better.

When buying service or product, the customers don’t want to hear about entrepreneur complaining why she is unable to fulfill all of the customer’s needs.

Businessmen, show us the cost of bureaucracy!

But this is exactly what more courageous businessmen should do – to display in their store or point of service signs such as these: no smoked ham, banned by regulations; this couch is 5% more expensive because we have to fill out insane amount of reports; to get fresh and cheap fish, you need to buy it from the boat at the harbor; etc.

The cause of these troubles is Utopian thinking that we will achieve the Western-European level of wealth and quality of life if we have the same regulations as in Belgium or Germany.

EU regulations are often inspired by conditions in Western Europe, but their wealth is not due to regulations but because of capital accumulated over many decades.

To apply these rules to Estonia is absurd – at best they describe current best practices in wealthy countries, but do not work in poorer countries such as Estonia.

They are of no benefit in Estonia, where they set bar too high for small businesses and neither in richer countries, where they codify status quo and make further economic development difficult, if not impossible.

Eurobans make it hard for Estonia to grow rich

Our problem is not that we have too little regulations but that we have (relatively) too little wealth i.e. capital.

EU regulations will not make us as wealthy as Western European countries, instead they stop us from escaping the Eastern European poverty. Instead of better living conditions (every small rural store must have high-tech kitchens!) it only makes our conditions worse (rural stores will be closed).

This is confirmed by the suffering of small businesses and poorer citizens.

Bigger companies might even be ok with regulations as they squeeze out of the market their smaller competitors, who might offer a competitive product but can’t afford production facilities that satisfy the bureaucrats.

Also the upper-middle class person in Tallinn might not notice how regulation strangles life in Estonia because he is almost living in the ideal world of euroregulations – buys his food from supermarket, lives in a new apartment and is entertained at a modern cinema.

Eurorules are made worse by our own “enterprising” bureaucrats when they adopt EU directives and add their own contributions – already restricting rules are made even more strict so that local bureaucrat’s toil and effort doesn’t go unnoticed.

The power of “forgotten” rules

With the growth of regulations we are in some ways moving back in time. In soviet times you could buy any car, if you had permit to do so. Nowadays you can produce any kind of ham, if you are doing it in a way that is agreeable to bureaucrats.

The economy of EU is not a command economy, more appropriate term would be ban economy. No unauthorized signs by the lonely dead-end road, no sale of ham smoked at home, no crossing of border with gas tank full, no using of florescent light bulbs, no sale of non-bottled beer and so on and on.

Luckily the state does not have resources to enforce all of the regulations and some of these are absurd enough so that even public servants understand that enforcing such rules benefit no one. But such submerged rules are even worse than the ones that are actively enforced.

“Forgotten” rules can be used against troublesome citizens/entrepreneurs or once in a while make a public spectacle of “order” being enforced. The latter is especially useful when really important rules are broken at higher levels and public’s attention needs to be diverted.

Besides making it hard to improve the living standard ban economy undermines the respect for law. Only those who ignore the rules to a lesser or bigger extent can truly be successful. While upstanding, law-abiding citizens are chained down with regulations the freedom of action is left to audacious entrepreneurs and just plain criminals.

Only by significantly lessening the regulatory burden can we legalize the reality we live in and make better tomorrow a possibility.

“Progress is precisely that which the rules and regulations did not foresee; it is necessarily outside the field of bureaucratic activities.” Ludwig von Mises, Bureaucracy, 1944.

(July 11, 2012) Estonia Should Ignore Paul Krugman and Become the Hong Kong of Europe
by Dan Mitchell

The Baltic nations do not get much attention in the United States, but that changed recently when Paul Krugman attacked Estonia for its policy of spending restraint.

That attack backfired when several people, ranging from Estonia’s President to American economists, pointed out that Estonia was doing much better, in the short run and long run, than other European nations that got in trouble because of fiscal or financial problems. Krugman also lost credibility when it became clear that he presented data in a misleading fashion.

Krugman’s biggest mistake is that he claimed that spending cuts caused the downturn, even though the recession began in 2008 when government spending was rapidly expanding. It wasn’t until 2009 that the burden of government spending was reduced, and that was when the economy began to grow again.

In other words, Krugman’s Keynesian theory was completely wrong. The economy should have boomed in 2008 and suffered a recession beginning in 2009. Instead, the opposite has happened. But that’s no surprise. Keynesian spending didn’t work for the United States in the 1930s when Presidents Hoover and Roosevelt increased the burden of government. It didn’t work for Japan in the 1990s. It didn’t work for President Bush in 2008, and it didn’t work for President Obama in 2009.

Krugman also produced a chart showing Estonia’s economic performance from 2007-present. This deceptive chart made it look as if Estonia’s economy was stagnant. In reality, the nation’s long-run economic performance is quite exemplary. Economic output has doubled in just 15 years according to the International Monetary Fund. Over that entire period – including the recent downturn, it has enjoyed one of the fastest growth rates in Europe.

This doesn’t mean Estonia’s policy is perfect. Spending was reduced in 2009 and 2010, but now it is climbing again. This is unfortunate. Government spending consumes about 40 percent of GDP, which is a significant burden on the private sector.

To be sure, other nations such as France, Germany, and Sweden have public sectors that consume an even larger share of GDP. But Estonia shouldn’t use Western Europe as a benchmark. Instead, Estonia should copy the Asian Tiger economies of Singapore and Hong Kong. These jurisdictions have maintained very high growth for decades in part because the burden of the public sector is only about 20 percent of GDP.

Picking the right role models is important because Estonia suffered from decades of communist oppression and fell behind the developed world. Hong Kong and Singapore both used to be poor, and now they are richer than the United States because tax rates are low and government spending is limited.

If Estonia mimics Hong Kong and Singapore, it can enjoy the same strong sustained growth over several decades. But if it copies Germany, that won’t happen. It takes about 30 years to double economic output for a nation that grows between 2 percent and 3 percent per year. But a nation that grows by an average of 5 percent each year doubles its GDP in about 15 years.

Fortunately, it shouldn’t be that difficult to emulate the successful fiscal policies of Hong Kong and Singapore. Estonia already has a flat tax, which is very important for competitiveness. The key goal should be to impose a spending cap, perhaps similar to Switzerland’s very successful “debt brake.” Under the Swiss system, government spending is not allowed to grow faster than population plus inflation. And since nominal GDP usually expands at a faster rate, this means that the relative burden of government spending shrinks over time.

By slowly but surely reducing the amount of GDP diverted to fund government, this would enable policymakers to deal with the one area where Estonia’s tax system is very unfriendly. Social insurance taxes equal about one-fourth of the cost of hiring a worker, thus discouraging job creation and boosting the shadow economy.

Reducing the heavy burden of social insurance taxes should be part of a big reform to modernize programs for healthcare and the elderly. A major long-term challenge for Estonia is that the population is expected to shrink. The World Bank and the United Nations both show that fertility rates are well below the “replacement rate,” meaning that there will be fewer workers in the future. That’s a very compelling reason why it is important to expand personal retirement accounts and allow the “pre-funding” of healthcare. It’s a simple matter of demographic reality.

Estonia has done a decent job in the past couple of decades. But if it wants to take the next step toward prosperity and fiscal sustainability, it needs to deal with the remaining problems of too much spending and high social insurance taxes. With the right policies, Estonia can be the Hong Kong of Europe.