The Little Country That Could
Confluence Investment Management
By Bill O'Grady, Kaisa Stucke
October 22, 2012
In this geopolitical report we will take a brief look at Estonia’s history, its economy after the break-up of the Soviet Union, its remarkable economic growth in the 1990s and early 2000s, and the ensuing downturn in 2008. The country stands out for choosing a different path to deal with the recession than many other European countries. The Estonian government implemented severe austerity measures through “internal devaluation” by reforming the labor markets and implementing budget cuts. At that time, the country had joined the EU, but still had an independent currency, so devaluation could have been an option. However, Estonia was on the path to join the Eurozone in 2011 and devaluation, or a large budget deficit for that matter, would not have allowed Estonia to join the monetary union. Austerity worked, with positive GDP growth returning in 2011, and Estonia has been brought out as an example of the effectiveness of austerity. We will look at how austerity worked, how it was designed to work and what other outside forces affected the process.
Brief History
Estonia is a small country that shares a land border with Russia and Latvia and a sea border with Finland. The culture and language are Scandinavian, not Slavic, with strong German attributes as a legacy of being ruled by Germanic groups for centuries. Until the early 13th century, Estonia was an independent group of tribes. The local tribes traded with the Vikings and fought over land with the Russians. In the early 1200s, Estonia was conquered by German crusaders and the pagans were converted to Christianity. In the 14th century, the Hansaetic Merchants set up a route through the Baltics, establishing Tallinn as a port, transporting goods and commodities from Russia to the West. In subsequent periods, the country was ruled by the Danes, Germans, Swedes and Russians, keeping the native Estonians as peasants working for the feudal land owners. Serfdom was not abolished in Estonia until 1816.
After falling under Russian rule in the early 1900s, revolts became more common and, as a result, Estonia was allowed to vote for a semi-autonomous government in 1917. However, with World War I advancing, the country was alternately under Russian and German rule until 1920, when Estonia fought for and attained its independence with the help of the British navy.
The first republic lasted 20 years until 1940, when Russia invaded it and imposed communist rule. Thousands of ethnic Estonians were sent to Siberia, and Estonia was merged into the Soviet Union. The Germans were successful in fighting back the Soviet forces, but both outside rulers were brutal to the natives. Soviets claimed the country once more in 1944, and Estonia was part of the union for almost fifty years thereafter.
Estonia was known for its agricultural products and livestock in the USSR, but oftentimes the inefficiencies of the system caused store shelves to be empty. Private
property was banned and farming was collectivized under the slogan, “From each according to his ability, to each according to his need.” The central government was not efficient in making production and distribution decisions and shortages developed. Hot water was turned off in the summer; toothpaste and toilet paper became a luxury.
Second Independence
In the mid-1980s, the Soviet system started to unravel. Estonia was granted some autonomy as General Secretary Gorbachev introduced glasnost (openness) and perestroika (restructuring). Things moved quickly and Estonia regained independence in 1991. Although tanks were a common sight, the process of independence was mostly peaceful. The Baltic countries took part in the Singing Revolution, during which a 400-mile long “human chain” was formed. People holding hands and singing stretched through three countries. Realistically, although this indicated the peoples’ desire for change, larger forces were dismantling the USSR.
The Estonian economy was straddled with the Soviet-era economic inefficiencies and an anti-entrepreneurial environment. The country had also become exceptionally poor. Before World War II, Estonia and neighboring Finland had about the same GDP per capita, but by the time the Soviet Union dissolved, Estonia’s GDP per capita was approximately $2,000 while Finland's GDP per capita was seven times higher at approximately $14,000.
Following its independence, Estonia has stood out as a radical pro-market reformer. Shortly after its independence, the country implemented a fixed exchange rate policy, strict fiscal discipline, trade and price liberalization and extensive privatization. Estonia has also fostered a favorable business environment by reducing and simplifying taxes, having strong property laws and encouraging start-ups (Skype was started in Estonia, for example). It became one of the first countries in the world to adopt a flat tax, with a uniform rate of 21% regardless of personal income.
The currency, kroon, was pegged to the D-mark, interest rates were based on Euribor and most loans were denominated in the D-mark or euros. Put simply, Estonia lacked an active monetary policy. Since the central bank promised to buy back each kroon at a fixed level, printing money would have caused a depreciating real currency and caused speculative pressures. Basically the only tool left for the central bank was the reserve requirement. During the boom years, the central bank did hike the reserve requirements to 15%, while the EU average was 2%.
The government also moved quickly to distance the country from Russia. In that effort, Estonia joined NATO in 2002 and the EU in 2005. Another long-term goal was integration into the Eurozone, which was realized in the height of the Eurozone crisis in 2011. The rules for euro accession were strict and the country had already missed the joining date once before due to higher than allowed inflation. In addition, the government could not carry a large budget deficit. During the 1997 Asian crisis and the 1998 Russian crisis, the budget ran only a slight deficit. For two years before the 2008 crisis, the budget was consistently in surplus.
Estonia grew rapidly after the liberalization, with the GDP rising 50% over a decade from 2000 to 2010. The boom years also allowed for large government programs while holding public debt levels low. The government budget almost doubled between 2004 and 2008.
2008 Recession
The story of Estonia’s economic boom and subsequent collapse is similar to many other stories around the globe from the 1990s and early 2000s. As globalization took hold, Estonia received significant inflows of foreign investment. The other Scandinavian countries were interested in expanding their market share in financial and mortgage services. As the economy experienced healthy GDP and wage growth, banks began to aggressively compete in the mortgage market, resulting in an oversupply of credit. Private debt increased from 10% to 100% of GDP. Wage growth outpaced productivity gains, leading to malinvestment. Anecdotally, real estate prices were on par with a U.S. mid-sized city, whereas average local incomes were a fraction of the U.S. average. In addition, Western Europeans were acquiring second homes in the country, also supporting prices.
Overheating resulted in double-digit inflation, appreciation of real exchange rates and accumulation of net foreign liabilities. Growth was fueled by availability of cheap international credit and when the international credit market froze, a liquidity crisis ensued.
Response
When the government met at year end 2008, the economy had already had three consecutive quarters of GDP decline, but on the back of the boom years the government expected the economy to grow at a 3.6% annual pace. In reality, the GDP declined 14.1%. Although the government had accumulated reserves during the boom years, the money at hand was not enough to cover the potential budget shortfall. This, in addition to fears that missing the budget deficit clause may derail the euro accession, scared the politicians into action.
In 2009, the average civil servant’s salary was cut by 10%, and ministers, leading by example, voted to cut their own wages by 20%. Some industries claimed wage declines as high as 30%. The pension age was also hiked, job protections were removed which made it easier to lay off workers, and laws were introduced that made it harder to claim health benefits. Overall, the government cut its spending by 7.8% in 2009 and 11.5% in 2010, but was able to increase spending by 10.4% in 2011.
Source: Estonian Statistics Agency, CIM
Although the flat income tax was maintained, the VAT (similar to sales tax) was hiked to 20% from 18%. As a result of this tax hike, total tax collection declined modestly, even though GDP per capita fell considerably. This type of tax increase usually affects the poor the most, since a larger proportion of their income is consumed.
The recession had already weighed on living standards, and the subsequent austerity policies caused an extremely painful, but brief, extension to the recession. The unemployment rate was more than four times higher in 2009 than it was in 2007. Since Estonia was part of the EU and its citizens could freely work in other countries, many workers left to seek employment in neighboring countries, especially Finland.
One way that countries have dealt with such an outstanding GDP collapse in the past has been to devalue the currency. A cheaper currency would, in turn, boost export growth and support overall GDP growth. Another option is to inflate by printing money. Estonia, however, chose not to devalue or inflate, since the country was on the path to join the euro in 2011 and the strict guidelines did not allow for inflation to be higher than the Eurozone average. Devaluation would have also disrupted the convergence to the euro. Instead, the country chose “internal devaluation,” lowering government consumption and making structural reforms. Privatization also helped to raise funds.
Another reason devaluation did not make sense was the fact that most of the loans were denominated in euros, so the debt burden would have risen and the default rate, no doubt, would have increased. Estonia also remembered the 1990s Scandinavian crisis with the loss of confidence and capital flight that ensued after devaluations.
Conditional international support was viewed as a loss of sovereignty, which reignited memories of the Soviet Union. The fact that all of Estonia’s banks were foreign-owned allowed the country to outsource the aid. The Swedish central bank had to extend credit to the banks that also operated in Estonia.
Why Austerity Worked
Looking back, Estonia had suffered a 20% peak-to-trough GDP decline over the course of the crisis, and austerity measures accounted for another 12% of GDP. However, in 2011, Estonia’s GDP grew 7.6%, five times the Eurozone average. Additionally, the country is the only Eurozone country with a budget surplus; national debt is a low 6% of GDP, much less than the 81% in Germany and 165% in Greece. We will now look at the economic, political and cultural reasons behind the success.
Austerity lasted for two years until the country qualified to join the Eurozone. Two of the more important criteria for joining the Eurozone are the inflation and budget deficit clauses; inflation declined over the course of the recession, while achieving a balanced budget was harder to achieve. However, as one of the poorest members of the monetary union it received substantial transfer payments after joining. Some of the aid was given even before the country joined the Eurozone and was substantial. In fact, 20% of the country’s budget in 2012 was made up of EU transfers. This source of funding is expected to end by 2015 and is unlikely to provide a continued degree of support.
Another reason for the rebound was the integration of the export sector with Scandinavian producers. Scandinavian companies often choose to outsource to Estonia for its close proximity, educated labor force and relatively cheaper wages. Post-recession export expansion was achieved in 2010. However, for a small and open economy, the continued recovery depends on the overall EU recovery, which promises to be a slow one.
The government should also be given credit for its swift and efficient action in the midst of the deepest part of the recession, and the lack of red tape worked in the country’s favor. Additionally, the labor markets proved to be more flexible than in most European countries, with labor reforms removing many job protections. The minimum wage was low compared to European standards. In 2011, the monthly minimum wage in Estonia was EUR 278, while Greece was EUR 863 and France was at EUR 1,139. Higher unemployment did not result in higher government expenditures, as many of the costs were covered by the EU structural funds, and mass emigration also reduced the cost of unemployment. The unemployment rate is still above the Eurozone average and the average monthly take-home pay of EUR 697 is amongst the lowest in the union. Interestingly, the increased emigration benefited the country during the recession, but the long-term effects of the loss of workforce could be catastrophic for a country with a population of 1.3m.
It is important to point out that while some countries have witnessed protests when public salaries have not been sufficiently raised, Estonians suffered through substantial salary cuts without social unrest. Workers recognized that austerity was necessary for the long-term health of the economy, and even re-elected the politicians that chose austerity. The protests that did occur were against corruption and not austerity. However, instead of protests, people were leaving Estonia for better work opportunities in other countries. Mass emigration means that the number of people seeking work is reduced and therefore so is the unemployment rate.
Another country specific attribute was the generational memory of the Soviet times. Western Europe has not experienced a sharp decrease in living standards since World War II, whereas most Estonians, on the other hand, still remember the decline in living standards under Soviet rule.
Ramifications
There’s no denying that Estonia has been able to return to growth after implementing steep austerity policies. However, there are several situational and country specific elements involved. First, implementing austerity allowed Estonia to join the Eurozone and, in turn, receive substantial transfers from the monetary union. Second, the mass emigration lowered the unemployment rate as job seekers often left the country to work in the richer neighboring countries. Third, the integrated export market still benefits from the lower cost production in Estonia and the high degree of trade with the wealthy Scandinavian countries and oil-rich Russia. Finally, the memory of the poor conditions of the Soviet Union makes the population more tolerant of needed cost-cutting. These reasons make for a unique confluence of circumstances, and while austerity programs worked well in Estonia, the prescription may not be the solution for other countries.
Bill O’Grady
Kaisa Stucke
October 22, 2012
This report was prepared by Bill O’Grady and Kaisa Stucke of Confluence Investment Management LLC and reflects the current opinions of the authors. It is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice. This information does not constitute a solicitation or an offer to buy or sell any security.
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