The Latvian and Estonian economies have recently experienced – an economic boom, a spectacular bust, and recovery. Their experience is a chance to evaluate the merits of fixed exchange rates, austerity and the issues of an economy based on trade and capital inflows.

Aspects of the Baltic economies

1. Boom period between 2000 and 2007
2. Great recession of 2008-2010
3. Readjustment policies of fiscal contraction whilst maintaining fixed exchange rate.
4. Economic recovery from 2011

Lessons from the boom

Both Latvia and Estonia experienced rapid economic growth in the early 2000s. This was helped by various policies and economic factors

• Free market reforms enabled growth of efficiency and productivity. From 1991, the economies became more market oriented with policies of privatisation and deregulation, enabling greater incentives to be efficient.
• Latvia and Estonia are both small, open economies where free trade has contributed towards economic growth. In Latvia, exports account for 33% of GDP, including raw materials, such as timber, agriculture and manufacturing products.
• The open nature of the economy attracted significant capital inflows from Europe. These capital inflows helped to finance a growing current account deficit, which reached 20% of GDP in Latvia and 16% of GPD in Estonia.

Source: Latvia report, EU

Record levels of economic growth in Latvia, led to a corresponding rise in the current account deficit.

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This years OCR F585 global economy pre-release stimulus material is about Estonia and its economic performance. This post gives a few extra graphs about the state of the Estonian economy and considers important issues and questions, related to Estonia.

Brief synopsis

From the early 2000s Estonia experienced rapid economic growth as it benefited from joining the EU (in 2004) and receiving greater inward investment from Europe.

Estonia’s economic growth since 1991 has been based on its transition to a market economy, e.g. policies such as privatisation. It also benefited from low inflation and macro-economic stability. It has also encouraged inward investment through low taxes. In the boom period of 2000-2007, Estonia was able to borrow on European capital markets to finance investment, which spurred strong growth in exports and international trade.

However, the credit crunch and EU crisis of 2007-11 harmed Estonia’s economy. It’s reliance on EU loans meant that it saw investment drying up and GDP contracted by 5% in 2008 and by 14% in 2009. In the recession, the Estonian government embarked on a controversial austerity programme, which saw spending cut by up to 20%, to try and reduce the budget deficit. After a deep recession, the Estonian economy has shown a strong recovery, though unemployment is still over 10%.

Firstly, these are some elements of the Estonian / Latvian economy not mentioned in the extract. In particular, the extract gives little mention of unemployment. Knowing the unemployment rate, helps give a wider perspective on Estonia’s economic situation.

Unemployment in Estonia

After falling to less than 5% in 2007, during the economic crisis unemployment in Estonia increased rapidly reaching a peak of 17%.

EU unemployment rates at Eurostat

However, unemployment in Estonia has now fallen to just below the EU27 level, but it is still high at over 10%.

Unemployment was even higher in Latvia. This suggests that Estonia achieved a more successful recovery than Latvia. Estonia has been much successful than Greece.

Estonia recession and recovery

Since the recession of 2008-09 Estonia has posted stronger recovery than other countries within the EU. However, if you have a deep recession, it is easier to recover lost output.

EU economic growth at Eurostat

It also depends which way you look at real GDP.

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No one doubts the commitment of many in the EU to seeking a way to prevent the Euro breaking up. The Euro project is deeply embedded in the European establishment. But, are they fighting a lost cause? Are the structural problems with the single currency so severe, they would be better off pursuing an orderly break-up? Or would the break-up of the Eurozone lead to an even worse period of instability and economic crisis?

Reasons Why the Eurozone is heading for a Break-up

1. There has been no Economic Harmonisation

Harmonised competitive indicators in the EU (2011 Q1), source: ECB Stats based on unit labour costs indices for the total economy:

Since 1998, Germany (DE) has seen a reduction in labour costs of 18.5%. By contrast, Italy and Ireland have seen an increase of 6.6% and Greece of 9.7%.

The Eurozone is not an optimal currency area. There is a huge difference between northern European economies (Germany) and Southern European economies. This is not a difference in debt levels. It is a difference in productivity and relative wage costs.

In normal circumstances, this would not be a problem because the German currency would appreciate due to its hyper-competitiveness – and the exchange rate of Italy, Greece e.t.c. would devalue, but this has not happened because the Euro permanently locks in exchange rates. See also: (competitiveness in Europe) | Two Speed Europe

2. Current Account Deficit

• This divergence in labour costs, productivity and inflation is reflected in the current account statistics within the Eurozone. In particular, it shows that Germany has had a persistently large current account surplus, which is matched by a current account deficit in other Eurozone economies.
• With a fixed exchange rate, German goods have become more competitive in the Eurozone. Southern Eurozone goods have been uncompetitive. The exchange rate imbalance is a significant factor in the persistently low economic growth in Southern Europe.
• Without a mechanism for exchange rate adjustment within the Eurozone, the current account imbalances will persist.
• Furthermore, this issue rarely gets much attention. The EU and Germany frequently talk about the need for internal devaluation for countries to regain competitiveness. But, internal devaluation is causing economic misery of unemployment and falling GDP.
• Economic Imbalances in the Euro by Christian Schoder 2011

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