The Baltics Show the Way Back

© Stefano Cellai/Grand Tour/Corbis

Since 2001, ed dolan has taught economics in a number of Eastern European universities, including the Stockholm School of Economics in Riga and Tallinn Technical University.

Published January 21, 2014.


Much of the economic news dribbling out of Europe in recent months has been bad, and much of that has come from its southern periphery. Greece, Italy, Spain and Portugal are still wallowing in deep slumps. Unemployment remains in double digits, and the rate of joblessness among young workers is catastrophically high.

Europe has another periphery far to the north, however, and here the news is very different. The three small countries at the eastern end of the Baltic Sea — Estonia, Latvia and Lithuania — were initially clobbered by the global crisis, but are now showing the rest of Europe the way back. Output and living standards are up, unemployment is down and GDP has almost recovered to precrisis levels.

What has made the difference? Perhaps more important, are there insights to be gleaned from the Baltic experience that are relevant to the larger ailing economies of Europe?

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Numbers Please

Two charts show just how striking the difference in recovery has been between the small Baltic states (which I'll call the Baltic 3) and four troubled economies on Europe's southern edge (which I'll call the Med 4, even though Portugal doesn't actually touch the Mediterranean). Start with GDP – total output in each group, adjusted for inflation.

A few things stand out. First, in the years before the global crisis, growth in the Med 4 was about average for the euro area, but the Baltic 3 experienced a remarkable boom. Although the Baltic countries were not formally in the euro area at that time, it is still the relevant comparison group, since all three had firmly pegged their exchange rates to the euro. Estonia formally joined the Eurozone in 2011; Latvia is joining in January 2014, and Lithuania hopes to join in 2015.

Second, although all of these countries took a hit in 2009, the dip in GDP in the Med 4 was relatively mild and in line with other euro area countries. In the Baltics, by contrast, the crisis wiped out three-quarters of the gains made during the preceding boom.

Third, the Baltic 3 recovered strongly after 2010, in contrast to the euro area as a whole, which slipped back into a mild recession. The slump in Med 4 members was far more severe: by 2013, their recession was in its fifth year. Forecasts call for a slight upturn in 2014, but whether the recovery grows legs remains to be seen.

Now compare the real GDP per capita in each region with that for the European Union as a whole. The Baltic 3 don't shine as brightly in this context since their living standards are still well below those in the Med 4. At the time they joined the EU in 2004, the Baltic 3 were its poorest members. (Bulgaria and Romania, which joined later, are poorer still.) Even Greece, the poorest of the Med 4, has a higher GDP per capita than Estonia, the most prosperous of the Baltic 3.

On the other hand, the Baltic 3 have sharply narrowed the gap with the rest of Europe. Although their total GDP has not quite recovered its precrisis peak, their standard of living is higher now relative to the rest of Europe than in the precrisis years.

Meanwhile, the Med 4 are stagnating. Their aggregate performance, of course, reflects in part the free fall of the Greek and Portuguese economies, where real GDP per capita has slipped to about 75 percent of the EU average. But even Italy, where per capita GDP was 20 percent above the EU average a dozen years ago, is now below the average. Much the same can be said for Spain, which also briefly made it above the EU average during its real-estate-fueled boom of the mid-2000s.

One more chart. Unemployment soared everywhere in Europe when the bubble burst, and at first, the impact on the Baltic region was the most severe. By 2010, however, jobs had begun to recover, and by mid-2013, joblessness had dropped below the EU average.

The picture is quite different for the Med 4. There, unemployment lagged the decline in output, thanks to regulations that make layoffs very costly to employers; however, unemployment has kept right on rising. The numbers for youth unemployment are even more distressing. In Greece and Spain, the figures exceed 50 percent; in Italy and Portugal, close to 40 percent. By contrast, youth unemployment in Estonia in mid-2013 was just 15 percent, and was only a little higher in Latvia and Lithuania.

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The Baltic Roller Coaster

The introduction of the euro at the beginning of the century was the most ambitious step yet in the integration of Europe, which began after World War II. The idea is appealing on its face. A common currency makes trade and travel among member states easier, just as a shared dollar does in the United States. And, provided the currency union is stable, it eliminates one source of risk in investing in another country. In political and psychological terms, it reinforces the notion that Europe is one – a reality much on the mind of the Eurozone's founders.

Unfortunately, though, currency areas also have drawbacks that were inadequately addressed in planning for the Eurozone. The big one is that members lose the ability to use monetary policy independently to smooth the business cycle and manage external shocks – say an increase in oil prices. In the Eurozone, monetary policy is made by the European Central Bank on a one-size-fits-all basis.

Although the Baltic 3 all retained their national currencies when they first joined the European Union, their decision to peg their exchange rates to the euro put them in much the same economic position as full euro members. By law, the central banks of Estonia, Lithuania and Latvia have to give first priority to maintaining the currency peg. That has meant abandoning the ability to influence interest rates, inflation and the quantity of money in circulation.

The loss of independent monetary policy leaves fiscal policy as the main tool for smoothing the business cycle. Subject to general rules set by treaty, Eurozone members can adjust taxes and government spending to stimulate or restrain demand.

Admission to the EU (as distinct from the currency union) in 2004 put the combination of fixed exchange rates and discretionary fiscal policy under severe strain in the Baltic states. With per capita GDP just over 40 percent of the EU average, membership opened huge opportunities for growth. Investment flooded in, partly in the form of official EU development funds, partly through loans from the Scandinavian banks that dominate their money markets and partly through private direct investment. As unemployment declined, wages rose. And rising wages increased demand for consumer goods and real estate. By no coincidence, inflation rose steadily – it was over 10 percent by 2008. The impact on housing was even more pronounced, with price increases exceeding 30 percent in some years.

Other countries that joined the EU in 2004 felt the impact of the same forces. However, the ones that allowed their exchange rates to float against the euro – notably, Poland and the Czech Republic – responded to the money slosh very differently. They allowed their currencies to appreciate steadily as money poured in. And the appreciation prevented the overheating of their economies during the mid-2000s. Then, when the crisis came, depreciation of the Polish and Czech currencies cushioned the impact on output and employment by making their products more competitive in global markets.

In principle, even without flexible exchange rates, the governments of the Baltic countries could have tempered the unsustainable boom with the wise use of fiscal policy. But the budget rules imposed as a condition of EU membership had little bite in the Baltics.

Those rules required only that EU members limit their annual budget deficits to less than 3 percent of GDP and their total government debt to 60 percent of GDP. But with tax revenues booming as their economies expanded, budget deficits fell below one percent of GDP in Latvia and Lithuania, while Estonia actually ran a small surplus. And since they were burdened with essentially no government debt at the time of their independence from the Soviet Union, they never got close to the 60 percent limit.

What the EU rules did not mandate (and Baltic governments did not pursue) were countercyclical fiscal policies – policies that moderate spending and/or raise taxes during booms, while going the other direction in response to recession. More precisely, the Baltic states failed to track their budgets' structural balances, the surpluses or deficits they would have experienced if their economies were operating at full capacity.

During the years of rapid growth in the mid-2000s, the Baltic 3 should have taken measures to achieve structural surpluses. Unfortunately, the extra tax revenue brought in by the boom masked the fact that structural balances remained substantially in deficit throughout the region. That was true even in Estonia, with its budget surpluses. Thus, rather than leaning against overheating, the fiscal policies of all the Baltic governments were adding fuel to the fire. Far from being countercyclical, their policies were actually pro-cyclical. Playing by the rules – the misguided rules embodied in the EU treaties – set them up for a bigger-than-average fall when the financial crisis hit.

The Med 4 countries also experienced the malign effects of fixed exchange rates and pro-cyclical fiscal policy, but not to the same degree. Except in Greece, budget deficits did not grow markedly in the period leading up to 2008. That helped to limit the extent of overheating, and as a result, made the immediate impact of the crash less severe. Why, then, are the Baltic 3 recovering, while the Med 4 lag?

©Barbara Santoro/Grand Tour/Corbis
Location Matters

Ask people in the Baltics what natural economic advantages they enjoy, and they'll mention their location at a strategic crossroads between North and South, East and West. Geography endows them with many of the healthiest EU economies as trading partners. To the north, there's Scandinavia, whose economies have outperformed the EU average since the global crisis. To the south, there's Poland, the only EU member to avoid a recession entirely, and Germany, the largest and strongest EU economy.

In contrast, much of the intra-EU trade of the Med 4 is with one another and with another underperforming member, France. Germany is the only major trading partner that the Med 4 countries share with the Baltic 3.

East-West trade is also important to the Baltic economies. Economic links with Russia are nowhere more apparent than in Latvia, which is geographically at the center of the Baltic 3. First, there are strong ties of culture and language imposed on Latvia during the long Soviet occupation: nearly half of the population of Riga, Latvia's capital, is of Russian origin. For people in the business community, whether of Russian or Latvian ethnicity, proficiency in at least three languages (Latvian, Russian and English) is a given.

Language is only part of the story, however. Latvians often emphasize that they understand not only the speech of their Russian business partners, but also their ways of thinking and negotiating – ways that can be quite foreign to Western Europeans.

Strong transportation links are a second plus. The first time I heard Latvians brag about their excellent rail system, I was taken aback since the Baltics lack good connections with the rest of the EU. A long-discussed project to build a high-speed line from Tallinn through Latvia and Lithuania and into Poland and Germany seems to be going nowhere.

The freight rail connections from Riga eastward are a different matter, however. Not only is the line in good condition, but, as a legacy of the Soviet period, it retains the wider Russian rail gauge. Rail traffic can go straight from the port of Riga to Moscow and beyond. And "beyond" can be a long way: from Riga through Russia by rail has been the cheapest and most reliable routing for tens of thousands of tons of American supplies for war and reconstruction in Afghanistan.

Third, Latvia is the preferred financial gateway to the EU for many Russian companies. Although Cyprus has received more attention as a venue for Russian offshore banking, Latvia is far closer to Moscow. And many Russians like the assurance of being able to do business in their own language in any branch of a Latvian or Nordic bank in Riga.

To be sure, Russia's economic relations with the Baltics are not without strains. Latvia and Lithuania resent their dependence on gas from Russia, for which they pay prices well above current global averages. (Estonia, by way of exception, is proud to be the most energy-independent country in the EU, thanks to its abundant deposits of oil shale.)

Furthermore, trade with Russia is always vulnerable to political disruption. In one incident, the 2007 relocation of a World War II memorial to the Soviet cause in Tallinn led to economic retaliation against Estonia in the form of of rail service disruption and cyber attacks. More recently, Lithuania used its turn in the rotating EU presidency to push for stronger linkages between the EU and Ukraine. Russia retaliated by banning imports of Lithuanian dairy products on the flimsy pretense of health concerns.

Such incidents aside, however, increasing Baltic integration with Western Europe has not displaced trade and financial ties with Russia and other former Soviet republics to the east, but rather has facilitated them.

©Jorge Fernandez/Alamy
The freight rail connections from Riga eastward retain the wider Russian rail gauge. Rail traffic can go straight from the port of Riga to Moscow and beyond.
Labor Markets Matter, Too

Baltic entrepreneurs complain that it's difficult to find qualified workers. The causes: emigration to more affluent EU members, an education system ill-designed to serve a business economy and low birth rates – a worrisome factor in the long run if it isn't reversed. But to an outsider, the contrast with Spain and Greece is striking. What Baltic employers see as an acute labor shortage is also a sign of economic growth and healthy diversification into enterprises needed to catch up with Western Europe.

The most important differences in labor markets between northern and southern Europe lie in the institutions that determine how easily workers can move in and out of jobs. A labor market with high mobility allows an economy to adapt better both to temporary shocks (like the financial crisis) and to trends like changing patterns of trade and diverging productivity. In times of change, there is a tension between the desire to protect incumbent workers from job loss and the need to move workers of all ages, including those just entering the labor force, into jobs where they are most productive.

Two aspects of labor market rigidity are of special importance in Europe. One is legal protection against dismissals, both individual and collective, that give employers an incentive to employ fewer workers in the first place. The other: limitations on hiring temporary workers. Taken together, they've created a dual labor market in much of Europe, where some workers have well-paid jobs from which they cannot be dismissed, while others, especially new graduates, are either unemployed or stuck in dead-end temporary jobs.

Which brings us back to the aforementioned contrast: on the whole, labor markets are much less rigid in the Baltic countries than in southern Europe. One measure of the flexibility gap is a set of employment protection indicators compiled by the OECD. On a scale where lower numbers indicate more flexibility, the Baltics score 0.97 for protection against dismissals compared with an average of 1.27 for the Med 4. (Note, however, that labor markets in both regions are less flexible than in countries that follow the so-called Anglo-Saxon model, including the United States, Britain and Canada, which average 0.22 on the OECD scale.)

The numbers for regulation of temporary work are similar. The Baltics score 1.21, compared with 1.39 for the Med 4 – but both are more rigid than the Anglo-Saxon group.

What's more, anecdotal evidence suggests that the contrasts on the ground are greater than those implied by the OECD numbers, which don't reflect how strictly (or laxly) regulations are enforced. Nor do they reflect differences in unions' inclination to defend the letter of the law or, for that matter, workers' willingness to invoke legal protections against layoffs and dismissals.

The World Economic Forum provides a different ranking based on perceptions of how efficiently labor markets actually operate. The forum's numbers suggest that the differences in labor-market efficiency between the Baltic 3 and the Med 4 are significant. The average ranking of the Baltic 3 is 31st out of 148 countries surveyed. Estonia is 12th, suggesting that it has one of the most efficient labor markets in the world.

In contrast, the average efficiency ranking for the labor markets of the Med 4 is 126th, with none of the Med 4 in the top 100! Italy's ranking, at 137th out of 148 countries, is downright dismal. Small wonder, then, that the Baltic 3 have unemployment rates just half those in the Med 4.

Room For Improvement

The top two complaints about doing business in the Baltics are corruption and bureaucracy – both of which are holdovers from the region's Soviet past. The Corruption Perceptions Index compiled by Transparency International gives the Baltic states an average ranking of 44 out of 178 countries, which is actually a bit better than the Med 4, with an average ranking of 57. Those averages, however, hide wide variations within each region. Spain is less corrupt than any Baltic country, while Portugal is in a virtual tie with Estonia, the cleanest of its group. What drags down the Med 4 average are the corruption rankings for Italy (72) and Greece (94).

All three Baltic nations score well on the World Bank's Ease of Doing Business index, with an average ranking of 21 out of 170 countries. That puts them collectively in a tie with Germany and ahead of Switzerland (29), France (38), the Netherlands (28) and all of the EU's southern and eastern peripheries. But Estonia and Latvia show contrasting weakness on the World Bank's Ease of Starting a Business subindex, ranking 61 and 57, respectively. That puts them ahead of Italy (90) and Spain (142!), but far behind most of northern Europe. And it reflects the burden of bureaucracy in post-Soviet states that haven't fully reformed their regulatory practices.

Interestingly, difficulties with corruption and bureaucracy apparently haven't slowed the emergence of new businesses very much. Latvia, for example, enjoyed four times the rate of start-ups as Spain, which is admittedly depressed. One American ex-pat entrepreneur who now lives permanently in Riga explained this paradox to me by noting that the Soviet experience taught Latvians how to cope with adversity.

Bloomberg via Getty Images
The Baltic market economies are younger and more flexible. Baltic labor and product markets adapt more rapidly to change than those in southern Europe.
The Baltic Advantage

The economic success of the Baltic 3 can't be attributed to a single factor, giving ideologues room to impose their own interpretations. Some have chosen to interpret the Baltic experience as a success story for fiscal austerity, as if tax increases and spending cuts were the best cure for economies in a slump.

I find that interpretation hard to support. Keynes argued – and no one since has really dented the argument – that pro-cyclical austerity during a downturn is part of the problem, not the solution. We can declare the disease of perverse fiscal policy cured only when we see that a country is able to maintain fiscal discipline during its next expansion.

There are early signs that the Baltic 3 are doing better during the current expansion than during the previous one, but it is really too soon to be sure. We have even less indication as to how well the Med 4 will manage their budgets during the next expansion since their economic cycles are, at best, just now reaching the perigee.

Part of the reason for a more rapid rebound in the Baltics, as we've noted, lies in their luck to be living in a good neighborhood. An even more important factor, in my view, is the fact that their market economies are younger and more flexible. Baltic labor and product markets adapt more rapidly to change than those in southern Europe.

Governments in both the Baltic 3 and Med 4 have made some of the same policy mistakes. But the bad habits are not deeply entrenched in the Baltics and should prove easier to break. Also, institutions that protect the interests of established workers and firms are not as strong in the Baltic region, making it easier for workers to change jobs or to enter the market for the first time, and for new businesses to emerge to replace those that fail.

Finally, there is the simple reality that the Baltic economies are small. The Portuguese economy, the smallest of the Med 4, is six times larger than that of Lithuania, the largest of the Baltic 3. Italy's economy is 100 times larger than Estonia's.

In recent conversations, corporate executives and entrepreneurs in Latvia mentioned size as a factor in economic success again and again. A few noted that small size has a downside, in that small economies are more exposed to external shocks from their giant neighbors. Much more often, however, they equated small size with the unity and flexibility needed to respond to emerging opportunities. For the moment, anyway, small is beautiful.