Baltic Austerity And Euro Area Contagion

Hilmar Þór Hilmarsson

I lived in Riga, the Latvian capital, from 1999 to 2003 just before the Baltic States became European Union member states in 2004. EU membership was to be a ticket to prosperity, and along with NATO membership, provide security. There was optimism that the Baltics would catch up with the richer EU15 countries and perhaps in a not too distant future offer a quality of life to their people resembling that of the richer Nordic countries. And the Baltics had periods that certainly gave reasons for optimism: GDP growth rates were for example at or near ten percent throughout the 2005 to 2007 period and exceeded ten percent for at least one year in all three countries during this period. At this rate an economy more than doubles in size every decade. Unemployment fell sharply. There was talk about the Baltic Tigers.

In 2008/9 the global crisis hit the Baltics hard, especially Latvia. Decisions had to be made on how to respond. All the Baltics chose a fixed exchange rate policy. This was favored by the EU and in effect became a condition for euro adoption. This also meant that drastic austerity programs had to be implemented with cuts in jobs, salaries, social programs, education and health expenditure. In Latvia the IMF recommended a 15 percent devaluation of the domestic currency, the lat. This was to improve the countries’ competitiveness in the hope of faster economic recovery. Foreign banks, mainly Swedish, opposed out of concern over the impact of a devaluation on their portfolio. Many of their clients had borrowed in euros. The EU said no to devaluation, concerned over the potential regional spillover effects. As with Greece in 2010, the “rescue” of European banks was to prevent contagion in the Euro Area. The Scandinavian-Baltic interlinkages are still extensive and continue to be risky for the whole region.

Banks on welfare

GDP growth in the Baltics 2005 to 2007 was not driven by fiscal imbalances; Estonia was in surplus, and Latvia and Lithuania were near balance. In 2007 government debt as a percentage of GDP in 2007 was low in the Baltics even if compared to the robust continental Nordics, much lower than in the EU or the Euro Area, not to mention countries in southern Europe such as Greece. The growth in the Baltics from 2005 to 2007 was driven by excessive consumption and investment fueled by both foreign lenders/investors and domestic mistakes. From European Union accession in 2004 to 2009 private sector consolidated debt as percentage of GDP doubled in the Baltic States.

The European banks were not made responsible for their behavior. Austerity was implemented in the Baltics that had and still have among the highest proportions of people at risk of poverty and social exclusion one can find in the EU. Income inequality there is currently close to that of much poorer Bulgaria and Romania. In contrast countries at similar income levels such as the Czech Republic, Slovakia and Slovenia have managed to preserve an income equality similar to that of the Nordic welfare states. In the Baltics the foreign banks were put on welfare, not the most vulnerable members of the population.

Friedmanite experiment

I have sometimes wondered how the Baltics became so neoliberal, so extremely pro-free market. In a Brussels Journal interview in 2005 when the Baltics were booming Mart Laar, who became prime minister of Estonia from 1992 (shortly after independence) said:

It is very fortunate that I was not an economist […] I had read only one book on economics – Milton Friedman’s Free to Choose. I was so ignorant at the time that I thought that what Friedman wrote about the benefits of privatization, the flat tax and the abolition of all customs rights, was the result of economic reforms that had been put into practice in the West

And Laar implemented this policy despite warnings. No other country in the world has implemented Friedmanite policies, not even his home country the USA (though maybe Pinochet’s Chile).

Over the last ten years I have lectured in universities in all the Baltics and talked to students. Many of them have chosen to leave for a better life in richer countries. Baltic people are not accustomed to opposing bad government policies, but choose the exit option. Outward emigration has been especially dramatic in Latvia and Lithuania. It is sad to see the rather slow post-crisis growth in the Baltics now close to the Euro Area average. At this rate they will not catch up with richer EU member states in a foreseeable future. And their young people are unlikely to return to lower salaries and weak welfare systems at home.

But the Baltics have opportunities to reform. They can become more competitive with more investment in education, science and research, and infrastructure. They can broaden taxation with progressive rates to scale up income tax and introduce higher bands on capital and land. They can gradually strengthen their welfare systems and better protect their healthcare systems. The Baltics are now modern states and they can and should provide viable opportunities for their young people.

Perhaps it’s time for them to consider the Nordic model to counteract the negative effects of the neoliberal policies? The EU should help them in this process. Not push them into a bad balance with austerity resulting in lower growth, high unemployment and the migration of their young to richer countries.