Estonia should have listenened to Marx

Published in Business Spectator (Melbourne), 6 January 2011

Groucho Marx once quipped that he did not want to belong to a club that allowed a person like him as member. With Estonia’s entry into the Eurozone on New Year’s Day, it is the other way around. The small but proud Baltic nation became the first former Soviet state to join Europe’s monetary union. However, given its splendid public finances Estonia should have deserved better than membership of a pan-European self-help group.

After a painful process of preparing itself for the common European currency, Estonia entered the eurozone in much better shape than its existing membership. The country had steered through the financial crisis with a programme of austerity and internal devaluation that would have seemed extreme to the Greeks, the British and even the Irish.

The reward for Estonia’s tough policy choices are healthy public finances that even Australia could only dream of, although this success came at the price of high unemployment. After massive declines in GDP, the Estonian economy is bound to recover in the coming years, though. These circumstances enabled Estonia to introduce the euro, to which the old Estonian kroon had been pegged since 2004. The only question remains why the Estonians would still want to join.

First-time visitors to Tallinn are in for a surprise if they expect to see remnants of Soviet communism. The Estonian capital, which is home to about a third of the country’s 1.3 million inhabitants, looks more like Copenhagen, Lubeck or Stockholm than a grey Russian satellite town. No wonder, really, since Tallinn’s history is steeped in the Hanseatic League, the medieval trading zone stretching across much of Northern Europe.

On a sunny summer’s day, Tallinn’s town hall square is as close to the picture-postcard image of a European city as it gets. Western tourists are discovering the long forgotten charms of the Baltic nations and flock to the city as weekend travellers or cruise passengers. The transition from a Soviet province to a country firmly established in Western Europe’s political and economic architecture is palpable.

Estonians had suffered enormously following the annexation by the USSR in 1944. During the collapse of Soviet communism, Estonia declared independence in 1991 and, in line with its Baltic neighbours of Latvia and Lithuania, moved fast to anchor itself in the West. Membership of the European Union and NATO in 2004 and entry into the passport-free Schengen zone in 2007 were the logical conclusions.

That Estonians were so keen to join the euro can only be understood in this post-independence context. Russia, the successor to their former Soviet occupiers, is still viewed with suspicion by Tallinn, and thus Estonia seeks refuge and protection in the West. Soon after independence, the Russian rouble was abolished and the Estonian kroon reintroduced. It was immediately pegged to the deutschemark, both as a symbol of stability and political orientation. This peg was maintained when Estonia entered the European Exchange Rate Mechanism in 2004, the only difference being that the kroon was now pegged to the euro at an almost unchanged exchange rate.

For a long time after its independence, Estonia was seen as an economic role model for the transition from communism to a liberal market economy. New technologies were embraced, not least in public administration where Estonia – or E-Stonia – became a pacemaker of global e-government initiatives. Under Prime Minister Mart Laar, privatisations of state-owned enterprises were pushed through, and the world’s first flat tax system was introduced.

As Estonia’s economy boomed following these reforms, it overheated. Capital was flowing in, mainly from neighbouring Scandinavian countries, and fuelled an asset and property bubble. It burst in the wake of the US sub-prime crisis in 2007.

In order to keep its ambitions of joining the euro alive, the Estonian government reacted with a policy of internal devaluation. Public spending was slashed; wages in the public sector were cut substantially. The result was that the Estonian budget deficit remained at 1 per cent of GDP in 2010 – much lower than the 3 per cent the European Stability and Growth Pact allows. Even more impressive, government debt is just 8 per cent of GDP, which is far below the 60 per cent mark the pact allows, and even further below the 79 per cent EU average.

Getting Estonia ready for the euro while maintaining its currency peg was a major feat. Other European countries, most notably Poland and Hungary, had devalued their currencies. To the Estonians, so keen to bolster their Western European credentials, this was never an option.

The dubious reward for this achievement is Estonia’s final entry into the eurozone. On the political front, this is the final step towards Western integration. This was succinctly put by Andres Kasekamp, director of the Estonian Foreign Policy Institute: “We are first class Europeans, no longer on the margin. The more international organisations we are involved in, the more secure we feel.” Seen from this angle, euro membership is a clear success for Estonia, not least against their Russian neighbours.

From an economic perspective, however, the benefits of Estonia’s euro membership are far less obvious. Although the Estonian government argues that the euro will reduce transaction costs and make the country more attractive to foreign investment, severe downsides remain.

As an economy representing less than 1 per cent of the eurozone, Estonia’s economic conditions will not be a major concern to the European Central Bank in making monetary policy. Ironically, Estonia is also likely to be punished for its enviable public finances.

While others let their budgets run out of control, Estonian public finances remained so well managed that they will now have to support other EU countries’ financing activities. Finance minister Jürgen Ligi has already announced Estonian loans guarantees for Ireland worth 130 million Euros – quite a substantial amount for this small economy. So Estonia, with a nominal GDP per capita of $US14,266, is assisting Ireland, whose GDP per capita at $US37,700 is almost twice as high. It is the price that Estonia is willing to pay to be a member of Western Europe.

Other European countries could learn a thing or two from both Estonia’s previous economic reforms and its tough but successful austerity policies. If Europe became a bit more like its latest eurozone member, everyone would be a winner. But does this sound even remotely likely?

For fear of its big Eastern neighbour, Estonia is seeking protection in the West. The danger, though, remains that Estonians are only trading in their hard gained independence from Moscow for new dependencies on Brussels and Frankfurt.

Perhaps Estonia should have really considered Groucho Marx’s advice not to join the organisation that was so keen to admit it as a member.

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