Learning from the Baltic Experience
The Baltic economies of Estonia, Latvia and Lithuania have been the hardest hit victims of the global economic meltdown. This year the Lithuanian economy is expected to shrink by at least 18 per cent, the Latvian economy by 16 per cent and that in Estonia by 13 per cent.
Each of these countries is a member of the European Union and had hoped to adopt the euro as its currency in the next few years both to spur foreign investment and to symbolize their acceptance into the western European fraternity of nations. Now those aspirations are on hold amid continuing worries about the Latvian lat, whose devaluation might force the others to follow suit. Such a move would impair Baltic ability to repay money borrowed from western European banks during the good years and that could trigger a European banking crisis that would sap western Europe’s own recovery.
Fortunately, the Baltics seem to have hit bottom. And there is renewed talk of Estonia meeting the criteria to join the euro some time next year, with the other nations hoping to join by 2014. But central and eastern Europe are not out of the woods yet and developments there could still unravel, cascading down on western Europe and by extension the global economy.
Nevertheless, it is not too early to begin to draw some lessons from the Baltics’ experience that could help shape future European policy toward economic conditions in its neighboring countries, especially those that aspire to join the euro.
First: even when they pursue sensible economic policies, small, open economies have little effective control over their destinies. Latvia has a population the size of Houston. Lithuania’s economy is smaller than that of Maine. And the value of their exports and imports actually exceed the size of both the Estonian and the Lithuanian economies. Such countries have no influence over Wall Street machinations. In this era of globalization, small nations, even those within the European Union, have only one choice: be autarchic, safe and poor or integrated with the economies around them, better off and extremely vulnerable.
Moreover, at one point, the Baltics were considered the model children among new EU member nations, pursuing economic policies – flat taxes, privatizations, low trade barriers–that were deemed more virtuous than virtually any other European country.
The crisis has reminded us that economic virtue is no protection against adversity and that precautionary measures, while they may deviate from economic orthodoxy, may prove less expensive than cleaning up the mess after a meltdown.
Second: an open economy without sufficient regulatory supervision and adequate provisioning against losses is a prescription for trouble.
The Baltics opened their financial sectors and attracted huge capital inflows that largely went into housing and finance, not into productive activities. There was little effort, such as taxes on real estate transactions, to control such speculation. But it can be done. Brazil has recently begun to tax capital imports to modulate the flow of hot money. The challenge facing Europe’s neighbors is to modulate short-term capital inflows without scaring away much needed long-term foreign investment.
The Baltic experience also underscores the importance of regional supervision of integrated financial systems. Baltic bank regulators were clearly overwhelmed by their responsibilities. But Swedish supervisors looked the other way. As a result, dangerous financial practices were left untamed.
One option may be to limit borrowing and lending in foreign currencies. In the current recession, some of the hardest hit countries – Hungary, Romania, the Baltics – have been those with the greatest corporate and homeowner indebtedness in euros, swiss francs and other non-national currencies. An outright ban on foreign borrowing would be costly, because the pool of loanable capital in small economies is often not sufficient to fuel robust growth. And the interest rate on foreign-denominated loans is often much lower than that for locally available money. Nevertheless there are measures governments can take. Poland has successfully constrained foreign borrowing.
The crisis was also a reminder that financial cushions can be invaluable. Latvia and Lithuania ran budget deficits in the good years. Estonia ran a budget surplus and was better prepared to weather the recent tempest. Larger reserve requirements for banks and forced savings for individuals and firms are prudent strategies for economies at the mercy of global financial markets.
Of course, for every lesson a debtor can learn from a crisis, there is a mirror image moral for a creditor. From 2003 to 2008, international loans on the balance sheets of Swedish banks rose from 190 per cent of the country’s GDP to 270 per cent stokes interview . Many of these were loans to the Baltics, putting the Swedish government on the hook to bailout its banks once those debts soured. If taxpayers are going to foot the bill for their banks’ foreign imprudence, governments may want to impose constraints on foreign lending.
The Baltics’ trauma has demonstrated the value of being a member of the European Union, whose deep pockets have allowed it to provide the lion’s share of funds to bailout Latvia at an affordable cost to Brussels. It suggests that the EU will play an increasingly important role in future bailouts of both member states and Europe’s neighbors. And it demonstrates that Brussels has its own agenda when it comes to these matters. The European Commission has pressed Riga not to devalue because such a move would reflect poorly on its aspirations to create an ever tighter union.
Yet this experience should be a cautionary lesson for the European Union, which in 2004 extended membership to Estonia, Latvia and Lithuania more as a political gesture of solidarity than for sound economic reasons. Brussels should think twice about politically-driven EU membership for Macedonia, Albania and Montenegro.
Third, and possibly most important, the strictures imposed by the European Central Bank on countries aspiring to join the euro may actually destabilize those economies. These criteria for joining the euro include inflation, budget deficit and government debt targets and a requirement that applicant countries peg their currencies to the euro for two years.
It is this prolonged pegging that makes countries vulnerable to external shocks while they are in the waiting room. “It’s like telling soldiers that you have to walk slowly over the battle field while people shoot at you,” notes Anders Aslund, a senior fellow at the Institute for International Economics in Washington, setting currencies up as a target for speculators.
“The single cause of their hardship,” Aslund claims, “was that their exchange rates were fixed to the euro, as requested by the European Union’s ERM2 (the European Exchange Rate Mechanism 2), which attracted the excessive capital inflows that caused the overheating. They were caught in the €˜impossible trinity’ of fixed exchange rates, free capital movements, and independent monetary policy.”
As a result, he says, “the ECB set up eastern Europe for a new east Asian crisis through it demand for ERM2.”
”One would hope that the ECB learns from this crisis,” he concludes, “that the enlargement and reinforcement of the euro zone should be facilitated rather than impeded for the financial security of both the euro zone and the European Union as a whole.”
Unfortunately, there is no evidence the ECB is listening. “The financial crisis has not changed our policy for adopting the euro,” Gertrude Tumpel-Gugerell, a member of the executive board of the ECB, said at a conference in Vienna on November 16.
The sustainable convergence of economic performance as a prerequisite for euro adoption is undoubtedly necessary to ensure stability and to guard against the problems created by premature entry into the euro area. In retrospect Greece and Italy probably should not have been granted euro membership given their subsequent problems. But the ECB’s obstinacy and its failure to learn any lessons in the face of the Baltics’ experience are disturbing.
The European Union should be called to account by the G20, the newly minted global economic directorate. Orthodox economic theories that have been demonstrated to create difficulties in practice, potentially triggering problems that could reverberate around the world, are everyone’s business, not just the preserve of the euro zone members. Europe needs to drop its head-in-the sand posture and adapt the euro criteria in light of the Baltics’ experience.
Bruce Stokes joined GMF as a transatlantic fellow in February 2008. He is the international economics columnist for the National Journal, and also a consultant to the Pew Research Center.
