by Marek Tiits

The global crisis stroke, as argued by many, by complete surprise and there was very little individual small economies such as the ones on the Baltic Sea Region could themselves do to avoid the domestic crisis that followed. Is this really so? What have we learned from this crisis? Are there any extra lessons to be taken?

The general hope and perception emerging from recent international media coverage is that the global financial and economic crisis is nearly over. The employment figures remain sluggish, but financial markets enjoyed last year extraordinary gains, and a number of economies have started to demonstrate again quite reasonable growth rates. In the Baltic Sea Region, also things seem to have started to return back to normal. The quarterly GDP growth was in Q4 2009 for the countries in the Baltic Sea region close to 0% or even slightly positive. Estonia prepares for adoption of euro in 2011 and the budget crisis in Greece has overshadowed the woes in the Baltic States. The view that the crisis is nearly over and everything will continue as previously represents a rather comforting outlook. This is a very tempting, yet dangerous way of thinking.

Finland, which was in the recent years known as one of the most competitive economies in the World, was hit by the global crisis severely. So, one could argue that small export led economies were hit harder than bigger nations. Still, the economies of the three Baltic States were in terms of the contraction of the GDP in 2009 among the worst hit economies in the World. How is this that the earlier very rapid GDP growth turned into the severest crisis of the kind?

The very rapid economic growth demonstrated by the Baltic States over the last years built on the inflow of foreign finance. The inflow of capital, which came at record low interest rates, triggered in the Baltic States major asset and consumption booms accompanied by large current account deficits. The subsequent domestically led growth triggered a very rapid growth of wages that outpaced significantly the productivity growth in the exporting industry. According to the OECD, the unit labour cost increased in 2005-2009 in the Baltic States by 50-60%, and the real effective exchange rate of these economies appreciated together with this very rapidly. The above reflects a very rapid erosion of the competitiveness of these economies.

The global financial and economic crisis was for this part of the World a perfect storm that hit the weakest point of these economies. The global financial crisis led in the Q4 2008 suddenly to the reversal of the flows of foreign capital. The earlier inflows of finance to the Baltic States turned suddenly into outflows, while the demand on the export markets contracted simultaneously as well.

The earlier economic imbalances were so large that it was basically impossible to compensate for this only by increasing the productivity at the existing businesses. For example, we calculated last year for Estonia that, in order to sustain the 2007 level of GDP, and to compensate fully for the previous inflow of capital, her export revenues would need to increase overnight twofold.

The gap between the wage and productivity levels appeared, as the result of the above, suddenly to be so large that the private sector had little choice but to cut heavily the costs. In the fixed exchange rate regime, wage cuts are essentially the only way out of such situation. Yet, the 20-25% wage deflation, which was very much needed in the Baltic States, takes a lot of time to actually take place throughout the economy. Therefore, wage cost cutting has worked mostly through decline in employment and rapidly increasing unemployment, while the hourly wage costs have declined very little.

The Baltic States have had throughout 2000s difficulties in closing their trade deficits. In the end of the 2008, when that the currencies of the neighbouring non-euro-based economies depreciated by 20-25%, it became even harder to compete at the export markets.  All of the above led to major decline of the foreign exchange income, domestic consumption and GDP.

The public sector response to the crisis has varied from country to country, but it has still involved, predominantly, attempts at closing the rapidly increasing public deficits and balancing the state budgets. Understandably, with declining tax revenues and increasing social costs, the public sector had in general very little resources available for supporting the upgrading and productivity growth in the exporting industry. Yet, this way, the contraction of the Baltic economies became even more rapid than it would have been otherwise.

The crisis has led to an increasing economic, regional and societal polarisation in the Baltic States. The situation is better in the capital cities and bigger regional centres, as they have always a bigger role in the international trade and services, but also in the provision of public services. The more remote regions, which are not lucky to have strong exporting industry districts, are in deep trouble as the decline in domestic consumption and increase in unemployment has hit these parts of the countries the hardest.

The hardship the Baltic States, and especially the more remote parts of these countries, are likely to continue face is in no way unique. It is just a part of a much broader pattern, where the peripheral Europe from the Baltic States or Balkans to the Spain or Ireland have all faced a similar externally fuelled consumption booms that have now went bust. There is no way for the domestic consumption led growth, be it public or private debt led, to come back. While the European periphery cannot (or do not want to) devalue, they are unable to earn enough export revenues to support reasonable levels of GDP growth and employment either. Unless anything changes, this hints of a forthcoming longer period of slow growth and high unemployment.

What the lagging regions and countries in Europe need is major anchor investments into their exporting industry. Such investments will serve as catalysts to the development of entrepreneurship and various smaller companies, which benefit from the presence of the above anchor investments that intermediate the smaller local companies and global market. The only problem is that such large-scale investments do not happen by the way of the automatic convergence of costs and living standards.

The above thinking is in fact very well known from the classical development economics developed by Paul Rosenstein-Rodan, Ragnar Nurkse and others more than the half of the century ago. Nurkse resumed in his theoretical excurse that a gold standard as the basis for exchange rates, or currency union such as eurozone, can only function if the exchange rate regime comes together with strong co-ordination of employment and economic development policies.1

The dilemma the European periphery faces now is that no member state is not necessarily willing to hand more policy power over to the Brussels; yet the role of the cross border policy co­ordination and of the EU cohesion and regional policies has still to increase.

1See also: Ragnar Nurkse, “Domestic and International Equilibrium”, in: Seymour Edwin Harris (ed.), The New Economics: Keynes’ Influence on Theory and Public Policy, New York: A. A. Knopf 1947, pp. 264-292.

This article appeared originally in April 2010 in the Baltic Rim Economies Bimonthly Review 2-2010.