Baltic Protests and Financial Meltdowns: Part I

On January 13, 2008, 10,000 people protested in the center of Riga, Latvia's capital, against the government's austerity policies and country's program with the International Monetary Fund.

The demonstration was followed by riots. Three days later a similar demonstration took place in Lithuania against its government's austerity policy — and it ended too, with riots. What is happening with the previously so calm and successful Baltic states?

The three Baltic countries – Estonia, Latvia, and Lithuania — have long been among the leaders in post-communist reform. In fact, in my book, How Capitalism Was Built, I concluded without any hesitation:

"The Baltic states… are the star performers [among post-communist countries]. They are full democracies with normal market economies and predominant private ownership. They have a steady, high growth rate of around 8% a year. Their corruption is low, and their budgets are close to balance. The Baltic governments are small and well-run."

Most of all, I praised Estonia which is the post-communist country with the least corruption.

I was not directly engaged as an economic advisor to the Baltic countries, although I was a member of the non-governmental International Baltic Economic Commission in 1991-1993. Yet I have visited them frequently for the last three decades — and been a strong supporter of their reforms policies.

Today, however, the three Baltic economies are in a deep economic crisis. Estonia and Latvia experienced a decline in their GDP of about 2.5% last year. And this year, the Baltic economies are expected to contract by at least 5%.

These economies have suffered from one key problem — excessive current account deficits. Latvia took the prize with a deficit of 23% of GDP in both 2006 and 2007, but Estonia and Lithuania were also above 10% of GDP, while a current account deficit exceeding 5 percent of GDP is considered unhealthy. But much of the deficit, 8-9% of GDP, was financed healthily with long-term foreign direct investment.

The problem, however, has been short-term capital inflows, largely from foreign (mainly Swedish) banks, which have led to overheating of the Baltic economies. Latvia had an average GDP growth of 11 percent in 2005-2007.

Because all three countries maintain fixed exchange rates to the euro, the inflows boasted the money supply and drove up inflation, which reached 15 percent in Latvia last year. High inflation, combined with a fixed exchange rate, raised the production costs, pricing the Baltic countries out of the market, especially as neighboring Russia, Sweden, and Poland let their currencies depreciate.

The expansionary bank lending stimulated housing purchases for mortgages, which grossly-inflated real estate prices. The currency inflow resulted in excessive imports and a large trade deficit. Finally, all this private borrowing left Latvia with a foreign debt of 137% of GDP at the end of 2008.

The Baltic's bubble burst in 2007, when foreign banks belatedly slowed their lending. Housing prices started declining, and with them investment and private consumption, reducing GDP growth and boosting unemployment.

And yet, the Baltic countries have been quite prudent in their fiscal policy. Until 2008, Latvia and Lithuania had almost balanced budgets, while Estonia was very conservative — with a budget surplus of 3% of GDP in 2006 and 2007. These countries have hardly any public debt, and Estonia has even accumulated a reserve fund from its budget surpluses.

The single policy mistake causing their hardship was the fixed exchange rates, which attracted the excessive capital inflows that caused the overheating. Because of the fixed exchange rate, the Baltic countries could not pursue an independent monetary policy, as the interest rates are determined by the market.

Even if these countries could have hiked their interests, the effect would not have been monetary contraction — but further attraction of short-term foreign capital given the fixed exchange rate. Bulgaria is in a similar bind, and Ukraine and Russia were so until their recent devaluations.

Ideally, the Baltic states should have abandoned their currency boards with fixed exchange rates four-five years ago to preempt overheating, but then it was politically impossible. The Baltic populations were happy with their stable exchange rates, and joining the European Union in May 2004, they wanted to adopt the euro as soon as possible.

The European Central Bank demands two years of fixed exchange rate plus a number of Maastricht criteria before a country can be accepted into the Economic and Monetary Union. The Balts were reasonably close — until their rising inflation disqualified them in 2006.

In hindsight, it was not wise to maintain the fixed exchange rates, but the choice was not obvious, and few countries committed fewer policy mistakes.

The fact remains that the Baltic countries have pursued more virtuous economic policy than virtually any other country in Europe. In a time of hardship, the Balts can and should be helped. Fortunately, the international community has agreed.

Editors Note: The author is a senior fellow at the Peterson Institute for International Economics. His most recent book is How Ukraine Became a Market Economy and Democracy (Peterson Institute, 2009).