The Estonian example

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Commentators such as Paul Krugman have been critical of Estonia’s austerity programme, but there are lessons that can be learned for other countries facing a similar deficit crisis

Last Friday I attended a lunch at the Centre for Policy Studies with Jürgen Ligi, Minister of Finance for Estonia.

This was of particular interest to me as Estonia’s approach to cutting its budget deficit and coping with austerity had been cited by British venture capitalist Jon Moulton on the Newsnight programme in which he was appearing with Paul Krugman, the Nobel prize winner and economist who writes for the New York Times.

Krugman was dismissive of the Estonian example both on and off the air. Krugman has criticised the Estonian model on the grounds that output has still not reached the level of the peak of the boom: ‘So, a terrible — Depression-level — slump, followed by a significant but still incomplete recovery. Better than no recovery at all, obviously — but this is what passes for economic triumph?’

As Estonian President Toomas Hendrik tweeted: ‘Let’s write about something we know nothing about & be smug, overbearing & patronizing’. And: ‘Guess a Nobel in trade means you can pontificate on fiscal matters & declare my country a “wasteland”’.

The facts are that when the financial crisis broke, the IMF forecast that Estonia was on course for a budget deficit of more than 10% of GDP in 2009. But the austerity programme ensured that it never exceeded 3% of GDP and was back in surplus by 2010. Unemployment, which peaked at 19%, is now back to around the European average of 10% (compare and contrast Greece or Spain). Real GDP is still about 8% below its 2007 peak.

I thought that Jürgen Ligi made some interesting points at the lunch about the Estonian experience including:

1. Economic activity has not yet recovered to the level preceding the period of austerity, but that previous level of economic activity was illusory-fuelled by a period of excessive lending and borrowing to spend which reached its peak in 2004-07. This is a vital and often overlooked point.

This puts into sharp relief Britain’s shadow chancellor Ed Balls’ continual sniping about the poor performance of the UK economy. It is inevitable. The previous highs from which it is struggling to make any progress were illusory.

At a more micro level, there are a number of managers in financial services businesses in particular who may have to realise that aiming to restore profitability to the level before the financial crisis may be equally impossible for the foreseeable future.

2. Two-thirds of the budgetary adjustment came from spending cuts, one-third from tax increases.

3. The tax regime adopted was a simple one with flat-rate income tax.

4. There were no exceptions to the necessary policy measures – whether taxes or spending cuts. VAT was raised from 18-20%, and imposed on food.

5. Everyone shared in the hardship, including politicians and civil servants. They didn’t just mouth platitudes about ‘all being in it together’. The Minister of Finance took a 27% pay cut.

Many people say that budgetary adjustment of the sort implemented in Estonia is impossible in a democracy because turkeys (the recipients of state aid) do not vote for Christmas (or Thanksgiving) as US presidential candidate Mitt Romney has recently pointed out to his cost. So how did the Estonian government manage this feat?

The Minister had an answer: The people of Estonia had experienced communism under Russian control and had no desire to go back to it. In contrast, the countries of southern Europe (and France) may have that ahead of them.

Terry Smith is chief executive of Tullett Prebon and Fundsmith. This post first appeared on Terry Smith’s Straight Talking Blog

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