The Fall and Rise and Fall Again of the Baltic States

A recessionary tale from Europe's new basket cases.

By , a nonresident fellow at the Center for European Policy Analysis.

Portraying the Baltic states in their current mess requires more than words and numbers. Only an old-fashioned chart, with a sea monster, a whirlpool, or perhaps a skull and crossbones, would begin to do justice to the plight of what were until recently the shining success stories of the ex-communist world. Eating a meal in a deserted restaurant in one of the fine old capital cities of Tallinn, Riga, or Vilnius gives a sense of the collapse. So does the silence of the half-finished construction sites, the rock-bottom rates in the glitzy hotels that shot up during the boom years, and the fall of a Latvian government under the weight of the current troubles. The Baltic states today are prime candidates to be the new basket cases of Europe, with their double-digit economic declines, beleaguered governments, and shriveling state spending.

Portraying the Baltic states in their current mess requires more than words and numbers. Only an old-fashioned chart, with a sea monster, a whirlpool, or perhaps a skull and crossbones, would begin to do justice to the plight of what were until recently the shining success stories of the ex-communist world. Eating a meal in a deserted restaurant in one of the fine old capital cities of Tallinn, Riga, or Vilnius gives a sense of the collapse. So does the silence of the half-finished construction sites, the rock-bottom rates in the glitzy hotels that shot up during the boom years, and the fall of a Latvian government under the weight of the current troubles. The Baltic states today are prime candidates to be the new basket cases of Europe, with their double-digit economic declines, beleaguered governments, and shriveling state spending.

But 20 years ago, when I first visited what were then still the Soviet Baltic republics, the current problems would have seemed an almost inconceivably desirable state of affairs. The Baltic states, for almost all intents and purposes, had ceased to exist to the outside world for nearly half a century. As a youngster in Britain in the 1970s, I had read of Estonia, Latvia, and Lithuania as one might read about the mythical land of Atlantis—a fabled place of the distant past, submerged by an unimaginable catastrophe. In the early 1980s, I huddled with demonstrators in London, their banners reading, "Estonians out of Siberia! Soviets out of Estonia!" It was hard to know which seemed less likely. In London, I met elderly, dignified survivors of the Baltic lost world in dusty rooms that reeked of irrelevance and desperation. Even just visiting the Baltic states during their years of Soviet rule was near impossible.

Then came the small miracle of the 1990s. When I lived in the Baltic states for the final two years of the Soviet era, I did not just discover Atlantis: I watched it rise out of the sea and join the United Nations. As the editor of the English-language weekly The Baltic Independent, I chronicled what happened next: how the reborn republics cleaved to the West, shrugging off the economic and political legacy of the occupation.

Today, Atlantis is buffeted again by cruel and threatening tides. One is the sharp downturn in the domestic Baltic economies, which began two years ago when their reckless credit bubbles began popping. These had been inflated by the belief that the Baltic markets were rapidly converging with Europe’s. Property prices and consumer spending rocketed, creating huge current account deficits as Estonians, Latvians, and Lithuanians took advantage of the easy credit offered by banks keen to increase their market share in Europe’s most dynamic new region. Square foot for square foot, prime apartments in the Baltic capitals were costlier than in Copenhagen.

On top of all that has now crashed an even larger wave: the global recession. As small, open economies, the Baltic states thrive when their neighbors are booming, and wither when they slump. In the current downturn, demand for Baltic products—food, furniture, tourism—is sinking both in European markets and in Russia. That has led to stunning gdp falls in all three countries. In the first quarter of 2009 alone, gdp dropped at a 12 percent annual rate in Lithuania, 15 percent in Estonia, and 18 percent in Latvia. Forced to accept an imf-led bailout in December, Latvia is now struggling to meet its loan conditions. Public-sector salaries there were cut by at least 20 percent. Discretionary public spending is to fall 40 percent.

A third crashing tide is geopolitics. Russia looms next door to the Baltic states as a contemptuous and even hostile neighbor that has played out repeated military exercises based on the scenario of reconquest. The three Baltic states are today members of nato but often feel they are on its margins: in the alliance on paper, but lacking the contingency planning and military presence that would bolster the security guarantee provided by Article V of the nato treaty. Russia’s increasingly angry rhetoric and ominous moves may seem like empty posturing from the safety of Brussels or Washington, but from a Baltic standpoint they are threatening—and all the more so for having thus far prompted no clear Western response.

It used to be Belgium that was counted as the "cockpit of Europe”—the place where great-power interests clashed and were settled. Now it is the Baltic states. At stake is not just nato’s credibility, but also that of the whole post-communist experiment: Is it possible for small countries on Russia’s borders to gain durable prosperity, security, and freedom, with their destiny determined by their own talents and virtues? Or will the ebb and flow of economic fortune ultimately prove that these small states are unsustainable as anything but satrapies for more powerful neighbors?

To answer those questions, one has to start with the past. For though the Baltic states share flat landscapes and culinary quirks (herring for breakfast, potatoes for lunch and dinner), what they really have in common is their tragic recent history.

For each Baltic state, Soviet rule effectively brought a cultural revolution. National elites were murdered or exiled. Hundreds of thousands were deported, executed, or starved to death. Collectivization destroyed the peasant farms that had been the backbone of Baltic economies and societies. Finally came the suffocation of national identity through mass immigration of Russian-speakers from other parts of the Soviet Union and the purging of books that might portray the era of Baltic independence in favorable terms. Estonia’s leading novelist, the late Jaan Kross, remembered watching books from his country’s main university library destroyed by an ax-wielding apparatchik.

What particularly aroused Russian ire (and still does) was that after the 1940-1941 Soviet occupation, Estonians and Latvians did not see the prospect of another one as "liberation." Indeed, from 1944 onward, many Baltic citizens fought hard against Soviet forces, even shoulder to shoulder with the Nazis at times. The bad blood still lingers, as seen two years ago when Estonia (or eSStonia, as Russian propagandists still call it) decided to relocate a Soviet war memorial from the center of Tallinn to a military cemetery on the outskirts of town. For Russians, the bronze statue was "Alyosha the Liberator”; for Estonians, it was "The Unknown Rapist." The result was a fierce diplomatic spat, the besieging of the Estonian Embassy in Moscow, and a mammoth cyberattack that briefly disrupted public services.

The bleakness of life inside the Baltic states during the occupation era was matched by overseas apathy, even hostility, toward their fate. Britain handed over to the Kremlin the Baltic gold reserves, which had been entrusted to the Bank of England for safekeeping. Dusty embassies in Washington and elsewhere maintained the vestiges of legal existence, and a dwindling band of elderly Baltic diplomats would gather for occasional meetings at the U.S. State Department, where their flags still hung in the lobby. It was a good way to annoy the Kremlin, but the cause of Baltic independence was all but dead. Those who persisted in raising it were seen as eccentric, out of touch, and irrelevant. Czeslaw Milosz, the Polish émigré poet and Nobel Prize winner, wrote in his seminal work on totalitarianism, The Captive Mind, that he could not stop thinking about the Baltic states, which he described as being "boiled down" in a pot with a "tightly closed lid." But he also said that others regarded his preoccupation as the epitome of futility: It would waste his life and awake the "wrath of Zeus."

After regaining independence in the early 1990s, the Baltic countries could easily have turned out like Moldova: semifailed states on Europe’s periphery, corrupt, geopolitically hamstrung, and surviving on remittances. Their foreign trade was entirely tied to the collapsed Soviet economy. They had no independent institutions and no civil servants capable of running a modern state. Their politicians were a mix of wily but untrustworthy Soviet holdovers, unworldly professors (Lithuania’s first post-Soviet president, Vytautas Landsbergis, was a musicologist), and inexperienced youngsters (Juri Luik, Estonia’s representative to nato, entered high office at 26). All the while, the kgb used its cash, connections, and intimate knowledge of "the lives of others" to preserve and expand its influence—a task made easier by the unsolved question of how to deal with the hundreds of thousands of Soviet-era migrants and their descendants.

That combination of problems meant that few saw the Baltic states as future members of serious Western clubs. They were too flaky for the European Union, too geopolitically sensitive for nato, and too poor for the oecd. And many in the West told them so. As the Cold War wound down, Baltic leaders aspiring to independence received not warm words of encouragement from the West, but rebukes. Why were they so impatient? Why were they impeding Soviet leader Mikhail Gorbachev’s reforms with their hard-line nationalism? A Finnish official even told me once that Estonian independence would be an economic and political disaster that would prove a "catastrophe”—for Finland! Such points went down badly in the Baltics, and not surprisingly. It was akin to telling a prisoner to consider his captors’ feelings, rather than trying to escape.

So how did the Baltic countries do it, succeeding so brilliantly and so quickly? Part of it was luck: Russia was weak, and its potential for mischief was initially quite limited. In addition, the Baltic diasporas provided a serendipitous assortment of unlikely leaders. Lithuania’s president, Valdas Adamkus, spent most of his life as a civil servant in the U.S. Environmental Protection Agency. His Estonian counterpart, Toomas Hendrik Ilves, was raised in the United States and educated at Columbia University. Former Latvian President Vaira Vike-Freiberga spent most of her life in Canada as a psychology professor. Hundreds of lesser-known others in the 1990s helped rebuild everything from the diplomatic service to business.

But the biggest reason for the success of the Baltic states was good policymaking, usually introduced first in Estonia and then copied by the other two. In barely two years, from 1992 to 1994, the radical reforming Estonian government of Mart Laar introduced a flat tax, privatized most national industry in transparent public tenders, abolished tariffs and subsidies, stabilized the economy, balanced the budget, and perhaps most crucially, restored the prewar kroon and pegged it to the rock-solid deutsche mark. As a result, Estonia became one of the most open and transparent economies in Europe, and with growth came political stability: Russian troops left the Baltic region by 1994, fears of Balkan-style ethnic conflicts receded, and Soviet noncitizens in Estonia and Latvia began to assimilate.

Competitive advantage began to emerge. The first business to boom was transit. Then, though the Baltic states had practically no indigenous metallurgical industry, they became major players in the metals trade. Next came manufacturing, thanks to outsourcing from old Europe. Foreign investment poured in, and with it technology and know-how. Productivity soared, and tourism took off, as foreigners discovered the chocolate-box charms of Tallinn, the vistas of Jugendstil buildings in Riga, and the baroque splendors of Vilnius.

Estonia did particularly well. High-tech companies set up there and became some of the country’s largest employers. Estonian geeks in 2002 invented Skype, a peer-to-peer Internet telephony software that now has more than 400 million users worldwide. The state also pioneered "e-government," the idea of putting public administration online. At a time when these innovations were unheard of elsewhere in Europe, Estonians could file their taxes on the Internet, vote electronically, and even watch a live Webcast of their prime minister’s official waiting room. Visitors the world over came to study the Estonian model of flat taxes, lean government, and rapid innovation, which inspired no little envy among Lithuanians and Latvians, not to mention resentment from the Russians next door.

As the new millennium dawned, Atlantis was back in business, free and democratic. But it was not secure. That seemed to change in 2004, when after frustrating false starts and Western foot-dragging the Baltic states gained membership in the European Union and nato. The change was partly nominal. The states passed huge lumps of eu regulation into law, often with only cursory scrutiny of their implementation. nato, for its part, fudged the question of whether it would really be willing to defend its new Baltic frontiers against Russia. The alliance’s presence to this day in the Baltic states consists of a small squadron of fighter planes, provided by other countries on a rotating basis.

Still, the Baltic states seemed set for their happiest period ever. They were useful allies, the epitome of post-communist success, and an integral part of the Euro-atlantic world. They were secure and prosperous as never before. And they had begun to lose the "ex-Soviet" label; that was for basket cases like Georgia and Ukraine.


It took the collapse of the Latvian government in February, amid fevered speculation about devaluation and political unrest, to bring the Baltic states’ problems to the world’s attention. Signs of trouble had been visible much earlier, however. For those who knew the countries well, the sense of hubris in the years of the post-2004 boom was almost stifling. Growth in Latvia, for example, was an unsustainable, debt-fueled 11.9 percent in 2006 and 10.2 percent in 2007. Current account deficits—a good sign of how far beyond its means a country is living—soared too, reaching nearly 25 percent of gdp. That made all three countries completely dependent on outsiders’ willingness to keep lending them money. As upsets elsewhere in Europe from Iceland to Ireland have proved, the trouble with this model is that borrowing money is easy when you don’t need it, but difficult when you do. In past years, the inflows inflated the bubble. Now, national survival depends on the willingness of Swedish taxpayers to guarantee banks that so unwisely overextended themselves.

The boom years in the Baltics—as in so many other fast-growing emerging markets—turned out to have been wasted. Instead of firmly applying the brakes, running large budget surpluses, tightening control of the banking system, and taking urgent action to preserve competitiveness, politicians harvested the proceeds and ignored the risks, thinking that the growth was the result of their own good decisions. Calls for caution were brushed aside. Rather, the impulse was, as Latvian tycoon-turned-politician Ainars Slesers put it, to "put the pedal on the metal."

The detrimental effects of this mentality were clear. A tight labor market sent standards in service industries plunging. At the region’s premier security thinkfest, the Lennart Meri Conference in Estonia in 2007, startled delegates turned up for breakfast on Sunday morning at Tallinn’s Radisson hotel to find that nothing was on offer. The staff simply hadn’t turned up; the manager shrugged, "Who wants to work on a Sunday morning?" Foreign tourism operators began complaining. Once a bargain destination for those seeking a quick break, the Baltic states became pricey before they became good.

The smugness not only fueled the boom, but it allowed for the dodging of decisions on issues ranging from corruption and cronyism in politics to structural economic problems. In Latvia and Lithuania particularly, politics stank. Lithuanian President Rolandas Paksas was forced out of office in 2004 amid allegations of extortion and links with Russian organized crime. Another high-ranking Lithuanian politician, Viktor Uspaskich, fled to Russia when his bookkeeper turned over evidence to the authorities of serious breaches of party finance laws. Latvia was run by a bunch of party bosses with strong business ties, irreverently dubbed the "Politburo." On repeated occasions they tried to fire the heads of autonomous public bodies, such as the chief of the anticorruption authority, who had come dangerously close to uncovering how the country was run behind the scenes.

The first clear sign of trouble came when the one big bank in the region not owned by a foreign parent, Latvia’s Parex Bank, got into difficulties in mid-2008. Parex had always been a questionable success story. In the late 1990s the bank used to advertise on Russian television with a spot showing a $1 bill and the slogan "We are closer than America." The clear implication was that Parex was a convenient means for rich Russians to get their money out of the country. Parex strongly denies that it ever broke any Latvian law, and it has never been prosecuted. However, the bank has come under intense scrutiny from international officials seeking to combat money laundering.

Parex’s weakness was that its depositors were mainly offshore and highly mobile, while its lending had mostly been to construction projects inside Latvia, many of which soured simultaneously. After depositors withdrew nearly $430 million in the course of six weeks, the bank was nationalized in November for the token price of a couple of dollars. It also received a bailout in excess of $380 million from the Latvian state and the European Bank for Reconstruction and Development.

The incident dented Latvia’s reputation hugely. The country’s institutions had so far done an impressive job in seeming to insulate the running of the country from the political shenanigans of the elite. Now they had failed glaringly to supervise the country’s best-known financial business, with near-catastrophic consequences. Latvia’s financial weakness suddenly revealed the hollowness of past success.

The crisis has not spared Estonia and Lithuania either. A vivid illustration of that is the loss of air links with the outside world. Flying direct to Tallinn or Vilnius from main European destinations has become difficult or outright impossible. Estonia’s national carrier, Estonian Air, has cut back its routes sharply. Lithuania’s FlyLAL went bust amid an acrimonious dispute with the owner of the Vilnius airport, endangering the country’s role as the intellectual and diplomatic hub of the Baltic. Also at risk is Lithuania’s cherished prize—its yearlong celebration of the selection of Vilnius as the "European Capital of Culture" for 2009. Faced with a time-consuming and costly stopover in Copenhagen, Helsinki, or Frankfurt, many potential visitors may simply decide to stay away. Once again, the Baltic states feel they are fading from the map.

The three countries face this round of economic hardship with many important policy levers out of reach. The obvious step would be to devalue their currencies, but because they are guarded by the banks, that move would shake each country to its foundations while also bankrupting the many households and firms that have loans in euros and Swiss francs. The Baltic states have no room to relax monetary policy. Nor can they use fiscal policy to ease the pain—borrowing money to boost state spending—because all three countries are trying to meet the euro area’s 3 percent budget deficit criterion.

Instead, the Baltic states are pushing through an "internal devaluation," cutting wages and pruning bureaucracy in the hope that these measures will boost their exports and attract renewed foreign investment. The sole cushion is money from the European Union and other international lenders. It could work. The three Baltic economies have already shown that they can turn on a dime. They did this in 1991 under far harder conditions and again in 1998, after the Russian financial crisis. Still, these austerity measures require extraordinary patience and a high tolerance for pain among voters who will see their living standards plunge for the next two years. It also requires Swedish and other foreign banks to stay the course on their bad loans, even as they will lose money hand over fist.

The big hope is that the crisis will prompt the reforms that Baltic politicians so smugly skipped during the boom years. It is a scandal, for example, that higher education in all three countries is so second-rate. At least one of their universities should have turned itself into a strong competitor for students and faculty frustrated with the lumbering state-run universities of old Europe. Health, transportation, local government, and criminal justice still retain striking levels of Soviet-style producer power, corruption, and inefficiency. Progress on these fronts would not just reassure voters that the state was doing its job properly—it would also encourage external lenders, such as the European Union, to help keep the Baltic states afloat. If none of this happens, though, the water level will just keep going up.

The Baltic states’ current fate epitomizes the wider story in Eastern Europe, of half-baked reforms pursued with more enthusiasm than judgment. Looking back on the 20 years since the Berlin Wall fell, it is clear that the economic difficulties facing the former captive nations were overestimated. Solidarity leader Lech Walesa once said that turning a capitalist economy into a communist one was as easy as turning an aquarium into fish soup. The difficulty was reversing the process. In fact, creating a thriving capitalist system on the ruins of a planned economy has proved the easier part. The difficulty has been in building strong institutions with the political supervision necessary for them to stay healthy.

A prime example is the currency regimes: To create credibility, all three countries adopted strictly fixed exchange rates. These gained totemic significance: The central banks that administer the currency pegs to the euro are the most trusted institutions in each country. Yet by 2004, it would have been far better to have the exchange rates more flexible. A revaluation in the boom years would have cooled overheating; a devaluation now would stave off hypothermia.

The big question today is whether the Baltic states’ extraordinary flexibility and determination will allow them to recover as quickly as they toppled. The danger is twofold. One is that the critical mass of patriotism and solidarity that helped them overcome past difficulties has dissipated. The most able people have another choice now: They can leave. Of my most impressive Baltic friends, one is married to a Dutch diplomat and lives in Asia; several have jobs in the comfortable bureaucracies of the European Union or nato. A sprinkling work in London or for multinational companies. When they see the mess back home, they are torn: Should they abandon their careers and return, or stay on the comfortable sidelines? The members of the Baltic diaspora, "who in their freedom had no homeland," had spent half a century waiting for the chance to help their cousins, "who in their homeland had no freedom," as the old toast goes. But it’s unclear whether that romantic history will repeat itself. Undoing the consequences of foreign occupation was a lot more glamorous than unraveling the consequences of a property boom or haggling about swap arrangements with other central banks.

Second, the Baltic states’ future is not just in their own hands. The economic crisis coincides with the rise of a resurgent, revanchist Russia and its alliances with a divided and demoralized Europe. The most threatening prospect for Estonians, Latvians, and Lithuanians is the "Schroederization" of German foreign policy—derived from former Chancellor Gerhard Schroeder, whose conspicuous friendship with Russian leader Vladimir Putin while in office morphed into the chairmanship of a controversial Russian-German gas pipeline consortium within months of his stepping down. The Baltic states feel squeezed. Who will defend their economic and political interests when big countries once again make decisions over their heads?

Those fears are a little overblown for now. Poland and Sweden are two European heavyweights determined to prevent a Russian-German axis from developing further. Russia’s own economic problems have somewhat lessened its bilious outpourings against the Baltic states. Yet the danger remains. As unemployment rises and social strains increase, the risk of local Russian-speakers feeling victimized—or the indigenous populations blaming them—also increases. Russia has said on repeated occasions that it reserves the right to intervene, even militarily, to defend the (unspecified) interests of its "compatriots" elsewhere in the former Soviet Union. After the 2008 conflict in Georgia, few can doubt their resolve to do so. Russia is also passing a law that will make illegal any attempt to equate Hitler and Stalin, which will criminalize the Baltic states’ own version of their history.

Russia can exert other kinds of leverage, too. Lithuania will be almost totally dependent on Russian gas, for example, when it has to close its nuclear power station at Ignalina at the end of the year. Latvia’s lucrative east-west transit trade is one of the few bits of the economy that is still thriving. This creates potential for political pressure. Until the Baltic states have developed not only their economies but also their political institutions fully to Nordic levels, and completed their reintegration into the Western world, they will not be completely secure. And at present, the combination of a nationalist Russia and an economic downturn is alarming.

"We needed another 10 years," says Asta, one of my oldest Lithuanian friends. She’s right. Atlantis rose from the depths. But the sea walls are still too low. And now the water is rising again.

Want to Know More?

  • Edward Lucas’s book The New Cold War: Putin’s Russia and the Threat to the West (New York: Palgrave Macmillan, 2008) offers an in-depth look at the Baltics’ neighbor and former colonizer to the East. Lucas also blogs about the region at

  • For a comprehensive history of the Baltic States from ancient times through the last century, read Anatol Lieven’s The Baltic Revolution (New Haven: Yale University Press, 1993). The Baltic States: Years of Independence: Estonia, Latvia, Lithuania, 1917-1940 (Georg von Rauch, New York: St. Martin’s Press, 1995) and The Baltic States: Years of Dependence, 1940-1990 (Romuald Misiunas and Rein Taagepera, Berkeley: University of California Press, 1993) together provide an integrated picture of Latvia, Lithuania, and Estonia’s survival through years of Russian colonialism, language discrimination, and nationalist struggles.

  • For a literary depiction of the region, William Palmer’s The Good Republic (London: Secker & Warburg, 1990) vividly captures the journey of a Baltic emigrant returning with soon-shattered innocence to his homeland. The Captive Mind, by Czeslaw Milosz, poses moral dilemmas from the lives of those living under totalitarian regimes.

Edward Lucas is a nonresident fellow at the Center for European Policy Analysis, a Liberal Democratic candidate for the British Parliament, a former senior editor at The Economist, and the author, most recently, of Cyberphobia: Identity, Trust, Security and the Internet. Twitter: @edwardlucas

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