The Baltic Bubble

Edward Lucas ("The Fall and Rise and Fall Again of the Baltic States," July/August 2009) accurately describes the current condition of the Baltic economies, but misses one of the primary underlying causes. As I read his article, I am reminded of the old adage — you can see evidence for Eastern Europe’s demographic crisis everywhere, except in the work of Economist staff writers.

As I write these lines, I have before me an article from the Estonian newspaper Aripaev, which informs its readers that Estonian nurses, doctors, and other health workers are being actively recruited by health systems in Spain and Britain. With unemployment in Estonia running at 70,000 and rising, applicants will not be hard to find.

As Lucas notes, the Baltic economies started to rapidly overheat after 2005 due to the "tight labor market." But what he misses is that the labor market was tight for essentially demographic reasons. The slump in fertility and the bleeding emigration that followed the fall of the Berlin Wall have cast a long shadow. It is remarkable how the Baltics’ drop in the output of children tracks almost symmetrically its drop in industrial output — but with a nine-month lag.

To paraphrase World Bank President Robert Zoellick, 20 years after the fall of the Berlin Wall, it would be a tragedy if all that magnificent potential so ably described by Lucas were to be flushed down the plug hole of history by ill-informed and shortsighted policies that fail to address the real problems.

Edward Hugh
Economist
Barcelona, Spain

As a longtime admirer of Edward Lucas, I was glad to see his analysis of the economic dislocation in the Baltic states. His personal knowledge and longtime interest in the region make him irreplaceable. So it is with some trepidation that I offer a slightly more optimistic assessment.

My optimism is not based on a specific factual disagreement, but rather a big-picture perspective. It is certainly true that the Balts are getting hit hard by collapsing bubbles and a global downturn (and an unfriendly Russia adds uncertainty to the mix). But there is a silver lining to this dark cloud. Estonia, Latvia, and Lithuania are getting hit hard in part because they rose so fast. When the dust settles, it is quite likely that they will still have better track records — measured by both per capita GDP and average growth rates — than most other post-communist countries.

Estonia is especially well-positioned to weather the storm and bounce back. It is steadfast in maintaining its pro-growth flat tax (politicians in Latvia and Lithuania are threatening to impose discriminatory "progressive" tax schemes). Equally important, the government is finally imposing some discipline on government spending — making up for some profligacy that occurred when there was a geyser of tax revenue during the boom years.

According to the Fraser Institute’s "Economic Freedom of the World" report, Estonia is the world’s 11th-freest economy. Lithuania and Latvia have decent rankings, 31st and 40th respectively, but Estonia’s deeper commitment to sound money, competitive markets, and limited government will yield dividends.

If only the United States — which is pinning its hopes on the toxic combination of easy money and Keynesian profligacy — would show similar foresight.

Daniel J. Mitchell
Senior Fellow
Cato Institute
Washington, D.C.

Edward Lucas replies:

I have never heard the "old adage" quoted by Edward Hugh except on his own (excellent) blog.

I agree with him that the demographic outlook in the Baltic states is poor, but I would not ascribe quite so much importance to it. The shortage is not so much of people but of good jobs and decent public services. Tens of thousands of people — particularly from Latvia and Lithuania — also went abroad during the boom years when wages were rocketing. This was not for financial reasons, but because of factors such as unpleasant workplace relations, a culture of low-level bribery, and demeaning treatment by public officials.

It is also worth noting that Estonia’s generous natalist benefit programs have had some positive effect on its birthrate.

I share Daniel Mitchell’s long-term optimism. However, it does Estonia no favors to treat it as an unblemished paragon of free market principles. This view ignores the botched privatization and renationalization of the railways, corrupt and incompetent local government, and a failure to maintain momentum in innovation (especially in higher education) that emerged during the boom years.

Economic liberalism alone is valuable but not enough. Post-communist countries must also concentrate on establishing the rule of law and strong, honest, effective institutions.