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Cool sights from the North

By Rok SPRUK


I recently noted an article entitled 15 things Estonia has given to the world since 1991. Some will probably remember ninja girls (Vanilla Ninja), a music group of sparkling girls who built a tremendous international success and golden beauty Carmen Kass, who was a candidate for the EU parliament. When someone mentions Estonia in discussing the international economic monitor, a couple of things come to the mind of the economist. Rapid economic success, the fastest economic growth in Europe, single flat tax rate on individual and corporate income, the most advanced and the fastest growing technology sector in the EU, open and non-regulated business environment are a couple of the foremost things that come to my mind. There is indeed one very important thing that Estonia has given to the world since 1991. When Mart Laar was at the conference in Ljubljana, he told politicians the simplest strategy on implementing a flat tax – “don’t be afraid, you can do it.”

Estonia pioneered the flat tax revolution through free-market reforms and credible enhancement policies. Private property rights were championed through the privatizing more than 90 percent of all public enterprises. At the turmoil of gaining independence, the economy was in a severe depression. Inflation peaked at 1000 percent, the unemployment was very high and there was a leaped 92 percent trade dependency on Russia. In the book “Estonia, a little country that could” issued by Center for Research in Post-Communist Economies, a center guided by Dr. Ljubo Sirc, Mart Laar, the first prime minister of Estonia after the independence, realistically described the economic devastation in 1991 marred by harshly bankrupted economy. He says:

“I was sitting in the office and watching through the window. Although the weather forecast was bad, I still hoped that the snowfall wouldn’t come. There was actually no money to clean the roads.”




Far-reaching structural reforms, implemented under the leadership of Mart Laar, have created a well-functioning and highly integrated market economy. Labor and product markets are under low regulation pressure. An important aspect of the economic success is presented by a well-sounded banking sector where banking institutions enjoy a high degree of international reputation. Prudent macroeconomic policies pursued price stability and relatively low inflation. The outcome of successful policies has been an impressive productivity growth and a large foreign investment penetration. In 2005, the GDP growth rose above 10 percent, furthermore showing the how prudently managed macroeconomic reforms galvanized the economy. Successfully restructured enterprises have continually shown high output rate resulted from cutting-edge productivity growth rates. The residual effect of propulsive net investment reflects adjusted growth wage rates. Enterprise sector has substantially benefited from tranquil price stability embodied by a low inflation rate. The latter has been moderate for a fast-converging economy. Though much of the stabilization policy has been successfully achieved, the inflation rate still remains above the Maastricht criteria. Post-Keynesian critics say that this is a clear sign that free-market oriented economic reforms have been so badly chosen option while the truth is quite the opposite. Given pegging the Estonian currency (Eesti krona) to euro, the effects of convergence have normally kept the inflation rate above the Maastricht criteria. The reason why inflation expectation have been so sensitive to targeting the Maastricht range is that the economy’s high energy intensity exposes it to oil and fuel price increases. The impulse is not warning and it does not pose any significant risk while the foremost source of the inflation rate above the required pace, has been laid in non-tradable sector. In economic theory, the so-called Ballasa-Samuelson effect sets an empirically coherent explanation based on two very much related things: (1) the Penn effect which states that consumer price levels in wealthier countries are systematically higher than in poorer ones. This converges into (2) an economic model based upon the assumption that productivity growth rates vary more in traded goods sectors than in other sectors.





In transition economies, the convergence speed sometimes creates the risk of overheating, the outcome of which is seen in higher inflation rates. In the future, it expected that non-tradable sectors will sustain a moderate rate of convergence so a strong commitment of the central bank to targeting inflation is needed to lower the inflation and keep it at a target range so that the performance of the financial sector will not suffer in case that monetary stability is in a risky position. It is thus crucially eligible for the central bank to follow the rules rather than discretion as Nobel laureates Fynn Kydland and Edward J. Prescott have identified the inflationary bias that results when a central bank does not precommit to a monetary policy rule. Liberalized credit sector has strongly supported economic growth through the penetration of competitive Nordic banking groups in the Estonian market where intense competition for the market shares has dropped the interest rates to levels similar to those Nordic countries. Due to lower fuel prices, inflation should slow in 2007 and 2008. It is admirable that economic policymakers have not pursued expansionary fiscal policy which could result in greater inflation pressures and increasing public debt. The Euro integration is likely to be a key objective for Estonia. Sustained economic performance, non-troubled budget pressures and a moderate level of external public debt are the most obviously identified indicators and stability signs that could result in the Euro adoption. Thus, balance sheet risk that comes from a separated currency will be eliminated and thus the degree of integrated openness of business sector to access the foreign and neighboring markets will greatly increase as well as the quality access to other foreign markets via stable and non-pegged exchange rate when the Euro is adopted. Without a strong commitment of the central bank to inflation targeting and minimizing internally controllable risks, the Euro integration could be postponed further while this could send unpredicted wave responses to uncommitted central bank policy in a small and open economy such as Estonian.

Another thing that Estonia has given to the world in the last 16 years since 1991 is a high degree of economic freedom that correlates with other freedoms as well. The State of World Liberty shows that Estonia is the freest country in the world. The degree of economic freedom has been constantly impressive as reported by Heritage Index of Economic Freedom. An incredible metamorphosis from Soviet-styled into free-market economy created one of the most dynamic and modern economies. As judiciary is independent and insulated from government influence, property rights have been soundly championed through privatization introduced free trade by abolishing tariffs and quotas and pursued tax competition via instituting the flat tax. Lending to public sector from the central bank has been abolished and thus, public debt has not posed further macroeconomic risk. Financial freedom has been exercised through the private ownership only. Government of Estonia owns no stake at any bank. Fiscal freedom, unrepressed regulation and comparably low level of government intervention have supported the freedom to invest. All in all, policymakers, editors and experts have questioned themselves how Estonia achieved such a great economic success in such a short time. Mart Laar, the recipient of the Milton Friedman Prize for Advancing Liberty at Cato Institute probably gives the best answer to the question what has he learned from freedom and growth:



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Rok SPRUK is a supply-side economist and a classical liberal. He currently lives in Slovenia where he studies economics. His fields of research are economic growth, macroeconomics, monetary economics, international economics, tax policy and international competitiveness. His articles, observations, views and ideas are posted on his blog Capitalism & Freedom



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