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Austerity, Krugman and Estonia

    In this extended blog post, CPS Head of Economic Research Ryan Bourne examines the facts behind the ongoing debate between Paul Krugman and the President of Estonia Toomas Hendrik Ilves.

    A few weeks ago CPS board member Jon Moulton appeared on Newsnight alongside Paul Krugman to discuss the UK government’s austerity measures. Towards the end of the conversation, Moulton challenged Krugman’s claim that austerity had not worked anywhere by highlighting the example of Estonia, which has been growing strongly in recent years.

    This seems to have planted the seed for an online row that has since developed. Krugman wrote a very short blog for the NY Times entitled ‘Estonian Rhapsody’ in which he posted the chart below:


     Estonian Output 1


    Krugman used this chart to claim that austerity policies in Estonia had failed. He said:

    “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?”

    The blog drew an angry response from Estonian President Toomas Hendrik Ilves, who 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". Must be a Princeton vs Columbia thing.”

    When you consider the context, it’s unsurprising the Estonian President is angry. Krugman merely plotted a raw real GDP line starting arbitrarily at the height of the boom to the present day. It’s a fine example of how statistics can be selected (in this case by pegging the start date at the top of the debt-driven bubble) to prove your point.

    Looking at the longer-term gives a very different picture:


    Estonian output 2


    This shows that Estonia was growing extremely quickly between 1999 and 2007, and though the contraction between 2007 and 2009 was large, the economy has at least been making good ground in recovering.

    On the 1st July, Krugman did a second blog entitled 'Defining Success Down in the Baltics' in which he looked at Baltic unemployment. Again, he arbitrarily started the chart at 2007 and suggested that unemployment had nowhere near recovered to pre-crisis levels. Again, Ilves was unimpressed:

    “Thought for the day...People who for political reasons cherry-pick data have axes to grind. X and Y axes;-)”

    Rest assured this is not the last we have heard of these two. But given Krugman’s influence in public debate, it’s worth examining what really happened in Estonia, and making a more dispassionate judgement about whether it can be discussed as an example of successful austerity.

    Estonia’s recent economic story

    As a starting point it’s clear Krugman’s story is too simplistic. Gauging whether the Estonian government’s actions were a success or failure depends on how you regard the crisis they were facing. As I’ve written before, the outcomes of any crisis must be judged against the sustainability of the preceding boom.

    It’s well acknowledged that the exceptional growth Estonia enjoyed between 2000 and 2007 was a two-tier phenomenon.  Initially it was driven by the annulled corporate income tax on reinvested profits in 2000. The following years brought FDI and export driven growth, supplemented by EU and NATO entry, which were both fulfilled in 2004. 

    From then on, however, the country’s open capital account, decreased risk profile, and the currency board facilitated substantial capital inflows, leading to credit and real estate booms beyond fundamentals, as seen in many other countries. These huge capital inflows meant substantial current account deficits, and the pass through into loans led to an explosion of private sector debt such that it exceeded 110% of GDP by the end of 2007.

    Just like in other fixed exchange rate countries, Estonia saw substantial inflation (averaging annual growth of 4.6% 1999-2008 and as high as 10.6% in 2008), real exchange appreciation and a loss of competitiveness, further amplified by overall real wage growth acceleration during 2004–2007 that stimulated domestic demand and private consumption.

    The boom inevitably started to unravel for Estonia in 2007, when Nordic banks tightened lending conditions due to concerns about increasing debt levels in the Estonian private sector. This led to a significant slowdown in housing loan growth and, subsequently, declining house prices, output and jobs in construction, finance and real estate services. The very industries that had driven the supposed growth of previous years were now being squeezed.

    The domestic slowdown was exacerbated by the international crisis in 2008. Credit tightened still further. Exports collapsed as trading countries contracted. Unemployment rose, and the continued weak outlook led to falling economic confidence and GDP (by 3.7% between 2007 and 2008, and 15.1% in the first quarter of 2009 relative to the same period in 2008).

    Faced with shrinking revenues and an economic crisis, the IMF forecast that Estonia would have a budget deficit of more than 10% of GDP in 2009 on unchanged policies. The Government thus reacted in a similar way to the UK government in the 1930s. With Mr. Jürgen Ligi taking the helm at the Ministry of Finance in June 2009, the government cut spending drastically – explaining that the surging revenue growth during the boom (2000-2007) had resulted in pro-cyclical expenditure based somewhat on illusory growth.

    This decision was at least in part due to the need to remain within the Maastricht criteria for euro entry in 2011 as well as to prevent speculation on a looming devaluation. As such it was the only option for Estonia in a competitiveness sense. Unable to devalue their exchange rate, the only way to eliminate the current account imbalance and improve competitiveness was through internal devaluation (which many argued was preferable anyway, since many of the private debts in Estonia were denominated in euros).

    Between 2008 and 2010, there were large cuts of operational expenditures in the public sector (20% compared to pre-crisis level), a freezing of the state`s share of payments to second pensions in June 2009 (restored fully by the beginning of 2012), reform of the compensation scheme for sick days and a reduction in health insurance costs by 8%, alongside many other tough measures. VAT was increased from 18% to 20%.

    In all 2/3 of the consolidation was done on the expenditure side and 1/3 on the revenue side. But unlike our cuts so far, the scale of the Estonian cuts meant a decline in total nominal spending between 2008 and 2010 of 10%.

    This did, of course, weaken output prospects in the short-term. The combined result of the severe downturn and 8.8% austerity contraction of GDP led to a total fall in output from the peak of the boom of 17.4%.

    The large cuts to public expenditure, on top of the crisis itself, therefore came at a larger short-term price than experienced by other developed countries.  With wages and prices sticky, the large public spending cuts meant unemployment increased much more quickly than in many other European countries from around 8% in early 2009 to 20% in early 2010.

    But since then, unemployment has fallen back to just over 11% today – around the EU average. With the economy projected to grow by another 3.8% in 2013 by Eurostat, we would expect to see this fall further in the future (though likely constrained by the continued Eurozone crisis).


    Estonian unemployment


    Part of the reason for this robust employment recovery has been the fall in real wages. But many Central and Eastern European countries have also undertaken significant supply-side reforms in the wake of the crisis. Reforms across the region have made it simpler to start businesses, resolve insolvency and enforce contracts. And due to the sound nature of the public finances and the economic liberalisation that the economy has extended, most international bodies consider Estonia well-placed for sustainable growth in the future.

    The cuts meant the Estonian government met their deficit target – it never exceeded 3% of GDP and is now back in surplus, and though the economy went through an extremely difficult two years as a result of the crisis, it has since rebounded with 2.8% growth in 2010 and 7.6% growth in 2011. Once the unsustainable boom of 2006 and 2007 is smoothed out, the economy seems to be back on trend. Public debt as a proportion of GDP is just 6%. What’s more, the huge capital account deficits have been quickly reversed, and the internal devaluation was achieved without the deflation that the likes of Krugman feared.


    Unwinding an unsustainable boom is never easy and it would be wrong to attribute the same policy prescriptions to all countries who face very different circumstances. Estonia had enjoyed a bubble period prior to 2007 and the subsequent financial crisis, but unlike many of the other countries in Europe its problem was primarily a current account imbalance rather than a public finance crisis. Nevertheless, the bubble popping threatened huge public deficits.  The private sector excess was not eventually carried over to the public sector and private sector develeraging has been the trend since 2009.

    The Estonian Government chose to take the short-term pain to rebalance quickly. Of course this is anathema to neo-Keynesians like Krugman who saw the rising unemployment and falling output, even in the short-term, as unacceptable. But the truth is Estonia is much better set than many countries today who have added huge debts and used loose monetary policy to try to ease the pain of the adjustment. It has little public debt, a balanced budget, falling unemployment and relatively strong growth prospects. Though the level of output hasn’t yet returned to the peak of the credit-induced bubble, it’s getting there.  A liberal and predictable tax environment will no doubt assist going forward.

    That’s not to say that it doesn’t face economic problems. Of those unemployed in 2011, 57% have been out of work for over year. This is mainly because of the huge rebalancing away from construction and a mismatch of skills for these workers preventing them obtaining new jobs. It’s a problem the government recognises, and can be seen through large increases in manufacturing vacancies.

    Nevertheless, Krugman’s critique of Estonian policy is simplistic and misleading. They shunned the stimulus spending and devaluation he advocates, and four years after the start of the crisis, they are in a similar place to many which took Krugman’s advice (and in a much better place than the PIIGS), but with a rebalanced economy and much better growth prospects. Whilst Krugman is quick to recognise raw effects on output and unemployment, he appears unwilling to examine the significant opportunity costs of the policies he advocates. Estonia provides an example of a country which took the pain, and now looks set to enjoy the gain.  Of course, it’s relatively liberal economy is very different to that of Greece or Spain. But in this case, Krugman’s knee-jerk opposition to the policies adopted seems misguided.



    Aslund, Anders, Lessons from Reforms in Central and Eastern Europe in the Wake of the Global Financial Crisis (2012). Peterson Institute for International Economics Working Paper No. 12-7.

    Brixiova, Z. M. Vartia, A. Wörgötter, Capital flows and the boom–bust cycle: The case of Estonia, Economic Systems, Volume 34, Issue 1, March 2010, Pages 55-72,

    Katterl, R. (2010). Financial and economic crisis in Eastern Europe. Journal of Post Keynesian Economics, 33:1, pp. 41-60

    Escudero, V. and Mourelo, E. L. (2012), Fiscal consolidation and employment growth. World of Work Report, 2012: 59–80.

    Marksoo, Ü., Białasiewicz, L. and U. Best (2010), The Global Economic Crisis and Regional Divides in the European Union: Spatial Patterns of Unemployment in Estonia and Poland.  Eurasian Geography and economics, Vol. 51, No 1, Bellwether Publishing, Ltd., pp. 52–79.

    Brixiova, Z., M. Morgan and A. Wörgötter (2009), “Estonia and Euro Adoption: Small Country Challenges of Joining EMU”, OECD Economics Department Working Papers, No. 728, OECD Publishing.


    Ryan joined the Centre for Policy Studies in January 2011, having previously worked for a year at the economic consultancy firm Frontier Economics.

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    Ülo Ennuste - About 3005 days ago

    Ülo Ennuste. 2012. “Waiting for the Commission Strengthened Governance Coordination Leviathans: Discourse Memo for the Actors in the Macro-Game “European Semester”- Baltic Journal of European Studies“ Vol 2, No 1, 2012 p 139-164 :

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    Anonymous - About 2984 days ago

    Much as I admire your diineglt research and incisive way of analysing problems, I feel that you are missing the underlying causes of the present precarious financial position.Mankind lives by exploiting the world’s resources. Not only are these resources badly depleted but the restrictions and regulations involved makes individual initiative all but impossible. Want earn a living from sea fishing? Just try to get a licence and a quota. Buy a shovel and go digging for coal? – Easier by far to become Chancellor of the Exchequer.The difficulties preventing a man from genuine production were a driving force behind the excessive move into construction, providing plenty of work for individuals and a focal point for capital. Unfortunately decades of debasement of the currency meant that the only capital available was the ‘fresh air’ money of bank loans, the copious quantities of which led to grotesque price levels. With the prices of even modest homes pushed to unaffordable levels something had to give and it has.Don’t ask for simple answers. Clearly a frugal life-style is essential but politically unacceptable.Stable currency. A gold standard would do that, but what chance?Your solution of more stimuli would help but only at the price of further currency debasement. Low interest rates might be helping but only by robbing savers and further impeding capital formation.Abolishing all planning regulations would help in getting men back to work but unthinkable to modern citizens and at the cost of collapsing house prices, which of course is what is needed but unthinkable to the modern mind-set.In the meantime austerity is the better, but dangerous, answer.Our present credit-based system is doomed. Protect your family by buying gold.Apologies for my meandering arguments.Melvyn Lindley

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