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Proximity to Europe Hurting Baltic States in Crisis

Ben Slay and Michaela Pospisilova | CSER | September 2009

According to established financial and economic theories, the three "Baltic tigers" were the ones who got everything right, prior to the international financial crisis. Estonia, Latvia, and Lithuania kept their state sectors small, promoted privatization, and pegged their currencies to the Euro. They reformed their tax and social security and joined the European Union in 2004. Their overall goal was to render the capital-starved Baltic financial markets attractive to foreign investment. Nevertheless, the financial crisis hit all three Baltic States with particular ferocity.

A look at GDP growth rates illustrates how severely the three "Baltic tigers" were impacted by the global financial upheaval. In 2007, Latvia recorded 10% GDP growth. By 2009 that number dropped to minus 12%. Lithuania and Estonia fared no better: In 2007, Lithuania had 8% GDP growth, which plummeted to minus 10% by 2009. Estonia's rate stood at 6.3% in 2007 and fell to minus 10% by 2009. These figures make the rapid "Europeanization" of the Baltic markets appear to have been of questionable virtue. After all, these efforts led to an enormous increase in foreign debt in the private sector. The large current account deficits were financed by subsidiaries of western banks in the Baltic States, primarily from Scandinavian countries. The Baltic financial markets soon became a target for "hot money", since exchange-rate risks were minimized by the Euro peg. The currency boards precluded appropriate measures to be taken by national governments to prevent a further deterioration of their competitiveness internationally. The predicament of the Baltic States proved the potential drawbacks of surrendering local competences to supranational institutions. Had countries like Turkey, Serbia, or Armenia been as integrated into European financial institutions as the Balts were, they might not have been in a position to conduct as successful a devaluation of their currencies as they recently did.

The rapid "Europeanization" of transition economies is no cure-all for their economic and financial woes. In spite of everything, it is not entirely clear - even in retrospect - that policies based on alternative theoretical approaches would have helped the Baltic States avoid the crash. In any event, the international financial crisis and the dilemma of the Balts, who strove to do everything right and still ended up in a lot of trouble, will provide theoreticians with food for thought for many years to come.

This summary was prepared by the Atlantic Community editorial team from "The Baltic Conundrum" published here by the Center for Social and Economic Research.