Hamish McRae: Estonia is a model of restraint

Economic Life: The Estonian state has virtually no debt at all. I can't think of another non-oil producing nation in this position
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The Independent Online

The eurozone looks different from the other side. Greece is clinging on at least for the time being, thanks to the now explicit support from the rest of Europe and the International Monetary Fund. But the fact that its continued membership is in question in the medium-term, and the disadvantages of not being able to devalue when recession strikes, have raised huge questions about the long-term prospects for the euro. Is this a club you would really want to join?

Well, yes, if you are Estonia. It looks very much as though Estonia will be the next country to adopt the euro, with the real possibility that this may happen as soon as 1 January next year. Estonia's experience has been quite the opposite of Greece's and is a good example of how the discipline of a steady exchange rate can bring long-term economic benefits, albeit at the cost of short-term pain. For Greece and Estonia are almost mirror images of each other when it comes to economic policy. Although Greece is a member of the eurozone, it has so far, at least, failed to accept the fiscal discipline that the zone is supposed to require. By contrast, while Estonia is not yet a member, it has had a more rigorous fiscal policy than just about any other democratic nation in Europe or anywhere else.

To take some very simple facts, Greece's fiscal deficit is around 12 per cent of its gross domestic product (GDP); Estonia's deficit is 2 per cent of GDP. Greece's total public debt is approaching 120 per cent of GDP; in Estonia it has risen as a result of the recession, but is – wait for it – close to 10 per cent of GDP. Yes, Estonia's total debt is less than the amount Greece (or, for that matter, Britain) is adding to its debt this year. In effect, the Estonian state has virtually no debt at all. I cannot think of any other non-oil producing nation with a government in such a position. Of course, there is debt in the country. People have mortgages and companies have debts, so it would be wrong to think of the country having no debt overhang. It is simply that the government does not.

This did not happen by magic; it was the result of years of self-discipline and a simple, flat tax system. Estonia chose to be fiscally conservative when the group of young and charismatic leaders took charge after it gained independence from the Soviet Union in 1991. One of the associated policies was a fixed exchange rate, now fixed to the euro, so what you can see is a country that has behaved as though it were in the eurozone for much of its life.

The policy has had its costs. Estonia did not have a property boom and bust on the scale of the Republic of Ireland. Its job market has been savaged by recession and, as a result, unemployment is close to 14 per cent. Much of its service exports were associated with the high-tech industries of Scandinavia – the main foreign investors here are from Finland and Sweden – and these were particularly hard hit. Last year, Estonia's GDP shrank by nearly 14 per cent, about the sharpest decline of any developed country – worse even than Ireland and a real contrast with the much smaller decline in Greece and the continued growth in the most successful of the more recent EU entrants, Poland.

You see the key point here. Discipline creates harsh outcomes. In a boom it means holding back domestic consumption, as Germany did right through the past decade, and in a slump it means putting many people on to the dole. In the case of both Estonia and Ireland, it has meant a loss of four or five years of real output growth. The countries are, so to speak, back to where they were in about 2005 or 2006. That raises the obvious question: does fiscal discipline carry too high a price?

There is one simple answer to this, which is that there may be no alternative. In the case of Greece, policy changes are being forced upon it. But the pressure valve of devaluation can allow countries a bit more time to make the adjustment and may make it easier to do so.

There is another answer, which is that how a society reacts to economic misfortune depends on a number of non-economic factors, at the head of which comes the sense of social cohesion and trust in government. Some countries have these qualities, while others don't. I suppose within Europe you would put Scandinavia at the top of the list (with Estonia behaving in a very Nordic way) and the Club Med countries at the bottom. I am told, and it is hard to pin this down, that economic misfortune has had a cohesive impact on Estonians. Despite the surge in unemployment, there have been no demonstrations in the streets.

Nor does there seem to be the distrust in government that we have managed to generate in Britain. The most famous example of this has been the rolling-out of a string of services by smart card. This is a government-issued identity card, with which citizens can do everything from paying their taxes (easier if you have a flat-tax system and a rate of only 21 per cent), or using it to transfer money from bank account to bank account, to accessing your medical records and voting in the next election.

All this we might regard as snooping – witness the resistance to ID cards in the UK. But then we don't trust our politicians nor many of the officials. If you trust the government and see it as a service provider, then using an ID card to make it simpler to get those services makes sense.

So the issue of fiscal discipline is not just one of accounting mathematics. It goes to the very core of society. Discipline can be imposed in a number of ways, and having your currency run out of Frankfurt is one of them. If you control your own currency you have to find other methods, as Britain will have to do after the election. But it is much easier to accept fiscal discipline if you have a culture that supports the government even when it has to make tough choices.

Apply this to the future of the eurozone. We have learnt a lot in the past few months. We have learnt that leaving the zone is no longer almost unthinkable. We have learnt there are some natural members who can easily fit in and there are some that are less naturally clubbable. We have learnt that the ultimate discipline on member countries does not stem from the fines and other penalties embodied in the Maastricht Treaty, but from the financial markets.

Greece did not have to change its policies because the EU required it to do so; it did so because it couldn't borrow the money to finance its deficit. And we have learnt that, just as there are some potentially disruptive club members, and I am afraid Greece is not the only one of those, this is a club which it still attractive to new entrants, of which Estonia is next in the queue – and there are more in line behind her.