Estonia and the Euro – hiring a speedboat to get on the Titanic?

Twitter is an interesting medium indeed. After the European Commission announced that Estonia will be joining the Euro in 2011, my spontaneous thought was: “Or dear, do we now get PIEEGS?” I did not hesitate to tweet this. What I did not know was that one of my followers was, well, Estonian.

And she was not amused: “Worry about PIGSUK, not us,” Karoli Hindriks replied from Tallinn. Since Karoli retweeted me, I got some more caustic responses from Estonia. “Check out Estonia’s public sector debt/GDP and then be somewhat ashamed of your statement,” I was advised by Peeter Koo

That’s  what I did today. After screening the latest Convergence Reports published by the European Central Bank (ECB) and the European Commission (EC) as well as the latest IMF Article IV Consultation, embarrassingly, I have to concede that Karoli and Peeter are somewhat right. Comparing Estonia with Greece, Portugal and the like really misses the point.  To some extend, I do have to eat my words.

So these are the facts. Before the financial crisis broke out, Estonia was enjoying several years with stunningly high GDP growth rates. According to the latest IMF World Economic Outlook, the average yearly growth rate between 2002 and 2007, was 8,2 percent. In 2006 GDP surged by 10 percent. Recently, however, the Estonian economy plunged into a deep recession. GDP shrunk by 3,6 percent in 2008. In 2009 the economy imploded by 14,1 percent. For 2010 the IMF is forecasting a mere 0,8 percent. At the end of 2009, the unemployment rate had ballooned to 16 percent. For Estonia, the crisis comes close to a Great Depression.

Amazingly, in spite of this brutal contraction Estonia managed to keep public debt in check. In 2008 (-2,7%) and in 2009 (-1,7%) the annual public fiscal deficit was below the 3 percent threshold of the Maastricht treaty. According to the IMF this will also be the case in 2010 and 2011. This is due to several factors, as the EC points out. Prior to the crisis Estonia accumulated large fiscal buffers. Additionally the Estonian government implemented ambitious consolidation policies after the crisis broke out. VAT was increased, benefits cut, state assets sold. Some money from the EU also helped. In October 2009, the IMF asserted in its Article IV consultation:

“Budget implementation in Estonia has held up remarkably well, given that the economic contraction has been only marginally smaller than in its Baltic neighbors. This can be attributed to a better starting position, strong budget institutions and tax collection. The procyclical impact on demand has been mitigated by the aggressive use of EU funding.”

To sum things up, that’s quite a performance. With regard to the public finances I have to concede that my comment on Twitter was rather injudicious.

However, the question remains: Is it a really good idea that Estonia joins the Euro area at this point of time?

From the perspective of the Euro Zone it probably doesn’t really matter if the county becomes the 17th member of the monetary union. Estonia is just too small to make a difference. This is true even in comparison to Greece. With a nominal GDP of 338 billion US dollar in 2009, the Greek economy was contributing around 2,5 percent to the euro area GDP. The Geek economy, however, is almost 20 times bigger than the Estonian one. Its nominal GDP currently merely has a size of 18 billion US dollar. So no matter what happens to it’s economy, it seems highly unlikely that it could destabilise the rest of the Euro zone.

But does it make sense to adopt the Euro from a purely Estonian perspective? That is a different question. Politically, the answer definitely is yes. Economically, however, I’m not quite as sure. The events of 2008/09 have shown how fragile the economy of the country is. Additionally according to the IMF the country has lost quite a bit of its external competitiveness:

“The expansion in domestic demand put pressure on the labor market, and generated wage increases that ran ahead of productivity growth even in traded sectors not immediately affected by the credit boom.”

Giving up your domestic currency and your monetary policy does not seem to be the most sensible thing in such an environment. With regard to this point drawing some parallels to Greece and Italy maybe is not as outlandish as my Estonian friends suggest. Admittedly, even today the country has more or less given up monetary independence since its running a currency board: the Kroon is closely pegged to the Euro. But if monetary independence proves necessary, getting out of a currency board is a little bit easier than leaving a monetary union.

Another issue is the long term survival of the Euro area itself. One year ago I would have considered the idea of a breakup as completely preposterous. Nowadays I’m not as sure anymore. Maybe in a few years time the Estonian desire to join the Euro zone will look like hiring a speedboat to get on the Titanic.