Abstract
Following the collapse of the USSR in 1991, Estonia regained independence but inherited a heavy economic legacy of poverty and underdevelopment. In spite of the disastrous situation, radical (occasionally unpopular) economic reforms were rapidly undertaken to speed the transition to a market economy in the pursuit of economic stability. This article analyses the main features of the Estonian economy's development encompassing monetary reforms, opening its markets to foreign investors and the introduction of a fresh economic legislation. Decisive and rapid political choices coupled with the establishment of democratically accountable institutions have made this transition a resounding success.
Estonia is a small country in North Europe on the shores of Baltic Sea, on the crossroads of east and west, north and south. The Estonian border is an example of what Samuel Huntington describes as a border of Western civilization, a border where civilizations clash. Throughout their history, Estonians have had to fight for freedom. In 1918 Estonia declared independence, but was occupied by the Soviet Union in 1940, during World War II. Estonia fought back but was defeated. In the war and during the communist terror and resistance movement, Estonia lost nearly 20% of its population. But Estonia never gave up. And when history offered a new chance in the 1980s, it was taken. Estonia became one of the first countries to pry open the cracks in the Soviet Empire. And so, in 1991, after 50 years of occupation, Estonia was free again.
But what kind of freedom was that? Estonia was destroyed during communist rule. This is especially clear when we compare its development with that of neighbouring Finland, whose living standards in 1939 were more or less at the same level as Estonia's. Then Estonia lost its independence, while Finland succeeded in keeping it despite suffering losses of territory and population. Life under two different political systems created a huge disparity in the development of Finland and Estonia. Despite the fact that people learned and worked hard on both sides of the Finnish Bay, only the Finns seemed to prosper. Starting from the same point, Finnish GDP had reached $14,370 per capita in 1987, while at the same time in Estonia it was by optimistic calculations somewhere below $2,000; that is, seven times smaller. International statistics on human development documented the widening gap between the two countries.
At the same time the real problems of communism were often not seen, even by opponents of the communist system. People hoped that it would be enough to remove communist rulers from power and that liberated countries would quickly reach the same living standards as in Western Europe. Nobody actually understood how backward and undeveloped the communist economies really were. As a result of this, return to the normal world became more difficult and painful than anybody had predicted. This was evident at the end of 1991, when the end of Communism created real chaos in Estonia. Shops were completely empty and the Russian rouble no longer had any value. Even during the Great Depression of the 1930s, industrial production did not decline as it did in 1992, by more than 30% over 2 years, with real wages falling by some 45% and fuel prices rising by more than 10,000% over the same period, while inflation ran at more than 1,000% per annum. People stood in line for hours to buy food. Bread and milk products were rationed. Estonia was economically absolutely dependent on Russia, since 92% of its trade was with Russia and there were not many things Estonia could sell on the world market. The Soviet command economy had ruined the Estonian environment, and to most of the world Estonia was just one of the ‘former Soviet republics’ with little hope for a better future.
There were not many who were hopeful in Estonia either. Considering the chasm dividing Estonia from normal life, there was no other option than to try to jump over it, because it is impossible to cross a chasm in two steps. What Estonia needed was one decisive leap. At the same time, there was no time to lose. Speed is one of the most important factors in this kind of situation. Reform-minded governments are not given much time to take the necessary steps. There are limits to the trust that people have in their politicians and also to the level of pain they are prepared to take. A radical economic programme, launched as quickly as possible after a breakthrough, has a much greater chance of being accepted than either a delayed radical programme or a non-radical alternative that introduces difficult measures in piecemeal fashion. ‘Bitter medicine is easier to take in one dose than in a prolonged series of doses.’ Even a short examination of Central and Eastern European experiences shows no link between the intensity of social discontent (demonstrations, strikes, etc.) and the type of economic programme pursued. It can even be seen that some necessary decisions can, if delayed, cause serious protests, while equivalent measures passed at the right time do not lead to any significant protests. The right decisions taken at the right time can provide countries with advantages and guarantee greater satisfaction of the electorate through more rapid development. The right decisions taken too late are usually still the right decisions, but the results are often not as successful.
Countries that did not take advantage of the period of ‘extraordinary politics’ to launch a radical economic programme still face the challenge of making the transition to a market economy, but now under more difficult economic conditions. The countries that have missed this opportunity are in danger of moving into some kind of macroeconomic instability, with detailed but chaotic state regulation and massive corruption. These countries are usually given a further opportunity after the parties in power have failed so completely that the people give the reformers a second chance. But if they then fail again, it is very hard to convince the people, who have suffered twice the pain and seen no benefits at all, that they should go through it all once more. It is also clear that if there is relatively little time to accomplish essential reforms, not too much time can be spent on preparation. Laws and decrees which are passed must therefore be as simple as possible.
Two main lessons have emerged from the Estonian experience. One is to take care of politics first and then to proceed with economic reform. The other is summed up by the well-known advertising slogan, ‘Just do it’. In other words, be decisive about adopting reforms, and stick with them despite the short-term pain they cause. Politics has to be dealt with first, because to initiate and sustain radical reforms there must be a legitimately formed consensus for change. This is possible only through democracy, using regular, accountable institutional structures and free and fair elections. To be successful in the new future, a clear break must be made with the totalitarian past and with the structures and people representing it.
The beginning of the period of economic reform in Estonia recalled the situation in other Central European states, but was in many areas even worse. The Central European nations could start their reforms as soon as 1989-1990, while Estonia could do so only in 1991-1992. Such a crucial loss of time placed the Estonian economy in a very bad situation. The transitional governments tried to start with liberalising the economy, but the reforms were not decisive enough. The first real reform in Estonia was the monetary reform of June 1992, making Estonia the first country in the former Soviet Union to introduce its own currency. Based on a currency board system, the Estonian kroon was made fully convertible from its very first days, its exchange rate pegged to the German mark at a fixed rate. The Estonian monetary reform was highly successful: the undervalued currency boosted exports and kept interest rates down, and the fixed exchange rate created trust in the Estonian economy. But to keep the results of the currency board stable, the new Estonian government, voted into power in September 1992 in the first democratic elections after World War II, had to balance the budget. This was quite popular as a slogan during the election campaign but turned out to be highly unpopular when actually introduced.
Whereas in many other Central and Eastern European countries it was price relaxation that acted as shock therapy to the people, in Estonia it was the balancing of the budget. The priority of stabilisation was thus not only well grounded in economic thought but also the only way out of a desperate situation. The developments in several other Central and Eastern European countries indicate that without strictly controlling the budget, monetary reform is of no great use, no matter how successful it may be. In order to balance the budget, it was necessary to cut radically all kinds of subsidies and to reduce the size of government. All of this was unpopular, but the budget was balanced. Afterwards we passed a law that the Estonian budget must be balanced when presented to parliament. This law enabled the government to pass subsequent balanced budgets more easily and resulted in a balanced budget becoming one of the trademarks of Estonia.
So Estonia set the achievement of macroeconomic stability as its first primary objective. Monetary reform, a strict monetary policy and a balanced budget were all aimed at achieving that goal. The harsh financial situation made it easier for the government to decide what to do. There simply was not any money, nor was there anywhere from which to obtain it. Budget subsidies to state-owned companies were abolished. This was important for the development of new private companies, as subsidies served to preserve old and often outdated production structures and hampered structural change in the economy. In summary, the Soviet industrial dinosaurs were sent a simple and clear message: start working or die out. As was shown by subsequent developments, the majority chose the first option.
In retrospect, of course, this all seems perfectly logical, but in the first months of 1993 it was not that simple. The reduction of industrial production had led to an increase in unemployment and a fall in the standard of living. In this kind of situation, it would have been easy for the government to take a step backwards, make concessions and drop some necessary but extremely unpopular policies, but this would have led to the suspension of the whole renewal process and to the abandonment of the most important reforms. The only way out was to continue along the path on which the country had already set out. Otherwise the people would have had to endure the suffering which inevitably accompanies stabilisation of the economy but would have failed to see the results. Estonia was confronted with an unavoidable J curve (Ian Bremmer, The J Curve: A New Way To Understand Why Nations Rise and Fall) in terms of living standards, industrial and agricultural output and GDP. Any movement forward and up from the J curve demanded the elimination of old, inefficient, artificially supported economic activities and the replacement of all this with the ‘invisible hand’ of the market economy. Already in 1993 we started to see the first real results of all these measures: the macroeconomic situation was stabilised; inflation decreased significantly, from 1,000% in 1992 to 89.8% in 1993 and 29% in 1995; the economy was reoriented from East to West, and exports to world markets started to grow very rapidly; the decline in the economy was stopped. This all provided good opportunities to move to the second stage of reforms and point Estonia in the direction of real growth.
The transition from the first stage of reform to the second is one of the most decisive moments for economic transition. Until then, many of the tasks to be performed by the government are relatively easy and in many ways determined by the situation, but now both the freedom to choose and the importance of the choices taken are increased. In the first stage of reforms it was possible to achieve macroeconomic stabilisation by a small team implementing the reforms, i.e., from the top down, while in the second stage it was impossible to succeed without involving a much broader group of people in the process, touching their hearts and changing their attitudes.
People were given a rude awakening by the shock therapy of macroeconomic stabilisation. Now it was necessary to give them new hope, new prospects. In the era of Soviet-imposed socialism people were not used to thinking for themselves, taking the initiative or assuming risks. Many had to be shaken free of the illusion—common in post-communist countries—that somehow, somebody else was going to come along and solve their problems for them. It was necessary to energise people, get them moving, force them to make decisions and take responsibility for themselves. The government declared that it could only help those who were prepared to do something for themselves. This principle proved unpopular but it helped all the more to change attitudes.
To do this, Estonia had to open itself to the world: to competition and foreign investments. Many people were afraid of such openness, so the government had to show the way. Openness provides many advantages for a smooth and rapid transition to a market economy. It provides a rational set of market-determined processes for resource allocation, introduces more competition, allows countries to specialise according to their comparative advantages and lets the market rather than the government pick the winners. So Estonia opened itself to the world, liberalising its trade policies and abolishing all export restrictions and import tariffs, making Estonia one free trade zone. This policy proved to be highly successful, boosting competition, reconstruction and through this growth. Openness brought many new companies to Estonia, who opened new, export-orientated factories. Foreign investment is very important for transition countries in such a situation. It is much more important than loans and development aid, which run the risk at some point of becoming factors that actually help to maintain the relative backwardness of the given country. Development aid may consist of obsolete technology and obsolete advice which is no longer needed in modern countries. But by using this assistance, countries in transition lose the opportunity to use their backwardness as a springboard for development. So, to put it simply, give us not aid but more trade.
Although interest in foreign investment is relatively similar in all transition countries, the results achieved differ enormously. Some countries try to encourage foreign investment by offering all sorts of benefits. Other countries, however, try to build a business environment that favours both local domestic and foreign investment, without making any distinction between them. Estonia chose to take this latter path. The passage of the law on the sale of land ensured that all foreign investors could feel a greater sense of security and also sent the signal that their property rights would be protected in this country. By 1993-1994, from being an almost unknown spot for foreign investors, Estonia had suddenly become a Mecca for them. In the second part of 1990s Estonia had more foreign investment per capita than any other country in Central Eastern Europe.
Radical economic reforms cannot be implemented without laws regulating the economic space. Although the rule of law has been and still is one of the pillars on which modern Western civilisation is built, its importance was not readily understood in several transition economies. It seemed possible to implement decisive reforms without laws, almost as if a free market economy did not need them and could manage by itself. The same is also true of government—often, insufficient attention is paid to the renewal and strengthening (not enlargement) of the government. But good laws are not enough on their own. Transition economies need to develop effective institutions to move their new laws from theory to practice. Formal legal systems place judges, prosecutors, arbitrators, court functionaries and the private legal profession in the role of primary interpreters and enforcers of the law. It is vitally important for the success of reforms that all those systems are developed and secured. Government reform, the creation of an effective civil service, is crucial for the success of overall reform.
The rule of law is especially important in the fight against one of the worst diseases of transition economies—corruption. Corruption thrives when public officials and private agents have much to gain and little to lose, precisely the situation that exists in most transition countries. Uncertain rules, heavy regulation and pervasive controls give officials exceptional power, many opportunities to seek bribes and a wide scope for appropriating public wealth. According to the Estonian experience, the most effective method of dealing with corruption and organised crime is the decisive implementation of market economy reforms and the development of a civil society and the rule of law. Any reform that increases the competitiveness of the economy will reduce incentives for corrupt behaviour. By lowering controls on foreign trade, removing entry barriers to private industry and privatising state companies in a way that ensures competition, we are supporting the fight. If the rules are transparent and clear and the state has no authority to license business or restrict exports and imports, there will be no opportunities to pay bribes in those areas. If subsidies, ‘soft’ loans and all other such privileges are eliminated, any bribes that accompany them will disappear as well.
Special attention must be given to bank reform. Banks are the most important part of the economy, and when organised crime takes them over, it quickly takes over the whole country. Money laundering, dirty money and all other shady operations must be removed from the banking system as quickly as possible. The government must be really tough in this issue, because dirty money is always followed by dirty people. Estonia did not keep any state banks, but was very clear about its expectations of private banks. We did not hesitate to let them go bankrupt when necessary. As a result, Estonia has the most effective banks in the Baltics and has become the least corrupt country among the European Union's new Member States.
At the heart of a transition lies a change in ownership relations. Without this change, without change to private ownership, a transition will no doubt fail. There are different ways to achieve an economy dominated by the private sector: through restitution of property to former owners, through privatisation of existing state assets, and through the re-emergence of private businesses. For reformers, the question is not how much to privatise, but how and when. Privatisation and clearly defined property rights are the fundamental priorities for all truly reforming economies. In Estonia the first laws on property reform were passed already in 1992, concentrating first on the return of property that had been confiscated from legal owners or nationalised by the communist rulers. In cases where it was decided that the direct return of property was not possible, owners were compensated, not with money but with vouchers, which were targeted for privatisation. Once it was clear which properties would be given back to legal owners, all other property was privatised. The land and housing was privatised by vouchers, allowing many people to become owners as quickly as possible. The bigger assets were privatised by the Privatisation Agency, Estonian Treuhand, in open competitions. In most cases, shares of the companies were sold to one core owner and minority shares were given to the people in exchange for vouchers. This provided in a single move real owners for companies while at the same time making it possible for everybody to participate in privatisation. The goal of privatisation was not only to gather money for the budget but to guarantee necessary investments and a minimum of workplaces as well. As a result of such a policy, the privatisation process was smooth and fast, making Estonia the country of owners.
To achieve a lasting breakthrough in Estonia's development, it was necessary to make the most of the people's energy. This meant creating a favourable economic environment for private enterprise and inspiring people to assume responsibility for their own future. Whereas the second aim was largely attained through shock therapy, the achievement of the first objective was much more complicated. It was partly accomplished through adopting legislation based on liberal regulation of the economy, thus depriving the bureaucracy of the opportunity to intervene in economic developments and making it relatively easy to found new companies. This, however, was not enough. When people who had founded their own companies understood that due to the tax system currently in force they were being punished for being successful, their enthusiasm to determine their own future declined considerably. The idea behind a progressive income tax system is simple: the more you earn, the more taxes you have to pay. Such a notion, however, lowers the motivation of people to work more and makes them rely more heavily on the public welfare system.
Estonia decided to choose a different route. We decided not to punish people who are good at what they do. On the contrary: we decided to give them the opportunity to work more and to take care of their future by themselves. We decided that the entire tax system should favour savings and investments and inspire people to create new values. The tax system Estonia needed had to be simple, inexpensive to implement and understandable to taxpayers. The tax base should be as broad as possible with a minimal exemptions, in this way minimising incentives for the underground economy. The tax rates had to be low, encouraging the activity of people and creating more growth. The best solution to all these goals was flat-rate personal income tax, which was introduced in Estonia on 1 January 1994. The tax system became simpler and easier to understand both for taxpayers and tax collectors. Taxpayers can easily fill out their tax forms and avoid overly complex calculations and bureaucracy. Tax collectors can avoid a lot of unnecessary work and concentrate their efforts on those who are interested in not paying taxes at all. As a result of these changes, tax administration started to work more effectively and tax compliancy increased. The grey sector was badly hit and the revenues of the state budget in Estonia started to increase very quickly.
Tax reform also supported a rapid increase in economic activity. As the Estonian people saw that if they worked more, they would earn more and would not be punished by the government through higher taxes, their attitude changed surprisingly quickly. Thousands and thousands of new small- and medium-size enterprises, restaurants, hotels and shops were established. In 1992, Estonia had in total about 2,000 enterprises. By the end of 1994 the figure was 70,000. Estonia had turned from the country of the working class to the country of entrepreneurs. This helped Estonia avoid massive unemployment. The Estonian experience with a flat tax rate was so successful that other countries started to copy it, first the two other Baltic countries and then Russia in 2001. Ukraine and Georgia have introduced it too, as did Slovakia in 2004 and Romania in 2005. In recent years most Central Eastern European and Balkan countries have moved to a flat tax. Comparing the growth rate of economies in Central Eastern Europe with a flat-rate personal income tax with the growth rates of economies in the same region with progressive income taxation, we can see that countries with a flat rate on average simply grow faster. The other clear difference between the flat-rate and progressive-rate countries is that the flat-rate countries’ revenues and budgets are in better shape. It is often argued that the flat-rate personal income tax is not socially just, that it creates greater inequalities in society than in the countries with progressive taxation. This is not true, as the Gini coefficient of income distribution has actually often decreased in flat-rate countries and is often lower than in progressive-rate countries in the same region.
All these and other radical reforms have changed Estonia beyond recognition. It is sometimes hard even for us to remember how this country looked under the socialist system. Estonia became the first former communist country to be raised to the status of a free economy by the Heritage Foundation's annual Index of Economic Freedom. And even more remarkable—it is not only a ‘free economy’, but one of the freest in the world. Estonia ranks sixth in the index of economic freedom. As a result, Estonia has become the country with fastest economic growth in Europe. The Estonian average economic growth after the start of reforms has been 7% per year, and during last years GDP growth has been over 10%. As a result of this, Estonia is catching up faster than anybody expected to average European living standards. Poverty and inequality are decreasing in Estonia and, according to the Human Development Index, Estonia has moved from the group of medium human development countries to the group of ‘high human development’ ones. Estonia has low unemployment and low inflation, and living standards are growing quickly. The budget is not only balanced but has a strong surplus. Estonia has passed several social reforms, such as health care and pension reform. Estonia has become a full member of both NATO and the European Union. By nearly all analyses, Estonia is the most competitive economy among new Member States. While only 10 years ago we clearly lagged behind most of them, by now we have passed them. Whereas in 1992 Estonia's GDP per capita in PPP was 15-20% of the European average, by 2008 it will be over 70% according to Eurostat, surpassing the top-ranked Western European country, Portugal. With its speed of growth Estonia has been the most successful transition country, not only in Central East Europe but also in the world.
All this has allowed Estonia to prepare itself for new challenges in the twenty-first century. Estonia has made a real jump forward in modern technology and it is a frontrunner in ‘e-government’. Its government uses no paper in its sessions; all members of the government use computers. Estonia will soon be ahead of many European Union countries in terms of Internet use. Estonians make a large part of their bank transfers through the Internet. You can send your tax declaration to the Tax Department electronically, as more than 70% of Estonians did this last year. It takes about five minutes to complete it. E-government is a very effective tool in the creation of a lean and open government. It makes government more transparent and allows people to participate more in decision-making. In 2007 Estonia became first country in the world where the people could vote via the Internet in parliamentary elections. This has created very favourable possibilities for new high-tech enterprises, and Estonia has become the birthplace of many of them. The most famous Estonian invention is the Skype electronic communication system, and more innovative new companies are under development.
The Estonian experience of a successful transition is a valuable example to the rest of the world. Several countries have studied Estonian reforms and introduced several of them in their countries. This has helped to speed up their economic growth and improve people's living standards. The most recent example of such development is Georgia. Five years ago Georgia was failing more seriously than any other transition country of the former Soviet Union. Thanks to its adoption of Estonian-type radical economic reforms, Georgia has made a real jump and is on the way to becoming a new economic miracle. There are, of course, many challenges ahead, but when Georgia succeeds in building up its democracy and rule of law, the way for success will be open. The ‘Estonian miracle’ teaches that only by trusting the people and empowering them are reforms made irreversible. Only in this way can we build a better future for ourselves and our children.
Footnotes