Economist Edward Hugh Photo: Courtesy Mr. Hugh
“Paying off debts is important,” says Edward Hugh, “but not if you destroy your economy in the process. Estonia has a debt to those who have worked in the past, but it also has an implied debt to those who will be born and work in the future. Squaring these two competing demands is not going to be easy.”
Edward Hugh is a Barcelona-based independent macroeconomist, who specializes in growth and productivity theory, demographic processes and their impact on macro performance, and the underlying dynamics of migration flows. He is a regular contributor to a number of economics weblogs, including A Fistful of Euros, Global Economy Matters and Demography Matters. He writes frequently for both the Spanish and English language press.
You wrote on August 22 that “The problem is that the part of Estonian industry which was internationally competitive before the bust still is [competitive], but that this part is not large enough to drive the whole economy, now that the economy is export dependent. It just doesn't have a big enough share in GDP to carry the whole economy.” We see that governments (Estonia’s included) are currently crying for more export, which is more easily said than done, especially in a small, developing economy like Estonia’s where a good part of existing export is sub-manufacturing operations owned by Scandinavian companies who, in effect, buy their own products for re-sale in yet another market. What’s your take on what a country like Estonia must to do build a “true” export economy? Or, in your opinion, should it turn its attention more to sub-manufacturing?
I agree that increasing exports is something more easily said than done, but that doesn't make it any less necessary. “Export or die” would be a good slogan for the Estonian economy right now, since if you cannot build a strong, sustainable export sector the economy simply will not grow vigorously, and more young people will be forced to leave in search of work, making your present demographic problem even worse. So, quite literally, the future of the country is at stake in this crisis, and it is important to get things right.
I also think it is important to recognize what economists can and cannot do. We are not entrepreneurs, and can't decide for Estonian entrepreneurs which sectors they should expand in, or for non-Estonian companies which areas they should invest in. Logically, they will be attracted to areas which they think will be profitable and in which Estonian has some sort of price advantage. That is why it is so important to get the relative price structure right. Macroeconomists know about monetary and fiscal policy, and how to work towards the right kind of price structure, which forms an important part of the kind of stable environment you need to get growth. Microeconomists, on the other hand, know more about the regulatory environment and how to implement the structural reforms necessary to get this part of the environment working. People often ask why more economists didn't see the present crisis coming, but I think it is often a question of putting the right question to the right people, and then listening to what they say. You wouldn't ask a physicist who was an expert in semiconductors how to build a particle accelerator. IMF economists, for example, were very clear during the Estonian boom that measures were needed to slow it down, but all too often their advice was not sufficiently heeded. Very often people take the easy path, turn a deaf ear, and then look for someone else to blame later.
Basically, Estonia finds itself in the midst of a serious global crisis that will not be resolved tomorrow. Many commentators point to the difficulty of increasing exports substantially in this environment, and they have a valid point. But this does not mean that doing nothing is an option. Estonia has to make an important transition from a being a consumer-driven economy to being an export-driven economy. There is now no avoiding this transition - it is partly a question of debt, and partly a question of population aging - and the sooner it is completed the better.
You cited Friedrich Schneider’s research and his conclusion that Estonia’s shadow economy is almost 40 percent of GDP. That report wasn’t well received here, as you might imagine. (Statistics Estonia says the correct number is 7 percent, and local economic thinkers say that Schneider’s MIMIC model produces inflated numbers that are only useful on a relative basis.) If you were to buy the Estonians’ number (7 percent), or if you could be convinced to be suspicious of Professor Schneider’s number, how would that impact your general prognosis for Estonia’s economy?
Well look, talking with Estonians it is clear the Professor Schneider's findings do not fit with the day-to-day perceptions of life inside the country. On the other hand, numbers like 5 percent and 7 percent simply are not credible. Even countries with the lowest levels of informal economy - like Switzerland and the US - still have underground economies of 10 percent or above. So the reality is somewhere in between.
What is interesting about Schneider's work is that it is produced by a team of highly-respected independent economists, and that the numbers in most cases look quite realistic to within a reasonable margin. So, if the Estonian findings don't fit, it would be interesting to learn why, and help improve the methodology and our understanding of the problem. Since Estonia is a small country, a relatively small number of large transactions can distort the data, but can everyone really put their hands on their hearts and say that they insist on paying VAT every single time they visit a dentist or an optician, or every time they have some home improvements done?
And be careful, if the informal economy is really so small then that means that unemployment really is around 18 percent - which means that the situation is much worse than in places like Spain or Latvia, where the official unemployment numbers surely overstate the real level due to the presence of substantial undeclared activity.
You note that Estonian “…living standards have fallen sharply due to the reduced hours worked and the rapid rise in unemployment…” but you write that “that is not the same thing at all as recovering lost competitiveness.” Prior to the recession, where did you see Estonia’s competitiveness? What, in your opinion, was the advantage the country had and could exploit?
Evidently there is a geographic and a cost advantage. Also an openness to entrepreneurial activity. Two of these three are still there. In the years up to 2005 most of the improvements in living standards were tied to productivity improvements. Post 2006 the two became detached and this is what has caused all the problems. Only part of this gap can be recovered rapidly enough through productivity improvements - remember we now live in a highly competitive global environment and doubly so in the post-crisis world, and everyone is trying to become more competitive. Estonia is entering the Eurozone next January with an overvalued real exchange rate, just as Germany did in 1999, and surely Estonia must now follow in the path earlier laid down by the Germans themselves. Naturally, John Dizard has a good point, Euro membership will have advantages and disadvantages, but one big advantage will be the reduction in borrowing costs for both companies and government.
You address FT columnist John Dizard’s claim that Estonians are in position for a relatively rapid recovery (because they started out with much less state and private debt than the others), by highlighting the fact that Estonia's private sector debt is quite high (100 percent of GDP). This will, you write, “continue to exert a significant downward pressure on credit growth for some time to come.” What’s the ticket out of that trap?
The ticket out of the trap is exports, exports and more exports. I'm sorry to repeat myself, but there is no big mystery here, the only way to pay off debt is to sell. Or find buyers for Estonian real estate. In comparison with countries like Spain, Estonian private debt is not that large, but Spain's debt is very, very big, and we lack historical precedents for what is happening now in the east, since we are in the midst of a substantial demographic transition which has specific characteristics in the east of Europe, and we don't know exactly what the future patterns of lifetime saving and borrowing will be in a country like Estonia. All I can tell you, based on empirical study, is that the only country in the EU 10 where domestic demand is currently alive and kicking is Poland, and most observers are not paying enough attention to this fact, or asking themselves why this is.
You’ve written several times that anyone’s future outlook for the Estonian economy depends on initial theoretical assumptions made at the outset. “If you assume that neo-classical steady state growth really exists,” you wrote, “and that all this stuff about aging, capital flows and export dependence is exaggerated, then you will see the recovery coming in the here and now, and if you don't…” If you could dictate Estonia’s economic policy, what’s the prescription for returning to growth?
Most of the solution is evident, to continue with the structural reforms, and follow the path laid down by Germany between 1999 and 2005 to restore external competitiveness. That is, to accept many years of substantial wage and price moderation (and possibly deflation). Unfortunately what is now involved is a long, slow path, given the chosen course of Euro membership. I would say Estonia is partly in the difficult situation it is now in because the authorities were far too complacent about earlier wage inflation. It is a lot easier to stop wages and prices rising than it is to bring them down again once they have risen.
My feeling is that the authorities should have had a much more flexible policy towards immigration much sooner (and not only skilled migration) to ease the pressures in the labor market. Basically, I am arguing that the whole demographic issue isn't being given the importance it deserves. We now face the problem that young people may be leaving in increasing numbers in desperation at the continuing high levels of unemployment, but, I ask myself, what sort of research is actually being conducted to discover the extent to which this is happening? What sort of a priority does this have? And what sort of priority is being given to helping young couples who want to have children actually have them? We are talking about the future of an entire country here, and the sustainability of pension systems in the longer run. I have seen research from Latvia and Lithuania, but to date no one has sent me anything from Estonia. Estonia urgently needs to create more employment, to encourage people to stay, to attract migrants, to have the resources to develop a more systematic family policy and to make the population pyramid much more stable. Put another way, Estonia needs to give more priority to its young people, and invest more in its future and less in its past. Paying off debts is important, but not if you destroy your economy in the process. Estonia has a debt to those who have worked in the past, but it also has an implied debt to those who will be born and work in the future. Squaring these two competing demands is not going to be easy.
Interview by Scott Diel