Why You Need Devaluation – An Open Letter To The People Of Estonia

The macroeconomic data coming out of Estonia in recent weeks are truly shocking even in the context of the ten percent annual drop in GDP for 2009 that most observers are now forecasting. Perhaps the most evocative number of all is not the 27% year on year drop in industrial output registered in January, but the announcement this week that Estonia’s registered unemployment rate rose to a record 7.4 percent during the first week in March, with a total of 47,774 job-seekers registering with the unemployment offices, up 3,019 in a week. Of course, for many outsiders these are not large numbers, but then Estonia is not a large country. Still this was the highest number since the Labor Market Board started disemminating data in 1993 (although not as measured by Eurostat, which uses a different methodology). The level was up from 7.1 percent at the end of February and 6 percent in January, although the important thing is not the volume of unemployment, but the rate of its increase.

At the same time it is estimated that nearly 250,000 Estonians are currently living in homes whose market value is insufficient to cover the outstanding mortgage loans which their owners have taken out, making “exposure risk” a growing problem for the country’s banks. During the boom, house sale transactions were commonly financed with a 90% loan to value (LtV) ratio. This is a very dubious practice at the best of time, but in the face of a sharp fall in both house values and wages it becomes well nigh disastrous.

Once boasting one of Europe’s fastest-growing real estate markets, property prices in Estonia fell by a whopping 23% in 2008 (following an 18% increase in 2007) according to data in the latest edition of the Royal Institution of Chartered Surveyors European Housing Review. The RICS tracked 2008 year-on-year house price inflation in 18 West and East European countries, and found that Estonia’s fall was the most substantial in the entire group.

Take, for example, a 50 sq metre apartment bought in the spring of 2007 for a price of around EEK 1.3 mln. This apartment is currently worth around EEK 790,000, but the outstanding loan balance is of the order of EEK 1.1 mln. Should the once proud owners of that lovely appartment now find themselves among those unfortunate enough to be queueing up outside the offices of the Estonian Labour Board and need to sell it, then even assuming they could find a buyer they would not only lose their home, but they would still end up owing the bank EEK 300,000 under Estonia’s “full recourse” lending laws (which are of course very different from those operating in the United States). With an average net monthly salary in the region of EEK 10,000 this means that the unfortunate ex-property owners would in all probability end up with a debt worth more than two years their total income.

Of course, in this climate buyers are likely to be scarce, and it is more probable that the banks themselves end up with a substantial direct interest in Estonia’s property market. And this would only add to the problem they are already having with overdue loans, which are rising and reached 3.6 percent of total credit in January, according to the most recent data from the central bank which now forecasts bad loans will hit 6 percent before the year is out. Of course, as is by now well know, more than 95 percent of Estonian banking assets are held by Nordic banks, and despite the fact that the banks don’t cease to reassure us that their Baltic operations form a “key part” of their business and that they have a “long-term commitment” to Estonia, this doesn’t stop them getting downgrades. Swedebank, for example, had its credit rating cut to A1 from Aa3 by Moody’s Investors Service last month, citing the risk of a “substantial increase in impairments” (read loan defaults and deteriorating asset quality) from the bank’s Baltic operations.

Meantime output and employment simply keep on falling, with Estonia’s industrial production dropping by the most in at least 14 years in January – 26.8 percent year on year, the most since 1995 (following a 22.4 percent slump in December).

Of course, as output drops and people are sent home to remain inactive, the one thing Estonia does have at the moment is a lot of loan offers. Thus the central bank recently announced that they will be able to borrow as much as 10 billion Swedish kroner against Estonian krooni from their Swedish counterpart in an attempt to boost confidence in Estonia’s financial markets. As Riksbank Governor Stefan Ingves said in the statement “The financial systems in Estonia and Sweden are closely linked”. But what Estonia needs is not more loans, and more debt, and people lying around idle, it needs work, and output, and exports to pay off all that debt which has been accumulated. And it is just at this central point that the current solutions are being tested and found wanting.

The Price and Wage Correction Is Too Slow

In order to understand what is wrong with the path on which Estonia has set itself we need to bear fully in mind that the problem is that the country (or its households) have become excessively indebted in relation to the economy’s competitiveness, and the consequent ability to pay. Estonia has a current account deficit, and this does not help things, but Estonia’s problem is not, in the longer run, a simple balance of payments and financial crisis one (against which external loans can of course help), but a problem of competitiveness and the ability to pay off debt.

And even despite the recent sharp fall – almost all of which is produced by a fall in imports and a reduction in living standards – Estonia’s current account deficit was still running at slightly over 9 percent of gross domestic product in 2008 (following the 18.1 percent shortfall achieved in 2007).

Estonian central bank data show an estimated current account defict for last December of 943 million kroons, down from a revised 1.87 billion kroons for November, and from around 3.5 billion kroons in December 2007, but since exports were down 6% year on year in December, it is obvious that the reason for the contraction in the deficit is the 17% drop in imports. Ouch!

Now, as I say, basically the problem here is to restore competitiveness and, although not everyone will be prepared to agree with me, I would argue that the only solution for Estonia is to export its way out of trouble. Given the problems the banking system is having and is about to have, it would be sheer fantasy-land (and very foolish) to imagine we are going to see a return at any point in the forseeable future to consumer credit driven growth (we are talking everywhere about more, not less, regulation), so as Estonians work hard (once they finally get a job again) to pay off their debts and try to save for their increasingly uncertain old age, the only really valid way to try to go for growth is by exporting. Saying that this is not possible, well… this is simply defeatism before you start, and I don’t imagine the Estonian character that way somehow, not after so many years of fighting to gain a hard won independence.

So if you want to export, you have one benchmark to work againt – Germany. And if we look at the chart below, we will see the extent of the competitveness gap which has opened up since 1999. Now Reel Effective Exchange Rates (REERs) are a nice measure of competitiveness, since REERs attempt to assess a country’s price or cost competitiveness relative to its principal competitors in international markets. Since changes in cost and price competitiveness depend not only on exchange rate movements but also on cost and price trends the specific REERs used by Eurostat for its Sustainable Development Indicators have been deflated by nominal unit labour costs (total economy) against a panel of 36 countries (= EU27 + 9 other industrial countries: Australia, Canada, United States, Japan, Norway, New Zealand, Mexico, Switzerland, and Turkey). Double export weights are used to calculate REERs, reflecting not only competition in the home markets of the various competitors, but also competition in export markets elsewhere. A rise in the index means a loss of competitiveness, and as we can see Estonia’s index has risen sharply against Germany’s in recent years.

Well, just in case anyone thinks that the comparison with Germany is not an appropriate one in Estonia’s case, here (see below) is the equivalent chart for Finland, which shows an equally strong loss, and let us remember that the worst year in this sense (2008) is still not included, since Eurostat have not processed the data yet.

And of course, I am only looking at eurozone comparisons here, we won’t enter at this point into the embarassing fact that Sweden and the UK have both devalued sharply in rcent months, as have Eastern EU rivals, Romania, Poland, Hungary and the Czech Republic, as well as non EU rivals like Ukraine and Russia. Really hanging on to the peg blindly in these circumstances is not only foolish, it is ridiculous, and I hardly see how following a ridiculous policy (which for sure won’t work) is going to enhance your credibility, which is what the decision not to devalue was all about in the first place. It won’t even shield the Nordic banks from the slew of incoming defaults.

Now, “plan A” is supposed to involve a very sharp downward adjustment in prices and wages, something of the order of 20% during 2009 and 2010. (Incidentally, talk of a V shaped recovery is misleading here, since the V shaped recovery only comes with a one-off devaluation, say getting the 20% out of the way all at once, and doing it over two years can only bring a U shaped process, as you simply spin the same thing out over two years, think about it, the issue isn’t that hard to see). Anyway, over two years it is, so how are we getting on? Well up to December last year (which is the latest data we have) not very well, since average hourly wages (the key number here) were still up 9.9% in the last quarter of last year, and so this is really another 10% or so to add to the 20% we were just talking about above (based on the 2007 REER). True, hourly wages did peak in Q2 at 78.26 kroon, and were down to 75.58 kroon in Q4 (or by 3.4% in six months), but this was only really taking back some of the excess from H1 2008, and the real hard work is still to come.


But if we move away from wages and take a look at prices, we find the situation is not much better, since while Estonia’s inflation rate fell in February to its lowest level in more than three and a half years it was still running at an annual rate of 3.4%. We need to see average price declines in the region of 10% in both 2009 and 2010, and not only am I not convinced we are going to see that, none of the major bank analysts or multilateral organisations are currently forecasting anything like this. Or are we going to run our correction from now till 2015 (and have something which looks more like an L-shaped correction)?


Of course, as many will point out, the price index has been falling in recent months (see chart below), but the question is: is it falling fast enough?

What we really need to think about here is not the general index, however, but the so called “core” index (the one that excludes volatile items like energy, food, alchohol and tobacco). Now as we can see in the chart below this index has stabilised, and has even started falling slightly, but if we keep in mind the rule of thumb idea of a 20% decline, and note that the core level peaked at 118.37 in December, then for the correction to have any hope of working we would need to be looking at a reading in the region of 95 come December 2010.

And the situation may be even more complicated than we imagine, since the Eurozone itself may fall into deflation, and if so every percentage point drop in the Eurozone index will need to be matched by an extra percentage point drop in the Estonian one. Unfortunately your leaders and advisers are a long way from explaining this harsh reality to you.

But there is reason to fear that this may actually be what happens, since if we look at Eurozone headline HICP inflation on an annualised basis, we will find that it fell more than expected in January – to 1.1 per cent, according to Eurostat data – down quite dramatically from the peak of 2.7 per cent hit in March last year. This was the lowest level we have seen since July 1999, and a sharp drop from the 1.6 percent rate registered in December. On a month-to-month basis, prices were down 0.8 percent. The “core” inflation rate – that is consumer inflation without the volatile elements of food, energy, alcohol and tobacco – we find it still stood at 1.6%, since the biggest impact on headline inflation comes from the decline in food and energy costs. But if we look at the monthly movement in the core index, we find that it dropped by a very large 1.3% (see chart below).

Now if we come to look at the core inflation rate over the last six months, we find that the index has only risen 0.1% (or an annual rate of 0.2%). This gives us a much more accurate reading on where inflation actually is at this point in time, and where it is headed. The chart below shows the six month lagged annualised rate for the last twelve months, and the sharp drop in January is evident. If things continue like this, then the eurozone as a whole is headed straight into deflation, for sure.

Retail Sales Dropping Sharply

Basically, to get economic growth, and thus to be able to pay down debts, you need one of three things: an increase in government demand, and increase in export demand, or an increase in private domestic demand. Now the first two of these are categorically excluded in the present situation (especially since the government is cutting, and not increasing, public spending as part of the crisis response package (the so called “plan A” strategy). However, private domestic demand is falling like a stone at the moment. According to the latest data from Statistics Estonia, retail sales were down 10% year on year in January (at constant prices).

As we can see in the chart below, Estonian retail sales peaked in February 2008, since which time they have been steadily falling.

So what are the chances that domestic demand can make a recovery? Well, according to some, quite substantial. According to a recent report from UBS bank on Eastern Europe Lending:

We retain our firm view that convergence is a ‘sure thing’ for those economies already in the EU – it is just a question of time before levels of GDP per capital approach those of the established members. If convergence is perhaps a thirty or forty year process, the most advanced are perhaps half way through (Poland introduced its free market reforms on 1 January 1990). The uncomfortable period we are entering is one where local growth goes from above-trend to sharply below. It may well take a number of years before nominal GDP (in Euro) recovers the levels of summer 2008, but we believe markets can be forward-looking when outcomes are predictable.

So the issue is convergence, and the justification for “plan A” is essentially based on this idea, as UBS analysts

Why does convergence matter so much? Because equity markets – and therefore companies – are essentially about growth. And convergence drives excess growth. The new EU members offer legal systems becoming increasingly like those in old EU states, with labour productivity comparable and labour costs a fraction of those back home – particularly following recent currency declines. Margins on banking products are typically higher than in ‘old’ Europe and levels of penetration much lower.

These arguments were a staple of a thousand corporate presentations through the good times and we suspect will be little mentioned except where necessary over the next twelve or eighteen months. But we believe them to remain essential to an understanding of likely outcomes in the region: they raise the bar for all stakeholders faced with a challenge of whether to prioritise the long-term or the immediate. It is an active debate what the Ukraine will look like several years hence; we believe it is not for the EU members: they will look more like the old EU states, in form and substance.

So we are putting all our money on the “convergence” bet, but just how realistic is this? Unfortunately, not very, since one key argument it simply fails to take into account is the effect of demographic processes. Basically, the whole of Eastern Europe has one large and little discussed problem, birth rates fell dramatically, but life expectancy did not rise: Latvia and Estonia are not only (along with Slovakia) the EU countries with the lowest per capita income, they are also those with the lowest life expectancy. Male life expectancy in Estonia is just 67.16, and for Latvia it is 66.68, compared to 76.11 for Germany, and 77.13 for Italy. Let’s not beat about the bush here, this means that each adult working male can contribute roughly ten years work less to paying down the country’s debts, and of course, extending the working age to 70 (25% of the Japanese population still work at 75) impossible. This is why the whole idea of “convergence” is a non-starter. And again, you don’t need to be an economics PhD from MIT to see this.

In the real world Estonia’s population is currently shrinking, which, with fertility around the 1.4 Tfr range is hardly surprising.

The birthrate has been rising (slightlly) in recent years, but as Afoe’s Doug Muir explains in this post here, this is more than likely going to unwind during the recession.

Interesting Fact #1: birthrates tend to drop during recessions, and the drop tends to correlate with both the severity of the recession and the speed of its onset. The current recession is looking to be a bad one, and it happened pretty quickly, so we can reasonably expect a sharp drop in birth rates. Makes sense, right? Babies are expensive; more to the point, babies limit your options. They make it harder to move to a different city, change careers, stop working for a while. When times are hard and uncertain, babies become a luxury. For individuals and families, a recession is a good time to put childbearing on hold.

Interesting Fact #2: all across Communist Eastern Europe, birth rates declined slowly through the 1970s and ’80s… and then crashed after 1990, dropping to very low levels and staying there through most of the decade. In some countries they bounced back a bit, in others not, but in almost all cases there’s a big “birth gap” from about 1991 until at least 1997, and often later.

Put these two facts together, and there’s a problem.

Indeed Statistics Latvia have already reported a 25% year-on-year drop in births in January 2009 (from 2310 in Jan 2008 to 1860 in Jan 2009), and looking at the Estonian Statistics we find that in January 2008 there were 1493 births and in January 2009 there were 1232. Again about a 20% drop year on year. Of course, one month’s data don’t prove anything, but since, as Doug points out, this is what the theory predicts, we should all be taking it seriously, and it should be taken into consideration when we talk about which kind of “correction” we want. It is no good saving the stream of external funding coming into your banks if you “meltdown” your population as you do it.

Unfortunately I haven’t noticed one single European leader who is seeing fit to even mention this issue – or the other, pending, one that when the recovery does come, if the Baltic countries are still stuck struggling with their pegs, the additional haemorrage out will be in young people looking for money to send home to their ageing and impoverished relatives, thus giving the whole demographic thing another turn of the screw.

The future already looks bleak enough in human capital terms, as this recent report from Statistics Estonia makes evident:

According to the Statistics Estonia, at the beginning of academic year 2008/2009, 154,481 pupils were acquiring general education, 27,239 vocational education and 68,399 students were acquiring higher education. The decrease in the total number of pupils is influenced by the number of pupils acquiring general education, which has decreased during the last decade. The decrease in the number of pupils in general education is related to the decrease in the number of births, which began at the end of the 80s and lasted till the end of the 90s. At the end of the 90s more than 220,000 pupils were acquiring general education, thus the number of pupils in general education has decreased by about a third during the last decade. In academic year 2008/2009, 147,519 full-time and 6,962 part-time pupils were acquiring general education. In autumn 2008, 12,426 children started school, which is over a third less than ten years ago.

So Is There A “Plan B”?

Well, of course there is, and everyone, no matter which side of the argument they are on, knows only too well what this is: devaluation. Of course of devaluation of the Baltic/Latvian pegs contains implied sovereign liabilities, and these need to be thought about. You cannoy do this alone, but you are members of the EU and you can ask for help with the process. But if you don’t start to ask for the help, then naturally you aren’t going to get it.

Technically the pegs can be maintained. The question which faces Estonians is quite simply which alternative – keeping or changing the peg – implies the greatest cost. The main stakeholder here is the EU, and you should be leveraging that for all you are worth. The capital erosion for Western European lenders would not be insignificant if you (and others) simply sink.

Naturally small open European economies like Latvia and Estonia can only hope to gain very minimal monetary autonomy outside currency board type arrangements, so the only realistic exit strategy is devaluation and Eurozone membership, as I explain in this post (and this one).

Of course this change in EU policy won’t arrive tomorrow (but it might come next week, or the week after). It’s just that you have to push for it. Stopping work and going home (as unemployed) while your country borrows more and more money is not going to bring the future you all so badly want. There is another path, choose it!

Appendix

Here is an extra chart showing Estonian unemployment rates from 1993 to date, as provided by Tööturuamet, the Estonian Labour Market Board.

and here’s a longer time series for the Eurostat labour survey data. The difference between the two is methodological, and the Eurostat data is more comparable with other EU countries. As we can see, on both measures unemployment has been rising very rapidly of late, and with a 10% contraction forecast for this year, the end result is almost certain to go higher than the 13.2% peak registered in 2000 according to the Eurostat data.

This entry was posted in A Fistful Of Euros, Economics and demography by Edward Hugh. Bookmark the permalink.

About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

71 thoughts on “Why You Need Devaluation – An Open Letter To The People Of Estonia

  1. Sorry, Edward, but no. An unemployment rate of 7.4% is neither a “record” nor is it “the highest since 1993”. What statistic data are you using? Because back in the early 2000, the Estonian unemployment rate managed to hit 14%, and that was also a result of a rather sharp and swift increase.

    Also, the comparison with Finland? Huh? This country has usually ranked as one of the most competitive economies in the World. Of course Estonia looks worse in comparison. Actually, that first comparison with Germany is probably _more_ accurate, because the present-day Germany contains at least one post-communist region.

    … and incidentally, if you want to include the question of birth rates and population, I have to wonder why you omitted the comparison with Finland on _that_ issue. Because in the same discussion that you cited, I mentioned to Douglas the fertility peaks during the Finnish Depression of the early ’90s. And at least on that realm, our southern neighbours tend to have more common with us than with Ukraine or Bulgaria, which were the countries that Douglas was primarily discussing.

    Other than that, your data is mostly correct, and I wouldn’t disagree with your conclusions – with the personal exception that since I remember all too well the Depression of the ’90s, I’m not quite as fond of devaluations as you are. Yes, I know, back then, the whole crap was impossible to avoid; doesn’t mean that the outcome was pleasant, at least in the short run, and that’s how people usually tend to assess their future.

    Also, I think you’re ignoring the outside effect on the Estonian labour market. F’rex, assuming that the Finnish stimulus package has the desired effect on the construction sector, that’s going to have an immediate positive impact also on the Estonian employment. But we’ll see how that turns out.

    Cheers,

    J. J.

  2. I agree with Edward said, I think Estonia had completely ignored messages sent to tehm in the past few years. I still remember vividly that the Estonian finance minister was ignoring warnings with regard to overheating…now it’s the people that pay the price.

    Finland will not be able to come to the rescue as they have major issues to handle…referring to the mass retirement to come and an ageing population combined with a very anaemic immigration (even though it’s low, far right party (PS) start to get an increasing popularity).

    I think Finland construction sector meltdown will have an even bigger impact on Estonia, as many were hired to work in construction site. Now most probably they will be sent home, filling up the unemployment queue…that could partly explain the sudden rise in unemployment.

    Russia was playing a major role in the region as it was a major importer…and I can tell you that the collapse of the Russian import were clearly visible in Finland. When I say visible, I ‘m talking by just opening the eyes: suddenly the number of Russian trucks, crossing Finland road, filled with cars just disappeared from the road almost overnight (exactly in November).

    I have the feeling that what we are going to get in the region will far, far greater than what was witnessed in the 90’s because at that time the global growth was still alive and was used as a lever to get out trough the mini 90’s depression.

  3. Hello Jussi,

    “Sorry, Edward, but no. An unemployment rate of 7.4% is neither a “record” nor is it “the highest since 1993″. What statistic data are you using?”

    Well…. The data comes from the Estonian Labor Market Board, from the data set they have which started in 1993. I have put the chart they provide online as an appendix, so you can see for yourself. However, this is only to say I am right by the letter of the law, since the spirit of the law is with your point, in fact if you look at the Eurostat labour force survey data, unemployment did hit much higher levels in in 2000, as you suggest. Quite why they classify things the way they do at Tööturuamet you will have to ask them, but their data is based on labour office signings, and for whatever reason a lot less people seem to have signed on in 2000.

    “Also, the comparison with Finland? Huh? This country has usually ranked as one of the most competitive economies in the World. Of course Estonia looks worse in comparison.”

    I’m sorry, I’m not sure what the point is you are trying to make here. In terms of exports Finland is a market for Estonian products, and is in the same St Petersburg, Helsinki, Tallinin triangle, as Hank notes. Plus:

    “Actually, that first comparison with Germany is probably _more_ accurate, because the present-day Germany contains at least one post-communist region.”

    well this is just it, Estonia has lost more ground vis a vis Germany than it has vis a vis Finland, so I put Finland in as a “weaker case scenario” (and also perhaps a regionally more relevant one, since all the other maincurrencies have devalued, but the Baltics are roped in with Finland via the euro peg, so perhaps, as Hank also suggests, it is Finland and not Sweden who will be dragged down – like Ahab after Moby Dick – to the icy bottom tied to the Baltic harpoon.

    “… and incidentally, if you want to include the question of birth rates and population,”

    This is one of my key research themes, the economic consequences of ageing populations and low birth rates, some people in fact call me an economic demographer, and I participate in a whole blog – Demography Matters – which deals expressly with the issues, which are too complex to go into here and now. But my view is that the consequences are large and important, and mean there will be no convergence for the east, which is the issue really.

    I have also written on specifically Finnish issues on this, on occassion.

    “Other than that, your data is mostly correct,”

    Well thanks. Now that we have clarified the labour market board thing, I would say it is all correct. This is something I am sensitive and meticulous about since I do marshall a lot of data I could make a mistake somewhere, but so far this post seems good.

    “and I wouldn’t disagree with your conclusions – with the personal exception that since I remember all too well the Depression of the ’90s, I’m not quite as fond of devaluations as you are. Yes, I know, back then, the whole crap was impossible to avoid; doesn’t mean that the outcome was pleasant, at least in the short run”

    Well it seems at this point we are in agreement 🙂

    Basically none of this now for the Baltics is going to be pleasant, in fact it is all going to be most decidedly unpleasant, which is why I was arrguing from the start about the overheating problem, but people said I was exaggerating, then I was arguing there would be a hard landing, and again ditto, the Nordic banks they said would save the day.

    Now the Nordic banks are themselves having trouble, and people are saying devaluation will be too painful, and I am saying yep, but which is worse, a lot of pain, and then devaluation (with yet more pain), or devaluation now and get it over with, since looking at the rate of price deflation over the last six months there is no way this “correction” they are carrying out can work. And as I point out, sticking it out on the no devaluation line, you might even get to meltdown your population in the process.

  4. “but they would still end up owing the bank EEK 400,000 under Estonia’s “full recourse” lending laws […]. With an average net annual salary in the region of EEK 10,000 this means that the unfortunate ex-property owners would in all probability end up with a debt worth more than two years their total income.”

    The numbers don’t add up for me. Are you talking monthly salaries or having typos?

  5. Hi IF,

    “The numbers don’t add up for me. Are you talking monthly salaries or having typos?”

    Whoops..Both. It should be “monthly” and 300,000.

    Thanks for pointing this out. I am obviously challenged by basic math 🙂

  6. The graph in your message didn’t go beyond 2006. But I could still remember well enough the 14% unemployment rate back in 2000, because it received quite a lot of coverage at the time.

    I’m aware that the unemployment rate is measured differently depending on who’s providing the data, that’s why I was asking about the source. Yes, you had actually already mentioned it in the post; I read that paragraph a bit too fast, so my apologies. Similarly, the two “official” rates for unemployment, one from the Statistics Centre and another from the Ministry of Labour, were a constant source of irritation in this country during the ’90s.

    As for why not all that many Estonian people registered back in 2000, it could perhaps be explained by the fact that they simply didn’t bother to sign up. Estonian unemployment benefits are pretty pathetic (or “motivating”, as a neo-liberalist might say).

    Incidentally, on that other part my interpretation of your writing was that you were actually putting up Finland as a stronger case scenario. And I wasn’t criticizing your data, I simply wrote “mostly correct”, because as noted, there were a few typos.

    On another note, I’m guessing that Hank is the fellow behind “Finland for Thought”-weblog Well, ’nuff said.

    (“Far right party”? “Mini depression”? Okay.)

    Cheers,

    J. J.

  7. Since Estonia has never violated the “currency board rules”, kept government debt at extremely low levels and never deviated from its exchange rate policy since the start of the currency board, then of course it can maintain the Kroon at its current rate. Additional credit lines give the government even more protection. The question is not whether it will have to devalue, but whether it should, and if so when.

    Of course wage levels have risen since ’93, from very low levels. They were not pushed up by monetary easing, but from an influx of foreign investment. A lot of that foreign investment went for imported machine tools, and a very remarkable record on the productivity front resulted.

    Estonia is certainly not Argentina, with it’s unpayable debts nor Portugal with its relatively illiberal policies.

    Perhaps my perspective is rather parochial, as a Hoosier, but asking Estonia to abandon its exchange rate is a lot like asking Michigan to devalue. Disruptive and beside the point. People have been leaving Michigan for most of my life, yet the problems of policy in michigan remain and the market continues to adjust.

  8. Hi again Jussi,

    “I’m aware that the unemployment rate is measured differently depending on who’s providing the data, that’s why I was asking about the source.”

    Yeah, well, sorry if I was crisp, I would like to thank you for raising this, because it is a very valid issue. Clearly Estonia isn’t at the worst level of unemployment in its history at the moment, whatever the labour board stats may actually say. You are right about 2000.

    The thing is, and I guess I lost it in how I put the thing (so mea culpa), unemployment accelerated very rapidly at the end of February, 3000 in a week, which is why I guess the Ministry were out making statements. Its hard to say from a distance, butI guess such a small country must feel a bit like one big family, and concerns spread very quickly.

    And the problem is, that unemployment is now going to get quite a bit worse, and Hank may well be right that we will see levels far higher than in 2000. So we are at some sort of turning point, and that is why I felt moved to write this. Of course, everyone is free to decide for themselves what they think is best, and I am not Estonian, but I just don’t feel good watching things like this happen, and doing and saying nothing.

    That is why there are so many “typos” (fortunately largely spelling, and grammar) in my stuff, becuase I write too much, but if I do it is because we are in the biggest crisis I have seen in my lifetime, and there is so much to be done, and so much of what we are doing, from a macroeconomic point of view could be done a lot better.

  9. Jussi,

    I just checked out with an Estonian friend of mine who is a journalist there. The answer is the one we could have expected:

    “numbers are correct, it is record. But unemployment was defiently much higher in the 1990s. But back then there was no unemployment benefit, so people just did not register themselves.”

  10. How should Estonia handle its full recourse mortgages in a devaluation scenario?

    If 250k households are underwater at the moment, leaving them saddled with substantial debt after losing their homes would mean years of penury and further hamper any recovery. Would the EU allow the government to declare all personal mortgages non-recourse by definition?

  11. The key argument against “convergence bet” is the male mortality in Estonia that seems to have kept the pension liability of the state so far fairly light and, the argument goes, if the life expectancy converges to that of the EU, this would leave the country bankrupt.

    The male mortality in Estonia is a problem indeed but from pension liabilities point of view, its impact is the reverse. Estonian males drink, drive and put themselves to death through other means at the age of 18-35. Once past this age group, the life expectancy is more or less equal to that in EU (male life expectancy at 65 is 13.2yrs vs 16 in EU15 – Eurostat 2006 data). So, the men die before reaching their most economically productive years but those who live to pension age, carry on longer.

  12. Good piece, Edward! I have usually been quite critical of your opinions, but as the crises develops, i’ve been forced to change my mind quite often.
    But two questions:
    1) Isn’t low life expectancy actually good for the economy. When the pension age is 65 in Estonia and Europe, we have much less pensioners to care for (as Tõnu Pekk already pointed out)?
    Also, Estonia has relatively high share of over 65-year-olds employed. That should reduce the burden a little.
    2) Instead of comparing real effective exchange rates, shouldn’t we take into account productivity growth as well? The picture should look a little better then, although 2006-2008 is still quite nasty.

  13. I’m from Lithuania, and I totally agree with DD and Jim Hass. Say you devalue a whooping 50 percent – the problem is that households, businesses and even the government would be up over their head in debts, like the household in your example would now have a debt of 4 times annual earnings, instead of 2. Sure, it will help exporters, but we would have a U-shaped recovery that would look less like a U, and more like a fallen-down closed parentheses.

    By the way, I loved what Jim Hass commented, the example with Michigan is brilliant. For the sake of argument, let’s assume Estonia had already adopted the euro in 2006. What could they do now to solve their problems?

  14. A few comments, Edward…

    1) If I remember correctly, the 250,000 number does not actually refer to underwater mortgages (although the headlines certainly allowed it to be read that way when it hit the papers – blame the sensationalist papers, and if you were getting it from BBN, crap translators). Rather it refers to the number of people whose residences are worth less than the owners paid for them. Which, in a country where down-payment levels on mortgages were always quite high, is not insignificant.

    2) Your doomsday scenario keeps mentioning government debt, which is a non-issue in Estonia. We haven’t had a budget deficit for as long as anyone cares to remember, and the coalition isn’t about to start now. We’ve cut government spending, and we have significant cash reserves. The prospect of the Estonian state defaulting is a non-issue.

    3) What would be the benefit of devaluation, exactly? You juxtapose Estonia to the EU, but we’re already part of the Euro economy for all intents and purposes; we get paid in Euros and we buy in Euros. Certainly I have personally seen foreign companies add clauses to their contracts saying that if the EEK’s value against the Euro changes, salaries will be readjusted according to the peg. Devaluation by not only making exports cheaper, but pricing imports out of the market, so the country becomes self-sufficient until it builds up enough of a productivity base to compete openly again; but the Estonian economy is already integrated into the European one.

  15. hi
    I own 2 flats in Tallinn and have mortgages in EEK. I ve been offered some months ago to convert my mortgages to EURO by my banks (NORDEA) at a much lower rate of interest. I wonder a bit what to do… Do you think it s a good bet to keep them in EEK and dream of devaluation? Or is it better to take the offer and pay a bit less now?

  16. 4) You talk of overheating and a hard landing; but what would have been the benefit of reigning in the economy? The current situation is due to the global credit crunch and sharp drop in consumer demand, but that is not of Estonia’s doing, and was not in our power to prevent. Had we raised interest rates and abolished mortgage tax credits, what would have been different? A number of people are now suffering from mortgages they could not comfortably afford, sure, but even if they default, it’s not the problem of Estonia – but rather that of the Swedish-owned banks. People’s living standards are now dropping sharply, compared to those of 18 months ago – but would it have been better if the standards never got that high? Unemployment is rising, but even discounting the fact that our export markets collapsed through no fault of ours, the state actually still has fairly little exposure on that front; social benefits in Estonia are far less than in most European countries.

    Last July, I wrote about the effect of the collapse of the property bubble; in itself it was unpleasant, but manageable. To really take the piss out of someone else for not foreseeing the collapse of the financial system, you’d have to be Andrew Lahde at the very least. 😉

    5) An interesting observation made on the ground here in Estonia: a lot of young families I have spoken to feel that this is actually a good time to have children. The Estonian birth benefits are substantial (unlike unemployment ones), and the parents expect the economy to recover by the time that most of the expenses kick in.

  17. Pingback: Global Voices Online » Estonia: A call for devaluation

  18. It seems to me that devaluation without Euro membership is a non-starter.

    If a political party wants to get reelected it can’t devalue without at least having the Euro ato show for it. The governing coalition has simply invested too much political capital in assuring everyone of Euro membership, if we can just do scrape by for a year…maybe two.

    There’s also a distinct lack of flexibility when it comes to joining the Euro from our EU partners as well as various institutions. I think you over estimate the willingness of tight assed bureaucrats who have nothing on the line to listen to Estonias, even less to act on what they say.

    Your economic analysis is through, but I think the political side needs developing.

  19. The options are more or less the following:

    1) Don’t do anything, let markets force productivity changes.

    2) Cut everybody’s wages to restore competitiveness

    3) Devalue the currency

    Out of these options number 3 is the least painful. It helps exports, lowers imports and doesn’t hurt domestic demand for goods produced in Estonia since people have the same amount of kroners in their pockets. The ability to pay off loans made in EEK is also unaffected. As for loans in foreign currencies, only option one could help with that.

    Note that Finland attempted number two back in the 1990s, but it wasn’t as simple as passing a law. Instead there had to be negotiations with all relevant parties, among them business owners and unions. And nearly all of them agreed on an “internal devaluation” through wage cuts. Nearly all…

    A major goal was improving the competitiveness of the export sector, yet that proved impossible when unions with many workers in export industries refused to play along. There was much talk about selfish union leaders and how they jeopardized national prestige (IE the personal prestige of ministers and central bankers). Nevertheless, it was a good thing the unions didn’t buckle under this intense pressure. Enlightened self-interest ruled the day, the markka was devalued and exports took off.

  20. Bulc –

    “It helps exports, lowers imports and doesn’t hurt domestic demand for goods produced in Estonia since people have the same amount of kroners in their pockets.”

    It hurts domestic supply. Why would a producer sell goods for kroons when he can export them for Euros?

    “The ability to pay off loans made in EEK is also unaffected.”

    Those amount to credit cards and SMS-loans. Pretty much all mortgage loans and, I suspect, all commercial loans are in Euro. Devaluation would not produce a considerable easing of private debt. It is designed to relieve a state’s public debt obligation, which is not an issue in Estonia.

    “Note that Finland attempted number two back in the 1990s, but it wasn’t as simple as passing a law.”

    In Estonia, it is. The law has been passed and will be applied from July. Employers are allowed to unilaterally cut wages for up to 3 months in a year if they can demonstrate force majeure economic hardship, as long as they reduce the employees’ workload by the same amount.

    Our unions are essentially powerless. A combination of options 1 and 2 is occuring naturally.

  21. Some basic observations:

    1) Three graphs are having same boring color scheme – certainly there is some room for improvement to make you point even more attractive for Estonian readers
    2) obscure economist
    3) talking about obscure economy practically nobody follows
    4) so getting more internet hits, than ever before
    5) making it personal business to convince you that he was still so right about devaluation even if his own data already shows that adjustment is taking place. As at today Estonian CAD is most probably ZERO.
    6) stupid IMF was wrong!
    7) People of Estonia, bail me out now!

  22. Hello Everyone,

    Sorry I haven’t been around, I’ve had a busy day.

    Firstly, tales from the crypt:

    “Three graphs are having same boring color scheme – certainly there is some room for improvement to make you point even more attractive for Estonian readers”

    Thanks! I’ll definitely bear that in mind. Incidentally, can I say, the dashboard for the Estonia Stats site is the most attractive I have seen in terms of the colour scheme, so standards are obviously high here.

    “making it personal business to convince you that he was still so right about devaluation even if his own data already shows that adjustment is taking place.”

    But this isn’t the only adjustment. As I say, simply dropping imports only reduces living standards, which is what we are seeing. Then people are sent home from work, which is what we are now seeing, then the economy contracts further, and so on and so on. Only when exports start rising will your economy stop contracting, and people start to invest money in new export capacity. As for investing in production for the domestic market, forget it as far ahead as the eye can see.

  23. @ DD,

    “If 250k households are underwater at the moment, leaving them saddled with substantial debt after losing their homes would mean years of penury and further hamper any recovery.”

    Darius K

    “Say you devalue a whooping 50 percent – the problem is that households, businesses and even the government would be up over their head in debts, like the household in your example would now have a debt of 4 times annual earnings, instead of 2. Sure, it will help exporters, but we would have a U-shaped recovery that would look less like a U, and more like a fallen-down closed parentheses.”

    Look, lets try and kill this argument once and for all: there is no difference on this count between internal devaluation (wage and price deflation) and outright devaluation, except, as Krugman points out, in the former case people with EKK debts are also forced into default.

    If people don’t accept that internal deflation produces the same defaults it seems to me they don’t realise how far you need to pull back wages and prices to get competitive. In addition to substantial wage cuts, you have to think about the unemployment, and what happens to defaults as unemployment benefit runs out.

    I don’t know how long such benefit lasts in Estonia, but here in Spain you get a maximum of two years. If we think that large scale unemployment really got going last winter, this means the biggest wave of defaults starts to hit the banks here as we enter 2011.

    If people think Estonia is going to turn around without a large surge in exports before this date, then I seriously doubt you have understood the depth of the problem.

    “The law has been passed and will be applied from July. Employers are allowed to unilaterally cut wages for up to 3 months in a year if they can demonstrate force majeure economic hardship, as long as they reduce the employees’ workload by the same amount.”

    This is the point. This law is useless. We are talking about reducing wages permanently, or at least till the general price level starts to rise again, and then only rising less than inflation.

    What you need is a law tying wages to prices, and then stand back and watch as output drops 10% a year for two years, that will bring prices crashing down, since you are certainly in US great depression territory. Of course all this will be pretty horrible, but then that is what most Estonians seem to be asking for.

  24. Hello Andrei:

    “Your doomsday scenario keeps mentioning government debt, which is a non-issue in Estonia. We haven’t had a budget deficit for as long as anyone cares to remember, and the coalition isn’t about to start now. We’ve cut government spending, and we have significant cash reserves. The prospect of the Estonian state defaulting is a non-issue.”

    Well I don’t think I’ve ever done this in the context of Estonia (at least if I have, please point me to where I have). I talk about default in the context of Hungary and Latvia.

    But…. when we get through to the serious defaults on corporate and household debt (which we surely will get round to) and assuming the law retains full recourse, then someone is going to have to bail out the banks. This could be Sweden, but if you go to the IMF at any point, then they will try and get you to transfer this over to the Estonian State (this is what has been happening in Hungary, and Latvia). I am not anticipating that at this point, but I don’t think we should assume it wouldn’t happen.

    Look, at the end we need a collective EU solution on all this, and Spain, and Austria, and Ireland and Greece, etc etc etc.

    My guess is it will come, since it will have to, otherwise the eurozone will simply dissolve at the edges. But my advise would be to devalue before entering the zone.

    We are about to see what gets to happen to Slovenia and Slovakia. Slovakia surely had a bubble, and you look and see what happens next. It won’t be any different from Spain or Ireland, just smaller since the bubble didn’t last so long.

  25. Wow Andrei, this is totally wrong:

    “The current situation is due to the global credit crunch and sharp drop in consumer demand, but that is not of Estonia’s doing, and was not in our power to prevent.”

    You should never have had the euro peg in the first place, you should have run a much higher fiscal surplus, and you should have had much tighter documentation rules and LtV levels on the mortgages. No wonder you don’t get why devaluation is necessary. The Baltics were contracting before the global crisis locked in in the east, look at Poland and Romania, who went on a lot longer.

    I don’t follow your logic here:

    “If I remember correctly, the 250,000 number does not actually refer to underwater mortgages (although the headlines certainly allowed it to be read that way when it hit the papers – blame the sensationalist papers, and if you were getting it from BBN, crap translators). Rather it refers to the number of people whose residences are worth less than the owners paid for them.”

    If “residences are worth less than owners paid for them” and people only put up 10% deposit then the mortgages are undercollateralised, and please remember prices have only just started to fall, if the general price level is going to drop AT LEAST 20%, then you have at least another 30% drop in property prices to come. And then don’t imagine they are going to bounce back again, since you won’t be allowed to have inflation, and especially if you stay on the peg. All in all a very difficult situation, the defaults have hardly started coming in, and they are going to be massive.

  26. Hello Stephan

    “I own 2 flats in Tallinn and have mortgages in EEK. I ve been offered some months ago to convert my mortgages to EURO by my banks (NORDEA) at a much lower rate of interest. I wonder a bit what to do…”

    Look, really I can’t offer this kind of advice. I can only say that I personally wouldn’t be moving out of EEK. My view is that the internal deflation won’t work, look how little the price level has moved so far, this is far too slow, and in the best event that we manage to argue for them all to enter the eurozone they will have to devalue first, otherwise they will just be bled dry.

  27. Hu Jüri,

    “It seems to me that devaluation without Euro membership is a non-starter.

    There’s also a distinct lack of flexibility when it comes to joining the Euro from our EU partners as well as various institutions. I think you over estimate the willingness of tight assed bureaucrats who have nothing on the line to listen to Estonias, even less to act on what they say.”

    Basically I agree with this. But what we need is a common front from the Baltics and Bulgaria that they need to enter now, and they need to devalue as they enter. In this sense all the current argument that devaluation isn’t necessary is ENTIRELY countreproductive, since it gives the impression that you can handle alone just fine, and thinking politically this isn’t the message you want to send.

    The Austrian government are doing your job for you, warning that Austria itself may have to default if this deterioration in the East is allowed to continue.

    Look, Almunia said last week that you would have to be crazy to leave the eurozone. Well the people in Brussels would have to be crazy to let everything simply disintegarte in their hands.

    They may be bureaucrats, but they are very apprehensive in the face of what may happen next. Trichet was quite explicit in the press conference last Thursday, the ECB’s hands are not tied, and they can rewrite the rules, now we need to persuade them that they need to.

    There is nothing like imminent economic collapse to concentrate people’s minds.

    We need:

    1/ EU Bonds
    2/ Eurozone membership for the Eastern States
    3/ Quantitative easing, money printing, and primary market purchases of the EU bonds by the ECB
    4/ A new and very strong Stability and Growth Pact to enforce the structural reforms.

    He who pays the piper plays the tune.

  28. It is what it is… Figures, facts, opinions and reality all in one pot. To compare Finland to Estonia is to compare night to day.

    Having lived in both countries many years one gets to see the reality of it all. Stats and other data, so called facts, are a tool that politicians use to make people believe something. Finnish government (political groups and organizations) use various internal opinion to obscure so called facts to say that they are the most competitive in the world. How, specifically, can that be? If a population of aging, 45 vacation days (that is a minimum, add all the sick days), limitation on working times, high taxation, location, subsidies, price fixing, unions, and weather conditions to name but a few, be at the top of competitiveness charts?

    One should note that this goes for many governments in data reporting or so called FACTS.

    I just had a meeting with a (highly educated, 2 PhDs) woman (35 years old) who said she worked for the treasury but now works as a small town practitioner.

    She told me that something has to be done (regarding the economic meltdown in USA). I commented that the problem was caused by educated idiots and that more money would be given to them to get us out of this mess? (Specifically banks and financial institutions.) She said that “no one really knows what to do”… “But, something has to be done and it is the best alternative”. Now, this comment she made is derived by others she has worked with or is working with – her education and expertise? Now I can relly see why we are in such a “shituation”. Book theory educated, “intelligent” people running the world who really cannot connect the dots is the main cause of all our human challenges we face today. The blind leading the blind? Where is the humility? The responsibility? A major wake up call is needed… that, it seems, is approaching soon.

    My colleague in California said the town where he farms has 34% unemployment rate… (that is in the top ten economic power houses if Cali was rated as a country.)

    The common sense and awarenss movement would be a good start… it’s time to start from scratch and build sysems based on reality – not theory. The money to IDIOTS theory is now a reality that it just does not work. It’s time to bite the bullet ladies and gentlemen…

  29. This number can’t be right: “… it is estimated that nearly 250,000 Estonians are currently living in homes whose market value is insufficient to cover the outstanding mortgage”. If you take information on how many loans to private individuals (http://www.eestipank.info/dynamic/itp/itp_report.jsp?reference=13&className=EPSTAT&lang=en), take the average household to be 2.3 people and consider that half of all morgages are now under (outrageous, this is certainly not right) you end up with an average loan size of roughly 35k eur.Which is most certainly an incorrect number. To put things into perspective, it would mean that almost 20% of people are in this condition. This is not even the proportion of people who have a morgage! Before you go out sending open letters to people, could you make sure you have the basics right, ok?

  30. “To put things into perspective, it would mean that almost 20% of people are in this condition. This is not even the proportion of people who have a morgage!”

    Look, I’m begining to worry. I am hopeful that Estonia can pull out of all this OK, but if people continue to have such basic reasoning difficulties, then the outcome isn’t clear, especially if you want to move up to higher value activities.

    (I am largely refering here to the difficulty everyone in Estonia seems to be having in understanding the simple point that internal deflation and external devaluation have the same impact on defaults, so defaults are a non argument here).

    Now…. 20% of the population do not have mortgages, you are right, but more than 20% of householders do, right?

    You have switched arguments from talking about total population to talking about families (you know your 2.3 per family).

    Now, what I don’t know at this point is how far back prices have fallen. Looking at the data from EEsti Paank for example roughly 50% of your euro denominated mortgages have been contracted since 1 January 2006. Now if prices aren’t back at the 1 January 2006 level already, they soon will be, and will of course be going way back beyond this (you are in favour of the internal correction in prices right, and you do recognise that house prices as of spring 2007 were grossly overvalued?).

    So it is reasonable to say that roughly 50% of the outstanding mortgage loan value (which is not quite the same as people, since the earlier loans were for less, I agree, and this is the mistake they may have been making) is now under water, or about to go there.

    Guessing, that maybe 50% of your housing is now privately owned, this would mean about 25% of the population in this situation, but as I say, this figure is rather biased towards values rather than people, so lets just settle for 20%, which is, I think, where we started.

    “Before you go out sending open letters to people, could you make sure you have the basics right, ok?”

    Well, I am still not convinced I didn’t have them right, and anyway I put “estimated”, and my source for the estimation were the Estonian journalists on BBN, so maybe:

    “Before you go out sending comments to people, could you make sure you have the basic reasoning right, ok?”

    Since as I say, I am trying (in my way) to defend Estonia, and offer what I consider to be sound economic advice, and franky, the sorts of argument which are being wheeled out against me are more likely to frighten investors away than encourage them, since they certainly don’t demonstrate that you all know what you are doing and are going to be able to pull it off.

  31. Edward, have you considered writing similar open letter to the people of Germany? As this country is closer to Poland, devaluation of the zloty is probably felt even harder? Or what?

    There are every day some news about 20-30-40% salary cuts in Estonia. All in the sectors, where this is unavoidable. This will show up in the statistics with a lag. According to your analysis it is almost impossible. But it have already happened. Get up-to-date.

  32. Edward, two questions to sum up:

    1. All three Baltic states import a lot of the materials they use for production, most notably energy resources. Devaluing the currency would increase the prices of these materials, hence the total effect of devaluation to exporters might not be very positive in the end. If on top of that you add on the increased debt burden, how do we know that Plan 3 (devaluating) will be better off than Plan 1-2?

    2. Finally, let’s assume that all three Baltic states are already in the Eurozone. What can be done to ease the suffering?

  33. Obviously nothing can’t stop the eternal suffering in the eurozone! Or perhaps an open letter to ECB would help?

  34. Hi again Tales From the Crypt:

    “Edward, have you considered writing similar open letter to the people of Germany? As this country is closer to Poland, devaluation of the zloty is probably felt even harder?”

    I have, as it happens, the question is (my) time. Estonia is a small country which has made a mistake in one simple matter, this is easier to influence. Germany has now let itself get far too old by not doing anything about ultra low fertility for the best part of 30 years. Germany is a large country. Thus we have a much bigger country and more difficult issue to influence with a simple letter. I still have hopes Estonia will do the right thing.

    “There are every day some news about 20-30-40% salary cuts in Estonia. All in the sectors, where this is unavoidable. ”

    Sorry, can you provide data and sources?

    “This will show up in the statistics with a lag.”

    Possibly, but all I can tell you is we aren’t seeing it yet, in the February inflation data for example. According to the data, prices only fell 0.3% month on month in February, and were up 3.4% year on year still.

    “According to your analysis it is almost impossible. But it have already happened. Get up-to-date.”

    Not impossible, but very difficult. But why the hostile tone? You already said we don’t have any data to back up your assertions, so what am I to get up to date with.

    Why is it that some people in Estonia insist on arguing that something which should have happened months ago is going to happen, but tomorrow. I thought Spain was the country of mañana.

    Now in China – where they can’t possibly devalue or they will have a direct confrontation with the US, but they do have felxible labour markets, we are already seeing the evidence:

    China’s consumer prices fell for the first time since 2002 as food, clothing and fuel costs declined, threatening growth in the world’s third-largest economy. Consumer prices dropped 1.6 percent in February from a year earlier, when they reached an 11-year high (8.7%), the statistics bureau said today.

    Now I’m sure you don’t want the kind of flexibility they have in China in Estonia, and I understand why, but this is what you are up against, and this is why I think the sooner you devalue the better.

  35. Darius K

    “If on top of that you add on the increased debt burden, how do we know that Plan 3 (devaluating) will be better off than Plan 1-2?”

    Sorry, but look, the debt burden issue is the same whichever way you go, and probably worse without devaluation. So either way it doesn’t belong in the argument, since it is (at best) neutral for the anti devaluation argument, yet it keeps coming up and up. We should forget this one, and get down to the real issues which are:

    i) Is an internal devaluation of sufficient magnitude possible (in a world of global deflation) in a democracy – ie outside somewhere like China.

    ii) Will Estonia ever get enough imports to make devaluation work. That is the more serious argument, and I will try and find the time to answer it tonight. Thanks for asking it.

    Edward

  36. Tonu and Raiko,

    Thanks for raising the life expectancy question. This is an important part of the whole debate, yet it is rarely even mentioned.

    “Isn’t low life expectancy actually good for the economy. When the pension age is 65 in Estonia and Europe, we have much less pensioners to care for (as Tõnu Pekk already pointed out)?”

    No. Look, apart from the simple human welfare argument (I do wish some of my Estonian critics would notice that in the general context of Eastern Europe I am arguing for a sizeable intitaive from the whole EU to help with issues like these) we should think about investment theory.

    Basically, every child is a burden (from an economic point of view, from a human one it is a boon, a joy) up to the age it starts to work. This innvolves upbringing in infancy and childhood and education in later life ((up to masters and PhDs these days, this is what human capital is about, and of course, as Gary Becker points out, one of the reasons we have less children – becuase we support them for longer – and move from quantity to quality).

    So having made the initial investment, you then need the individual to be able to work (or help with childrearing tasks for future generations) for as long as possible. Basically, these days as the age groups at the bottom contract it is even more important that people participate in the labour force till at least 65 and probably (and incraesingly 70). So all those people dying so young is a net loss.

    Also, most of the evidence suggests that people are a major charge on the health services during the last 5 years of their lives, and it doesn’t really matter what age these five years come at.

    I will try and find time for the other question tonight.

  37. From IMF today:

    Executive Board Assessment

    Directors commended the Estonian authorities for the progress made in recent years in achieving economic convergence and deepening real and financial ties with the European Union. Economic policies have built up considerable financial buffers, although sizable vulnerabilities have accumulated following a domestic consumption and housing boom that was fueled by high credit growth. With the global deleveraging, Estonia has entered a severe recession that will test the flexibility and resilience of its economy. The domestic demand contraction has already reduced the external current account deficit and lowered inflation. Recovery however will require a revival of foreign and domestic demand, continued financial stability, and prudent macroeconomic management.

    Directors agreed that the currency board arrangement has served Estonia well by anchoring expectations and policies. Nonetheless, contagion risks have heightened. Directors considered, therefore, that euro accession would provide a safer haven. They noted staff’s assessment that the real effective exchange rate is somewhat overvalued, but that competitiveness is projected to remain adequate as real wage increases are aligned with productivity.

    Directors commended the authorities for their planned substantial fiscal restraint in 2009 that was intended to keep the fiscal deficit within the Maastricht ceiling of 3 percent of GDP. They considered that this fiscal stance would have had only a modest impact on activity, given the open economy and was necessary to support the currency board. Important steps to rein in the fiscal deficit included a freeze on the wage bill for 2009-10, which would also send a strong signal for wage moderation in the private sector, cuts in operational expenditures, and postponement of previously agreed tax reductions and pension increases. Directors encouraged the authorities to achieve a modest structural fiscal surplus over the medium term and supported their intention to review medium-term expenditures and revenue policies.

    Directors noted that the financial sector has been thus far resilient to the global crisis. Nevertheless, loan quality will likely suffer as the recession progresses and liquidity buffers may erode further with global deleveraging. Against this background, Directors commended the authorities for their decisive steps to strengthen the bank resolution framework and financial safety nets, including regional safety net cooperation agreements. They welcomed the changes to the deposit guarantee scheme that reduce incentives for bank runs. They endorsed the recent swap agreement between the Estonian and Swedish central banks that underpin a new framework for extending emergency liquidity assistance to large banks, providing an additional liquidity cushion. They supported efforts aimed at improving regional collaboration through continued coordination of supervisory activities and exchange of information.

    Structural policies to ensure market flexibility were considered by Executive Directors to be crucial for facilitating real adjustment including a reallocation of resources from the non-traded to the tradable sector and from low wage to high-value added activities. They supported the new labor contract law, which aims to reduce the, albeit limited, labor market rigidities, while improving the social safety net.

    http://www.imf.org/external/np/sec/pn/2009/pn0933.htm

  38. Edward, why I’m hostile?

    OK, what follows, is half-joke but still:
    Estonians are the least religious country in the world:

    http://www.gallup.com/poll/114211/Alabamians-Iranians-Common.aspx

    But as people still want to belive in something they belive in their currency.

    So everyone attacking this sacral object is sort of anti-christ. So be careful with your “open letters” to those savages!

  39. Darius K asked you “Let’s assume that all three Baltic states are already in the Eurozone. What can be done to ease the suffering?” You didn´t answer, why?

    Another question – do you agree that best remedy for some eurozone economies is quitting the eurozone as fast as possible? I think, you should – if you want to be consistent with your recommendation to Estonia.
    (Of course, recession in Estonia is deeper than in Ireland, for example, but at the same time it is much easier to cut wages in Estonia.)

    It seems to me that many analysts – Edward among them – have small irrational bias toward devaluation – they just can´t imagine how competitivness can be restored through deflation. But if euro is here to stay, jump-starting economy with wage-cutting is the trick all EU economies have to learn.

  40. I forwarded this article to someone with very close government contacts, don’t think they’ll agree but here’s hoping. Email me for a more detailed explanation (I couldn’t find your email address).

  41. Edward wrote: Why is it that some people in Estonia insist on arguing that something which should have happened months ago is going to happen, but tomorrow. I thought Spain was the country of mañana.

    Try to be practical. You do not have any chance for across the board salary cuts when the news flow is still positive, unemployment low etc. You need some real pain BEFORE. What is happening in Estonia is the opposite of the mañana. Nobody is waiting for some kind of big solution from the government, but doing whatever necessary for survival from their part. Hoping for devaluation would be mañana.

  42. > Now…. 20% of the population do not have mortgages, you are right, > but more than 20% of householders do, right?
    Probably should have worded my comment more carefully, I meant households. Have still difficulties to see where this percentage comes from and why it’s plausible. If you consider that rentners (~21% of households) very seldom have it aswell as people in the countryside and look at the size of the existing building base bought for EVPs it is not very obvious why it should be that high.

    > Now, what I don’t know at this point is how far back prices have
    > fallen. Looking at the data from EEsti Paank for example roughly 50%
    > of your euro denominated mortgages have been contracted since 1
    > January 2006. Now if prices aren’t back at the 1 January 2006 level
    >already, they soon will be, and will of course be going way back
    > beyond this (you are in favour of the internal correction in prices
    > right, and you do recognise that house prices as of spring 2007 were
    > grossly overvalued?).
    Oh, surely. But AFAIK there is little information as to how big is average self-financing is and what is the exact distribution of morages. If you put 20% in (it used to be 30% and seldom fell below 10% even during the boom) the prices need to go down at least that amount before you end up underwater. When you buy a flat with 20% of self-financing before the tip of the boom and see 10% of growth post purchase the price needs to go down at least 38%. before you get underwater. Not saying it does not happen, am saying there is not enough data available to make that sort of assumptions.

    > “Before you go out sending comments to people, could you make
    > sure you have the basic reasoning right, ok?”
    I apologize if any of my comments sounded too rude.

    > Since as I say, I am trying (in my way) to defend Estonia, and offer
    > what I consider to be sound economic advice, and franky, the sorts
    > of argument which are being wheeled out against me are more likely
    > to frighten investors away than encourage them, since they certainly
    > don’t demonstrate that you all know what you are doing and are
    > going to be able to pull it off.
    People quite often don’t take unsolicited advice (especially if taking it is going to hurt your personal finances badly) very well so this might be the reason for the negativity. Certainly I’d like to hope that my personal comments on a blog do not prevent investors from coming to Estonia.

  43. Sweden has devalued (floating rate) its currency and they are as f*ucked as we are:
    industrial production down 23% in january.

    Estonia needs exports,but not cheap outsource jobs, but high value added products. such products sell at higher prices and input resources/prices don’t really matter (no real difference is your margin 200% or 220%).

    by devaluing we just encourage cheap outsourcing. and this will not get us forward. but by not devaluing we take longer recession and pain, but as we all know, lack of money is source of ingenuity.

    of course we can argue that there is not enough intellectual capital in Estonia and until we manage to develope those high value added export articles we need to live too.

    but I’d rather take longer pain than cheap outsource.

  44. To Nutt ja Hala:

    You are one hundred per cent right in saying that Estonia needs to export high value added products.

    But, at the moment, Estonia does not have many such products, so it will need to develop them. And to develop such products, you need human capital, that is clever people. A very scarce and quite mobile resource indeed.

    Now, it would seem to me that at the moment, Estonia is going straight off the cliff and without devaluation, the economy will collapse in a matter of months.

    Do you believe that those people who have brains will voluntarily choose to stay in a collapsed economy? Most of them will take the first flight to Zurich, Dubai or Singapore. Who will then develop the high value added products?

    You know, I would not be making this comment if most of the Czech cities were not flooded with Ukrainian workers, who since 1998/9 left Ukraine in search for decent living. Although many of them have university degrees, they take whatever jobs we can offer, especially in construction.

    It is simply so bad over there that you may be a rocket scientist, but you still rather build metro tunnels in Prague than stay in Kiiv.

    I do not believe that at the end of the day Estonia will end up at the bottom of the pit right next to Ukraine. However, if it keeps the current course, it most certainly will.

  45. In Central Europe where zloty, forint and koruna lost much of their value against Euro exports decreased by 13%-17% y-o-y in Euro terms in December.

    In Estonia exports decreased in the same month (last for which data is available) by 6%.

    While industrial output is declining more rapidly in Estonia then in Central Europe main culprit seems to be (lack of) domestic demand.

    So will devaluation work and kick-start exports? It surely will help but … perhaps not much given shrinking markets of Estonia’s main trading partners.

    All in all devaluation may not be worth it.

    If I were Estonia’s PM 🙂 I’d give it a few more months to see how foreign trade and current account evolve. If they keep recent pace of improving, sticking to Euro may just be the best option.

  46. btw Edward, you have any positions that will increase in value when estonia defaults or devalues kroon?

  47. Hi Nutt,

    “btw Edward, you have any positions that will increase in value when estonia defaults or devalues kroon?”

    Thanks for asking this question, since even though I find it a ridiculous one, it does give me the opportunity to answer it. But first, let me say that I think it is a ridiculous one. If I were an investor and I backed my views with my money, would that be wrong??? We live in a free market economy. That is what you want in Estonia, isn’t it?

    As it happens I am a theoretical economist, not an investor, and I have no positions on anything, except my own human capital.

    I even rent my flat, and sold the last home I owned in the early 2000s, since it was obvious all this whole property bubble thing was coming after they introduced the euro in Spain, and we started getting negative interest rates.

    The only thing I have a position on is cash. In the present environment I keep as much of the little money I have as possible in cash. But I’m not an investor.

    I don’t even accept money for giving economic advice so I can avoid the silly question you just asked altogher. If I ever have a tomb, I would like someone to carve on it “he never accepted a penny for offering an economic opinion”.

    I earn my living – my needs are few – in other ways, and somehow I feel better this way. Still, each to his or her own.

  48. Hynek wrote: Do you believe that those people who have brains will voluntarily choose to stay in a collapsed economy? Most of them will take the first flight to Zurich, Dubai or Singapore. Who will then develop the high value added products?

    If “those people, who have brains” include at least some with home mortgage they can’t leave without going through personal bancruptcy. Their underwater and illiquid home is their “ball and chain” fo a while.

  49. Hi Andres,

    “Probably should have worded my comment more carefully, I meant households.”

    Well look Andres, I know you mean well, and I know you want to best for your country, but you and others really need to think much more carefully about how you address questions and arguments to other people. If we look back up this column you will find a lot of silly things have been said by people from Estonia. In each and every case I have tried to answer the questions, and in each case, apart from some silly typo I made in the math, I have demonstrated that what I said was based on sound information. Yet no one has apologised for addressing me in a way which, at least in the culture I come from, could be considered rude.

    So my point is, you want to belong to the euro, well then you have to convince the people in Brussels – not me, I am backing your immediate membership – that you are mature enough to operate inside the euro.

    I think tales from the crypt may have some of the point:

    “OK, what follows, is half-joke but still:
    Estonians are the least religious country in the world. But as people still want to belive in something they belive in their currency.”

    The whole thing does have an air of quasi religiousness about it.

    And to boot, you just ran a huge boom bust programme, and have not really made a clear self criticism for what went wrong there, someone in the thread up above even tried to blame the current problems on the global financial crisis. Com’on, who are they trying to kid. Not anyone who matters, becuase they all are more or less well briefed on what went wrong.

    Then you try and tell those who told you you were on boom-bust that they did’t know what they were talking about then, and they still don’t know what they are talking about now. You also tell those who told you you would get a hard landing (when the people who are currently arguing for devaluation said you would get a soft one) that they are offering “unsolicited opinions” – we are in that same eurozone you all want to join, surely we have some sort of right to an opinion – and finally you just carry on being as reckless as you have always been without paying too much attention to what those who have a bit more experience with this type of crisis – Krugman, Roubini, I wouldn’t be so immodest as to include myself – have to say. May I remind you that the IMF were in favour of a 15% devaluation in Latvia, and only reluctantly agreed to accept the peg when it became clear that the EU would not agree to immediate Euro membership. Oh yes, a programme similar to the one the Baltics have embarked on was carried out in Côte D’Ivoire in the 1980s, but the results are ambiguous and hard to interpret (see IMF report on Latvian Stand-by loan).

    I think its time the debate in Estonia grew up a bit, since that is one of the ways you can show you are mature enough and responsible enough to be in the euro. Also, I’m not blaming you personally for all I am complaining about, but simply dumping it round your neck, since you offered the unsolicited comment on my unsolicited letter 🙂

    Now, on the specific argument about householders:

    I would point out that I use the specific wording “estimated”. Now who exactly was it who did the original estimating? Well, it was an Estonian journalist, and the original source for the 250 000 number was an article in newsaper Postimees (27/02). The reasoning went like this: between 2006-2008 there were 100 000 households who bought real estate. Average household is 2,5 persons, so altogether 250 000 Estonians.

    Now, as you are saying this approach may be suspect, and we could enter a rational debate about all this, but rational debates have rules, and ways of addressing people.

    Now here here is the real data from The Estonian Land Registry:

    ****************************************

    There are 387 009 registered mortgages in Estonia (01.01.2009).

    These includes everything: houses, apartments, buildings, land for both households and companies. Around 200 000 of these mortgages are in the name of private households

    There are 459 397 registered apartments and 427 529 registered land ownerships(includes houses and buildings) and 4281 other rights(01.01.2009).

    Recorded real estate transaction totals for Estonia:

    2008 – 50 584
    2007 – 65 191
    2006 – 72 511
    2005 – 64 186
    2004 – 56 027
    2003 – 34 155

    It includes all (land, apartments, houses.) About 80% of these transactions are purchases, others are inheritance etc.

    It also includes transactions of foreigners, all sepucalative transactions, all repeated transactions. My wild guess is, about 20-30%
    of these transactions are repeated. I mean for example, somebody bought an apartement in 2005 and sold it 2007.

    There are 583 700 households in Estonia. 85.5% of these households are homeowners, 6.6% are renting, 7.2% are useing free. (2007 data from Statistics Estonia).

    **********************************************

    OK, so what can we make of all this. Firstly there were about 190,000 transactions after 1 January 2006 (not all real estate). This is a lot for such a small country. Secondly that 85.5% of the population are homeowners, this again is very high. Add to this that around half (in value) total mortagage debt outstanding was taken out after January 2006 (see my earlier comment), and your level of exposure is very high.

    So I have no doubt at all that at least 20% of your property owners are holding assets which are worth less than their outsanding mortgage at this point, and I would stand by that, although my reasoning would be rather different from that of the Postrimes journalist.

    Also:

    “(it used to be 30% and seldom fell below 10% even during the boom)”

    I really doubt this. My impression is that there was a lot of 110% mortaging going on (incudling loans for furniture and notary fees, taxes etc), and a lot of the valuations being used to justify the lending, and a lot of the papers used to justify salaries etc were just exaggerated. (This also happened massively in Spain).

    The evidence for the above. Well the IMF documentation is full of references to these kind of issues, which is why they pressed the central bank to tighten up on the application of the lending regulations. And when they did, guess what? The bubble came to an end.

    “When you buy a flat with 20% of self-financing before the tip of the boom and see 10% of growth post purchase the price needs to go down at least 38%. before you get underwater.”

    What happens is that you are – as most people defending the no devaluation view – presenting best case scenarios all the time.

    I doubt many of the 50,000 odd people who bought in 2008 saw any increase in “theoretical value”, obviously those who bought in 2006 saw quite a bit. But the question is, where are prices now. Somewhere back in 2006 I think, and falling, by the end of this year they will surely be back in 2005, and so on. So really we have a hell of a lot of people already under water, and more every day. 20% is going to be a conservative estimate soon.

    And remember, they will probably keep falling in 2010 and 2011. Then, if we look at the evidence from post bubble societies like Japan 1992 and Germany 1995 – you won’t see any movement at all for a decade, this is going to be the biggest part of the problem.

    Then let’s look at the employment situation. Unemployment is now going up rapidly – and it is not my fault is the numbers provided by the Estonian Labour board hopelessly underestimate the numbers of unemployed at various moments in your history. People would be a lot better off, rather than suggesting my figures may be wrong, explaining to would be investors why the numbers form the Labour Board are as they are.

    Anyway, as I understand you situation you have two kinds of benefits providing by the state:

    – unemployment benefit
    – unemployment insurance payments

    The first is about 59 euros a month and goes on indefinitely.

    The second is 40-50% of the last salary and is provided for between 6 months and a year after you lost your job, depending on how long you have worked before.

    So what can we say from all this?

    Basically, since the unemployment started to go up really about the turn of the year, this means you have about 12 months before things really start to get difficult, since obviously, even in the new “low price” Estonia, you can’t live on 59 euros a month.

    Basically the anti devaluation people have a maximum of six months to make this work, before the level of social distress gets so great that the political system cannot stand any more

    Of course, the net result in the short term is that a lot of things are going to move back into the “informal economy”, people really are going to have little alternative, since you can’t simply expect people to starve.

    But this is just one more argument in favour of the more rapid devaluation approach – basically you need people back in work and start to pay off the debts, not send everyone home, borrow more money from international agencies and wait till resources run out. By the time you eventually cry for help, there may be a queue that is so long that your little voice will not be heard.

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