Laar's star rises

Eastern Europe's stars

The dynamic duo

Dec 13th 2006 | RIGA AND TALLINN
From The Economist print edition

Europe's booming Baltic corner

DOUBLING your living standards every six years would seem a breakneck pace of growth even in east Asia. In Europe it is unheard of. But two Baltic countries, Estonia and Latvia, are growing at 11.6% and 10.9%, respectively. This speed is unexpected. Of 13 forecasts looked at last year by the European Bank for Reconstruction and Development, the highest for Estonia was 6.4%; even Estonia's own central bank reckons that the long-term growth rate is only 7-8%.

The pair's high growth is an exceptional product of good luck and good policies. Both countries are stable, business-friendly and cheap, and lie close to large, rich markets. They have flat taxes, cleanish government, balanced budgets and stable currencies pegged to the euro. Foreigners like all this: Estonia is Europe's biggest recipient per head of foreign investment.

Consumption is soaring in both countries, as is credit. Estonia will see money-supply growth of 33% this year; in Latvia mortgage lending rose by 90% in the year to October, and credit-card lending doubled. That reflects the rise of a western-style financial industry that lends in a way yet to develop in most of eastern Europe. “Foreign banking is a big reason for our success,” says Andres Lipstok, governor of Estonia's central bank.

Can the good times last? Signs of a property bubble abound. The authorities want to tighten banks' lending. If a crash came, its effects should be contained by outside ownership of banks (99% in Estonia, and 80% in Latvia): foreign shareholders, not local taxpayers, would suffer if loans went bad. Both countries have huge current-account deficits (17.9% of GDP in Latvia and 12.5% in Estonia). But for poor economies trying to catch up on 50 years of development missed under communism, a thirst for imported technology is commendable. Balance sheets are strong—indeed, Estonia has no net foreign debt.

The bigger worries are twofold. Even as the Baltic hot rods scorch across the tarmac towards European living standards, they lack any brakes. Monetary policy cannot contain inflation (their currency boards give the two countries no independent control over interest rates). Fiscal policy works in theory but not in practice: Estonia already runs a big budget surplus, and Latvia is not far behind.

AP

Mart Laar: a star turn still to come

Wages are spiralling thanks to a boom in labour-thirsty industries such as construction, retail and tourism. Both countries are struggling to integrate Soviet-era immigrants, so importing more labour from the east is hugely unpopular. But tempting back the many locals—especially 100,000-plus Latvians—who have moved to work abroad is tricky. Latvia's president, Vaira Vike-Freiberga (herself a returned émigré), says it is not just the money: Latvians find that foreign bosses and colleagues treat them more kindly and respectfully than their compatriots do, and public services such as health care and transport are better abroad.

So far, soaring productivity growth has masked the labour market's tightness. But that will not last. The big task for both countries is to move to an economy based on brain not brawn. That requires a liberal immigration regime—at least for skilled foreigners—and a transformation of the calcified, self-satisfied education system. Neither is yet in sight: in both countries, smugness rules.

Latvia's coalition government, closely tied to local big business, shows little appetite for reform. Estonia, which has a parliamentary election in March, looks more hopeful. Its star politician, Mart Laar, is now leading the opposition after a break evangelising for the flat tax that he introduced when prime minister in 1994. His party slogan is “happiness does not lie in money”. That would once have been laughable. Now it sounds quite good.