A Moderate Proposal for how to Manage the Crisis in Estonia

Wolfgang Drecshler

This past Wednesday, I attended a conference at the German Bundesbank on lessons from past financial crises for the current one, and there was one quite amazing consensus regarding the US, England, Germany and Japan: Crises can perhaps not be avoided, but they can be managed well – which always entails bold leadership – or managed badly, and this makes all the difference regarding their severity and duration.

The current crisis is hitting Estonia hard, things will get worse (if you think that’s not the case, don’t bother reading on), and so good crisis management is certainly required. This is not so easy, however, because it would have to be based on acknowledging that many beloved old beliefs, including that in a specific kind of free market absolutism and in the stability of the Kroon, were perhaps appropriate for past times but certainly are wrong now. Too many biographies, too many identities hinge on those beliefs, especially within the current political-economic leadership. And anyone in Estonia opting for any policy whatsoever is attracting the e-idiots and their accusatory tirades of Communism and betrayal.

This might be overcome, and it should be, because doing nothing or wrong things is certain to prolong and worsen the crisis, and Estonia is not in a situation where this can be afforded. However, even beyond politics, the country is stuck between a rock and a hard place in many respects: All possible measures are genuinely ambivalent, i.e. they have good and bad effects at the same time – salary cuts, for instance, could make the country externally more competitive (unless other countries follow the same policies), but ruin domestic consumption demand and produce losses for domestic industry, leading to actual job losses.

So, what is called for is to steer the boat between Scylla and Charybdis, the two sea monsters, which – as is told in the Odyssey – sadly cannot be done without some serious sacrifice. The point is to minimize the costs, so what is needed is a moderate and synergetic plan, i.e. one that groups a few measures that by themselves would not be sufficient, but that when pursued together might not ruin too much, both economically and socially, while decisively helping the economy. It should be designed to balance the finances and return trust and confidence in the country internally and externally, and to avoid social unrest and other bad consequences. In short, what is needed is bold action in implementing fairly moderate and politically still realistic measures.


Odysseus in front of Scylla and Charybdis. (Füssli, Johann Heinrich, 1794-1796)

The basis is, again, the insight that Estonia’s finances are currently basically unsound and cannot be redeemed just by waiting, that the crisis will last not weeks or months but years and that most Estonians will experience losses both in income and property. This cannot be prevented anymore, but it can be significantly reduced. (For most of those with loans in non-Kroon currencies, this is a no-win situation: They will either lose because of devaluation or because of income loss, but lose they will.)

With this in mind, I would propose the following five measures, which I will not explain in detail, because by now anyone interested should know the reasons and implications [but I have been persuaded to add some broad-brush explanatory hints in brackets]:

1. The Kroon is devalued as soon as possible by 15% towards the Euro but maintained as pegged. [This is a very necessary but in the end very minor devaluation that is below the psychologically important barrier of 20% – it will adjust the nominal value of the currency towards the real value while maintaining the sacred cow of the peg. Harsh, yes, but shoulderable.]

2. Salaries are frozen for four years. (If this does not suffice, they could be cut by up to 15% as well, but freezing should do.)
a. The date of freezing is 1 September 2008.

b. This only concerns salaries in excess of EKR 10,000.

c. Government salaries are frozen directly; private-sector salary increases are taxed at 80% to the extent that this is technically possible.

[Together with 1., this is less severe than only salary cuts or only devaluation would be, because of true synergy effects. This is not far from what is happening already, partially less so; it is necessary, however, to guarantee the point internationally and to set the mood and perspective internally. It is also key to avoid or limit inflation and thus work towards the Euro.]

3. The government will create an institution that will take over from lenders all housing (of generously appropriate size) lived in as first residence by citizens or residents who cannot pay their mortgage anymore, so that the otherwise soon-former owners can continue living there for an affordable rent and with the goal to eventually repurchase them. [This is to soften the blow with the worst social consequences, though many of those in non-Kroon real estate debt have only themselves to blame.]

4. Aid and loans by IFI’s or the EU etc. to the State will only be used for infrastructure and the most basic life-quality – preserving measures (‘net of decency’), not for any running costs beyond that. Aid and loans that are linked to policy impositions, including cutting public expenditures, are not accepted. [The IFI’s do not have a good track record in actually helping failing economies. On the other hand, running a government on outside funding has never worked for long. Still, a minimum ‘net of decency’ needs to be preserved, because otherwise, what would be the State’s raison d’être at all?]

5. If State income will be too low to cover all costs, cuts will be made completely across the board of expenses, with no sections spared except those mentioned in point 4. [So as to have the burden shouldered by the entire society which, and whose priorities, is mirrored in the budget already.]

This is actually not a ‘Left’ plan but quite a (classically) Conservative one; it is one that tries to maintain as much from the current order and social arrangement as at all possible, and it tries not to penalize the ‘good guys’ too much. And it is based on a well-working public sector, so it assumes that any nitwit plans to cut it under the pretense of saving money (which never works) are shelved right away as well. It’s also not a plan for growth – such a plan would have to entail serious thinking about industrial and innovation policy as well as public finance, including taxation – but one to ‘stop the bleeding’, nor does it address all problems at hand. Most crucially, this plan can work now, but not anymore once the situation in Estonia and/or around it will get worse, which it will soon enough if nothing is done.

Will something like that be done? Even though I tried hard to be realistic and to take the mood in Estonia into account, I fear that even something like that would still be judged as too radical, partially people are told or are telling themselves that things are not so bad, while they are actually worse. But sometimes scenarios and situations change abruptly, sometimes even the attitudes and insights of those already in power, prompted by times and circumstances. Hopefully, this will happen sufficiently swiftly, because the time for the bold leadership that has always been the hallmark of sound crisis management is now, and now is the time when a moderate policy such as the one proposed can still be pursued with considerable hope of success. Later it will be too late, as can be seen from the Latvian case.

  • jamie1047

    I may have completely missed something but…

    1. However good a policy measure, devaluation, to have the necessary effect should be implemented in complete secrecy. This is not possible as 3 readings in Riigikogu are required. In real life, this action has to be agreed between the 3 Baltic states if we want to play nice. If we don't, hopefully they don't remember it for long.

    2. Assuming 15% devaluation – freezing, not increasing, cutting of salaries: what then? The process of cutting is seen daily – possible but too slow to have any major effect. Public sector still uncut. EEK 10000 is less than current average salary. Median salary is probably lower. Excluding lower than average salary from growth restrictions still means a very significant inflationary pressure considering that there will be remarkable inflation due to increased import prices. You can tax levels. It is very difficult to tax increase. So what we talk about here is progressive income tax not some hypothetical income growth tax.

    3. A rational choice for all borrowers independent of their creditworthiness is to mimic payment problems. Affordable rent will most probably be lower than mortgage payments. As it reads, government should pay for this fun. What are we talking about here? 5, 10 or 20 billion EEK? Per annum? Sounds like a reverse Parex Bank deal for the Estonian government.

    4. Luckily, financing running costs is not the temptation here. Shall they lend for implementing p3? Deficits in pensions, employee and other benefits financing are in these terms running costs.

    5. Cutting everything that has not been cut yet is very much the current mood. But I agree with one limitation: no cuts to the parental compensation, still possibly restructuring all other child benefits. The reason being simple – this is the best business plan yet to invest into the “production” of future taxpayers eg donors of the pension and welfare system.

  • http://twitter.com/marugusu marugusu

    It would be interesting when Estonia decide devaluate before Latvia….

    Suppose Estonia to devalue by 15% and then Latvia 30%. Whether Estonia should be further devalue?

  • http://twitter.com/marektiits Marek Tiits

    See also Marek Belka's article in the latest edition of Finance and Development, and especially this graph http://www.imf.org/external/pubs/ft/fandd/2009/06/images/belka1.gif

  • Wolfgang_Drechsler

    Jamie, I am going against my firm principle here never to reply to anonymous comments, but very briefly and just once: As I said, I am proposing genuinely ambivalent measures, i.e. they do have uncertainties and negative effects. However, what’s a better option? The currently prevailing no-policy policy definitely is not viable. Yes, instant devaluation would be difficult (but actually not impossible) in Estonia, but what is the alternative to a slower one – keeping the peg as is? The Baltic states’ economic and fiscal unity is a myth detrimental to the interests of Estonia, especially in this case. The salary freeze must, in order to be synergetic with devaluation, be announced, imposed, and kept, but then it can easily have a sufficient effect already. Yes, it is difficult to tax increases, but again, saying it's difficult implies that it can be done (and anyway, a proportional income tax is somewhat nice, labor-saving, and easily collected, but that’s about it regarding the advantages). Sure there’ll be inflationary pressure regardless, but less, and that is all one can currently go for. Cheating is always a rational choice (which people don’t generally pursue anyway), so that’s not an argument against any policy measure, but rather for high implementation capacity (as is the taxation of salary increases mentioned above). And yes, I absolutely agree that helping out mortgage payers is not moral high-ground, but that’s not the point of this proposal either. It’s not “fun” but strikes me as socially necessary, especially in balance with the other measures. Financing running costs will most certainly be a temptation. And just because cutting across the board might be the mood of the times (I don’t think it is), this does not automatically mean that it’s wrong. Finally, I actually don’t agree with exempting parental compensation from cuts at all because that’s precisely a policy priority – and not part of the ‘net of decency –; it’s not meant to “produce” new taxpayers, which anyway is a problematic notion.

  • Wolfgang_Drechsler

    Marugusu, I think it would be great if Estonia would decide to devaluate before Latvia. I don’t think by any means that a race to the currency bottom would be necessary here (I can see the temptation of course); the situation of the two countries is, after all, different (and it is the main task of the Estonian government right now to keep it that way!), and it really depends how much the Kroon will actually be worth by then. But naturally, all depends on timing and global context.

  • jamie1047

    Wolfgang, I would actually love to do as you suggest with a notable exception of p5 eg parental compensation. If you were a native Estonian, I think you would have the same issue with demographics.

    With policies there is always the issue of necessity vs possibility and it is not easy to distinguish clever advice from wishful thinking, subject to political realities.

    1. The main obstacle in devaluation seems to be not the limited secrecy or Baltic brotherhood but some agreements with ECB, IMF and possibly also some Swedish commercial banks. The whole set-up between those has to be a little bit different. Estonia, of course can do it their own stubborn way as we did in 1992 with Kroon, but times have changed. We are a member of EU.

    The big question is – does devaluation help? Obviously there is pressure to the monetary setup but the main argument is related to price levels, in particular labor cost levels that devaluation would help to sort out. Does this increase export demand? My subjective impression from the exporting companies of Estonia is that the problem is not price levels. The problem is that there just is NO demand for the particular goods and services we are into. It is very probable that the outcome will be very similar with or wo devaluation. Investors are hesitated now (in fear of devaluation) and they will be (in fear of the aftermath).

    So the question is not devaluation->prices down->export demand up but investment in + entrepreneurship->new goods and services->exports. Labor cost is still 3-5 times lower than developed countries.

    2. Salary deflation and freezing. Point taken but it is several times more simple to do it without/before devaluation than after it. Increased and/or progressive income tax does not seem to be bad at all.

    3. In the exact wording of p3 “government takes over all housing”, I don't think it will work. Government should come in say 6 months after the collection/collateral liquidation agents have not been able to do their jobs and renting out should be under market terms. Nothing should be automatic. Otherwise we shift real estate price correction to the unknown future.

    Clearly a safety net should be provided, but with devaluation, I guess, the social cost lies in lower income quantiles with higher monetary volumes than the borrowing strata who tend to be more socially mobile (enter entrepreneurship, cross subsidize inside families or emigrate).

    All in all, the question is, how wrong is the hypothesis that the salvation is Euro ASAP for which we have to starve another 19 months or so. Even in a heavily (hopefully not spirally) deflated economy but with Euro we are possibly better off than when being devalued, still with an untrusted currency, no or little export demand and foreign investments. I don't preach a religion here, I am just confused.

    As to the anonymity, please accept my apologies. But lets distinguish anonymity from lack of identity and misuse of the fact of not being connected to a real life person.

  • Wolfgang_Drechsler

    Jamie, anonymity is everyone’s individual choice. I think, however, and have said and written about that several times, that communication modes and platforms that enable it are in the end destructive, at least damaging, for public discourse (as the Estonian case shows very well), nor is there any reason for encouraging it (except in elections). Hence my principle to always just completely ignore anonymous comments. However, obviously, here I go again… :-)

    On demographics, even if it were a personal issue, as you make very clear in your last comment, parental compensation is not an economic or financial priority but a policy one. This is not what my proposal is about; it’s about stopping the bleeding. The same goes for your views on Estonia having in the end to export itself out of the crisis – I basically agree with you there (and would even say that if there is a clear example for policy failure regarding the Estonian economy, this aspect is it), but it’s not my topic right now but rather the next step – although the investment you mention clearly hinges on previous devaluation and most of all on some certainty about the future. There is none now, as you say, and that is the problem; no relevant entrepreneurship without financing, even in new and sensible fields. (Low wages alone don’t help at all in the Estonian case; they are always lower somewhere else.) Again, my main point is that quite moderate devaluation (which I doubt would necessarily be not be welcomed by the institutions you mention, even if unilaterally declared) and – it needs both – salary freeze, in synergy, are possible and will indeed have the desired effect of stopping the slide downwards if implemented right now. As regards the housing issue, real estate price correction would in essence mean eviction for too many people, so in some sense delaying it is precisely what the respective measure tries to accomplish, and the State can do that – and for less money than the alternative would cost in the end. Here, however, I would agree with you that the how and when is of crucial importance, and that there should be as much market n this process as possible.

    And finally, I think that it would precisely be following this plan what would bring Estonia closer to the Euro (although, as you say, as I very much agree with, and as we can see right now, membership in the Eurozone will not solve all, I would say not even most, problems of the Estonian economy – this is just wishful thinking). Sitting there and doing nothing for the incredibly long time of 19 months you suggest, and during which we do not know what might happen in the Eurozone, on the other hand, would surely get the country farther away from the Euro than ever.

  • madismuller

    I readily admit that we are in a situation where it is much easier to criticize policy proposals made by others than it is to provide constructive ideas.

    Having said that, I really don't see what would be the point of trying to limit salaries or the growth of salaries in the private sector by some sort of a government decision (either by prohibitive taxation or otherwise). There is certainly reason to be concerned that the salaries of government employees are not flexible enough and will not be cut sufficiently even if necessary. Private companies at the same time will never pay their staff more than they can and excessive pay increases in such difficult times are simply out of the question. If there is a particularly smart entrepreneur that can find a niche to exploit in the current economy and is able to make good money, I don't see any reason why he should not be allowed to pay the employees as much as he feels necessary. As long as there is a crisis, the risk of generating whatever inflationary pressures by such pay increases is zero, as the growth in salaries in a relatively small number of companies is most likely more than offset by increasing unemployment and/or declining incomes for everyone else that has a job.

    As for the rest – I still don't see what could be the real advantages of devaluation over a fairly quick cut in nominal costs/incomes. One can argue that the first is just stronger medicine that achieves the same goal of improved competitiveness more quickly, but it also comes with some higher risks and can create more instability. I also agree with jamie's comment that it is not really obvious how much would the competitiveness of the Estonian economy be improved after a devaluation. But we need to cut costs simply to remain solvent over a medium term..

    Point #3 is certainly interesting, but the main problem here is clearly the cost of such a housing program and I believe it might raise some serious questions about fairness depending on the relative size of the effective subsidy. But I agree that the government probably does at some point need to step in and provide some more help related to housing, if people start defaulting on their mortgages in large numbers.

  • Wolfgang_Drechsler

    Madis, questioning policy proposals is certainly legitimate even if one does not have a better plan oneself. However, any policy comes with risks – and this includes the no-policy policy just like any other. In times of great uncertainty, the risks are even bigger, but so is the necessity to be clear what one wants and how one could feasibly achieve that. I am sure you actually do see why I am proposing the measures in question; you just disapprove and/or disagree that they will work.

    Very briefly once again, the combination of salary freeze and modest deflation is, among other things, designed to make the financial development of Estonia more certain, within and without, and hence stop a further slide downwards and even re-enable investment; after all, the Kroon is grossly overvalued. Somewhat risky? Yes. More so than doing nothing? No.

    I know that wanting to cut public sector salaries is a knee-jerk reaction to almost anything in Estonia, including bad weather, but under the current circumstances, when one needs a particularly competent (senior) civil service, that’s particularly misguided. My concern is rather to retain and improve high administrative capacity, because without it, the current crisis cannot be overcome. If the private sector is anyway self-regulating its salaries on an ideal basis (I am not sure why it would; that requires faith in certain automatisms the crisis has shown do not exist), then there should be no problem with a freeze either. Genuine entrepreneurs are not salaried anyway, and already the original definitions of entrepreneur entails that he is not just motivated by money, often not even primarily.

    Once again, sure the housing program is somewhat expensive, but any alternative would be more so, and it is ‘unfair’ only to the extent that the people who will suffer most from deflation and salary freeze will not be completely congruent with those who have taken too high mortgages (and yes, I agree that they shouldn’t have, but it was the mood of the times and they clearly were encouraged, though certainly not by myself). I admit that I am a bit queasy about that, but much less so if I consider the alternatives.

    Finally, the entire proposal is precisely designed to enable Estonia to stay solvent (even) in the mid-term. To try doing so only by cutting expenses right away is the worst of all scenarios, as it will lead to disastrous side effects right away and later on as well. As a possibility of the very last resort and on a temporal basis, if really done across the board excepting the ‘net of decency’, it’s however exactly what I propose in the last point.

  • tarmojuristo

    I guess I'm with Madis here. I really don't think that there is a genuine problem of there not being enough motivation for private sector employer to keep salaries in check in the current environment ;). Also, according to your last comment one might get an impression that entrepreneurs are not primarily motivated by money but public sector employees are?

    The problem with such a freeze is not that it's a freeze rather than, as Madis also implied, that it is a *uniform* freeze, it doesn't allow to pay more for, to borrow your own phrase, competent senior management – which is not necessarily the same people as entrepreneurs, mind you.

    And it is the same point about the devaluation – it would be a uniform administrative measure that wouldn't allow any differentiation. I am not saying that it should be off the table when it comes to discussing different policy options, but I too would consider it only after it is very clear that the economy doesn't adjust “organically”, or that the adjustment is too slow for it to have an effect.

    I really don't see where is the notion that of “doing nothing” (that's the proposed package of measures is supposedly better than) coming from. I am a shareholder, if currently not necessarily an entrepreneur, in a company that employs a lot of people; many of my friends and acquaintances run businesses both in Estonia and elsewhere – and I really don't see that these people are “doing nothing” and simply hiding their heads in the sand and hoping that sun will be out again next month.

    But, with a possible minor exception concerning the devaluation, it seems to me that in 2009 Estonia most of this discussion belongs into the realm of social science fiction (i.e. “not gonna happen”) anyway – be it for better or worse.

  • jamie1047

    I guess both the devaluation supporters and the opposition agree on the following items
    – salaries should be at least frozen if not decreased;
    – most vulnerable social groups should be supported by just but affordable policies (not just borrowers, banks and the real-estate sector);
    – government should lend but should not use it to finance current costs;
    – areas previously not subject to cuts (pensions, parental compensation etc, salaries in health care and education) should also be cut. Amounts and emphasis subject to decisionmakers tastes and political compromise

    All the latter has been done and it looks that will be continually done even without devaluation.

    Now it looks that it all comes down to what is the point of devaluation and what is the balance between good and bad consequences it brings.

  • Wolfgang_Drechsler

    PS: It seems at least the illustration of this posting preempted Edward Lucas in Foreign Policy (never mind the partially rather naive rest of the piece, especially as regards the historic description of the boom)…


    “Portraying the Baltic states in their current mess requires more than words and numbers. Only an old-fashioned chart, with a sea monster, a whirlpool, or perhaps a skull and crossbones, would begin to do justice to the plight of what were until recently the shining success stories of the ex-communist world. Eating a meal in a deserted restaurant in one of the fine old capital cities of Tallinn, Riga, or Vilnius gives a sense of the collapse. So does the silence of the half-finished construction sites, the rock-bottom rates in the glitzy hotels that shot up during the boom years, and the fall of a Latvian government under the weight of the current troubles. The Baltic states today are prime candidates to be the new basket cases of Europe, with their double-digit economic declines, beleaguered governments, and shriveling state spending.”

  • http://twitter.com/marektiits Marek Tiits


    The IMF blog has compared recently the evolution of crisis in the Baltic, Central Europe, and East Asia (1997).

    Notably, they remind us that crisis in the Baltics has proved by now by far worse than than it was in East Asia 10 yrs ago.

    Also, real effective exchange rates of the Baltic currencies have appreciated while we keep insisting for “internal devaluation”…


  • http://twitter.com/marektiits Marek Tiits


    The IMF blog has compared recently the evolution of crisis in the Baltic, Central Europe, and East Asia (1997).

    Notably, they remind us that crisis in the Baltics has proved by now by far worse than than it was in East Asia 10 yrs ago.

    Also, real effective exchange rates of the Baltic currencies have appreciated while we keep insisting for “internal devaluation”…